Why Insurers Fail

Insurance is a promise to pay claims in the future in exchange for premiums today. Confidence in the industry rests upon the foundation that these claims will be paid. Over the past 30 years, inadequate pricing and reserving has been the leading cause of failure for Canada’s insurers.

Canada’s solvency regulators have involuntarily wound-up 32 insurers since 1979. Several (11 companies) were financially sound, yet were closed because their foreign parent became insolvent. But most became insolvent (21 companies). Two-thirds of the insolvent Canadian insurers over the past 30 years failed due to inadequate pricing, deficient loss reserves or rapid growth (14 of the 21 companies).

Insolvency arises when insufficient assets and capital are in place to cover the claims liabilities incurred. A few insurance companies have failed over the last 30 years because of shocks to their capital or reinsurance arrangements (three companies). One company failed because it was overwhelmed by claims from a catastrophic event. A few companies failed due to alleged fraud (three companies). But two-thirds (14) of the Canadian insurance failures over the past 30 years were due to some form of price or reserve inadequacy.

PACICC recently completed a major research project on the causes of insurance price inadequacy as part of its Why insurers fail publication series. We examined in depth what could be learned from the experience of the 14 Canadian insurers that failed over the past 30 years due to price inadequacy and deficient loss reserves. Our review of these failures identified three primary reasons why some insurers get their pricing wrong to such an extent that it threatens their solvency. We also identified two factors related to the operating environment that can weaken the ability of an insurer to return to financial health. This article summarizes PACICC’s key findings on the relationship between inadequate pricing and insolvency risk.

Claims, the largest cost for insurers, are unknown when the customer is accepted. Pricing is determined and agreed to before costs are known. Actuarial analysis is used to anticipate the expected frequency and severity of future claims, but actual costs are not known when prices are set. Some have described this as an “inverted production cycle,” noting that insurance is quite different from the other financial industries and most businesses where input costs are largely known when prices are set. For Canadian property and casualty insurance companies, fully 72.5% of the costs of the product are incurred in the form of claims costs after the insurance contract has been delivered. As comparative examples, manufacturers and deposit- taking financial institutions in Canada both incur, on average, a much lower proportion of “post-production” input costs — 21.9% and 6.6%, respectively.

Insurance Pricing

Difficulties in pricing

Data deficiency and poor information management

Most Canadian insurers that have failed due to price and reserve inadequacy had poor information management systems. The specific deficiencies varied, yet consistently failed to provide meaningful and timely information about claims costs needed to properly manage solvency risks. The main problem appears to have been an inability to apply loss experience data properly to the pricing of risks, rather than to the lack of such data (although in a few cases, particularly for commercial lines, a lack of loss data contributed to the problem). It is also likely a lack of appropriate managerial experience contributed to the poor information-management practices exhibited by Canadian insurers that failed due to price inadequacy.

Pricing is difficult in new markets

North American data show that almost one quarter of new insurance companies fail within their first five years of operation, and 70% of failed insurers were less than 10 years old. Among failed new entrants that were in business less than 10 years, 57% were wound up as a result of inadequate pricing. Setting adequate prices is always a challenge, even for experienced insurers. But lessons from the Canadian experience suggest the risk of inadequate pricing of insurance is significantly higher for new entrants into a line of business, or for experienced in- surers entering new lines unrelated to their existing business.

Pricing under duress

Troubled companies frequently assume additional risks when they are struggling to survive. Distressed insurers sometimes enter into new markets where the risks are unfamiliar, or they may temporarily offer aggressive pricing to attract customers and generate addi- tional revenue. For example, Figure 1 compares the pricing experience for automobile insurance policies issued by Advocate General and Markham General — two Canadian property and casualty insurers that became insolvent and were ordered to be wound-up — to the industry average price. In addition to the evident under-pricing, both of these companies also incurred higher-than-average claims severity and frequency. There may be scenarios in which “gambling the company” in this manner proves to be successful, but more often these approaches cause even greater trouble for already-vulnerable companies.

Claims Costs And Insurance Pricing Need To Stay Linked

Anything systemically disrupting the link between pricing and expected claims costs increases the risk of insolvency. Experience in Canada and the United States indicates that stricter forms of rate regulation can weaken or even disrupt the link between insurance prices and claims. Figure 2 illustrates the much closer relationship that exists between average claims cost and average premiums when rate regulation is absent. When rate regulation is present, the dispersion between average claims cost and premiums is much greater. Table 1 further illustrates the point: it shows the sizeable drop in correlation between average claims cost and premiums that occurred when stricter regulation of auto insurance rates was introduced in Alberta, Ontario and Atlantic Canada.

To be more specific, stricter forms of rate regulation can reduce the capacity of insurers to make rate changes consistent with changes in underlying claims patterns. As a result, an insurer may be forced to draw down its capital to pay claims, possibly impairing its solvency in the process.

CONCLUSION

In competitive markets, insurance companies will occasionally run into financial difficulties, especially when economic conditions deteriorate. When this happens in Canada’s property and casualty insurance industry, PACICC’s job is to ensure policyholders are protected.

PACICC launched the Why insurers fail series of research reports to stimulate discussion about solvency issues in the property and casualty insurance industry. It is important to learn from past failures in order to strengthen our capacity to reduce the risk of insurer failure in the future.

PACICC’s latest research demonstrates that inadequate pricing of insurance is by far the most pervasive insolvency risk factor. First and foremost, this finding highlights the critical importance of the product pricing decisions taken by the senior managements of insurance companies. In addition, it may help insurance supervisors better focus on risks that have historically signalled potential insolvency concerns, particularly for insurers underwriting rate-regulated products.