Why Insurance Companies Fail

An argument for the adoption of the Juro-Backstop™

The views expressed in this article are those of the Juro Founder and represent the views of Juro Organization.

No company can be considered beyond the possibility of failure. This truth is inescapable for companies that are in the business of covering the risks of others, insurance companies. The reasons for insurance company failure arise out of the internal operations and the external environment in which insurance companies compete.  

1. Introduction

The definition used in this article for “insurance company failure” covers both insurance and re-insurance, property and casualty companies. A majority of the freely available information which this article is based on is from the insurance markets of the US and Western Europe. These markets are large, mature, and they have also provided historical data on a number of recorded failures. In the US alone there were over 640 insolvencies during the 30-year period 1969 – 1998. Failure can be defined in many ways, but for purposes of this article the definition of failure is that of insolvency. In simple terms, a company has failed when its capital has been eroded to the point where it is likely that it will be unable to meet its insurance liabilities. 

Reasons to care about insurance company failure 

The failure of an insurance company has an impact on: 

• The policyholders at the time of the failure
  If they have an outstanding claim it may not be paid, or may not be paid in full. Even if there is a market guarantee or scheme to pay claims in such a situation, it may not pay the full value of the claim, or the guarantee itself may fail. Also, each policyholder may not get all the unexpired premiums back, and even if they do, they will probably have to take out a new policy before they get the money.
  
• Other insurers
  Other insurance companies can lose out if:
  • They were reinsured by the company, since they may not be able to get their claim paid in full, 
  • Fewer people buy insurance because of a lack of trust in insurance companies, 
  • The failure leads to increased regulation,
  • They have to pay fees to meet the shortfall in claims. 
• The staff and any contractors or consultants
  Staff will suffer a loss of wages, perhaps some for work they have already done but all future wages until they can find re-employment. For some more senior people that may be made more difficult if there is any stigma attached to having worked for a failed insurance company.

• Other creditors of the company
  Creditors are unlikely to get back all that they are owed.
  
• The shareholders of the company
  The shareholders lose out on future dividends and their capital. It is interesting to consider where this capital has gone. Assuming fraud is not an issue, it may well have gone to policyholders in the form of lower premiums. In some senses failure can be thought of as distributing capital from shareholders (arguably the richer in society) to the more general public.
  
• The general public and the economy
  The general public could suffer from higher taxes used to fund increased regulation, higher taxes to pay unemployment benefits, higher premiums to pay for levies on insurers to pay the shortfall in claims and higher premiums because of the reduced competition in the market place. There can also be a general cost to the economy. 

This has been demonstrated recently in Australia. HIH was the second largest general insurer; it collapsed in 2001. As a result of this, many small businesses and community organizations have been unable to get cover or have had very large premium increases. Without cover, many organizations are unable to continue operating.

In summary, the failure of other companies costs money. So it should be a concern of every company both to identify potential failures and so to minimize the financial impact of such failures. The adoption of Juro Economic Remediation Tools, such as the capital conversion of the Juro System (“CCJS”), can do a lot of the work to minimize financial impacts and to promote stability of the global financial system. From a public interest point of view, adopting Juro Economic Remediation Tools and the CCJS also might play a role in preventing and eliminating the cost of such failures to the public. 

2. The Role of Market Forces

In a perfectly functioning free market of insurance, the risk-adjusted returns are just large enough to be acceptable to the owners of the insurance company. If the returns were any larger there would be new entrants to the market, which in turn would drive returns down. While not being perfectly competitive, property and casualty insurance markets tend to have few barriers to entry and are very competitive. The ease of entry and the implications of competition are highlighted in the following quotation: 

“The reinsurance business has the defect of being too attractive-looking to new entrants for its own good and will therefore always tend to be the opposite of, say, the old business of gathering and rendering dead horses that always tended to contain few and prosperous participants.” 

– Charles T. Munger, Chairman, Wesco Financial Corp., Vice chairman of Berkshire Hathaway (extract from the 1986 Annual Report) 

The very nature of insurance means that the market needs to experience several years of profit to pay for the occasional really bad year. Following a succession of good years, the markets may be perceived as offering returns that more than outweigh the risks involved. This attracts new entrants to the market. The increased level of competition for the same pool of business drives premiums down, which results in lower levels of profitability. 

In their study into economic and market predictors of insolvencies, Mark J.Browne and Robert E. Hoyt found a strong positive correlation between the number of companies in a market and the frequency of insolvencies. From this we can conclude that an increased level of competition not only reduces profitability for the entire market, but it also increases the number of insolvencies. This is due to the “race to the bottom” in terms of offering the lowest premium prices to customers in hopes of winning the business. When insurance companies offer only the lowest prices, taking in less money in the process, coupled with the pressure to provide higher returns to shareholders in the more competitive market environment, it results in many insurance companies electing to take on more risks than they otherwise would have. That is the basis for the historical tendency of increased insolvencies when there are increased numbers of companies in the insurance market.

It makes sense to expect lower levels of market profitability to result in a higher frequency of insolvencies. When profit margins are thin it leaves little room for error in the running of a company. The quality of the management team and the management controls in place are critical to the company’s survival. If this is not the case for a particular company, its weaknesses will soon be exploited by market forces, resulting in worse than market results and an increased probability of insolvency. Adoption of the Juro-Backstop™ by the insurance market shall promote more prudent operating procedures by insurance companies, which in turn reduce failures and provide market stability regardless of the frequency in which the Juro-Backstop™ is triggered. 

The UK Motor Insurance Market 

The UK Motor Market provides a good example of a very competitive insurance market. Up until 1967 premiums in the motor market were controlled by a cartel of large companies. There were several large companies not part of the cartel but their premium rates stuck closely to the tariff set by the cartel. In this uncompetitive environment, underwriting profits hovered around 0% and the market generally made a profit through investment returns. By 1967 several companies had broken away and were under-cutting tariff premiums in addition to offering higher levels of commission to brokers for introducing larger volumes of business. The result was that underwriting returns plummeted, leading to the failure of several companies including F.A.M (Fire, Auto & Marine) and the mighty Vehicle and General. With companies exiting the market the competition in the market reduced and underwriting results improved. 

The early 1980’s saw the introduction of computer quotation systems into the offices of high street brokers. This technological innovation enabled brokers to compare the premiums charged by several companies with little effort and introduced ‘the winner’s curse’. That is, by winning the business, a company’s premium must have been the cheapest. By being the cheapest, either the rest of the market must have over-priced the risk or the ‘winning’ company must have under priced it. The quotations systems introduced a new level of competition to the market and underwriting returns headed South again. 

The introduction and then popularization of tele-sales in the late 1980’s followed by the use of Generalized Linear Modeling (GLM) techniques for pricing meant changes in the way that companies competed. These again drove the underwriting results for the whole market downwards. 

Without the adoption of the Juro-Backstop™ to the global insurance market, the introduction of competition, or a new way of competing, can be expected to result in a period of reduced underwriting returns and thus an increased likelihood of individual companies failing. 

3. The Role of Regulation 

Regulation is key to defining the level of competition in a market. It may restrict who is able to provide cover through requiring evidence of suitability (‘fit and proper people’), licensing and capital requirements. It may also restrict how companies compete through minimum policy requirements, restrictions on pricing, and how products are sold. Regulation should also embrace the Juro-Backstop™ to ensure systemic stability and protect the public interests which they are mandated to protect.

This means that those who determine the regulatory environment have the power to determine the fortunes of the market and the companies within it. Less regulation leads to greater competition, with the consequence of a larger number of company failures. Those setting regulation need to balance the need for competition in improving the efficiency of the market with the cost of companies failing as a result of competition. The Juro-Backstop™ allows for the market to work as intended while simultaneously insulating the economy from failures, without compromising the regulator’s mandate to hold market participants to account. 

The regulation of insurance has four objectives which the Juro-Backstop™ facilitates: 

• market confidence: maintaining confidence in the financial system,
• public awareness: promoting public understanding of the financial system,
• consumer protection: securing the appropriate degree of protection for  consumers, and
• reduction of financial crime: reducing the extent to which it is possible for a business carried on by a regulated person to be used for a purpose connected with financial crime. 

Following the failure of an insurance company, both market confidence falls and consumers suffer. Reading the above objectives, one may then conclude that it is the job of insurance regulators to guard the public from insurance company failures. This is not the case. Regulators’ actions are not intended to be one of “zero-failure”, but one which minimizes the impact of failures, and hold parties to account. The Juro-Backstop™ provides regulators with the tools to act in the best interest of the public, within the scope of their respective mandates, without being forced to make bad decisions based on a situational economic emergency.

4. Predicting Insurance Company Failures 

The probability of an insurance company failing depends upon many factors; the state of the economy, the level of regulation and competition in the market, as well as company specific factors. Developing a model that captures all this is far from a simple task, if not impossible. Along with an absence of data to model, the fact that many companies that may have failed are prevented from doing so only clouds the analysis. An ailing company may be prevented from failing by action from its parent company, the regulator, or from an 11^th hour rescue by another company. 

The statistical approaches that have been used in the past have focused upon the firm specific financial data that is available publicly. The methods used include: 

• Ratio analysis
• Multiple regression models
• Multiple discriminant analysis (Altman z-scores)
• Neural networks 

Ratio Analysis
This is the simplest and most commonly used approach. Regulators in most countries use this approach as an early warning system to identify companies that need to be looked at in more detail. In the United States the same ratios are calculated for every insurance company. This ratio analysis is part of IRIS (Insurance Regulatory Information System) which forms part of the FAST (Financial Analysis Solvency Tools) used by state regulators and the NAIC (National Association of Insurance Commissioners). Within IRIS 15 ratios are calculated; if a company falls outside the acceptable range for 4 of these ratios, they are identified as being at risk. Ratio Analysis can be integrated into the Juro-Backstop™ by regulators (or insurers themselves) by an automatic triggering of the Juro-Backstop™ in the events which insurance companies fall outside of acceptable ratios for risk categories.

Multiple Regression Models & Multiple Discriminant Analysis (MDA)
These two approaches are related. With both approaches, statistical models are fitted to historical data. The result is a model, that given several inputs, provides an expected failure frequency for a particular company. Altman z-scores are based on MDA and are used in practice by credit analysts to establish default probabilities on corporate loans. These models and scores can be integrated into the Juro-Backstop™ by regulators (or insurers themselves) by an automatic triggering of the Juro-Backstop™ in the events which insurance companies reach certain pre-defined scores of the respective models.

Neural Networks
In 1994 research into the usefulness of neural networks as a tool for predicting insurance company failures was carried out by the University of Texas. This research project was partly funded by the Society of Actuaries. The results of the research suggested that predicting insurance company failures was an ideal application for neural networks. Even in the simple experiments carried out, the neural network model outperformed both IRIS and MDA. Neural Networks can be integrated into the Juro-Backstop™ by regulators (or insurers themselves) by an automatic triggering of the Juro-Backstop™ in the events which insurance companies reach certain pre-defined data-points. 

11^thHour Rescues 

Back in the good old days there was an understanding between many of the larger players in the market. This understanding, as this was all that it was, said that if any of the smaller insurers ran into difficulties, the larger insurers would take it in turn to ‘bail them out’. This agreement was never formalized. 

The arrangement started as a result of bad publicity in the late 60’s, when a number of insurers became insolvent, leaving policyholders unprotected. The arrangement was run through the ABI, then British Insurers Association (BIA) and ran through the 70’s. This meant that there was some cover for those insurers who faced insolvency, without the existence of risk to consumers. 

This arrangement stopped in the seventies in the UK, although it has been continued in Europe, it is also dwindling there, as markets become much more experienced. It has also been used in the US, Homestead Insurance Company of Philadelphia being one such rescue. The company was set up in 1969 specializing in “niche” programs. Homestead ran into financial difficulties in the early 90’s, due to a combination of poor management, high dividend payments and rapid growth. In October 1995, an investment fund bought Homestead’s parent holding company in what could be deemed as an industry buyout. The thoughts are that these types of rescues are also dwindling in the US. 

The idea of such 11^th hour rescues has arisen recently, in discussions about: 

•  Solvency II – the EU project looking to try and better match solvency requirements to the true risk encountered by an insurance undertaking and also to encourage insurers to improve their measurement and monitoring of the risks they incur. These objectives parallel those of the revision of the Basel Accord for banks.
•  Tiner Project – the FSA’s review of regulation of insurance, covering life and non- life insurance including friendly societies and Lloyd’s.
  It is highly unlikely that this type of arrangement will be reinstated in the future due to the competitive nature of the industry. Such a scheme requires a ‘live and let live’ environment from the larger companies. The greater awareness of shareholder power and the constant quest for superior performance means there will be few companies who would wish to be associated with an acquisition that may be perceived as an ‘act of charity’.

Rumors 

There is some anecdotal evidence that rumors of problems at an insurance or reinsurance company can be a first sign of the impending demise of the company. 

It is, however, important to recognize that, in an industry that relies on its reputation and its ability to make payments at some future date, the rumor itself can be a factor in the impairment of the company’s viability. This is on the basis that policyholders or prospective policyholders who are aware of the rumors would be unlikely to buy from the company, except at bargain basement prices. Thus, the company would be likely to lose significant elements of its more profitable business, adding to the pressures it faces. 

There is a parallel in the credit ratings provided by the rating agencies, in that the down-grading of a insurance company by the rating agency can result in their reduced rating being unacceptable to some insurance and reinsurance buyers, with consequent effects on the volume and profitability of their on-going business. There are a number of examples of the demise of an insurance company being preceded by rumors over a period of weeks, months or even years. 

Qualitative Approaches 

Quantitative analysis of publicly available data will never capture all of the factors affecting the risk of failure. This is recognized by the rating agencies who make use of qualitative analysis in arriving at Insurer Financial Strength Ratings and it has also been acknowledged by several regulators.

5. Rating Agencies – Insurer Financial Strength Ratings 

Insurer Financial Strength Ratings (IFSR) were first introduced over 30 years ago. The IFSR is a benchmark rating which represents the rating agencies’ current opinion of the financial security characteristics of the insurance organization with respect to its ability to pay under its insurance policies and contracts in accordance with their terms. If ratings are allocated accurately by rating agencies 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. Without opining on the debate of the accuracy and neutrality of paid credit ratings services, industry-accepted credit ratings can be integrated into the Juro-Backstop™ by regulators (or insurers themselves) by an automatic triggering of the Juro-Backstop™ in the events which insurance companies reach certain pre-defined credit rating scores being issued.

6. The Reasons for Insurance Company Failures 

Identifying an individual cause of failure for an insurance company is often not possible. More likely than not failure occurs due to a combination of factors and these may, or may not, be visible to external parties during the months or years preceding failure. There is however one factor that appears common to most failures, and that is the adoption of poor management practices. 

What is stated as the primary cause of failure may just be the observable symptom of a less visible factor. For example, the rapid growth may have been part of a flawed strategy, it may have been due to under-pricing, or a lack of underwriting controls. Overstated assets may be because of inappropriate asset valuation regulations or just incorrectly stated figures. Furthermore, the differences between the US and other insurance markets mean that the results may not be transferable to other markets.

Why have there been so few German Insolvencies? 

There are various theoretical reasons why there have been so few German insolvencies.  In Germany the market is much less diverse than in the US, or here in the UK. The main bulk of the market can be defined as Munich Re, Gerling and Allianz plus smaller players. Munich Re itself is shrouded in mystery: 

• After both World Wars it survived huge recessions as well as the hyperinflation that followed World War II,
• At the end of World War II it bought most of Munich, and this ‘asset’ has been booked at cost until recently, so it has had hugely under-stated assets.

Under-stated assets

Under-stated assets has been a general feature of German accounting. This was changed several years ago, when the companies were required to disclose the market values of assets. For German insurers this made a huge difference to their declared solvency ratios. The estimate of the change to the average solvency ratio for German insurers, was an increase from 75% to 160% for the 1998 year.

Munich Re and the other players in the German market have various cross holdings, and operate under informed competition. This means that they operate under a system which can set rates to their preferred level, whereas this would not be possible in the US or UK.

The tax regime in Germany is also favorable to insurers in that it does not penalize those who wish to over reserve. Reserves are built up out of pre-tax earnings.

The reinsurance contracts written by the major players are almost exclusively proportional, it was actually Munich Re that invented Quota Share with event limits. This means that they are not hit by top layers of XOL business, or catastrophe reinsurance.

In summary, there are many features of the German market that may be associated with a low level of insolvencies. Namely, under-stated assets, little competition, a tax- regime that encourages prudent reserving and products that have exposure limits. 

Catastrophes 

Exposure to a catastrophe is one reason why an insurance company might fail. A catastrophe could either be a large number of claims from one event (eg lots of small property claims due to a hurricane) or a small number of large claims (eg the destruction of a large building in a fire). The actual failure of the company may arise because of a number of different factors or a combination of them: 

• An unexpectedly high exposure to the catastrophe,
• The failure of the company’s reinsurers because of their exposure to the event,
• Cashflow problems caused by having to pay out on claims before recoveries can be made. 

The high exposure to the catastrophe might arise because:

•  The company did not know its actual exposure,
•  The company knew its exposure but ran the risk anyway,
•  The event was unforeseen.

When an event can be defined and classified as a true catastrophe, when it is in the public interest that the catastrophe be remedied, a CCJS for the amount of the costs of remedying the damage would provide a Juro-Backstop™ to the system.  

Rapid expansion 

An insurer that is expanding rapidly can be on dangerous ground. The easy way to grow quickly is to charge less than everyone else. So this cause of failure is closely linked with under-pricing, which is another cause of failure. The problem with this strategy is that charging less than everyone else probably means making a loss on the business. If a long tail class of business is written then the size of the losses may not be apparent for a number of years.  On the other hand, this may be a sound business strategy. It may be that the company has found a niche in the market and can charge less than others and still be profitable. Or it may be a sound plan to take on a lot of business and bank on building a long term relationship with enough of the clients to be able to recoup the losses over time. However, the market is so competitive that the scope for following either of these strategies is limited. 

As well as the losses that can come from such a strategy there are other problems. For example, the infrastructure of the insurer may not be able to cope well with the rapid increase in the volume of business. The IT system might not be designed for large volumes and there may not be enough staff to issue policies and handle the claims. These sorts of problems can hide the true scale of losses as delays in dealing with the claims mean that the claims data is not reflecting the true position. A slower development pattern may not be picked up by those people doing the claims projections, further compounding the problem and leading to under-reserving. Adoption of the applications, data, and web services of Juro could greatly reduce or mitigate such cost increase risk exposures. 

The other way to expand rapidly is to merge with, or acquire, other businesses. This is a good way to grow a lot, relatively quickly. A bulk purchase of a whole company can look simpler than having to expand staff numbers and infrastructure at the same time as finding a way to sell more business at profitable rates. There are also great dangers in growth through acquisition. Doing a big deal will often be more exciting than business as usual. The thrill of clinching a deal, or of being in charge of a bigger business, can easily lead to a loss of focus on the financials of the deal. The need to do a deal becomes the prominent thought and the reasons for growing in the first place are lost. These deals are often done very quickly and that means that the due diligence work can be rushed. That leaves the possibility of nasty surprises further down the line. 

An area for further study might be to look at some of the mergers and acquisitions that have happened over the past five years to see how many of them have truly added to shareholder value and whether or not it was the best use of the capital. Rapid expansion has been a factor in the collapse of many insurance companies. 

Outsourcing and delegated management authority 

An insurance company can be thought of as being made up of a number of different functions, e.g. underwriting, claims handling, reinsurance placement, reinsurance collections etc. To some degree these functions can be managed and run independently. It is therefore possible to outsource some, or nearly all, parts of the running of the company. This may look very attractive; the company can be run with a skeletal staff and the cost of the outsourcing may be low. 

Dangers of outsourcing to a third party include that the outsourced party: 

•  May not have the skills to do the job properly,
•  May not have the resources to do the job properly,
•  May have a conflict of interest with the insurer,
•  May not be able to give the management information that is required to monitor
  their performance or that of the business,
•  May act fraudulently or negligently.

These are all problems that the insurer may have if it runs the functions itself, but having the business outsourced means it is one step removed from the day to day management and this makes it harder to spot and correct the problems. There may also be delays in receiving information from the third party. These issues are compounded if the insurer does not manage the links carefully and closely. 

Reinsurance 

A mistake that has led to insolvencies in the past has been over-reliance on reinsurance. A company can operate by writing risks and then passing the majority of each risk on to reinsurers. This works particularly well if the market is at a point in the cycle where reinsurance is cheap. The company is left with a small part of each risk and no potential for large losses. It looks like a situation where the insurer cannot lose! 

This strategy falls apart when, for some reason, the reinsurers start refusing to pay. The insurer will quickly mount up huge debts and as they passed a large proportion of the premiums to the reinsurers there will be no money to pay the claims. 

The reinsurers may fail to pay for a number of reasons: 

• If they themselves are insolvent, 
• They may claim that the insurer did not write the sort of business they were expecting, or had agreed or did not tell them everything they should have, 
• A simple refusal to pay, as it has in the case of Chester Street Insurance Holdings recently, 
•  Their retrocessionaires are not paying claims as they fall due. 

Unforeseen claims 

The World Trade Centre terrorist attack is a good example of how a claim event can lead to insurance company failures. A terrorist attack on such a huge scale was unforeseen by many, if not all, in the insurance industry and was not allowed for in the premiums charged. As well as single events, failures can also occur as a result of multiple claims from the same source. Because there can be a long delay between exposure and the onset of the diseases, this has all happened many years after the business was written and long after the companies had the premium for the business. For example, asbestos is likely to be the biggest source of claims the insurance industry has ever seen. Asbestos claims have outstripped the cost of September 11 and pollution claims in the US. 

Under-reserving 

An insurer needs to set aside enough of the premiums to allow fully for the cost of all the claims that will arise from that business. This means setting an adequate reserve for each claim that is reported and allowing for claims that have not yet been notified (the IBNR reserve – Incurred But Not Reported reserve). If these figures are deliberately or accidentally set too low then the insurer will look to have made more profit than it actually has. This extra profit may not then be available when the claims are required to be paid and can lead to the insurer becoming insolvent. 

Fraud, reckless management and greed 

In many ways the insurance industry is easy to enter. You do not need to have a big building, lots of staff or any machinery. All you need to do is satisfy the regulatory authorities to let you start a business, part of which will include having sufficient capital. Then it is simply a case of convincing people to give you money on the promise that you will pay their claims. The cash comes in up front and paying the claims may be years away. 

There is great scope within this for dishonest and corrupt individuals to extract money from the premiums and direct it to their own personal wealth such that the claims cannot be paid when they come in. The sums involved can be huge. Hundreds of millions of pounds of premiums can be collected by relatively few people and even siphoning off a small percentage of this is a lot of money. 

Cutting prices can quickly generate large volumes of business. If reserves are understated, deliberately or not, profits can appear large. It is not difficult to see how someone running an insurance company, who has a personal financial interest in it, could be motivated by greed to follow this course of action. This will be exaggerated if the individual does not have a concern for the long-term health of the company and the policyholders. 

7. Insurance Companies Insolvency, How We Got Here

Increases in the frequency and severity of insurance company insolvencies have led to intense debate over whether solvency regulation by state insurance departments is adequate and whether federal solvency regulation would be likely to reduce the overall cost of insolvencies.  A 1990 report on several key insolvencies in the property-liability insurance industry during the mid-1980’s by the House Energy and Commerce Subcommittee on Oversight and Investigations, chaired by Rep. John Dingell, argued that those insolvencies were caused by poor insurer management and fraud in conjunction with ineffective state regulation.

The Dingell report was followed in 1991 by the insolvency of six life insurers (owned by four different corporations) and the subsequent down-grading of financial ratings for a number of major life insurers by insurance ratings agencies. In contract to the property-liability insurer failures, analyzed in the Dingell report, the major problem in those insolvencies was the quality of invested  assets. Those insurers had been damaged by significant reductions in the value of their investments  in commercial real estate (primarily mortgages), “junk” bonds, or both. Several of those insolvencies were preceded by large cash withdrawals by policyholders. Those insolvencies and policyholder “runs” received substantial publicity in the national media. They also provided considerable impetus to proposals for federal solvency regulation. 

Most analysts believe that the life and health insurance industry, which holds one-third of all corporate bonds and about 30% of commercial mortgages, is fundamentally sound, although some large insurers with substantial holdings of commercial real estate have been weakened by the severe slump in commercial real estate markets. 

Accurate estimates of the total shortfall of assets relative to liabilities for impaired and insolvent life and health insurers are not available. Also, the existence of, and actual coverage provided by, any guarantee funds for purposes of ensuring that all contract holders with accounts up to a certain amount (ie €250,000 or currency equivalent) are inconsistent at best, and non-existent at worst.

The magnitude of any shortfall of assets relative to liabilities and the need for significant assessments for companies such as EUROVITA are uncertain. 

While the details vary by company and by jurisdiction, the basic story is similar for insurers facing a policyholder run. They generally wrote large amounts of investment-oriented contracts that promised fixed yields on principal for one or more years: annuities, guaranteed investment contracts, and interest-sensitive life insurance. In some cases, insurers offer equity returns rather that fixed yields. To provide high yields on those products, the insurers pursued high-risk investment strategies. In some cases, this has resulted in substantial holdings of junk bonds (40 percent of assets or more).  When the junk bond market plunged following the COVID-19 pandemic, so did the fortunes of those companies. The insurance companies which invested heavily in commercial real estate with limited geographic diversification also saw their fortunes plunge as the work-from-home mandates (“telecommuting”) which swept the world effectively destroyed the commercial real estate markets of several downtowns and main streets regardless of geography or jurisdiction. When a significant portion of investment holdings of an insurer are tied up in mortgages and real estate which are classified as nonperforming; the company’s demise is not too far off. 

In today’s information-driven society, such news is readily available to policyholders, as are analysis and reports of what that means for them. It should be no surprise then that as news of insurer’s financial challenges spread, that many policyholders would choose to surrender their contracts. These runs are slowed by regulatory provisions in the European Union, however they are not stopped. 

The sharp increase in inflation and short-term interest rates during the last 24 months has made yields on savings in traditional whole life insurance contracts, which largely reflected slowly changing book yields on long-term investments, look meager at best. A competition based on investment yields developed and some insurers were influenced to pursue high-risk strategies (some including cryptocurrencies or crypto-industry investments). Investment in assets with limited liquidity and considerable potential volatility and sales of contracts that often had few restrictions or relatively small penalties for early cash outs by policyholders produced and exacerbated risk for some insurers. 

The depth of the asset quality problem in the life and health industry is difficult to assess. Overall holdings of high-yield bonds are low. Commercial real estate represents a greater problem for more insurers. The value of a given insurer’s real estate portfolio depends on many factors including the extent of diversification across different geographic regions. In addition, an insurer’s vulnerability to cash withdrawals depends on the amount of its liquid assets and the extent of restrictions and penalties for early surrender of contracts. 

The crash of quality assets. 

The low interest rates and excessive selectively-allocated money supplied from the fiscal policies of the government administrations along with the monetary policies of many central banks (ie quantitative easing) conditioned the markets to low interest rates and plentiful money supply (in other words “cheap credit”). Insurers made the same play as many of the banks that failed in March of 2023 (ie Silicon Valley Bank, Signature, and Silvergate). They invested in long-term bonds because these are usually seen as safer than stocks and provide a steady return. This is based on the premise that when interest rates are low newly issued bonds pay lower interest rates or returns making existing long-term bonds that pay higher rates more attractive. This leads to an increase in demand for these bonds and an increase in their market price, even though the nominal value is the same if held to maturity. The premise is that whoever’s holding these long-term bonds earns a profit. 

Many insurers, like EUROVITA, saw this situation and invested billions of their policyholders money in long-term bonds and other securities. This in and of itself raises the question as to what should be deemed “sound and prudent standard operating procedures for life insurance contracts” in regards to policyholder funds which are liabilities of the insurer.

The plan was to buy long-term bonds and other securities and turn around and pay their policyholders a lower rate. The insurer’s profit would be the difference between the higher rates from their long-term investments plus premiums received and the cost of paying lower rates for their policyholders minus any early withdrawals. This arrangement works particularly well when long-term rates on investments are higher than short term interest rates and when there are simultaneously low redemptions and low levels of withdrawals.  Even if some clients decided to withdraw sooner than anticipated, the insurer would simply sell the bonds in the open market and get the liquidity necessary to pay back the policyholder. 

But what happens when everyone wants to withdraw their money all at once?

The post-2008-crisis financial markets are not used to a high interest rate environment and higher interest rates (especially in shorter maturities) could create risks in vulnerable areas of the financial system. The risk management team of insurers that are subject to policyholder runs have underestimated this risk.

The problems for insurers and the global economy at large started to develop in late 2021 when inflation began to rise around the world. Many central banks and governments assumed that inflation was “transitory”, which turned out to be completely wrong. However, upon realizing their mistake in the United States,  the Federal Reserve made the decision to raise interest rates very quickly to make up for lost time, which impacted interest rates around the world. This jolt in higher rates did not allow for any time for the financial markets to adjust to the higher rate environment. 

Simultaneous to the central bankers’ decisions to rapidly increase interest rates, the investment portfolios of insurers began to flip on its head. As the interest rates rose, the newly issued bonds began to pay higher interest rates and this made the older long-term bonds in the insurers’ portfolios less attractive to investors. This resulted in a decline in demand for the lower-rate long-term investments, causing their prices to fall.

Normally this would not be an issue because if insurers held onto these bonds until their respective maturities, they wouldn’t lose anything. But this was not a normal time in a higher interest rate environment, and policyholders were becoming aware of the financial stresses of the insurers and the overall economic picture that was changing due to inflation and higher interest rates. It now seems clear even to the layman that senior management of these insurers and financial institutions have made a basic mistake: they invested short-term liabilities in longer term fixed-rate assets.

As credit began to dry up around the world at the end of 2022, many policyholders needed to access the values of their contracts and withdraw cash to fund their lives, and also to mitigate losses due to failures of the insurer holding their life insurance policies..

With every large withdrawal, insurers had to sell some of their long-term bonds to cover the transaction. As policyholders continue to withdraw funds, the insurer’s liquidity is increasingly and severely stressed. 

To prevent further losses and to shore up stability of the insurers, many regulators instruct the management of insurers to increase their regulatory capital and increase cash reserves to cover the withdrawals. While this seems like a logical choice to an insurance and banking outsider to raise capital from the markets in times like these, this is a grave error from a timing standpoint. The market conditions, sentiment, and the somewhat universal access to data which investors around the world have will result in stalled or failed capital raises,  along with rebukes from the financial markets in the form of stock prices.  Alternatively, it leads to failed institutions which are taken over by regulators and generally sold to other industry players at pennies on the dollar, while destroying the equity of the insurer’s shareholders. 

Gross incompetence 

Insurance is a complicated business. Although some policies are relatively simple, some are much more difficult to understand clearly. Even some of the concepts, such as the methodology for computing IBNR reserves, may be hard to grasp. Therefore there is great scope for companies to go wrong simply through sheer incompetence. This could be at a senior or a junior level. 

For example, it is easy to give the message to staff to grow the business. It is much harder to understand all the ramifications of that message and whether or not profitable growth will be possible. A simple message to grow may kick off a chain of events that will cost the company dearly. 

Another example would be one single risk, incorrectly understood and poorly priced, or badly worded policy, that gives a company a far higher exposure than it thought it had to a risk. Alternatively there might be an accumulation of risk that the company might not be aware of and hasn’t bought reinsurance for (eg a predominance of properties in one area that might be hit be a freak weather event). 

Expansion into new products or areas 

Many insurers has been brought to its knees by trying to expand into areas other than the ones in which it has expertise. This may be into new products or geographical areas or even diversifying into business other than insurance.  The danger is that the insurer does not have enough expertise or knowledge to be able to successfully do business. Unless the expansion is carefully controlled then it can quickly escalate out of control. A lot of business could be written before it becomes clear how large the losses are. 

8. Conclusions 

This article has identified some common causes of insurance company failure supported by both recent and past failures. In addition to the fraudulent activities and management incompetence, which may be found in any industry, there are many closely linked factors that are more specific to insurance company failures. The adoption of the tools and services of the Juro System should be integrated into the insurance industry from a regulatory and management standpoint. The Juro-Backstop™ will provide for systemic stability, reduce the shocks of failures, mitigate if not eliminate tax-payer bailouts, all while empowering regulators to act in the public interest within the scope of their respective mandates, without exception due to “special circumstances” or “systemically important” entities or other special interests.