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ED_6C3
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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
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Proximate causes of involuntary exit
- inadequate pricing or deficient loss reserves (DLR)
- foreign parent
- rapid growth
- foreign parent (DLR)
- alleged fraud
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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
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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
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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
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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
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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
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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
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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
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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
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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)
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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
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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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