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Why do insurers fail?

The European insurance industry generates premium income of more than €1 trillion, employs more than 1 million people and invests nearly €7 trillion in the European economy annually. The stability of the insurance industry is fundamental to the economic growth of the European Union (EU). Long before the financial crisis emerged in 2008, it had been recognized that existing risk management and solvency regulations were inadequate.

Fortunately, the frequency of insurer insolvency is very low. Between 1970 and 2000, there were approximately 700 failed insurance companies throughout the world. Although this may at first glance seem a great many, the number must be viewed in the context of the banking industry. The US savings and loan crisis of the 1980s alone resulted in the insolvency of more than 500 institutions. The low insolvency rate of insurers has resulted in high consumer confidence in the industry.

Solvency endangered

No industry is immune to failure – no matter what the prevailing institutional characteristics – and over the past few decades, there have been several examples of significant insurance company failure. The most comprehensive research to date into why insurers fail was produced by A.M. Best in 1999. The published report was based on A.M. Best’s findings as to the failure of 640 US insurance companies between 1960 and 1998. Of these 640, no primary cause of failure can be identified in 214.

Primary causes of insurer failure

Primary causes Number of companies % of total identified
Underreserving 145 34
Rapid growth (underpricing) 86 20
Alleged fraud 44 10
Investment failure 39 9
Catastrophe losses 36 8
Expansion 28 7
Impaired affiliate 26 6
Reinsurance failure 22 5
Total 426 100

*Numbers do not add to 100 due to rounding.

The Sharma Report to the European Commission, published in 2002, identified and analyzed risks that had led to actual solvency problems or “near misses” occurring between 1996 and 2001. Usefully, the report includes a discussion of the full causal risk chain from underlying causes, through proximate causes and triggers, to ultimate financial outcome and resulting policyholder harm for 21 case studies. The most interesting finding of the report was the emergence of a chain of multiple causes, implying that an effective supervisory system should have the capacity to deal with the full range of causes and effects of risks faced by insurers.

Causes of failure:

Underreserving – If historic underreserving results are used by actuaries and underwriters to price new business, then future underpricing results; on and on in a continual downward spiral. Underreserving may even occur in a more deliberate fashion rather than by accidentally or poor insurance practices.

Forecasting – Another major reason for insurance company failure is the inability to forecast risk of catastrophes and offset the losses. A catastrophe could be either a large number of claims from one event or a small number of large claims.

Expansion – This can prove to be a causal factor in subsequent insolvency if an insurance company attempts aggressive growth through underpricing procedures in an effort to attract new customers and retain existing policyholders. Rapid growth may also occur as a result of the introduction of new products, expanding into new territories, or mergers and acquisition.

Overreliance on reinsurance – A strategy of underwriting risks and then passing the majority of each risk on to reinsurers may work particularly well if the market is at a point in the cycle where reinsurance is cheap. However, this strategy begins to fail when reinsurers begin refusing to pay or become insolvent themselves.

Fraud – Nearly every example of insurance company failure is to some extent a result of incompetent management, fraudulent activities, or both. False reporting, whether deliberate or accidental, can hide insolvency and other reasons for failure. Insurance is a prime target for fraud. It is an easy industry for a new insurance operator to enter, money is received in advance of advance of expenses (claims), and, although regulated, it has proven to be easy to manipulate profitability.

Solvency protected

Given the complexity of the insurance industry, and the growth of the European Union in the last 10 years, Solvency II is probably the most ambitious financial services legislation ever implemented. It will completely change the measurement of the financial stability of European insurers and affect more than 5000 insurance companies in 30 countries across the EU.

It is expected that the legislation will also have implications throughout the world as non-European insurers implement similar solvency and risk management requirements. The complex approval process and the delays in finalizing the requirements and implementing the legislation merely serve to highlight the significance of the Solvency II Directive.

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