By Ralph Savage
At a time when regulators are pondering the ‘too big to fail’ question, Standard & Poors has issued a timely reminder of the reasons so many insurers have hit the wall during recent decades.
Poor liquidity, under-pricing, under-reserving, and management and governance issues are among the main recurring issues that have caused, and still are causing, the failure of rated and unrated insurers, according to the report published by S&P.
With the catchy title, “What may cause insurance companies to fail; and how this influences our criteria,” the report explains how S&P’s observations, from the 1980s onward, of how and why insurers may fail, have informed its ratings criteria for insurance companies.
For example it makes reference to the high profile failure of Independent Insurance, which resulted in custodial sentences for three of its directors, explaining: “The 2001 failure of Independent Insurance in the U.K. also reflected problems associated with rapid growth and inadequate governance, and ultimately fraud. Growth was achieved through underpricing, followed by under-reserving overseen by a dominant chief executive. The uncertainty surrounding the adequacy of reserves was exacerbated by claims that were suppressed from the company’s systems, which in turn affected actuarial projections of claims development. Reinsurance irregularities were another problem. The company also had a history of price undercutting and reserving issues.”
“When we refer to insurer failures, we mean company defaults, liquidations, or regulatory takeovers, or “near miss” situations where such events would have occurred if the company had not received external support,” said Standard & Poor’s criteria officer Michelle Brennan.
“Since the 1980s, we’ve seen waves of failures that have informed our criteria developments. From the cases of distress or failure that we’ve observed over this period, one or more of a set of common key factors was present, and often these factors reinforced each other.”
These key factors are:
- Poor liquidity management;
- Under-pricing and under-reserving;
- A high tolerance for investment risk;
- Management and governance issues;
- Difficulties related to rapid growth and/or expansion into non-core activities; and
- Sovereign-related risks.
Liquidity issues, spurred by problem assets and heightened by weak liability structures in times of stress, have historically been a main cause of insurer failure, said S&P. However, it added that even with improvements in how companies manage liquidity and reserving, management and governance issues continue to prompt insurance distress, and under-pricing and managing rapid growth remain key risks.
“Our observations of insurer failures have informed our criteria over the past two decades including our new insurance criteria published on May 7, 2013. For example, support – whether from another part of a group or from a government body – has, in our opinion, prevented the failure of several distressed insurance companies over the past decade. Assessing the likelihood of receiving such support is therefore a crucial feature of our rating methodology.”
More idiosyncratic causes of failure, such as specific issues with management and governance, are the focus of S&P’s criteria for assessing the effectiveness of management and risk management structures. In compiling its revised Group Rating Methodology, it considered cases where subsidiaries collapsed or where it thinks they would have done so in the absence of group support.
By contrast, past insurer failures and distress also indicate how insurers can attain stronger creditworthiness. The insurers that performed best in times of systemic stress share notable common attributes; robust franchises, solid liquidity management, and good capitalization are all characteristics of the most resilient insurers, said S&P. “These companies also display strong underwriting and reserving policies, competitive cost structures and investment returns, and prudent risk management structures and risk appetite.”