Chapter 7 Insolvencies Solvency Ratings and Solvency Regulation

Chapter 7 Insolvencies, Solvency Ratings, and Solvency Regulation Mc. Graw-Hill/Irwin Copyright © 2004 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

Frequency & Severity of Insurer Insolvencies H&N, Ch. 7 T 7. 2

Frequency & Severity of Insurer Insolvencies H&N, Ch. 7 T 7. 3

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. 7 T 7. 4

Factors Affecting Life Insurer Insolvencies • Drop in asset values • Junk bonds (First Executive) • Commercial real estate (Mutual Benefit) • “Run on the bank” H&N, Ch. 7 T 7. 5

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. 7 T 7. 6

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. 7 T 7. 7

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. 7 T 7. 8

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 H&N, Ch. 7 T 7. 9

A. M. Best Rating Categories H&N, Ch. 7 T 7. 10

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. 7 T 7. 11

Overview of Solvency Regulation • Monitoring & intervention • Restrictions on activities • Pricing, asset choices, dividend payments • Capital requirements • Issue: Should regulators attempt to eliminate insolvencies? H&N, Ch. 7 T 7. 12

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. 7 T 7. 13

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. 7 T 7. 14

Examples of IRIS Ratios for P-L Insurers H&N, Ch. 7 T 7. 15

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. 7 T 7. 16

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 • Example: activities RBC = $100 million actual capital = $80 million • Regulatory action depends on the ratio of actual capital to RBC H&N, Ch. 7 T 7. 17

Regulatory Actions Based on RBC H&N, Ch. 7 T 7. 18

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. 7 T 7. 19

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. 7 T 7. 20

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. 7 T 7. 21

RBC Example for Hypothetical P-L Insurer Calculating RBC H&N, Ch. 7 T 7. 22

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. 7 T 7. 23

RBC Example for Hypothetical P-L Insurer H&N, Ch. 7 T 7. 24

RBC Example for Hypothetical P-L Insurer • Finally, • Calculate ratio of accounting capital to RBC: • Surplus / RBC = 5 / 2. 616 = 191. 1% • Regulatory Response (see Table 7. 3) H&N, Ch. 7 T 7. 25

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. 7 T 7. 26

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. 7 T 7. 27