Financial Markets and Institutions
The fundamental principles of an insurance company
1. Type of insurance
2. The fundamentals of the insurance business
3. The structure of an insurance company
4. Reinsurance market spirals
5. Other way to generate value
6. Competition
7. Regulations
8. Systemically Important Financial Institution
Abstract
Insurance companies provide insurance policies that are legally binding contracts.
Insurers provide economical protection from identified risks occurring or discovered within a specified period.
According to the insurance contract, the insurance company or only "insurers" promise to pay specified sums contingent on the occurrence of a specified future event or events, such as debts or an automobile accident.
Insures are risk bearers. They accept or underwrite the risk in return for a fee, referred to as the policyholder's insurance premium.
With the funds available to invest from the premiums received, Insurers are vital participants in a country's economy as suppliers of risk management products and significant investors.
They provide investment-oriented products and are considered Systemically Important Financial Institution (SIFI) representing a significant player in the global financial markets; they raise concerns that could eventually pose a significant systemic risk.
The article intends to constitute an overview of the Insurance companies.
1. Types of insurance
There are different kinds of insurance policies that insurance companies may issue:
- life insurance
- health insurance
- property and casualty
- liability insurance
- umbrella insurance
- disability insurance
- long term care insurance
- strict tourist sentiment.
Umbrella insurance
Apart from the most obvious on the list above, particular mention deserves the umbrella insurance; they are pure liability coverage, over and above the content provided by all the policies beneath it, such as homeowner, automobile, and boat policies.
The name came to the fact that they cover liability claims of all the policies underneath it.
In addition to providing liability coverage over the limits of the underlying policies, they provide coverage for claims excluded from other liability policies, such as the invasion of privacy, libel, and false arrest.
Typically, users of umbrella policies have many assets that would be placed at risk in the event of a catastrophic claim.
Structured settlements
However, the industry knows also what is called structured settlements; those are fixed, guaranteed periodic payments over a long period, typically resulting from a settlement.
To settle the suit, the insurance company may purchase a life insurance company's policy to make the agreed-on payment.
Property and Casualty
Varied are also the property and casualty, and the most common are:
- Automobile: coverage for personal injury, automobile damage sustained by the insured, and liability to third parties for losses caused by the insured.
- Homeowners insurance: covers the house and other structures on the property and personal possessions inside the house, against a wide variety of perils, including windstorms, fire, and theft.
- Homeowners: insurance also covers additional living expenses (the cost of living elsewhere while the house is being restored after a disaster) and accidental injuries caused to third parties and or their property. Coverage for flood and earthquake damage is excluded.
- Workers' compensation: coverage for benefit payments to employees for work-related injuries, deaths, and diseases, regardless of fault.
- Commercial multiple perils: package coverage, including most property and liability coverage except workers' compensation, automobile insurance, and surety bonds.
- Professional liability: covers physicians, surgeons, dentists, hospitals, engineers, architects, accountants, attorneys, directors, and other professionals from liability arising from error or misconduct in providing or failing to provide professional service.
- Fire and allied lines: coverage for fire, windstorm, hail, and water damage (but not floods).
- Inland marine: range for a property that may be transported from one place to another, as well as bridges, tunnels, and other instrumentalities of transportation.
- Ocean marine: coverage for ships, cargos, and freight.
- Accident and health: cover loss by sickness or accidental bodily injury, including disability income insurance and accidental death and dismemberment insurance.
- Fidelity insurance: protects employers for loss due to embezzlement or misappropriation of funds by an employee.
- Surety insurance: a three-party agreement in which the insurer agrees to pay a second party or complete an obligation in response to the default, acts, or omissions of an insured.
2. the fundamentals of the insurance business
Before agreeing on the terms and conditions of a policy, insurers must decide which applications for insurance they should accept and which ones to reject.
This process is called the underwriting process.
Instead, the insurance process determines how much to charge for the insurance if it accepts the application, called policy pricing.
Once policies are in place, the companies collect the premiums to make the payment eventually later, if the event occurs, for this proper reason, the insurance maintain the premiums collected in an investment portfolio that generate a return.
Consequently, an insurance company’s profits result from the relationship between its revenue and its costs. The fact that the payment is contingent on potential future events makes the profit challenging to calculate.
Although actuaries can predict the pattern of a broad portfolio of insurance policy, making the aggregate data more predictable using a standard actuarial basis, nowadays, the prediction is even more accurate with our ability to manage and present big data.
3. the structure of an insurance company
For what we have stated above, an insurance company is generally compose by three main functions:
1. Manufacturer and Guarantor
2. Investment company
3. Distribution component
this independently from its corporate structure, they could be part of the same corporate structure or separated in different companies.
The manufacturer and the guarantor design the insurance contract and provide the baking for the financial guarantees on the contract. They also ensure that the policy holder will pay off in case the event occurred.
Instead, the investment division generate value investing the money collected within the premium.
Finally, the distribution is the side of the business that sale the policy into the market, doing so can use different channel:
- Agent associated with the insurer
- Brokers not associated with the company
- Brokers operated in group, called producer group
In the modern era the manufacturers for a most do not sell their products directly but trough broker non associated or, produced group.
For concluding this brief description, is important refer to the fact that very often most of the line of product reinsure some or all the liabilities they incur in providing insurance.
Companies established for that purpose are called reinsurance companies or reinsurers, in this scenario the initial insurer transfer the risk of the insurance policy to the reinsurer, in the so-called spirals.
4. Reinsurance market spirals
The primary function of the spirals is to mitigate the exposure of an insurance company to failures.
Often the operation consists in purchasing sufficient reinsurance to protect accounts against known exposures, or an irrational premium structure, as it happens in the catastrophe reinsurance and retrocession markets for example.
In a normal situation when an insurer or reinsurer makes a claim on a reinsurance policy it has purchased the recovery does not lead to any further claims on that insurer.
In an insurance market spiral, however, claims made by reinsurers at one level result in the same reinsurers receiving additional claims under reinsurance policies that they have written.
In practice spirals are most likely to occur when reinsurers provide cover for each other on similar lines of business, In these conditions the reinsurance claims generated from insured losses in excess of the primary insurers’ and reinsurers’ deductibles are passed on in full, and continue to recirculate until some reinsurers run out of cover.
These conditions applied to syndicates at Lloyd’s and many other members of the London Market since second half of the 1980s: they participated in both direct and reinsurance business, and provided mutual reinsurance and retrocession cover for each other, with the result that claims arising from the same loss event were passed to and trough the group.
As result Insurance spirals serve to concentrate, rather than disperse, risk.
Finally, the capacity of an insurance market for risk can be measured by the sum of the deductibles of the insurers and reinsurers in the market regarding that risk.
However, because the spiral inflates the level of gross claims, the level of reinsurance required to achieve this may be very high; and if outside insurers are less willing to provide high layers of cover than insiders, the end-result is that insiders will be left to carry the residual losses.
The effect of a spiral on the probability of loss is complex but, in any case, is existence modifies the normal relationship as regards the probability without changing necessarily the premium structure.
5. Other way to generate value
In other to generate more value along the complex business that is represented by the insurance, some time the insurers decide to retain certain risk, and insure against these risks.
Most of the time the operation describe above is design by creating a purpose vehicle called captive insurance companies.
These insurers provide to their owners a form of self-insurance and can provide for insurance protection against any-types of commercial risk.
In U.S.A., the majority of Fortune 500 companies has established captive insurance companies, and around the world there are about 5000 captives, even government can establish a captive.
A vivid example: the government of China has created a captive marine and cargo specialist to established captives for a few of its state-owned enterprises.
There are several types of captives:
- Single parent captives
- Association captives
- Industry captives
- Diversified captives
Single parent captives provide the captives provide pure self-insurance for the parent company that created them.
Association captive are created by a trade association or members of an industry to provide insurance coverage for their members. Typically, association captives insure against liability risks, such as medical malpractice lawsuits.
Industry captives are created by a group of industry to deal with a specific insurance problem face by the industry it-self, example is captive vehicle created to provide employ benefit for international workers.
6. Competition
Insurance markets are highly competitive both as to price and service, many insurers sell relatively homogenous products, there are modest barriers to entry, minimal economies of scale, and low levels of market concentration.
Insurers compete for business on the basis of price, financial strength, availability of coverage desired by customers (servicing specific customer groups or needs, or offering a degree of customization that is of value to the insured), and quality of service, including the quality of the claim adjustment service.
7 Regulations
Since the end of nineties there is an effort to regulate the insurance market globally, the International Association of Insurance Supervisors (IAIS) has created a voluntary membership representing insurance regulators and supervisors form 140 countries that make up 97% of the world’s insurance premiums.
IAIS has two objects:
- Promote effective and globally consistent supervisionof the insurance industry in order to develop and maintain fair, safe and stable insurance markets for the benefit and the protection of policyholders and to
- Contribute to global financial stability
To achieve is result adopt a strategy compose by three actions:
- Establishing: principles, standards, and guidance for effective insurance supervision.
- Promoting: implementation of its supervisory principles and standards by international organizations, regional groups, and supervisors.
- Playing: key role in financial stability issues, which includes developing a methodology for the identification of global systemically important insurers and policy measures to address their systemic risks.
However, we still distinguish several regulatory regimes around the globe, below the once closer to our experiences:
- U.S. regulatory system
- E.U. regulatory approach
- U.K. new strategy
U.S. regulatory system
Regulation of U.S. insurers is governed by McCarran-Ferguson Act of 1945, which grants states the right to regulate business of insurance.
Furthermore, there is a state-based regulatory system of insurers. Insurance companies whose stock is publicly traded are also regulated by the SEC.
The current state-based regulatory system has an insurance department that is either part of a state financial regulatory department or an independent state agency.
The head of the insurance regulatory department, typically referred to as the insurance commissioner, is either appointed by the state’s governor or elected.
Taking as example, the state of New York, the insurance Division is part of the state’s department of Energy, Labour and Economic Growth, and the commissioner is appointed by the governor.
Insurance regulation deals with solvency regulation and consumer protection.
Insurance companies file an annual statement, prepared based on Statutory Accounting Principles (SAP), with each state in which they are licensed as well as with the National Association of Insurance Commissioners (NAIC).
These monitors watch the financial stability of the insurance companies based on the level of synchronicity between the premiums and insurance policy payments and the volatility of the payments.
Base on those data insurance company are typically rated by credit rating agencies (e.g. Moody’s, standard & Poor’s, A.M. Best Company, Fitch) with respect to both their ability to pay claims and their outstanding debt, if any.
Equity analyst who work at investment banks and broker dealers also evaluate the attractiveness of the outstanding common stock of publicly traded insurance companies.
EU regulatory approach
The first insurance regulations for members of the European Union were enacted in 1994, the primary concern of the regulation was protecting the consumers by focusing on insurance products and pricing policies.
Instead the last regulation Solvency II, January 2016, completes the framework by replacing 14 directives, within the principal objectives of:
- Give policy holders great confidence in the products of insurers
- Harmonize regulatory regimes
- Modernise supervision
The “Supervisory Review Process” required by Solvency II directive shifts the focus of regulators from compliance monitoring and capital to evaluating the risk profiles and the quality of insures’ risk management and governance systems.
Solvency II has an extra-territorial impact into these four categories:
- Non-EU subsidiaries of EU groups
- EU subsidiaries of non-EU groups
- Recognition by EU insurers of reinsurance purchased from non-EU reinsurers
- Non-EU countries that will eventually adopt a new capital and regulatory regime like Solvency II
Non-EU Subsidiaries of EU groups
The EU groups are required to calculate consolidated Solvency II results covering their global insurance business, including their overseas operations.
This requires either
- the application of all Solvency II detailed calculations to that non-EU business or
- that the subsidiary be in a jurisdiction whose own regulatory regime has been certified by the EU to be equivalent to Solvency II.
In the latter case, the EU group will be able to use the subsidiary’s local capital position.
Equivalence to Solvency II
The notion of “equivalence to Solvency II” is used in three distinct areas in the Solvency II regulations:
- Equivalence of reinsurance supervision
- Consolidating non-EU subsidiaries into EU group Solvency II
- Reliance on group supervision from outside the EU
A country assessed with respect to equivalence need not ‘go for’ all three, and the verdict may indeed be different across the three for a single country for its European parent.
It will effectively have an additional reporting basis, on top of its local statutory, IFRS or US GAAP, tax, and internal bases like embedded value (EV).
Where the local regime has been judged equivalent for the purposes of the consolidation
- Switzerland has a national solvency regime that is conceptually like Solvency II but takes a technical approach that is materially different from Solvency II in some areas, illustrating the focus on regulatory outcomes in the assessment.
- Bermuda sets an interesting precedent for the bifurcation of an equivalence decision, in that the Solvency II equivalence determination excludes the rules applicable to captives and special purpose insurers. This illustrates the targeting of an equivalence assessment at the most relevant segments of a national market.
- The United States of America has signed a bespoke bilateral agreement with the EU that falls outside the Solvency II equivalence framework.
However, in its July 2019 Communication on Equivalence in the Area of Financial Services, the European Commission reiterates the flexible, unilateral and, most importantly, discretionary nature of the equivalence assessment, stating, for example, that “third-country regimes do not need to be identical to the EU framework, but they do need to ensure in full the outcomes as set out in that framework” and that “as part of its discretion the Commission may decide to formally adopt, suspend or withdraw an equivalence decision, as necessary”.
For UK following Brexit any future equivalence assessment will inevitably be carried out in the context of many factors beyond the technical and outcomes alignment of the UK regime with Solvency II, including, for example the perceived impact of the UK on the EU industry, and potential financial stability implications.
Insurers and Global SIFIs
The Financial Stability Board, in consultation with the International Association of Insurance Supervisors (IAIS) and national authorities, began identifying global systemically important insurers (G-SIIs) since 2013.
However, The AIG debacle was the opportunity for the insurers to reflect on their impact on the market and understand the fact that they represent a systemic risk.
The definitions were meticulously analysed in The Geneva Association Systemic Risk in Insurance (SRI) reports and has been crafted by the Financial Stability Board (FSB) and the International Association of Insurance Supervisors (IAIS).
The SRI reports identifythe criteria of size, interconnectedness, substitutability, and timing as the components to examine insurers’ activities for the identification of potentially systemically risky activities.
The case
AIGFP was not regulated by insurance regulations but by the Office of Thrift Supervision (OTS), that soon after the collapse admitted their inability and incapacity to regulate a sophisticated unit such as the AIGFP.
The OTS did not recognize the risks inherent in AIG’s sales of credit default swaps, and did not understand its responsibility to oversee the entire company, including AIG Financial Products
The complexity of AIGFP was the fact that the group was selling credit default swaps (CDSs), unregulated product, and carrying the securities lending activities, investing in mortgage-backed securities (MBSs).
Both activities in conjunction within the liquidity crisis, brought the company down.
AIGFP’s credit default swaps were the key factor to the AIG collapse, and created the needs of the government intervention for its losses in the financial derivatives markets, credit default swaps.
The bail out from the U.S. government was around the US$182 billion, and the case pinpoint areas that can generate systemic risks and clarify the chronicle of the demise in terms of its components.
The global regulators decide then to define indicators for Systemically Important Financial Institutions (SIFIs).
Since then, those macro factors have been integrated into any created regulatory framework:
- Use credit ratings with care and avoid exploitation of high ratings,
- Be aware of banks’ capital being replaced by new opaque financial products,
- Remove gaps in regulations and require transparency,
- Forbid companies to select their own regulatory bodies,
- Understand insurance vs. non-insurance or quasi-banking activities and products, and
- Create clarity to delineate between the banking and insurance models.
What happen to AIG proved the point, and the regulators noted that without surveillance and risk management, the market cannot protect the public at large in regard of the insurance products.
In January 2011, the National Commission on the Causes of the Financial and Economic Crisis in the United States’ Report:
“AIG’s failure was possible because of the sweeping deregulation of over-the counter (OTC) derivatives, including credit default swaps, which effectively eliminated federal and state regulation of these products, including capital and margin requirements that would have lessened the likelihood of AIG’s failure. The OTC derivatives market’s lack of transparency and of effective price discovery exacerbated the collateral disputes of AIG and Goldman Sachs and similar disputes between other derivatives counterparties.”
Since then, the market has been evilly regulated and more attention has been placed on the supervision activities to prevent systemic risk.
October 2020
by Daniele Lupi