In the previous article, we have explained why regulation is important for the insurance industry. We have also understood how the focus of regulation has changed from merely restricting prices to protecting the rights of the consumer. In this article, we will have a closer look at the solvency regulations i.e. the rules regulators create to ensure that insurance companies do not go bankrupt.
It needs to be understood that the financial services industry is a closed loop. Hence, bankruptcy of one company also ends up severely affecting the other companies. Hence, solvency is not the company’s private matter. This is the reason why companies which manufacture goods and service do not have to follow regulations while utilizing their capital, while financial services like insurance companies have to!
The way insurance companies deploy the funds that they receive via premium is highly regulated. Some of the principles that form the basis of solvency regulation are as follows:
- Capitalization: Insurance companies in different countries are governed by different regulators. However, in each of these countries, there are rules and laws which restrict how much money an insurance company can invest. Insurance companies receive cash upfront but need to pay back the money when a claim is made. It is for this reason, they need to have adequate cash on hand to pay claims.
The question is what constitutes an adequate amount of cash. All over the world, regulators are the ones who determine the minimum capital that needs to be kept on hand in order to pay claims. Insurance companies are obligated to maintain at least the amount of cash specified by the regulator. Failure to do so can lead to fines, penalties and even disbarment in the long term.
It is the responsibility of the regulator to ensure that the rules are set in a fair and unbiased manner.
It is for this reason that the formula to calculate the minimum capital requirements needs to be same for all companies.
However, the formula does have factors such as size of the company, its current financial position and the riskiness of their investments. This is the reason why different companies may have different amounts that they need to maintain as minimum capital. In some countries like the United States, there might be different minimum capital requirements at state and the federal level. In such cases, federal laws supersede the state laws.
- Asset Quality: Insurance companies are also one of the biggest investors in the market. They collect premium from people and invest them in market traded securities. Prior to 2008, there was very little oversight regarding what assets insurance companies are holding.
As long as the asset was AAA+ rated by credit agencies, insurance companies were allowed to invest money in them. As a result, many insurance companies were left holding mortgage backed securities during the 2008 financial meltdown. This incident almost bankrupted AIG which sent alarm bells ringing as far as insurance regulators were concerned.
Ever since the AIG incident, insurance companies have now started taking more interest in where insurance companies invest their money. There are various limits and sub-limits regarding the asset classes where the money can be parked. The regulators want to ensure that some of the money is available in liquid form.
Hence, the mandate holding of some cash equivalents. Also, they want to ensure that all the money is not concentrated in few asset classes. This would expose the insurance company to unnecessary risk.
The very basis of insurance is risk diversification. As such, it is only understandable that insurance companies themselves would want to hold a diversified portfolio. The insurance regulators also keep an eye on risks such as interest rate risk and counterparty risks and ask the insurance company to change their asset portfolios accordingly.
- Reinsurance: Regulators across the world insist on the use of reinsurance in order to mitigate risk. These regulators provide incentives to the insurance company using reinsurance. For instance, when a company uses reinsurance, its capital requirement is reduced. As such, the company is left with more money which it can use to invest and earn a higher profit. This profit offsets the premium that needs to be paid for reinsurance. Hence, insurance companies can offload a big chunk of their liabilities at a very low cost.
The regulators ensure that there is genuine pooling of risks via reinsurance. This means that they have rules to check that the reinsurance is not being done by an overseas branch of the same company. Also, the regulators want to ensure that the risk is not contained within the same country. This is the reason why regulators insist that some of the risk be transferred to overseas companies. However, it is also the job of the regulators to ensure that these overseas companies are financially stable to take on the risk.
- Liquidity: Regulators across the world want to ensure that insurance companies are always in a position to pay a claim if the situation arises. This is the reason why they ask insurance companies to keep aside some of their money in investments which can be easily liquidated if the need be. If investments are parked in illiquid assets, it can trigger the insolvency of an insurance company even though they do have the assets.
