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
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 ratios
Life & Health 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 is then
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 / = 191.1%
Regulatory Response (Table 5-3)

27. Guaranty Fund Coverage and Funding
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