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

2. T7.2 H&N, Ch. 7 Frequency & Severity of Insurer Insolvencies

3. T7.3 H&N, Ch. 7 Frequency & Severity of Insurer Insolvencies

4. T7.4 H&N, Ch. 7 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

5. T7.5 H&N, Ch. 7 Factors Affecting Life Insurer Insolvencies Drop in asset values Junk bonds (First Executive) Commercial real estate (Mutual Benefit) “Run on the bank”

6. T7.6 H&N, Ch. 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

7. T7.7 H&N, Ch. 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

8. T7.8 H&N, Ch. 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

9. T7.9 H&N, Ch. 7 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

10. T7.10 H&N, Ch. 7 A.M. Best Rating Categories

11. T7.11 H&N, Ch. 7 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?

12. T7.12 H&N, Ch. 7 Overview of Solvency Regulation Monitoring & intervention Restrictions on activities Pricing, asset choices, dividend payments Capital requirements Issue: Should regulators attempt to eliminate insolvencies?

13. T7.13 H&N, Ch. 7 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

14. T7.14 H&N, Ch. 7 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

15. T7.15 H&N, Ch. 7 Examples of IRIS Ratios for P-L Insurers

16. T7.16 H&N, Ch. 7 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

17. T7.17 H&N, Ch. 7 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

18. T7.18 H&N, Ch. 7 Regulatory Actions Based on RBC

19. T7.19 H&N, Ch. 7 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

20. T7.20 H&N, Ch. 7 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

21. T7.21 H&N, Ch. 7 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

22. T7.22 H&N, Ch. 7 RBC Example for Hypothetical P-L Insurer Calculating RBC

23. T7.23 H&N, Ch. 7 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

24. T7.24 H&N, Ch. 7 RBC Example for Hypothetical P-L Insurer

25. T7.25 H&N, Ch. 7 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)

26. T7.26 H&N, Ch. 7 Guaranty Fund Coverage and Funding Coverage Typical limit: $300,000 Funding Post insolvency assessment of solvent insurers New York is an exception

27. T7.27 H&N, Ch. 7 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