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Chapter Outline

Chapter Outline. 5.1 Insurer Insolvencies Frequency and Severity of Insurance Company Insolvencies Causes of Insolvencies Property-Liability Insurer Insolvencies Life-Health Insurer Insolvencies 5.2 Solvency Ratings 5.3 Overview of Solvency Regulation

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Chapter Outline

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  1. Chapter Outline 5.1 Insurer Insolvencies Frequency and Severity of Insurance Company Insolvencies Causes of Insolvencies Property-Liability Insurer Insolvencies Life-Health Insurer Insolvencies 5.2 Solvency Ratings 5.3 Overview of Solvency Regulation Objectives of Solvency Regulation Regulatory Monitoring Regulatory Controls and Risk-Based Capital Requirements

  2. Chapter Outline 5.4 Illustration of Risk-Based Capital 5.5 State Guaranty Systems Coverage Property-Liability Insurance Life-Health Insurance Funding Design Issues Level of Coverage Pre-Insolvency versus Post-Insolvency Funding Risk-Based Assessments 5.6 Summary

  3. Frequency and Severity of Insurer Insolvencies

  4. Frequency and Severity of Insurer Insolvencies

  5. Factors Affecting Property-Liability Insolvencies • High claim costs relative to premiums • Catastrophe losses • Awards for environmental, malpractice, products liability • Why were premiums too low? • Bad luck • Deliberate risky strategy by some insurers • Regulation held rates too low

  6. Factors Affecting Life Insurer Insolvencies • Drop in asset values • Junk bonds (First Executive) • Commercial real estate (Mutual Benefit) • “Run on the bank” • Illustrate using First Executive case

  7. First Executive Case • Jan. 1990 announcement: • $515 million write down of its junk bond portfolio (30% of equity value) • stock price declined over 57% in two days • Concern with insolvency led to $4 billion of withdrawals • Bad press concerning junk bonds and CEO (Fred Carr) probably contributed to “run” • Seizure by CA insurance department in April 1991

  8. Methods of Dealing with Insolvency Risk • Consider three methods: • Private Market • Regulation • Guaranty Funds • Tradeoffs: • more regulation or more guaranty fund protection ==> less incentive for consumers to worry about insolvencies

  9. Effectiveness of Private Marketplace • Without regulation, do insurers have incentives to reduce probability of insolvency? • Yes • Improve contractual terms with policyholders • Protect franchise value • The first factor requires that consumers have information

  10. Solvency Ratings • Private companies gather and report information about insurers’ insolvency risk • A.M. Best • Moody’s • Standard & Poor’s • Duff and Phelps • Insurers pay these companies to obtain a rating

  11. A.M. Best Rating Categories Table 5-1 Major Category Sub-Category Letter Ratings Secure Superior A++, A+ Excellent A, A- Very Good B++, B+ Vulnerable Adequate B, B- Fair C++, C+ Marginal C, C- Very Vulnerable D Regulatory Supervision E Liquidation F

  12. Facts and Issues Related to Ratings • Facts: • Most insurers receive a rating • Most rated insurers receive a high rating • Ratings help predict insolvencies • Issue: • Are ratings biased upward?

  13. Overview of Solvency Regulation • Monitoring & intervention • Restrictions on activities • Pricing, Asset choices, Dividend payments • Capital requirements • Should regulators attempt to eliminate insolvencies?

  14. Regulatory Monitoring - IRIS • IRIS - Insurance Regulatory Information System • Early warning system • Property & Liability - 11 ratios • Life & Health - 12 ratios • If insurer fails 4 or more + other criteria ==> regulatory attention

  15. Examples of IRIS Ratios for P-L Insurers

  16. Regulatory Monitoring - FAST • FAST - Financial Analysis Tracking System • Early warning system • Looks at more ratios than IRIS • Assigns scores for each ratio and calculates an aggregate score • Regulatory attention if score is too low

  17. Risk-Based Capital (RBC) Requirements • History • Life RBC adopted for 1993 statements • P-L RBC adopted for 1994 statements • Basic Idea: • Riskier activities require more capital • Implementation is complicated

  18. Implementation of RBC Requirements • Essential aspects of RBC • Insurer’s activities (e.g., how much is invested in junk bonds, amount of reinsurance, etc.) are plugged into a formula, which determines the insurer’s dollar value of RBC • Regulatory action depends on the ratio of actual capital to RBC

  19. Regulatory Actions Based on RBC - Table 5-3 If Ratio isthen greater than 200% nothing needs to be done 150% - 200% insurer must file a plan 100% - 150% commissioner investigates 70%-100% legal grounds to rehabilitate or liquidate less than 70% required to seize

  20. RBC Example for Hypothetical P-L Insurer • Insurer writes $30 million of auto liability premiums this year, but only $15 is earned this year • Expected claim costs = $20 million • $10 million incurred this year • $5 million in paid losses • $5 million in incurred losses, but not paid • $10 million incurred next year • Expenses = $10 million

  21. RBC Example for Hypothetical P-L Insurer • Assets • $7.5 million in US government bonds • $15 million in investment grade corporate bonds • $2.5 million in stock • $25 million in total assets • No receivables & no off-balance sheet risk

  22. RBC Example for Hypothetical P-L Insurer • What is surplus? • Assets = $25 million • Policyholder liabilities: • Loss reserve (losses incurred, but not paid) = $5 million • Unearned premiums reserve = $15 million • Total = $20 million • Surplus = $5 million

  23. RBC Example for Hypothetical P-L Insurer • Calculating RBC

  24. RBC Example for Hypothetical P-L Insurer • Covariance Adjustment • Idea: • risk factors reflect risk of individual activities • actual risk depends on correlation across activities • Implementation: • square each required RBC amount • sum the squares • take square root of sum • Finally, as a adjustment factor, multiply by 1/2

  25. RBC Example for Hypothetical P-L Insurer

  26. RBC Example for Hypothetical P-L Insurer • Finally, • Calculate ratio of accounting capital to RBC: • Surplus / RBC = 5 / 2.616 = 191.1% • Regulatory Response (Table 5-3)

  27. Guaranty Fund Coverage and Funding • Coverage • Typical limit: $300,000 • Funding • post insolvency assessment of solvent insurers • New York is an exception

  28. Guaranty Fund Design Issues • Coverage Limits • Effect on incentives to become informed • Commercial versus personal limits • Pre-Insolvency versus Post-Insolvency Funding • Risk-based Assessments

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