Transcript Insolvency

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
H&N, Ch. 5
T5.1
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
H&N, Ch. 5
T5.2
Frequency and Severity of Insurer Insolvencies
P r o p e r ty -L ia b ility In s u r e r s
70
$ 1 ,4 0 0
N o . o f In s o lv e n c ie s
$ 1 ,2 0 0
50
$ 1 ,0 0 0
40
$800
30
$600
20
$400
10
$200
0
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
$-
1981
H&N, Ch. 5
A s s e s s m e n ts (m i l l i o n s o f $ 1 9 9 6 )
N u m b e r o f In s o lv e n c ie s
A s s e s s m e n ts
60
T5.3
Frequency and Severity of Insurer Insolvencies
L ife -H e a lth In s u r e r s
70
$ 1 ,4 0 0
N o . o f In s o lv e n c ie s
$ 1 ,2 0 0
50
$ 1 ,0 0 0
40
$800
30
$600
20
$400
10
$200
H&N, Ch. 5
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
$-
1981
0
A s s e s s m e n ts (m i l l i o n s o f $ 1 9 9 6 )
N u m b e r o f In s o lv e n c ie s
A s s e s s m e n ts
60
T5.4
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
H&N, Ch. 5
T5.5
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
H&N, Ch. 5
T5.6
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
H&N, Ch. 5
T5.7
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
H&N, Ch. 5
T5.8
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
H&N, Ch. 5
T5.9
Solvency Ratings

Private companies gather and report
information about insurers’ insolvency risk
•
•
•
•

H&N, Ch. 5
A.M. Best
Moody’s
Standard & Poor’s
Duff and Phelps
Insurers pay these companies to obtain a
rating
T5.10
A.M. Best Rating Categories
Table 5-1
Major Category
Secure
Vulnerable
H&N, Ch. 5
Sub-Category
Superior
Excellent
Very Good
Adequate
Fair
Marginal
Very Vulnerable
Regulatory Supervision
Liquidation
Letter Ratings
A++, A+
A, AB++, B+
B, BC++, C+
C, CD
E
F
T5.11
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?
H&N, Ch. 5
T5.12
Overview of Solvency Regulation
• Monitoring & intervention
• Restrictions on activities
• Pricing, Asset choices, Dividend payments
• Capital requirements
• Should regulators attempt to eliminate
insolvencies?
H&N, Ch. 5
T5.13
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
H&N, Ch. 5
T5.14
Examples of IRIS Ratios for P-L Insurers
H&N, Ch. 5
Ratio
Acceptable
premium to surplus
< 300%
% change in premium written
-33% to 33%
% change in surplus
-10% to 50%
2 year operating ratio
(loss ratio + expense ratio
- investment income ratio)
< 100%
T5.15
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
H&N, Ch. 5
T5.16
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
H&N, Ch. 5
T5.17
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
H&N, Ch. 5
T5.18
Regulatory Actions Based on RBC - Table 5-3
If Ratio is
greater than 200%
150% - 200%
100% - 150%
70%-100%
less than 70%
H&N, Ch. 5
then
nothing needs to be done
insurer must file a plan
commissioner investigates
legal grounds to rehabilitate or liquidate
required to seize
T5.19
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
H&N, Ch. 5
T5.20
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
H&N, Ch. 5
T5.21
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
H&N, Ch. 5
T5.22
RBC Example for Hypothetical P-L Insurer

Calculating RBC
Activity
US govt bonds
Inv. grade bonds
Common stock
Loss reserve
Premiums written
H&N, Ch. 5
Amount
risk factor
Amt x risk factor
$7.5
0.00
0
$15
0.003
$45,000
$2.5
0.15
$375,000
$5
0.155
$775,000
$30
0.172
$5,160,000
T5.23
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
H&N, Ch. 5
T5.24
RBC Example for Hypothetical P-L Insurer
D escription
R equired R B C
R equired R B C S quared
0
0
45
2,025
C om m on stocks
375
140,625
L oss R eserve
775
600,625
5,160
26,625,600
U S G overnm ent B onds
H ig hest quality b onds
P rem iu m s w ritten
T otal
S qaure R oot of T otal / 2
H&N, Ch. 5
27,368,875
2,616
T5.25
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)
H&N, Ch. 5
T5.26
Guaranty Fund Coverage and Funding

Coverage
• Typical limit: $300,000

Funding
• post insolvency assessment of solvent insurers
• New York is an exception
H&N, Ch. 5
T5.27
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
H&N, Ch. 5
T5.28