H&N, Ch. 5
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
T5.1

H&N, Ch. 5
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
T5.2

Frequency and Severity of Insurer Insolvencies
No. of Insolvencies
Assessments
Property-Liability Insurers
50
40
30
70
60
20
10
0
$1,400
$1,200
$400
$200
$-
$1,000
$800
$600
T5.3
H&N, Ch. 5

Frequency and Severity of Insurer Insolvencies
No. of Insolvencies
Assessments
Life-Health Insurers
70
60
50
40
30
20
10
0
$400
$200
$-
$1,400
$1,200
$1,000
$800
$600
T5.4
H&N, Ch. 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
T5.5
H&N, Ch. 5

H&N, Ch. 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
T5.6

First Executive Case
H&N, Ch. 5
• 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
T5.7

Methods of Dealing with Insolvency Risk
 Consider three methods:
• Private Market
• Regulation
• Guaranty Funds
H&N, Ch. 5
 Tradeoffs:
• more regulation or more guaranty fund protection
==> less incentive for consumers to worry about insolvencies
T5.8

H&N, Ch. 5
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
T5.9

H&N, Ch. 5
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
T5.10

H&N, Ch. 5
Vulnerable
A.M. Best Rating Categories
Major Category
Secure
Table 5-1
Sub-Category
Superior
Excellent
Very Good
Adequate
Fair
Letter Ratings
A++, A+
A, A-
B++, B+
B, B-
C++, C+
Marginal
Very Vulnerable
Regulatory Supervision E
Liquidation F
C, C-
D
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
H&N, Ch. 5
 Issue:
• Are ratings biased upward?
T5.12

H&N, Ch. 5
Overview of Solvency Regulation
• Monitoring & intervention
• Restrictions on activities
• Pricing, Asset choices, Dividend payments
• Capital requirements
• Should regulators attempt to eliminate insolvencies?
T5.13

H&N, Ch. 5
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
T5.14

H&N, Ch. 5
Examples of IRIS Ratios for P-L Insurers
Ratio premium to surplus
Acceptable
< 300%
% change in premium written -33% to 33%
% change in surplus
2 year operating ratio
(loss ratio + expense ratio
- investment income ratio)
-10% to 50%
< 100%
T5.15

H&N, Ch. 5
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
T5.16

H&N, Ch. 5
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
T5.17

H&N, Ch. 5
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
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% then nothing needs to be done insurer must file a plan commissioner investigates legal grounds to rehabilitate or liquidate required to seize
T5.19
H&N, Ch. 5

H&N, Ch. 5
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
T5.20

H&N, Ch. 5
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
T5.21

H&N, Ch. 5
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
T5.22

H&N, Ch. 5
RBC Example for Hypothetical P-L Insurer
 Calculating RBC
Activity
US govt bonds
Inv. grade bonds
Common stock
Loss reserve
Premiums written
Amount risk factor Amt x risk factor
$7.5
$15
$2.5
$5
$30
0.00
0.003
0.15
0.155
0.172
0
$45,000
$375,000
$775,000
$5,160,000
T5.23

H&N, Ch. 5
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
T5.24

H&N, Ch. 5
RBC Example for Hypothetical P-L Insurer
Description
US Government Bonds
Highest quality bonds
Common stocks
Loss Reserve
Premiums written
Total
Sqaure Root of Total / 2
Required RBC
0
45
375
775
5,160
Required RBC Squared
0
2,025
140,625
600,625
26,625,600
27,368,875
2,616
T5.25

H&N, Ch. 5
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)
T5.26

H&N, Ch. 5
Guaranty Fund Coverage and Funding
 Coverage
• Typical limit: $300,000
 Funding
• post insolvency assessment of solvent insurers
• New York is an exception
T5.27

H&N, Ch. 5
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
T5.28