Dibra and Leadbetter

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  1. Characteristics of insolvent companies
    • size: less than $10M in capital
    • ownership: subsidiaries or branches of a failed parent company
    • type of license: federally supervised
    • age: operated for less than 10 years
    • growth: experienced unusual growth in premiums
    • underwriting: occurred in property and auto lines
  2. Proximate causes of involuntary exit
    • inadequate pricing or deficient loss reserves (DLR)
    • foreign parent
    • rapid growth
    • foreign parent (DLR)
    • alleged fraud
  3. History of involuntary exits in Canada
    • 3 waves which coincided with periods of poor profitability
    • shift in nature of exit: number of institutions under federal supervision has declined
    • all but one since 1990 were liquidity risk rather than insolvency, reflecting OSFI’s work
  4. 2 causes of insolvency
    • insolvency risk: assets insufficient to meet contractual and other financial obligations
    • liquidity risk: high level of risk that assets could disappear
  5. 2 frameworks for theoretical models
    • dynamic equilibrium model: characterizes the process for entry and exit of firms
    • hazard model approach: estimates probability of survival based on certain attributes
  6. Dynamic equilibrium model
    • industry is composed of a continuum of firms which produce a homogeneous product
    • firms behave competitively by taking output price and input price as given
    • following each shock, firms and new entrants evaluate environment and value of the firm
    • when a firm productivity falls below the reservation value, the firm exits the market
  7. Hazard model approaches - factors considered
    • diversified firms survive longer and grow faster than new entrants
    • diversifying firms with experience in related fields perform better than less experienced 
    • a strong reservoir of support is important for firm survival (e.g. subsidiaries)
    • quality of a subsidiary parent is important for survival
    • firm performance is increasing with the industry experience of their management
    • new entrants learn by doing, with results improving over time
  8. Empirical analysis
    • A.M. Bests’s study: primary causes are DLR and inadequate pricing, and rapid growth
    • rapid growth occurred most frequently during soft market with weak industry profits; diminished capital strength drives insurers into aggressive expansion strategies, including LOBs where UW experience is lacking
    • A.M. Best’s opinion: all primary causes are related to some form of mismanagement
  9. Costs of Insolvency
    • reduced confidence in financial institutions
    • policyholders face potential financial losses (UEP, claims)
    • costs incurred by regulatory authorities, agents, accountants, reinsurers
    • lost wages, commissions, taxes and other expenditures of liquidated assets
    • still, claims and UEP are simplest measure of the cost despite not representing full cost
  10. Role of PACICC
    • protect policyholders from undue financial loss in the event of insurer insolvency
    • assess member companies for resources required to pay cost of an insurer failing
    • required to return liquidation dividends to the solvent members of the industry, unlike US and UK where such dividends are used to reduce current or future assessment needs
  11. Impact of External Environment
    • volatility in operating environment can trigger involuntary market exit
    • external environment is unlikely to be the primary cause, but can exacerbate vulnerability
    • insurers are more sensitive to financial distress than all other industries
    • involuntary exit is closely linked to profitability and the insurance cycle; correlation is higher in US (60%), because 1/3 of Canadian exits are due to failing foreign parent
    • weather catastrophes have lower impact in Canada (modest exposure to hurricanes)
  12. Economic and financial market factors
    • key risk is not the level of the financial variables, but their volatility
    • little correlation between interest rate levels and financial impairment
    • however, a volatile financial environment increases risk of involuntary exit
    • overall, solvency risk is heightened when volatility coincides with a softening of UW cycle
  13. Summary of biggest influencers
    • governance/management: inexperience, mis-judgement, fraud, lack of internal control, "gambling for survival" strategies
    • operational risk: concentration of risk (geographic, product), expansion strategy
    • underwriting: UW cycle and profitability, inadequate pricing and DLR, rapid growth
    • capital: risk-based supervision should reduce solvency risk; reinsurance is also a factor
    • macro-economic environment: volatility in financial markets; UW cycle
    • monitoring and supervision: maintain efficient, fair, safe and stable market

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Dibra and Leadbetter
2014-04-12 17:08:00
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