Insurance Regulation
Introduction
First of all, I want to draw a clear line separating two widely used titles: insurance law, and insurance regulation. Frequently, many people use those two titles interchangeably, as those two titles mean the same thing, but they do not. As I will discuss insurance regulation, I ought to explain, in a simple and concise manner, the main difference between the two titles.
Insurance law consists of legal articles and rulings that are used by the judicial authorities and courts to judge disputes among all parties of the insurance contract, whether it is the insurer, the insured, the broker, or the agent. It is apparent that this definition has a judicial sense.
On the other hand, insurance regulation consists of policies and decisions that are formed by the legislative and/or executive authorities for the purpose of controlling the insurance industry and monitoring all parties of the industry who are engaged in producing, marketing, or selling insurance products such as insurance companies and insurance agents. This definition has an executive and legislative sense.
In this paper, I discuss, generally, the issue of insurance regulation. This paper is divided into three main outlines: First, a discussion of the rationale and the main objective of insurance regulation are presented. Second, the main risks that face insurance companies. Third, the question: Is the current insurance regulation in
Assumption: Not every insurance company sells insurance contracts continuously be able to meet its financial promise under these insurance contracts at all times.
(1) The rational of insurance regulation
It is known that the market failure framework is usually used by economists to analyze the case of state intervention. A well-functioning financial system is a public good, and it is justifiable for regulators to intervene in order to rectify market failure, especially when benefits of regulatory intervention outweigh its costs. Although it is relatively easy to show that one form of market failure, like an asymmetry in information, exists in financial markets; however, the problem is to find the best way to correct such a failure. In order to find this best way, it is first necessary to ascertain the precise nature of the market failure. Obviously there is information asymmetry problem in every industry, but its magnitude differs from industry to another. It is more serious in industries that involve intangible products, like insurance contracts, than in industries that involve tangible products, like automobiles. In the insurance industry, the asymmetric information problem cannot be eliminated entirely. In this context, there are two potential reasons for insurance regulation. First, the nature of insurance as a contingent claim for which the insured pays in advance creates the need to instill some guarantee of insurer performance. It may be noted that this in itself is an insufficient reason since it is true of any intertemporal contract. However, the 'long tail' of some insurance contracts, such as personal liability claims, obviously creates special problems which may provide a justification for regulation. Second, parties to insurance contracts typically have different bargaining positions and levels of knowledge with respect to the range of exposures. Insurers have access to actuarial data that policyholders do not have. This information asymmetry leads to complex insurance contracts. Unsophisticated insureds may be unfairly exploited by insurers. This is the standard 'consumer protection' argument for regulation.
Generally, insurance regulation plays an important role in monitoring and controlling the reliability and solidity of insurance companies in order to minimize the frequency and severity of insolvencies. The primary objective of insurance regulation is to correct market imperfections and protect the public interest. One way to achieve this objective is through insurance regulation whereby regulators monitor and control the financial strength of insurance companies.
There are two different schools of thought on the case of insurance regulation. On the one hand, many scholars believe that regulatory interventions should be made to promote competition in the market. They want regulatory control which maintains and furthers competition and counters the development of a monopoly. This will lead to an efficient market that will produce the greatest benefits to society. On the other hand, the other group of scholars believes that insurance regulation is needed to protect the interest of consumers. Any regulation should ultimately benefit the consumer. The consumer should get better prices and safety. They do not fully trust the market to protect consumer safety. Additionally, they argue that insurance is a business different from any other, primarily because of its fiduciary nature and uncertainties inherent in the insurance-pricing process. Yet both groups agree on the importance and necessity of regulatory intervention. It is noted that the objective of insurance regulation is to promote competition and efficiency. Thus the efficiency objective of regulation is directed toward protecting the insurance-buying public. Specifically, ensuring the solidity of insurers is the main objective of insurance supervision.
The need for insurance regulation is due to information asymmetry issues. It is clear that in a perfectly efficient insurance market, all policyholders would know the probability of their insurer becoming insolvent and that the insurance market would be priced accordingly. Insurers with a higher insolvency probability would have to offer lower prices than insurers with a low insolvency probability in order to get new business. The consumer would then just select the insurer that matched the consumer’s risk versus cost preference. However, since consumers do not have access to this information and even if all companies provided it, the accuracy of the information would have to be verified; regulation fulfils this role. However, regulation is only one of the ways of giving the necessary information and assurance to the consumer. Insurance rating companies like A M Best, Standard & Poor’s and Moodys also furnish relevant information to the consumer.
The main objective of insurance regulation
There are many areas of insurance regulation that were modified to achieve the goal of protecting the public interest. Insurance regulatory responsibilities are divided into two major categories; solvency regulation and market regulation. Theoretically, solvency regulation is to protect the interest of the policyholders against the risk of those insurance companies that will not be able to meet their obligations. Market regulation ensures fair insurance prices, products and trade practices. Solvency regulation and market regulation must be coordinated to achieve their objectives because each one undoubtedly affects the other. Although both the objectives are interlinked, solvency regulation is concerned with the rights of existing policy holders whereas market regulation is more oriented towards prospective customers. The aim of solvency regulation is to protect the rights of the policy holders through monitoring and controlling the solvency of the insurance companies. Market regulation, on the other hand, is concerned with insuring fair insurance transaction between the prospective customers and the insurance company. The objectives of solvency regulation (solidity) and the objectives of market regulation (fair and reasonable rates) can be in conflict with one another. An over-emphasis on keeping rates low could lead to solvency problems and an over-emphasis on solvency could lead to higher rates. Therefore, insurance regulation needs to strike a balance between these conflicting objectives.
In summary, the goal of insurance regulation should always be to protect policyholders and to promote the public interest.
(2) The main risks that face insurance companies
The major risks which endanger the financial stability of an insurance company and propel it towards insolvency have to be addressed by any insurance regulatory agency. This is essential to understand how insurance regulators can enhance the efficiency of monitoring process and control insolvency of an insurance company to better protect the interests of the policy holders. The main three risks include underwriting risk, investment risk, and reinsurance risk.
A. Underwriting risk:
The process of underwriting is an important operation in the insurance industry. Underwriting is the process where an insurance company reviews potential applicants and decides which applicants should be selected and which should be rejected. Underwriters also decide the extent of insurance coverage that the company should provide and at what price. The primary goal in the underwriting process is the selection and maintenance of a profitable, growing book of business. The insurance company’s underwriting operation can reach this goal through three supporting objectives: (1) providing proper coverage, (2) maintaining proper selection standards, (3) maintaining proper pricing standards.
The financial implications of underwriting are very important in the success and solvency of an insurance company. For instance, a study of insolvencies in the US property-liability insurance industry showed that companies wich had poor underwriting results were more likely to become insolvent and this correlation was statistically significant. Additionally, an insurer that applies poor underwriting practices continually increases their opportunity of increased financial losses, and therefore is a determining factor in the overall risk of the insurer.
Ratios have been defined to assess the underwriting performance of a company and aid in the regulation and the management of the insurance industry. The loss ratio is defined as an insurance company’s total losses divided by the total premium collected and is expressed as a percentage. Similarly, the expense ratio is defined as the insurance company’s operating expenses divided by its total premiums collected. The combined loss and expense ratio or combined ratio is the sum of the loss and expense ratio. If the combined ratio was 100 percent, the company would have broken even on its underwriting operation and its profit would be equal to its investment income. If the combined ratio is less than 100 percent the company would have an underwriting profit and if the combined ratio exceeds 100 percent, the company would have an underwriting loss. However, an insurance company can still be profitable with a modest underwriting loss if it has adequate investment income to offset this loss.
B. Investment risk:
Risk is an inherent part of investing. All investments involve some kind of investment risk. Investment risk is the measure of the potential increase and/or decrease in the value of an investment. The conventional wisdom is that greater the risks, greater the returns and vice versa.
Broadly speaking, there are four main classes of investment assets; (1) cash including regular savings accounts and money market funds, (2) debt instruments, including bonds and bond mutual funds, (3) equities, including stocks and stock mutual funds, and (4) property. Each class has its own characteristics, performance history and associated risk.
It is important to understand that there is an inescapable trade-off between investment performance and risk: Higher returns are associated with higher risks of price fluctuations. Stocks and property historically have provided the highest long-term returns of the four major asset classes and have been subject to the biggest losses over shorter periods. At the other extreme, short-term cash investments are among the safest of investments when it comes to price stability, but they have provided the lowest long-term returns.
C. Reinsurance risk:
Reinsurance can be defined as a contractual arrangement under which one insurer, called the primary insurer, transfers to another insurer, called the reinsurer, all or a part of one or more risks that the primary insurer has assumed under one or more of its insurance contracts. Primary insurers who use reinsurance are also called ceding insurers or cedants. Reinsurance is an important method used by insurance companies to manage their portfolio of risks. The core objective of reinsurance that affects the solvency of an insurance company is related to the concepts of pooling and diversification. Basically, an insurance company can insure a high valued risk, like a large industrial factory, and retain part of the sum insured and cede the remaining to a reinsurer. The reinsurer can again retain a part of the sum reinsured and cede the remaining to another reinsurer, this process is known as retrocession. Thus, the risk insured will be spread over many insurers which lead to the reduction of an insurer’s vulnerability to a single event.
The solvency of reinsurers is very important to primary insurers, particularly smaller companies that are highly dependent on reinsurers to cover large losses. Therefore, reinsurance companies’ financial condition is reviewed by regulatory agencies and independent rating services, such as A. M. Best. These reviews are very similar to the reviews that are conducted for primary insurers. This monitoring improves the solvency of reinsurers, and thus provides more protection to primary insurers, which in turn provides more protection to policyholders.
A primary insurer should establish a good reinsurance strategy and a good process for managing their use of reinsurance. A thorough review of potential reinsurers should take place before selecting one. This includes looking at the coverage offered, price, the reinsurer’s size and independent rating, and other relevant factors. Generally, a primary insurer should diversify their use of reinsurers, so they are not totally dependent on one reinsurer that could run into financial or operational problems that delay payments to the primary insurer. Once a portfolio of reinsurers is in place, the primary insurer should perform periodic monitoring to make sure the reinsurer remains in sound financial condition.
(3) Is the current insurance regulation in
Supervision of the insurance sector rests with the insurance department in the Ministry of Commerce and Industry. The scope of regulation and supervision is defined by a dated law that is missing many of the key elements of a modern insurance supervision regime. The law includes unclear provisions for financial reporting and for supervisory staff to conduct on-site inspections, as well as a (high) minimum capital requirement and deposit reserve requirements. However, the focus of the law is on regulation and compliance, and the supervisor does not have the mandate, powers, or capacity to undertake a thorough analysis of possible financial and operational risks. As a consequence, in practice the insurance department has limited ability to go beyond compliance-oriented functions and to assess the operations of the companies.
It is evident that
With the prospect of economy opening up and with the government allowing 100% foreign ownership of insurance companies, the market is bound to see new insurance companies mushrooming. This calls for a tighter supervisory and regulatory regime.
The existing insolvency regulation does not address the key issue of preventing insolvency nor does it have a mechanism which will trigger a series of action in time to prevent an insurance company from slipping to insolvency. No functional model is available to assess the risk and capital adequacy levels of insurance companies. Most of the laws were formed in the 1960’s and were applicable to the economy as it existed then. They do not address the stringent requirements for effective solvency monitoring in the new millennium.
