A Multivariate Model for Predicting Financially Distressed P-L Insurers

Abstract

This paper is concerned with insurance company insolvency and the ability to identify a firm with a high probability of financial distress. Financial distress is defined as a firm that entered into liquidation, receivership, conservatorship, or rehabilitation during the time period of the study (1966-1971). Multiple discriminant analysis was used in this study to classify firms into two groups (solvent or distress). The model developed was able to classify correctly forty-nine out of fifty-two firms included in the study. One solvent firm was classified as being distress while two of the distress firms were classified as belonging to the solvent group. The six variables that were used to classify firms were: 1) agents balances/total asset ratio, 2) stocks-cost (preferred and common) /stocks-market (preferred and common) ratio, 3) bonds-cost/bonds-market ratio. 4) (loss adjustment expenses paid + underwriting expenses paid) /net premiums written ratio, 5) combined ratio, and 6) premiums written direct/surplus ratio. Insurance regulation involves at least three distinct activities; agent and company licensing, rate regulation, and company solvency. This paper is concerned with the latter of these three responsibilities of the insurance commissionerinsurance company solvency. More specifically, it is concerned with those property-liability insurance companies that experienced financial distress in the time period 1966 to 1971. Financial distress is defined as those firms that entered into liquidation, receivership, conservaThe authors are respectively: Assistant Professor of Risk Management and Insurance in the University of Georgia, and Associate Professor of Finance and Faculty Research Associate, University of Missouri-Columbia. The authors would like to express their appreciation to the University of Missouri Research Council and the Insurance Departments of the states of Arkansas, Illinois, Indiana, New York, Ohio, Pennsylvania, Texas, and especially Missouri for their support and cooperation. This paper was presented at the 1972 Annual Meeting of A.R.I.A. torship, or rehabilitation during this period. Insurance company insolvency has been a major concern of regulators, consumers, and insurance company executives for many years. L. B. Brainerd, past president of the National Association of Casualty and Surety Executives (NACSE), said that insurance company insolvency is the main area of concern of insurance regulation, and that regulation in this area has been lax compared with the other areas of insurance company regulation.' He advocates stricter supervision, rather than reimbursing of policyholders for their losses due to insurance company insolvency. Presently, the National Association of Insurance Commissioners (NAIC) has a model bill that will reimburse policyowners for losses up to $50,000 due to insurance company insolvency. This or simiI Business Insurance. October 25, 1971. n28