Insurance companies, like any other venture, are susceptible to insolvency. In fact, as organisations that manage the risks which others do not want, insurers are uniquely positioned to fail under certain circumstances.
It’s not something that insurance companies make much noise about, but it’s certainly a reality that they need to contend with. In essence, each insurance policy is an “educated guess”, the insurer forecasting that the claims arising will fall within their expectations (their “pricing assumptions” or “educated guesses”). Underwriters (and their actuaries) are well versed in making carefully calculated forecasts in this sense, but they are forecasts nonetheless.
Why Do Insurers Fail?
The principal event that can lead to insurers failing is built into the product itself. The nature of insurance is such that there needs to be long periods of profit (low claims) to subsidise even a short downturn (high claims). However, periods of boon drive profits, which in turn increase competition and reduces premiums leading to reduced profitability. This cycle eventually leads to market players either failing or being pushed out.
A case from recent memory is the bankruptcy of AIG in the United States as a consequence of the financial crisis. Ultimately, a US government bailout rescued AIG to prevent a bigger disaster but it’s a good example of how even a company that was considered safe can quickly buckle under pressure. Examples in the UK include Municipal Mutual Insurance (2012), Horizon Insurance (2018) and LAMP Insurance (2019).
Effects and Risk Management
When an insurance company becomes insolvent, it can be forced to terminate or disclaim policies. For individuals, this can be a serious problem, but they are usually covered by the Financial Services Compensation Scheme (FSCS); however, for public bodies (who are exempt from FSCS coverage), it could be a catastrophe, requiring central government intervention. With so many parties relying on (say) a Council’s insurance claims, an insurer suddenly announcing insolvency can make the council’s insurance buyer wonder what “early warning” signs they might have missed.
Public sector policyholders are left with no recourse in these cases, and that’s why vigilance and monitoring are necessary to prevent this kind of situation.
The good news is that predicting the failure of an insurance company is not hopeless. An insurance company’s relative health is often estimated through various factors, and that’s something that serious brokers can provide as a service. It mostly involves statistical tools such as ratio analysis, regression models, and multiple discriminant analysis. However, the best approaches focus on the sole measure used by Regulators, the Solvency Margin (also known as the Capital Coverage Ratio, or CCR).
The services of any insurance advisor should include clearly and concisely monitoring insurers’ Solvency Margins, which are published, communicating any concerns to policyholders with enough time to work through the implications for them. It should also include a comprehensive evaluation of the steps that need to occur in the eventual case that their insurance company does fail and how to design a plan for that.
Manage Risk Transfer Wisely
Having insurance is clearly desirable (in some cases, mandatory – but not for the public sector) to transfer unwanted risk. But that doesn’t mean that all insurance is created equally and all it takes is getting insured and never thinking about it again.
A legitimate risk is posed by the potential failure of insurance companies that can have widespread repercussions within the context of public bodies. When council taxpayers’ money is on the line, this is a risk which should be clearly evaluated and managed, not hidden behind your insurance advisor’s “black box” of software or security committees.
Therefore, insurance buyers should look to their independent insurance advisors to conduct clear, timely and unbiased analyses into insurers’ published Solvency Margins/CCRs.
