Figuring out the future and the now

I’ve been updating my presentation from 2021 on “How and Why Insurers Fail”. I now estimate the annual failure rate (or at least getting into serious financial difficulty) for an insurer in South Africa at 0.4% using an approximation over 2009 to 2024.

With a hefty additional dose of approximations, I get about the same figure all the way back to 1998.

This amounts to an insurer failing every other year.

The primary causes? In every case it’s more than one thing. Here are some of the recent common causes – I’ll expand on each of these in a series of posts.

1 Underwriting risk and pricing

Mispricing, particularly when moving into new markets or new lines of business is a common starting point.

Funeral insurers feeling competitive pressures are looking for new markets – typically semi-underwritten life products, misguided savings products, niche legal expense cover products, or further afield into non-life proper. Here be dragons.

For all the benefit of diversification from a statistical perspective, the research says that focussed insurers fail less often.

Climate change is going to break underwriting and pricing models, meaning that even previously well understood risks increase the chance of failure.

Non-life insurers need to get claims inflation under control – or at least continue the unpopular premium and excess increases to restore sustainability to premium rates.

2 Cost of customer acquisition outstripping funding and VNB

Rapid growth may be many insurers’ dreams.

However, too rapid growth can strain capital adequacy. Rapid growth can also be a telltale sign of under-pricing, leading to large volumes of unprofitable business. Selling many policies that don’t cover their acquisition expenses is a short cut to real trouble.

A worrying sign here is the reduction in VNB margins across broad sectors of the underwritten life insurance space. This ramps up pressures to dilute new business metrics, which is a terrible idea.

3 Misuse, and misrepresentation of (financial) reinsurance

Reinsurance is a fundamentally important tool to manage risk, manage capital requirements, gain expertise in a new market, and to provide liquidity.

Reinsurance, especially financial reinsurance when misused, can obscure the deteriorating solvency position of an insurer and lead to a false sense of security for risk managers, NEDs, and regulators.

The principles on how to treat financial reinsurance and contingent commissions are about right – but the detailed rules and the rigour and honesty with which those principles are implemented sometimes are not.

The overall lesson is – the improvement in your solvency should reflect the actual risk transferred and economics of the transaction.

The most egregious error is claiming that a FinRe deal has resulted in an increase in assets without an increase in liabilities. Tricks of claiming that repayment of the commission (a loan) is contingent on future profits and therefore isn’t a liability are invalid. Games with contract boundaries include recognising the upfront commission (which is to be repaid over many years of renewing contracts), but not recognising years of future reinsurance premiums because the in-force policies have annual contract boundaries.

On contingent commissions, the key question to ask is “has my SCR gone down by more than the risk transferred?”. If one reinsures 70% of the portfolio using QS, but 90% of that risk comes back through contingent commission, then applying the FSIs blindly can result in a 10x overstatement of the benefit of reinsurance. You have shared 7% of the risk, not 70%.

My rule of thumb is not to take advice on the regulatory, solvency, or accounting treatment of the reinsurance from the one selling you the reinsurance.

4 Complex, incestuous asset transactions, and poorly controlled ALM

Aggressive asset valuations, typically of unlisted, illiquid investment that have some related party in the mix, are one of the clearest red flags for an insurer about to fail.  There is always the next Warren Buffet wanting to “invest the float” and make money in some undeveloped property, associated business, or beautiful basket of tulips.

Careful ALM is critical for long-tailed policies. There it needs to be managed carefully and regularly. Monitoring isn’t enough – there needs to be a mechanism to change the portfolio when mismatch parameters breach thresholds.

For other portfolios, sometimes a simpler portfolio that introduces less complexity, fewer tax risks, less operational and liquidity risks, is better than a supposedly more ALM-tuned portfolio that actually increases risks of catastrophic failure.

Asset concentration has been a primary cause of at least one major South African insurance failure before too. Although, as always, this wasn’t the single cause.

5 Taking large (binary) risks when already in trouble

As solvency positions decline, some CEOs, seeing the writing on the wall, choose to take significant risks that will either solve their solvency problem, or increase the impact of insolvency to policyholders.

Something as simple as continuing to write business, especially long-term business, when the solvency capital isn’t available to support this business places existing and new policyholders under additional risk.

Pinning hopes (and management bandwidth) on big-bang investment deals without addressing underlying operational concerns usually don’t pay off.

6 Failed corporate governance

Corporate governance failures are usually the second or third thing to go wrong. Poor internal controls, ineffective or insufficiently independent risk and compliance teams, and outright financial statement fraud mean that serious problems are overlooked, sometimes for years.

Fraud is more often a response to problems (especially where management believes they are in the right and it’s just a matter of time before markets/the cycle/business turns). In select cases, insurers are used as vehicles to instigate fraud as first step

Some boards and shareholders deprioritise good governance. When times are good it’s easy to emphasise good governance. What about when governance gets in the way of decisions executives want to make? Or when it raises awkward questions about pet projects? Or where the business is struggling but management is confident they can trade out of the difficulty as long as they are given the space and time?

It’s easy to do the right thing when it doesn’t come with costs.

7 Slow regulatory intervention

Too often, regulatory intervention is too slow and not targeted at the underlying causes. It’s hard to blame the regulator entirely, given the massive opposition to statutory managers and curatorships.

There are many amazing, skilled, and experienced individuals at our regulator. Are there enough? Is the quality and approach consistent? Are they hamstrung by insurers under resourcing their own control functions and lines of defence?

Can anything be done to decrease failure rates?

Having a strong, experienced, and independent actuary who pays close attention to the regulations and guidance is crucial. Your head of actuarial function should provide good advice on business issues. They should also occasionally constrain your options and make you rethink your positions.

A solid, experienced, and independent Head of Actuarial Function goes a long way.

Appropriate risk management and governance practices are defined in multiple different places, and they can all work well enough if followed diligently. Making sure the teams are experienced and skilled and empowered to tell truth to power is rather more difficult.

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