Why do insurance companies fail?

25.06.2020
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Introduction

Insurance is the “promise” that insurers make to policyholders in exchange for premiums. The insurance industry is built on policyholder’s confidence that insurance contracts will be fulfilled and eligible claims paid. For consumers, the purchase of insurance is a key component of how they manage their financial risk. Consumer confidence in the industry is, therefore, insurance is closely linked to confidence in the solvency of their financial institutions.

Insolvency arises when insufficient assets and capital are in place to cover the claims liabilities incurred. Insurer liquidation shows claimers and policyholders to the risk of unexpected financial loss and the potential for considerable personal and economic costs. A lot of insurance companies have failed over the last few decades because of many reasons. In this blog, we will discuss some of the reasons behind the failure of insurance companies.

Reasons for the failure of insurance companies

Close analysis of insurance companies’ failures shows that they often stem from a mixture of causes. The main reasons that play a vital role in the failure of insurance companies are the following:

Lack of Confidence
The insurance business thrives on trust and commitment. Any contract between an Insurer and the Insured is a commitment of utmost good faith and as such requires honesty and trust from both parties. For this to happen successfully, the insurance companies must first win the trust and confidence of the insuring public. Unfortunately, the common challenge faced by the industry is low public confidence coupled with a deep-seated mistrust of insurance companies. This issue can mainly be attributed to very high expectations of insurers and greater awareness of how insurance policy operates and also leads to the lack of clarity of insurance policy documents.

Free Market Failures
Sometimes, the reason companies or insurers fail can only be explained as a consequence of free-market forces. They result in cases where larger companies overpower the smaller ones, new concept makes an old one unattractive, an unexpected event is just too large to recoup losses, lower prices prevail over benefits, higher interest rates win over lower rates or the economic climate is simply not conducive to making a profit. It is suggested that a combination of all these factors is responsible for reasons why some insurance companies fail in a free market.

Slim Profits
Declining profits are still another explanation for insurance failures. Premium wars and unusual natural disasters have whittled profits in property casualty companies to levels lower than most other industries, while risk remains high. Life insurers have suffered from thinning margins of profits and greater exposure to interest rate cycles. In severe situations, either of these problems could cause a company to operate below-accepted levels or force a conservatorship (is a legal concept whereby a person is appointed by a court to manage an incapacitated person or minor’s financial and personal affairs).

Management Mistakes
Identifying a single cause of failure for an insurance company is often not possible. More likely 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. These practices include multiple regulators and infrequent examinations, rapid growth in risky business areas, poor underwriting, extensive underpricing, excessive reinsurance or loan participations, bad management, and inadequate loss reserves.

Real Estate Investment Losses
Without a doubt, another contributor to the insurance insolvency war is “real estate”. Specifically, nonperforming and underperforming commercial real estate. Most insurers hold real estate mortgages in commercial properties. It is the nature of these loans, not delinquencies that have caused problems. Owning and managing foreclosed real estate can drain insurer resources. A decision must be made whether to continue holding the asset until the economy rebounds or risk further deterioration if the economy goes the other way. Selling foreclosed real estate may also be difficult to accomplish in today’s depressed market. With many other lenders and insurers selling nonperforming real estate, a deep discount may be required to unload a problem property. This can result in further write-downs from the value carried on the books. In either case, holding or selling depressed real estate, the process can adversely affect earnings, capital requirements, dividends, and ratings.

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.
  • Their retrocessionaires(a reinsurance organization that insures other reinsurers) are not paying claims as they fall due.

From where do insolvency arise?

Insolvency arises when insufficient assets and capital are in place to cover the claims liabilities incurred. Insurer liquidation shows claimers and policyholders to the risk of unexpected financial loss and the potential for considerable personal and economic costs.

What is the common challenge for insurance companies?

The common challenge faced by the industry is low public confidence coupled with a deep-seated mistrust of insurance companies. This issue can mainly be attributed to very high expectations of insurers and greater awareness of how insurance policy operates and also leads to the lack of clarity of insurance policy documents.

When do Free Market Failures occur?

Free Market Failures occur in cases where larger companies overpower the smaller ones, a new concept makes an old one unattractive, an unexpected event is just too large to recoup losses, lower prices prevail over benefits, higher interest rates win over lower rates or the economic climate is simply not conducive to making a profit.

What are management mistakes?

Management mistakes include multiple regulators and infrequent examinations, rapid growth in risky business areas, poor underwriting, extensive underpricing, excessive reinsurance or loan participations, bad management, and inadequate loss reserves.

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