Solvency Regulation of Insurance Companies
By Jinjing Wang
Expanding Horizons, August 2021
Insurance companies are heavily regulated in every country with a well-developed financial system and the regulation focusing primarily on solvency. The new regulatory system with an emphasis on introducing the risk-based capital regulation has been developed or revised in various jurisdictions in the past three decades. Risk-based capital (RBC) regulatory systems were first introduced in Canada in 1992 and in the United States in 1994. The National Association of Insurance Commissioners (NAIC) in the United States started its Solvency Modernization Initiative (SMI) in 2008, with the aim of reevaluating its RBC system. The most recent adoption of an RBC system was the implementation of Solvency II in the European Union (EU) in 2016, with a focus on the group supervision applied at both domestic- and foreign-market levels through internationalized insurance groups. This article will discuss the theoretical rationale for insurance solvency regulation, the general equilibrium framework needed to design and evaluate solvency regulation, and the cross-border impacts of solvency regulation, especially when regulation standards are inconsistent across countries.
Why Regulate Insurance Company Solvency?
The adoption of risk-based capital standards for insurance companies has been motivated by the financial failure of such companies. Insurance failure can arise from a reduction in asset values (e.g., bond investment default or equity value decline); increases in liability claims (e.g., large natural catastrophes such as hurricanes, earthquakes or pandemics); and excessive risk taking due to misguided management incentives. Insurance failure is costly. The resolution of an insurance company is typically about three to five times more expensive than that of other financial institutions.[1]
Aggregate Shocks to the Assets and Liabilities of Insurance Companies
The adoption of RBC in the United States was spurred by a surge of insurer insolvencies that occurred in the late 1980s and early 1990s. Those insolvencies were driven by liability crises for property liability insurers and deteriorated asset quality of life insurers. European insurers were also financially distressed due to their heavy investments in equity markets, which declined in the early 2000s. The failure of AIG, which was eventually bailed out by the federal government in 2008, implied that “systemically important” insurers could be closely interconnected with banks and other financial institutions as counterparties of derivative transactions (e.g., credit default swaps). Therefore, the impact of their failures can be transmitted to the whole financial system and exaggerate the systemic risk. The recent COVID-19 pandemic has also been accompanied by greater financial market turmoil that strains both the assets and the liabilities of insurance companies and reinforces the need for regulators to monitor insurance company solvency and ensure financial stability.
Agency Problems and Risk Shifting
Risk shifting or excessive risk taking, the well-known agency problem in corporate finance, also applies to insurance markets.[2] Policyholders pay premiums that provide insurance companies with capital to invest in financial assets and grow new business. Insurance companies cannot commit to their investment choices when they collect premiums. Hence, the insurance contract is incomplete in the sense that it cannot be explicitly contingent on the risk of insurers’ investments and/or new policies to be sold.
Insurance companies are also protected by limited commitment and limited liability, which provide incentives for companies to increase the risk of their assets and liabilities. For example, insurance companies can aggressively invest in riskier assets or lower underwriting standards (or charge insufficient prices) for new policies, without injecting sufficient equity capital or purchasing sufficient reinsurance. The risk shifting problem significantly increases the chance of company failure and creates market inefficiency. A study by AM Best identified that the most common drivers of insurance failure from 1960 to 1990 were inadequate prices and deficient loss reserves.[3]
Weak Policyholder Monitoring and Market Discipline
Unlike in nonfinancial firms, the holders of senior claims with insurance companies are not sophisticated, tough investors but the policyholders, who take a large stake on the right-hand side of the balance sheet, typically around 90 percent.[4] The policyholders are dispersed and insufficiently informed, and they lack the financial resources or effective controls to monitor the management of their insurance companies. Government guarantees that provide protections to policyholders when their insurance companies fail further reduces market discipline and fosters more risk shifting as policyholders with access to these guarantees become less responsive to risk deterioration.[5]
The incompleteness of insurance contract, the limited liabilities, the weak monitoring by dispersed policyholders and insufficient market discipline together provide the theoretical rationale for solvency regulation of insurance companies. Dewatripont and Tirole formulated the “representation hypothesis,” stating that regulatory authority can represent current policyholders of outstanding claims in the governance structure of insurance companies. In other words, the regulators should ideally behave like tough policyholders, monitoring companies’ solvency risk. The solvency regulation serves as an optimal corporate governance mechanism to reduce market inefficiency.
A General Equilibrium Framework for Solvency Regulation Debate
The RBC systems at the center of solvency regulation aim to set capital requirements in accordance with the amount of risk insurance companies take and to ensure that companies hold sufficient capital to meet their financial claims.
There is an ongoing debate about the stringent level of solvency regulation. Standards that are too strict may raise insurance prices, as it is costly for insurance companies to hold more capital. Alternatively, when regulations do not sufficiently incorporate the interaction between insurance markets and the broader economy, it may lead to unintended, excessive risk taking in the shadow or outside of regulation. The rapid growth of shadow insurance in the life insurance industry has been blamed for the adoption of Valuation of Life Insurance Policies Model Regulation 830 (commonly referred to as Regulation XXX) and Actuarial Guideline 38 (commonly referred to as Regulation AXXX) in 2000.[6] These regulations raise statutory reserve requirements on both term and universal life insurance with second guarantees, thereby forcing life insurers to hold more capital to meet the RBC standards. However, they also give insurance companies the incentive to cede more liabilities to shadow reinsurers, which are usually captives or special-purpose vehicles domiciled in the jurisdictions with more favorable capital or tax regulations, thereby increasing the risk of whole insurance markets.
A rigorous analysis of insurance regulation necessitates a general equilibrium framework that endogenizes insurance supply and demand and incorporates aggregate shocks to companies’ assets and liabilities. As regulation is intended to improve the efficiency of insurance markets, it is important to investigate the sources of inefficiencies in unregulated insurance markets (e.g., insurance contract incompleteness and limited liability). Previous theoretical studies have examined the isolated impacts of individual regulatory tools in partial equilibrium settings. Because partial equilibrium models, by design, do not consider the interactions between insurance markets and the broader economy, it is difficult (if not impossible) to characterize efficient allocations in partial equilibrium models. Thus, such models provide limited guidance on the optimal design of insurance regulation and how different regulatory tools interact with each other to mitigate market inefficiencies.
Subramanian and Wang have adopted a general equilibrium model of competitive insurance and equity markets to derive the Pareto-efficient allocation of the economy with aggregate asset and insurance liability risk.[7] They show how efficient allocation can be implemented via multiple regulatory policies that combine RBC requirements, asset risk constraints, reinsurance and bailouts. The general equilibrium model provides implications for an optimal regulation design. It shows that there is no need for capital requirements when aggregate asset or liability risks are low. However, when aggregate asset or liability risks are high, capital requirements are necessary to ensure that insurance companies invested sufficiently in safe assets. An efficient regulatory policy with a lower capital requirement must be accompanied by a more stringent asset risk constraint, and one with a capital requirement that is more sensitive to insurer assets should be less sensitive to insurer liabilities.
This model also provides insights into the relationship between aggregate shocks and insurance prices in the economy with efficient regulation. The aggregate asset and liability risks have directionally similar impacts when the elasticities of efficient investment in risky assets with respect to such risks are both either low or high; they have opposing impacts when one of the elasticities is high and the other is low. Therefore, tailoring regulatory policies to aggregate risk levels is important to the analysis of how regulation influences insurance prices and insurer capitalization.
Cross-Border Impacts of Solvency Regulation
When standards are inconsistent across regulatory jurisdictions, cross-border transmission effects or regulatory arbitrage effects may arise. A cross-border transmission effect occurs when the impacts of a strict regulation in one market transmit beyond the market border. A stricter regulation may reduce the risk taking and/or increase the capital holdings of insurance companies, not only in the home market but also in foreign markets. The impacts on foreign markets arise because insurance companies in the home market expand their business operation to the host countries and bring along the high-quality governance required for the regulations in the home market. On the flip side, regulatory arbitrage allows international insurance groups to transfer risks from markets with more stringent regulation to those with less stringent regulation. While regulatory transmission reduces risks in less-regulated markets, regulatory arbitrage reallocates risks to these markets, resulting in a heightened insolvency risk there.
Jia et al. use the Solvency II reform in the EU as a quasi-natural experiment to study the cross-border impacts of solvency regulation on the risk and capital dynamics in the U.S. property-casualty insurance market.[8] Solvency II would require twice as much capital for a representative U.S. property-casualty insurer as the RBC standards in the United States.[9] The impact of Solvency II can penetrate the U.S. insurance market through the international insurance groups operating in both the EU and the U.S. markets, which are subject to regulations of both Solvency II and RBC standards, where the former is stricter than the latter. On one hand, the group supervision of Solvency II may transmit high capital standards from EU insurers to their affiliated entities in the U.S. market. On the other hand, EU-affiliated insurers tend to find channels to circumvent the higher regulatory pressure to comply with Solvency II at the group level. Using a difference-in-differences empirical design, they find that EU-affiliated insurers operating in the U.S. market appear to improve their financial strength compared to domestic U.S. insurers after Solvency II reform. This advantage is achieved through reducing asset and underwriting risk taking. Interestingly, after the reform, EU-affiliated insurers cede more risks to affiliated, unauthorized and unrated reinsurers that are in the shadow of any solvency regulation. The seemingly improved financial strength of EU-affiliated insurers also disappears after adjusting for the use of shadow reinsurance. These results indicate that the transmission effect of Solvency II is offset by the arbitrage effect of shadow insurance. Therefore, regulators are advised to consider both regulatory transmission effects and arbitrage effects when designing a regulatory framework. Both U.S. and EU regulators should reevaluate and update RBC and Solvency II, respectively, to impose some capital requirements on shadow insurance.
Jinjing Wang, PhD, is an assistant professor of finance in the College of Business at the University of Akron. She can be reached at jwang2@uakron.edu.