Solvency Matters

In a competitive property and casualty insurance industry, it is inevitable that some insurers will encounter financial difficulties. Although rare, some may become insolvent. Industry fund association’s offer an alternative, providing a national guarantee fund for members and ultimately protecting policyholders from undue financial loss in the event a member insurer becomes insolvent.

The risk of insolvency in Canada is moderate compared to other major markets (see chart 1). However this risk has been increasing as P&C insurers are experiencing as many insolvencies in the last five years as they did in the entire decade. The challenge is to prepare for the next insolvency by developing a strong and effective response fund.

A RISKY ENVIRONMENT

In 2002, industry earnings were at a record low and there was a marked erosion in capital. Since, financial strength rating downgrades of Canadian-based insurers occurred three times more often than upgrades (see chart 2).

Recently, the improved ratings are escalating. A renewed focus on underwriting, including significant rate adjustments, has brought a return to profitability and a strengthening of capital and loss reserves – financial health seems inevitable. For the first time in years, rating upgrades have exceeded rating downgrades. Solvency concerns persist, but they are easing off.

Vulnerability to external shocks remain an issue due to the growing international nature of the industry, the increased frequency and severity of extreme weather events, and financial market volatility. Research, conducted by PACICC, confirms that guarantee funds are facing greater challenges today than they did 16 years ago.

The recent wave of consolidation and the formation of financial conglomerates in the 90s increased the number of large insurance institutions. In general these insurance/financial groups are better diversified and possess strong corporate governance structures that should reduce the risk of insolvency. However, where firms experience financial distress resulting in insolvency, the resulting impact and challenges to the guarantee fund system are considerable.

This risk of international and cross-pillar insolvencies is highlighted by the failures that Barings (1995), Reliance Insurance Company (2000), HIH Insurance Group (2001) and Home Insurance Company (2003) have incurred. To date, Canadian exposure to international and cross-pillar insolvency has been limited, although two of the last three insurer wind-ups were precipitated by the failure of parent companies in other jurisdictions where small Canadian companies experienced growing risks and challenges associated to an international insurer becoming insolvent.

PUMPING UP FINANCIAL PREPAREDNESS

Extensive research and analysis on financial preparedness and an assessment of international best practices for the financing of insolvencies and the impact of the various options on member insurers, conducted by PACICC, offered evidence that consolidation and growth in the industry is widening the financial capacity gap.

Industry-wide consolidation is eroding the capacity to respond to an insolvency. According to Swiss Re, 57 mergers have occurred in the Canadian P&C industry since 1997. In addition, the number of smaller insurers has been falling relative to the number of mid-sized and larger insurers. The net result is that general assessment base grew at half the rate of the majority of insurers, diminishing a funds ability to respond to the failure of a mid-sized or larger insurer. Mirroring this, the severity of a fund associations claims liabilities will increase.

A Financial Capacity Assessment Model (FINCAM) will estimate liabilities and financial resources following an insolvency of a given size. The model estimates the movement of payments from member insurers – through general assessment and the use of the Compensation Fund – to claimants and policyholders. The model estimates potential inflows and outflows of financial resources, identifying the amount and timing of member assessments. These inflows and outflows of funds determine the capacity that is available to pay claimants.

FINCAM is used to evaluate financial preparedness by simulating whether or not enough cash is on hand. It also evaluates if there are enough funds to cope with an insolvency. Testing against historical insolvencies reports that, in all but one case, it was able to predict claims liabilities within a few percentage points of actual claims-related payments.

Insolvencies of virtually any size can be handled through continuous assessment of the industry, but this may not be sustainable or healthy. In the event of an insolvency, under accounting rules, members are required to book the entire amount of any future liability as soon as it becomes known. As a result, liabilities would flow through the MCT/BAAT and have associated capital costs if payments are delayed due to a comparatively low general assessment rate. Liabilities in an insolvency are independently determined by the court-appointed liquidator. Therefore, a guarantee funds level of financial preparedness has no impact on the total liability or the amount paid for claims, but it can influence the timing and flexibility of payments to resolve legitimate claims.

REBUILDING FINANCIAL PREPAREDNESS

Guarantee funds exist in order to offer an effective response to an insolvency of a member P&C insurance company. It is important to avoid unnecessary delay of payments to legitimate claimants, as this would increase reputational risk for members and potentially subject the industry and member companies to negative media and government attention.

A study conducted by PACICC by consulting with member companies concerning financial preparedness, found that 94% of its members endorsed doubling financial preparedness by raising the maximum annual general assessment rate to 1.5% of eligible direct written premium. This change moves Canada’s maximum assessment rate in line with the average for OECD countries.

IN SOLUTION…

Guarantee fund organisations must change as member insurers are growing and consolidating. The frequency an d relative cost of P&C insolvencies in Canada has increased, though it is still well below U.S. levels. Insolvency risk remains elevated, lagging behind improvements to the insurance cycle – and the potential for disaster losses and financial shocks is ever present. It is essential to be prepared to respond to insurer insolvencies.

Strengthening financial and operational preparedness offers an appropriate response to protect policyholders on behalf of member insurers. “There are no secrets to success,” Colin Powell says, “It is the result of preparation, hard work and learning from failure.”