A number of insurers have gone bust in recent years. Roger Massey examines what put them beyond resuscitation.

Events such as Enron, last year's European floods and falling stock markets have put the solvency of many insurance companies under severe pressure. In this climate, it is timely to examine why insurers go bust.

With every major failure there follows a postmortem. But whereas in a biological postmortem the cause of death is often clear, in a corporate postmortem it is not. It is usually the result of a combination of contributing factors.

Competition is often a significant factor. The insurance market tends to have few barriers to entry, and so it is extremely competitive. The very nature of the market means that insurers need to experience several years of profits to pay for the occasional really bad year. But after several good years, the market may seem to offer returns that more than outweigh the risks involved, attracting new entrants. Greater competition for the same pool of business then drives insurance premiums down, and that in turn reduces profitability and increases the number of insolvencies. There is a close correlation between the combined ratios and the number of failures over the past two decades.

So what do all the postmortems have to teach us? Following a spate of high-profile failures in the late 1980s, the US Senate commissioned an in-depth investigation into the collapse of several insurers, the results of which were published in what is commonly known as the Dingell Report. The study identified seven main reasons why insurance companies fail:

  • rapid expansion;
  • l delegated management authority;
  • fraud;
  • under-reserving;
  • excessive reliance on reinsurance;
  • expansion into new areas; and
  • gross incompetence.
  • More recent postmortems have added other reasons to this list, such as overstated assets, under-pricing, unforeseen claims and catastrophic events.

    These findings have been corroborated by similar studies. In 1999, for example, insurance rating agency AM Best published a special report in which it identified the principal causes of failures at 426 US companies over the 1969-1998 (see figure 1). A large percentage of the failures - some 34% - were due to insufficient reserves.

    In June 2002, AM Best published an update to its earlier report. Astonishingly, 73% of the 60 failures that took place in 2000-2001 could be attributed to insufficient loss reserves. This underlines the importance of the process for calculating claims reserves and getting accurate figures.

    However, it is also worth considering whether inadequate reserves are a symptom of failure, rather than the real cause. Clearly, under-reserving can trigger insolvency, but the real causes of failure may lie elsewhere. For instance, was the under-reserving due to poor quality or inadequate data, or was it the result of errors in calculation or behavioural issues underlying the reserving process?

    Reasons for failures
    In fact, failures can occur for various reasons, although fundamental issues of control often contribute to an insurer's demise.

    Giving away the underwriting pen: In the US, several insurers, including Integrity Insurance, failed owing to lack of control over their managing general agents (MGAs). As a result, the MGAs had little incentive to exercise quality control over the business they were writing on behalf of the insurers.

    Lack of appropriate regulation: Regulatory loopholes can create problems. In the US, requirements vary on a state-by-state basis. Transit Casualty, for example, employed one MGA that operated an unregulated captive reinsurance company in the Cayman Islands - even though handling the business of both insurers represented a conflict of interest. Changes in regulation can also trigger insolvencies. Recently introduced legislation in Australia has already caused ten general insurers to enter run-off - often the first step towards liquidation.

    No control over exposures: The LMX spiral in the London market demonstrates what happens when insurance risks are repeatedly reinsured within a small group of insurers in the same market.

    Over-reliance on reinsurance: Ceding written risks to a reinsurer can look an attractive option, particularly if reinsurance premiums are low, because this enables an insurer to grow its book rapidly from a given capital base. However, the strategy can fall apart if the reinsurer starts refusing to pay. The insurer will quickly amass large debts, but it will have only a limited income with which to pay claims (as it will have ceded much of the premium income to the reinsurers). Over-reliance on reinsurance was a major factor in the demise of Mission Insurance in 1985. Equally, cutting back on reinsurance programmes can be dangerous. Take Drake Insurance, one of the top 20 UK motor insurers, which failed in 2000 because of under-pricing and lack of reinsurance.

    Unforeseen claims: The attack on the US World Trade Center is a good illustration of how a single, unanticipated event can trigger substantial claims. But failures can also arise as a result of multiple claims from the same source. One such example is asbestos, where the long time-lag between exposure and the onset of asbestos-related diseases means that insurers face considerable uncertainty in estimating their total liability to present and future claims. Claims regarding asbestos-related diseases have forced many insurers, including Chester Street Insurance, into insolvency.

    Causes of failure
    Close examination of insurance failures show that they often stem from a mixture of causes.

    Fire, Auto & Marine Insurance: Motor insurer FAM, which collapsed in 1965, is best known for the famous David Frost interview with its founder, Dr Emil Savundra, in 1967. It failed for three major reasons: over-rapid expansion; fraud and greed; and under-pricing.

    St Helen's Insurance: The company ceased underwriting in 1968 after suffering large losses from Hurricane Betsy in 1965, and was only wound up in 1997. It also wrote large lines on layers of long-tail p/c business, which subsequently gave rise to claims in the mid-1980s. It failed mainly as a result of unforeseen claims and insufficient reinsurance.

    Transit Casualty: US motor insurer Transit entered liquidation in 1985 as a result of substantial management incompetence, excessive reinsurance and reckless expansion through the use of MGAs to write business on its behalf.

    Independent Insurance: Independent, a leading UK p/c insurer, went into liquidation in 2001 after several years of meteoric growth. The causes of its failure have yet to be confirmed, but appear to include under-pricing and rapid expansion; expansion into new areas; dubious reinsurance contracts; false reporting; and potential fraud.

    HIH Insurance: The failure of HIH, Australia's largest corporate collapse, can be attributed to a number of causes, but the core problem was the fact that it was substantially under-reserved. The legal team assisting the Royal Commission investigating the collapse identified four 'dominant' reasons for its failure: consistent underestimation of liabilities; UK losses; US losses; and the 1999 acquisition of FAI, which was seriously under-reserved as well. In essence, the causes of failure were inept management and injudicious expansion (see fuller story on p42 of this issue).

    More proactive?
    A recent discussion paper issued by the UK's Financial Services Authority (FSA) corroborates these findings. It reports on the results of a working party of insurance regulators in the European Union (EU), which examined insurance failures since 1996. The focus was on identifying the key risks that threatened the solvency of the companies concerned, and on examining current supervisory practices and how these could be enhanced to deal with such risks.

    The study confirmed that management problems lay at the root of every case of failure or near-failure. Moreover, there was a causal connection between many of the risks, which interacted in complex and sometimes unexpected ways. One such case was a financial guarantee insurer which invested in commercial property and suffered a double-gearing effect when a recession hit the property market. This increased the number of claims and reduced its investment income, a situation made worse by the comparative illiquidity of its property portfolio.

    There is a complex interaction of causes and effects in an insurance company failure. Internal issues such as poor systems and controls often lie behind external triggers such as increased competition or recession, which then exacerbate these internal difficulties.

    So what can be done about management problems? The EU working party concluded that insurance regulators should adopt a risk-based approach that relies less on quantitative methods, such as regulatory returns and solvency requirements, and more on qualitative methods that require regulators to assess the quality of management, governance, systems and controls. This would provide the regulators with flexibility and a range of tools to deal with potential problems in the insurance sector. It would also enable them to be more proactive in seeking out potential insurance failures. Such an approach underpins the FSA's Tiner Project, which is overhauling the regulatory regime for insurers in the UK.

    Predicting insolvencies
    Predicting the probability of failure for an individual company is far from simple. The main focus of research so far has been on the development of tools to assist in the regulation of insurers. The statistical methods used in the past have focused upon firm-specific financial data. They include:

  • ratio analysis;
  • multiple regression models;
  • multiple discriminant analysis (Altman z-scores); and
  • neural networks.
  • The main failing of all these methods is their reliance on quantitative data which is publicly available. Such data is often of limited value, since the quality and level of detail is often low.

    The ratings agencies which provide insurer financial strength ratings (IFSRs) acknowledge this fact and draw on much wider sources of information. The IFSR combines quantitative factors such as capitalisation or gearing with qualitative factors such as brand or quality of strategy. The importance of IFSRs has increased over time, especially since the large number of insolvencies in the US during the late 1980s and early 1990s.

    The IFSR is a benchmark rating which represents the ratings agency's current opinion of how financially secure a particular insurer is, with respect to its ability to pay under its policies and contracts in accordance with its terms. If ratings are allocated accurately, then it is reasonable to expect a close correlation between the current rating of a company and its likelihood of failure in the near future.

    However, how successful a rating agency is at identifying the risk of failure from different causes varies greatly, as a 1992 discussion paper by Redman and Scudellari, presented at the Casualty Actuarial Society in the US, showed. It assessed the percentage of companies with an AM Best rating of A+ (superior) to C- (fair) for the three years prior to the year of failure. By doing this separately for each cause of loss, the authors were able to establish how well AM Best performed in identifying the increased risk of failure from particular causes. They reasoned that early identification of an increased risk would result in a downgrading, and the percentage of A+ to C- ratings should fall as the time of failure approached (see figure 2).

    It showed that failures due to inadequate pricing/reserving and significant changes in business were anticipated well before the insurers actually failed and were reflected in rating downgrades. Failures due to rapid growth and reinsurance failure were also clearly identified, but only in the year of failure. Not surprisingly, failures due to catastrophes, over-stated assets and alleged fraud were not well identified and did not result in significant ratings downgrades.

    By acting as an early warning system, IFSRs have been credited with reducing the number of insolvencies. However, they are only as good as the information (both quantitative and qualitative) upon which they are based. And, as the discussion paper noted, some causes of failure are easier to anticipate than others.

    Greater awareness
    It is important to bear in mind that preventing every failure is not an optimal solution. There are good reasons for wanting to prevent failures, but in a free market it may be healthy to let some insurance companies go to the wall. The FSA has also made it clear that it does not aim to prevent all failures, since this would necessitate so much regulation, at such a cost, that it would probably not be in the interests of policyholders or the UK insurance industry.

    Clearly, the failure of an insurance company is often down to more than one cause. For instance, under-pricing is often connected with rapid expansion, entry into new areas or delegated underwriting. Moreover, in some areas, there is little that can be done to prevent failure. If someone is determined to defraud the company, there is always a way of doing so, no matter what regulations are put in place. However, greater awareness of what can go wrong and what the danger signs are, such as rapid expansion or uneconomic prices, can help to reduce the number of insolvencies, by triggering more prompt action on the part of regulators, management and shareholders.

    Management has a key role to play in minimising failure. In this context, it is worth quoting from Warren Buffett's letter to Berkshire Hathaway shareholders in the 2001 annual report on his three key principles for running a successful insurance business:

  • "They accept only those risks that they are able to properly evaluate..."
  • "They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency."
  • "They avoid business involving moral risk: no matter what the rate, trying to write good contracts with bad people doesn't work."
  • If all managers of insurance companies followed these principles, we would have far fewer insolvencies, but sadly the world is not a perfect place.

    By Roger Massey
    Roger Massey is a manager in Ernst & Young's Property & Casualty Actuarial Group.