This is the tipping point. Multiple insurers would be distressed and could fail, including both smaller regional insurers and large national insurers. These failures would cause contagion in the industry, as PACICC Assessments to address losses from failed insurers would trigger the default of other surviving insurers. At this level of catastrophe, the Canadian economy could be permanently damaged without an effective Federal Government backstop.
Importantly, mechanisms exist to manage the risk of loss from unlikely but high-consequence events. They are in place in many, if not most, other developed nations with significant earthquake exposure. Backstop programs can be designed such that the insurance industry is responsible for most catastrophic events, but there exists a role for government in responding to catastrophic losses above a defined threshold.
It is a fundamental gap in the public infrastructure of our nation that we do not have such a pre-defined mechanism today — so that we are properly prepared for a rare, but quite certain, peak peril event. Environment Canada issues more than 10, severe weather warnings in Canada each year.
None of these extreme weather events have caused an insurer to fail over the past 60 years. Many other industrialized nations, however, have experienced very large catastrophes, much worse than anything experienced in Canada, with severe knock-on effects for the insurance industry. Some of these failures occurred in modern, well-functioning societies.
Read more in the full report: How Big is Too Big? For more information, visit www. Search for:. The primary or proximate cause for the purposes of this study is defined as the factor or trigger that led to a winding-up order being issued.
In most cases, the proximate cause was merely the final challenge following a set of other contributing causes that led to the insurer's failure.
For the early impairments prior to , the data lack detail and in some cases were not available. For companies showing signs of impairment after and especially after , the data were available and highly detailed.
The qualitative data were gathered from court documentation, liquidator reports and other confidential reports available to PACICC as the industry guarantee fund responsible for paying the claims of insolvent property and casualty insurers. Since insurers voluntarily file their financial data with many of the data sources, some data may not have been available.
Data for provincial companies were provided from provincial superintendents annual reports. In some cases financial data from these sources were supplemented by data from the liquidation. External factors such as catastrophes, volatile interest rates or financial markets may contribute to an involuntary exit of an insurance company but in our sample they are never the exclusive cause of an involuntary exit.
Profitability, whether measured by return on equity ROE or a loss metric such as the combined ratio has not surprisingly been consistently found to be linked to insolvency.
Effectively, every insurance company in the market geographic or product is exposed to catastrophes, volatility in interest rates or changes in equity prices. Therefore, the key question is, what characteristics distinguish companies that exit involuntarily from those that survive?
We identified four characteristics that played a role in most Canadian insolvencies:. Both A. Further, a number of studies suggest that management styles and internal processes persist strongly over time. Footnote 29 Risks that are persistently poorly managed create an environment where an insurance company is more vulnerable to adverse external events.
The A. Best Footnote 30 and McDonnell Footnote 31 findings are largely consistent with the firm survival research that links quality of management with firm survival. For the majority of the insolvencies in Canada 61 percent , the cause of involuntary exit can ultimately be traced to a strategic risk decision by management. Internal controls and financial reporting are an important aspect for the accountability and operational efficiency of an insurance company.
Internal controls and processes may break down for a number of reasons, but company solvency risk is further increased when they are purposefully circumvented.
In 10 cases, internal controls — defined as a failure in oversight processes — were identified as being weak or non-existent. Alleged fraud was involved in an additional three 9 percent of the identified involuntary exits in the entire period covered in the study — It was also identified as a contributing factor to other insolvencies. Most of these failed companies were newly licensed and operating for less than 3 years. The research literature has consistently shown that the likelihood of firm survival tends to increase with the age of the firm.
While the literature is largely confined to the manufacturing industry, this finding holds across different sectors, time periods and even countries. Footnote 32 As can be seen from Figures 3 and 4 , the age distribution of insolvent insurance companies is consistent with this literature.
The literature generally notes that new entrants face strong competition from companies already entrenched in the market and may have inexperienced management teams. Age distribution of insolvent insurance companies Canada and U. Nearly one-third The average age of these failed companies at the time of insolvency was 7. From the sample of involuntarily exiting insurers, 39 percent failed within the first 5 years, and Footnote 33 As shown in Figure 4 , survival probability for new entrants levels off after 10—15 years of operation.
Rapid growth — defined for companies with more than 2 years of operation as being growth that is more than twice the industry average in the 2 years preceding the wind-up order — is the third leading cause of involuntary exit in Canada and was involved in six 18 percent of the identified involuntary exits.
On average, these insurers grew by more than five times that of the industry. Rapid growth was identified as a contributing factor to exit for 23 percent of the failed companies. Excluding companies that exited the market as the result of the failure of a foreign parent, two-thirds of insurers exhibited rapid growth in some or all lines of business that they wrote, prior to exiting the market involuntarily.
In many cases failing companies tended to grow rapidly in the last few years of business. The population of involuntarily exiting companies, where rapid growth was not identified as either a proximate or contributing cause about one-third of the population , grew rapidly, on average, for 1.
The subgroup of companies, where rapid growth was identified as either a main or a contributing factor, on average, grew rapidly for 2 years prior to being wound-up.
Commonly, these insurers were using incoming premium revenue to pay claims. In these periods prior to wind-up, financial ratios began to deviate from previous company and industry patterns. For an insurance company, rapid growth is usually accompanied by deteriorating loss reserves and was the most frequent contributing cause 67 percent for companies of involuntary exit. Furthermore, two-thirds of the companies with rapid growth as their main cause had deficient loss reserves contribute to involuntary exit.
The incentive to embark on long-term, aggressive expansion strategies tends to increase during periods associated with diminishing capital strength. Companies may also enter new areas of business where they lack expertise. Moreover, during periods of rising short-term interest rates, some insurers may grow rapidly in the hope that investment income from the increased premium writings will offset underwriting losses.
Involuntary exits in Canada have typically been small insurers writing significantly less than 1 percent of total industry premium. In the firm survival literature, a key empirical regularity is that survival is highly dependent on firm size and age. Footnote 34 The literature exploring these relationships has found that age and firm size are positively correlated, suggesting that firm size is largely a proxy for age.
This is the expected result if larger firms are also more diversified and have better access to capital. However, the impact of the size factor was much smaller than other risk factors. While some larger and older insurers do exit the market involuntarily, the risk of exit in Canada appears to be substantially higher for newer and smaller insurance companies.
Figure 5a identifies the primary or proximate causes of involuntary exit for the 35 Canadian insurance companies that were wound up between and However, as we have noted previously there is rarely a single cause of involuntary exit.
Insurance company failures are generally caused by multiple factors. The primary or proximate cause is defined as the factor that led to a winding-up order being issued.
Source : Authors. Figure 5b identifies the primary causes for insurer involuntary exit since The reason for segmenting at is based on significant changes in corporate governance, and the introduction of early warning tests such as MAT Minimum Asset Test that occurred around that time. Prior to , deficient loss reserves were identified as the leading cause of involuntary exits, accounting for nearly one-third of such exits.
The failure of a foreign parent home office accounted for one-quarter of the involuntary exits experienced by the industry. Rapid growth and alleged fraud together accounted for another quarter of all involuntary exits. Fourth on the list of main causes pre is overstated assets, accounting for 8 percent of involuntary exits. Since , and similar to A.
Best's findings, inadequate pricing and deficient loss reserves are an important cause of insurer involuntary exit in Canada. This is not surprising as the adequate pricing of risk and reserving for future claims is the core function of an insurance company and getting it wrong would be expected to have important implications.
In an analytical framework this means that the premiums collected should match expected losses. In this framework, assuming that insurers are rational decision makers in that they utilize all available information in their pricing decisions, then an insurer would set prices using data that are one-period old. Footnote 37 The following function describes the pricing of insurance:.
In a competitive market, without a systemic error, which introduces mispricing throughout the system, we would expect this function to hold. In subsequent periods as claims become realized, if insufficient reserves were set aside, an insurer must deplete capital — the margin between solvency and insolvency — to increase reserves.
A company with insufficient capital must use current revenues to support current claims and a portion of past claims. Persistent and consistent underpricing and inadequate reserving may ultimately lead to insolvency. Every insurer identified as failing due to under-reserving failed when the underwriting cycle worsened and the industry entered a period of low profitability. Among Canadian insurers who got their pricing wrong, nearly half Several insurers were also subject to large unexpected increases in liability claims that were not priced into the product with adequate reserves established.
Also, several insurers in run-off, which may have entered into run-off due to low profitability, initially were also eventually found to have price misestimation and inadequate reserves and ultimately were wound-up.
When combined with rapid growth, which is often future deficient loss reserves, inadequate pricing and deficient loss reserves account for nearly half of all insolvencies prior to and more than half 55 percent following Best notes that insurers that embark on aggressive expansion strategies, particularly in new lines of business, typically experience deterioration in loss reserves and diminished capital.
Reinsurance is identified as a cause of impairment when a company's reinsurer is unable to fulfill its obligations to the insurer. Although reinsurance was found to be a main cause of insolvency only for one insurer, it was a contributing factor for 26 percent of the involuntary exit population during the period of — Several studies have been undertaken to identify the primary causes of involuntary exit in different jurisdictions.
Table 1 summarizes key conclusions and information pertaining to these studies. The study by Chen and Wong Asian study Footnote 39 uses a logit regression analysis instead to identify the main factors that impact an insurer's financial health. Table 1 shows that inadequate pricing and deficient loss reserves are the leading cause of involuntary exit in all jurisdictions.
The study by Chen and Wong found that inadequate pricing and deficient loss reserves had a significant negative impact on insurer profitability.
Unlike the other jurisdictions, the failure of a foreign parent home office was found to be one of the top three leading causes of involuntary exit in Canada. The studies of both EU and Asia identified asset risk as a leading cause of impairment. In these cases, insurers were not appropriately considering the correlation between the risk profiles of their assets and liabilities.
Rather, insurance company failures are generally the result of multiple factors. Table 2 summarizes the proximate causes of involuntary exit identified for the 35 involuntary exits reviewed. Table 3 presents a summary of the contributing causes of involuntary exit. While none of the factors are surprising in their appearance among the causes of insolvency, they do highlight two things. First, other than inadequate reserving and pricing, when compared with other jurisdictions, the causes of insolvency are not in the same order of frequency across jurisdictions, suggesting that cookie cutter approaches to understanding and applying insolvency research from different jurisdictions may not always be appropriate.
Second, while supervisory authorities have traditionally focused on asset risks, liability-related risks and the stability of foreign parents have historically mattered more for Canadian solvency.
The high-level analysis presented in this report and observations drawn from risk maps of individual insolvencies offer a number of specific lessons and observations.
These observations are outlined and grouped into relevant categories and presented below. Whether it was inexperience, underwriting misjudgement, capital management decisions or fraud, in the end strategic choices and risk appetites were at the root of all causes of insolvency.
From the Canadian experience with insolvency, the following observations can be made:. While there are too few observations for any conclusions on whether market discipline is effective, we nevertheless observe that every involuntary exit identified with internal control deficiencies was domiciled in provincial jurisdictions with limited e.
In the Canadian experience, insurers that involuntarily exited often had a substantial concentration of risk or initiated sudden changes in the business they underwrote. While diversification does not prevent involuntary exit, there appears to be some evidence that it does increase the survival rate of companies. Further, when expanding into new lines, sticking to related lines reduces the risk of exit.
Several involuntary exits were in the process of reinventing themselves and expanding into new lines of business in which the company had limited experience.
At the macro level, insurer involuntary exit was found to be related to industry profitability and the underwriting cycle. During the period —, insolvency involuntary exits after excluding liquidity risks occurred disproportionately in years where ROE was less than 10 percent. Over the period, insolvency was 3. The relationship between profitability and insolvency appears to have become more evident in Canada since Since then, insurance company insolvency has been limited to years of poor profitability.
Unfortunately there is insufficient data to test whether there was a structural change in the environment as a result of the introduction of rate regulation, reforms in financial reporting, governance and capital requirements implemented since , or whether the result is coincidental.
Among insurer-specific factors, the leading cause of involuntary exit in Canada is inadequate pricing and deficient loss reserves, accounting for 31 percent of the impairments. This is consistent with international experience. In addition, sudden rapid growth was evident 67 percent for a majority of failed companies even if it did not directly contribute to the involuntary exit and was particularly prevalent for companies where deficient loss reserves were a proximate cause of involuntary exit.
In general, sudden growth in unpaid claims liabilities was the primary driver of involuntary exit. In 77 percent of involuntary exits, the failed insurer experienced sudden growth in unpaid claims liabilities. In the majority It should be noted that there is great diversity among companies in terms of solvency in any environment, but underwriting profitability is an important predictor of insolvency.
In this context, the following observations can be made:. A number of complex theoretical models of firm performance offer insight into factors that influence entry into and exit from an industry. In particular, they suggest that risk-based supervision should reduce solvency risk. To date, the limited data available from the adoption of a risk-based framework for federally regulated insurers seem to support this.
Reinsurance was not a major source of insolvency but it was a contributing factor in 26 percent of failures. Reinsurance allows insurers to transfer risks that exceed their underwriting capacity or share risks that they choose not to bear alone.
The purchase of reinsurance may reduce the volatility of insurer underwriting results, provide capital relief and provide specific expertise and services for an insurer. Acting as a risk transfer mechanism for large losses, reinsurance has been an important part of the insurance industry for nearly years, contributing directly to the stability of the Canadian insurance markets.
However, reinsurance assets are risky in that they can deteriorate quickly, cannot be readily sold and must be actively managed. In the majority of cases the issue appears to have been one of reinsurance management by the failed insurer, rather than reinsurance failure.
In some cases there were complex inter-group arrangements, in others there was over-reliance on reinsurance assets that became more difficult to obtain when the reinsurance market hardened. None of the cases involved the insolvency of a non-affiliated reinsurance company. Analysis of the Canadian insolvency experience has identified the following general observations:. Volatility in financial markets, specifically in interest rates, also had modest solvency implications. The interest rate volatility in the early s and mids in combination with the insurance cycle appears to have contributed to the relatively high rates of insurer involuntary exit during those periods.
Catastrophe losses were not found to be a source of involuntary exit in Canada, with severe weather contributing to the failure of a single regionally concentrated agricultural insurer. This result may be more fortuitous than real, as large catastrophe losses have occurred in years of strong profitability. Since catastrophe losses do not time themselves to the insurance cycle, it is possible that they may be linked to involuntary exit in the future.
Among the three waves of Canadian insurer involuntary exit, the insurance cycle and interest rate volatility were identified as catalysts for involuntary exit Table 4.
The periods with the greatest frequency and severity of Canadian insurer involuntary exit involved more than one catalyst. When interest rate volatility and the insurance cycle did not coincide, the estimated frequency and severity of involuntary exit was substantially reduced. Many of the causes of involuntary exit — particularly governance and operational risks — identified in Canada would not be found through analysis of financial indicators. This highlights the importance of using a broad-based enterprise risk management approach to solvency supervision.
Our review of the Canadian insolvency experience has identified a number of general observations relevant to solvency supervision:.
We conducted 35 case studies of Canadian insurance companies who involuntarily exited the market. Nevertheless, we note that these non-surprising sources of insolvency continue to retain the capacity to surprise. For a topical but currently non-insurance example, witness the recent subprime crisis. This issue is reminiscent of historical financial crises that involved straying away from fundamentals. Old things are often repackaged and seen as new things.
For solvency supervisors and guarantee funds, understanding and being reminded of the core causes of insurer insolvency — particularly where there is staff turnover or retirement — can help mitigate this. While highly useful and an important part of the supervisory toolbox, there is no single indicator or set of indicators that are consistently strong predictors of insolvency. Therefore, supervisory authorities and policyholder protection systems that focus solely on financial outcomes are likely going to receive an early warning later than they might have.
From the few studies in various jurisdictions, there also appear to be few universal causes of involuntary exit across jurisdictions and hence no cookie-cutter solutions or supervisory approaches. Nevertheless supervisory authorities and policyholder protection funds can take stock of the causes of insolvency in their jurisdiction and learn from other jurisdictions and offer lessons as well while at the same time taking into account their own environment.
Given the complex and long-term nature on many lines of business, even accurately measuring the assets or liabilities of an insurance company may be challenging.
Therefore, an insurance company may be deemed insolvent if the estimated assets are insufficient to meet the company's obligations with a very high level of confidence e. BarNiv and Hathorn Only a brief outline of the model is presented here.
The model is fully outlined in Hopenhayn Variations of this model exist within the literature. Jovanovic pioneered innovative work on firm selection and survival and forms the basis from which Hopenhayn and others further developed. Hopenhayn Dunne et al.
Mitchell Carroll et al. Klepper and Simons Klepper and Sleeper Walsh et al. Klepper and Thompson Eisenhardt and Schoonhoven Thompson Cummins et al. Best Sharma McDonnell Chen and Wong Lee and Urrutia EU With only 35 involuntary exits over the past half century and only 15 since when data become more detailed , there are too few observations for meaningful statistical analysis. Nevertheless to get a sense as to whether the results might be consistent with other studies, we did regress the involuntary exit rate on macroeconomic variables such as profitability ROE and combined ratio and financial markets interest rate volatility as defined by the annual standard deviation of 3-year government of Canada bonds and changes in the Toronto Stock Exchange Composite index.
Interest rate volatility and profitability robustly had p -values below 5 percent in the post period under a number of specifications with an R 2 around 0. However, using the data over a longer year sample does not provide any macroeconomic variables that are significant. The change in accounting and actuarial standards and in the regulatory model in the late s to one of more rigorous monitoring and early intervention from one of preventing insolvency may be a contributing factor.
Adding a dummy variable for these changes makes the profitability variable significant at the 10 percent level of confidence but the R 2 remains small 11—15 percent range. Nelson and Winter ; Nelson ; Dosi et al. Thompson ; Dunne et al. This is a conditional probability the probability of being a survivor not insolvent at the end of the interval on condition that the insurer was a survivor at the beginning of the interval.
Survival to any time point is calculated as the product of the conditional probabilities of surviving each time interval. Firms that exit in a solvent fashion are considered survivors. Cummins and Phillips When there is some uncertainty in the losses e. Cummins and Outreville outline a simple model for insurance pricing that demonstrates this. Note that the result does not hold when there is systemic error.
Mispricing could occur where there is incorrect or lagged information on loss costs. Some accounting conventions, rate regulation or inappropriate estimation techniques could introduce systemic mispricing.
This includes both actual invoices sent to insurers and the recoveries from past liquidations that were used for current liquidation instead of being returned to insurance companies.
Historically, the number of insolvencies declines by half with an industry ROE lagged by 1 year of 12 percent and does not decline again until industry ROE lagged 1 year exceeds 15 percent. Barniv, R. Article Google Scholar. Best, A. Insurers —, Oldwick, NJ: A. Best Company. Google Scholar. Carroll, G. Chen, R. Cummins, D. Cummins, J. Dosi, G. Dosi, R. Nelson and S. Dunne, T. Eisenhardt, K. Grace, M. Hopenhayn, H. Jovanovic, B. Klepper, S. Lee, H. McDonnell, W. Mitchell, W. Nelson, R.
Pottier, S. Sharma, P. Thompson, P. Walsh, S. Reynolds, S. Birely, J.
0コメント