Insurance companies are heavily regulated in every country with a well-developed financial system, with 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 A-sociation 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.
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 A-sociation 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.
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 a-set 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]
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 a-set 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 a-sets and the liabilities of insurance companies and reinforces the need for regulators to monitor insurance company solvency and ensure financial stability.
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 a-sets 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 a-sets and liabilities. For example, insurance companies can aggressively invest in riskier a-sets 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]
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