Guaranty Fund Research Articles

Genetic programming for the prediction of insolvency in non-life insurance companies

Prediction of non-life insurance companies insolvency has arised as an important problem in the field of financial research, due to the necessity of protecting the general public whilst minimizing the costs associated to this problem, such as the effects on state insurance guaranty funds or the responsibilities for management and auditors. Most methods applied in the past to predict business failure in non-life insurance companies are traditional statistical techniques, which use financial ratios as explicative variables. However, these variables do not usually satisfy statistical assumptions, what complicates the application of the mentioned methods. Emergent statistical learning methods like neural networks or SVMs provide a successful approach in terms of error rate, but their character of black-box methods make the obtained results difficult to be interpreted and discussed. In this paper, we propose an approach to predict insolvency of non-life insurance companies based on the application of genetic programming (GP). GP is a class of evolutionary algorithms, which operates by codifying the solution of the problem as a population of LISP trees. This type of algorithm provides a diagnosis output in the form of a decision tree with given functions and data. We can treat it like a computer program which returns an answer depending on the input, and, more importantly, the tree can potentially be inspected, interpreted and re-used for different data sets. We have compared the performance of GP with other classifiers approaches, a Support Vector Machine and a Rough Set algorithm. The final purpose is to create an automatic diagnostic system for analysing non-insurance firms using their financial ratios as explicative variables.

The implied reserves of the Bank Insurance Fund

Option models of deposit insurance pricing view assessment rates as put option premiums. However, such models ignore the risk of guaranty fund default. This paper attempts to link risk-based premiums with guaranty fund reserves in a partial equilibrium setting, by employing a methodology based on options with credit risk. The value of full insurance per coverage period is expressed as a standard options premium and is decomposed into two parts. The explicit part is due to the available assets (reserves) of the guaranty fund, while the implicit part comes from federal support, contingent on the adequacy of reserves at the end of the coverage period. Implied reserves are derived under an exogenous insurance coverage rate as a policy parameter. The method is illustrated on a sample of 40 large bank holding companies and an extension to the case of several insured banks is provided.

Capital asset pricing models with default risk: Theory and application in insurance

The Capital Asset Pricing Model has been used frequently to derive a fair price of insurance. But the use of this model overestimates insurance premiums because it does not account for the insolvency risk of insurers. This paper examines how the insurance price should be fairly adjusted when insurers' default risk is considered. It develops a model which shows that fair insurance premiums are lower when insurance firms have a positive probability of being insolvent. Using data of property liability insurers during the period from 1943–99, the paper further estimates the effects of the insolvency risk on insurers' underwriting profit rate. It shows that the incorporation of the default risk of insurers in the model, by significantly reducing the required price for insurance, would lead to lower profit potentials. Some writers argue that including the insolvency risk when calculating insurance premiums is not so necessary because of the existence of states' guaranty insurance funds which protect consumers. However, as shown in the paper, these funds have provided inadequate protection to consumers. Therefore, because of the increase in the number of insolvencies in recent years, and because of the limited coverage provided by states' guaranty funds, it seems that considering the insolvency risk in insurance pricing has become very necessary.

The Effects of Competition on Banks' Risk Taking With and Without Deposit Insurance

We consider the joint effect of competition and deposit insurance on risk taking by banks when the riskiness of banks is unobservable to depositors.It turns out that the magnitude of risk taking depends on the type of bank competition.If the bank is a monopoly or banks compete only in the loan market, deposit insurance has no effect on risk taking.In that case the banks are too risky but extreme risk taking is avoided.In contrast, introducing deposit insurance increases risk taking if banks compete for deposits. Then, deposit rates become excessively high and force the banks to take extreme risks.Regarding the effects of increasing competition when there is deposit insurance, the results imply that deposit competition encourages risk taking but loan market competition does not.Our results can be extended more generally to insurance guaranty funds. Keywords: Deposit insurance, Insurance guaranty funds, Bank and insurance regulation, Moral hazard, Credit rationing, Financial Fragility.

Monitoring, Ownership, and Risk-Taking: The Impact of Guaranty Funds

ABSTRACT This study provides evidence regarding the risk-subsidy and monitoring hypotheses by investigating the relation between insider ownership and risk-taking in the property-liability insurance industry. The structure of guaranty funds provides incentives for owners to encourage insurer risk-taking. However, the ex post funding mechanism and incompleteness of guaranty funds may create monitoring incentives that inhibit risk-taking. Moreover, the extent to which managers engage in risk-taking may depend on how well their interests are aligned with those of the owners. The empirical results provide support for the risk-subsidy hypothesis and demonstrate the essential link between insider ownership and risk-taking. INTRODUCTION The institutional details of insurance industry guaranty funds have the potential to create competing incentives regarding risk-taking by insurers. Guaranty funds use an ex post financing mechanism to assess surviving insurers for the losses generated by insolvent insurers, and, at the same time, the assessments do not account for the riskiness of the insurers. Lee, Mayers, and Smith (1997) use the risk-neutrality and ex post funding of guaranty funds to develop two hypotheses regarding the impact of guaranty funds on the risk-taking behavior of insurers. They refer to these hypotheses as the risk-subsidy hypothesis and the monitoring hypothesis. They examine the relative strength of these hypotheses, and their empirical evidence leads them to conclude in favor of risk-subsidy. This study complements the work of Lee, Mayers, and Smith (1997) and addresses several additional issues. For stock market-based measures of risk, the evidence shows that the risk-subsidy hypothesis appears to hold, and the extent of risk-subsidy-related behavior is directly related to insider ownership. This point is related to the ownership structure hypothesis advanced by Lee, Mayers, and Smith (1997). [1] In addition, the authors are able to validate this result by exploiting the option characteristics of the risk-subsidy. Specifically, the study shows that the relation between risk and ownership is stronger for insurers whose put option is closer to being in the money. Finally, as monitoring and risk-subsidy are not mutually exclusive, the authors attempt to avoid a complete dismissal of the monitoring hypothesis by examining a series of piecewise linear relations between risk and ownership. This approach effectively relaxes the condition under which the authors might conclude in favor of the existence o f monitoring. The results appear to have important implications for the effectiveness of guaranty funds and other financial institution insurance programs. BACKGROUND, THEORETICAL ARGUMENTS, HYPOTHESES The Insurance Guaranty Fund System During the years 1969 to 1981, all states enacted laws to establish guaranty funds to protect the policyholders of insolvent insurance companies. [2] The protection provided by these state guaranty funds, however, is far from complete. [3] For instance, the funds typically limit the maximum amount that can be recovered to $300,000 per claim ($100,000 in some states), including all loss adjustment and defense costs. Deductibles are also common. In addition, certain lines of insurance typically have no coverage (e.g., reinsurance and marine insurance), and some states provide no protection for commercial insureds that exceed a particular net worth limit. Beyond these restrictions, payments from a guaranty fund are likely to be delayed compared to payments from a solvent insurer. In addition, guaranty funds do not provide reimbursement for the risk management services that the solvent insurer would have provided. The funding method used by insurance guaranty fund programs is also very important. Guaranty fund programs are funded on a post-insolvency assessment basis. [4] Thus, surviving insurers are responsible for paying the guaranty fund obligations created when one of their peers becomes insolvent. …

Property–casualty insurance guaranty funds and insurer vulnerability to misfortune

The enactment of property–casualty insurance guaranty fund statutes in the US was associated with a decrease in insurers' reserves for Homeowners and Commercial Multi-Peril insurance. The evidence is: loss ratios among states enacting guaranty fund statutes declined relative to other states. Tests on loss accruals confirm that the effect was due to decrease in reserves. Other tests that distinguish between guaranty fund statutes offer no evidence that guaranty funds encouraged sound insurers to monitor competitors and assist regulators in identifying weak insurers. Instead, the data are consistent with an explanation where insurance regulators identify and discourage risk-increasing activity.

Regulatory Free Cash Flow and the High Cost of Insurance Company Failures

Why is the cost of resolving insurance company failures so high? Evidence in this article suggests that the state insurance regulatory bodies in charge of the liquidation process turn over an average of only $0.33 for each $1.00 of pre-insolvency assets to the guaranty funds (the state agencies responsible for paying claims). This very low "recovery rate" could result from ex ante regulatory failure-the assets of the company are not worth much, reflecting regulatory problems before liquidation. Alternatively, the low recovery rate could reflect ex post regulatory failure-a regulatory version of the "free cash flow" theory (Jensen, 1986). In this latter case, cash-rich liquidators, who pay their own expenses out of the liquidation receipts first, are reluctant to turn over the money from asset sales to the guaranty funds. The evidence suggests that the low recovery rates arise from both types of regulatory failure.

Regulatory Free Cash Flow and the High Cost of Insurance Company Failures

Why is the cost of resolving insurance company failures so high? Evidence in this paper suggests that the state insurance regulatory bodies in charge of the liquidation process turn over an average of only 33 cents for each $1.00 of pre-insolvency assets to the guaranty funds (the state agencies responsible for paying claims). This very low ex ante regulatory failure -- the assets of the company are not worth much, reflecting regulatory problems prior to liquidation. Or the low recovery rate could reflect ex post regulatory failure -- a regulatory version of the 1986). In this latter case, cash-rich liquidators, who pay their own expenses out of the liquidation receipts first, are reluctant to turn over the money from asset sales to the guaranty funds. The evidence suggests that the low recovery rates arise from both types of regulatory failure.

A financial-economic evaluation of insurance guaranty fund system: An agency cost perspective

Recent occurrences of financial distress to some insurers have raised questions about whether the current guaranty system is adequate to protect policyholders. Four new systems have been proposed. Using the state preference model, it was found the Stewart's national system faring the best, if it adopts uniform regulation. Based on agency theory, the pre-assessment approach and the policyholder surcharge (or premium increase) recoupment method were found to be better than the current post-assessment approach and premium tax offset method. Furthermore, uniform policy limits and regulations are recommended.

The Role of Monitoring in Reducing the Moral Hazard Problem Associated with Government Guarantees: Evidence from the Life Insurance Industry

State guaranty funds provide partial protection to life insurance liability holders in the event of an insolvency, thus creating a potential moral hazard problem akin to the one associated with deposit insurance in the banking industry. Consistent with this theory, we find that risk taking by life insurers is higher in states with guaranty funds that are underwritten by taxpayers. In states where taxpayers pay for the costs of resolving insolvencies, life insurers hold portfolios with higher overall stock market risk and higher levels of risky assets. By contrast, in states where the guaranty funds are underwritten by the industry, overall risk is no higher than in states without these funds.

Guaranty funds and risk-taking evidence from the insurance industry

This paper examines change in property-liability insurers' risk-taking around enactments of state guaranty fund laws. Our evidence suggests that the risk of insurers' asset portfolios increases following enactments. But this increase in risk is significant only for stock insurers. Our evidence of increased risk-taking following guaranty-fund adoptions suggests that the way these funds are organized creates counterproductive investment incentives, especially for stock companies. Because these laws were enacted by states over the period 1969–1981, our evidence on changes in risk-taking helps resolve statistical problems that have been troublesome for studies of bank deposit insurance.

The Impact of Firm Risk on Property-Liability Insurance Prices

This article examines the impact of an insurer's level of insolvency risk on the prices the insurer obtains for its products in the property-liability insurance market. The measures of insolvency risk used are those implied by the option pricing model of insurance. The key finding is the existence of a negative relation between insolvency risk and insurance prices. This implies that property-liability insurers are penalized for default risk through lower prices, despite the existence of guaranty funds. Other firm-specific determinants of insurance prices are also identified. The results have significant implications for insurance researchers and regulators.

Property-Casualty Insurance Guaranty Funds and Insurer Vulnerability to Misfortune

The presence of third-party guarantees such as insurance guaranty funds can induce managers of covered institutions to take actions that increase the level of risk or increase vulnerability to unfavorable developments. This paper presents evidence of these effects taking place under insurance guaranty funds. The strongest evidence appears for Commercial Multi-Peril insurance, where the enactment of a guaranty fund is associated with a significant decline in a state's loss ratio. Similar effects appear in Homeowners' Multi-Peril coverage, although evidence for Homeowners' is not as strong as for Commercial Multi-Peril coverage. The observed decline in the loss ratio is not explained by other factors such as state regulation, investment yields, or other time-related trends. The observed decline is too large to be explained by the level of guaranty fund assessments. Understatement of expected future claim payments (underreserving) offers the most plausible explanation. A concluding section of the paper discusses a pricing method for guaranty fund coverage that could diminish any rewards arising from understatement of future claims. The design of a pricing system could benefit by applying lessons from bank deposit insurance as well as the insurance industry's considerable experience with pricing methods designed to overcome moral hazards.

Price regulation in US automobile insurance. A case study of Massachusetts private passenger automobile insurance 1978–1990.

This short note highlights price regulation in the United States Personal Automobile Market by reviewing the results of the most highly-regulated U. S. market, the fix-and-establish system in Massachusetts during 1978 to 1990. Financial outcomes of the state-run market are shown. Effects of pricing policy on the size of the residual market, interclass subsidies and the participation of national property-casualty companies in the Massachusetts market are discussed. Contrasts with the post-proposition 103 California personal auto market are explored. Implications for guaranty funds are derived. Finally, the outlook for the Massachusetts and California personal auto markets is discussed together with implications for the upcoming integration of the EEC insurance markets.

Price Regulation in US Automobile Insurance A Case Study of Massachusetts Private Passenger Automobile Insurance 1978–1990

This short note highlights price regulation in the United States Personal Automobile Market by reviewing the results of the most highly-regulated U. S. market, the fix-and-establish system in Massachusetts during 1978 to 1990. Financial outcomes of the state-run market are shown. Effects of pricing policy on the size of the residual market, interclass subsidies and the participation of national property-casualty companies in the Massachusetts market are discussed. Contrasts with the post-proposition 103 California personal auto market are explored. Implications for guaranty funds are derived. Finally, the outlook for the Massachusetts and California personal auto markets is discussed together with implications for the upcoming integration of the EEC insurance markets.

"Other's People's Money" Revisited: Collective Embezzlement in the Savings and Loan and Insurance Industries

This paper compares what is called here “collective embezzlement” in the savings and loan and insurance industries, tracing this embezzlement by top management in these two industries to structures of opportunity and risk that are specific to their location in finance capitalism. Using data from government reports, congressional hearings, and media accounts of particular cases, we argue that the deregulation of the 1980s combined with protective insurance and guaranty funds set the stage for this white-collar crime, but that its prevalence is more fundamentally related to a number of other structural factors. Specifically, the primary function of these industries as trustees of other people's money, within the context of a “casino” economy where profits are made from speculative investment, not production, simultaneously expands the opportunities for embezzlement and other abuses of trust and sets in place structural contradictions that stymy policymakers and regulators and limit the risks of detection and prosecution. Future research should build on the rich literature on white-collar crime, which has traditionally focused on the production processes and market structures of industrial capitalism, to examine the implications of the shift in the late 20th century to an economy increasingly centered on the management and manipulation of money itself.

An Empirical Analysis of Risk-Related Insurance Premiums for the PBGC

Abstract In 1986, one component of the single-employer plan termination insurance program was altered in an attempt to assure its financial integrity. A year later, the Pension Benefit Guaranty Corporation proposed that the basis for computing premiums for plan sponsors also be changed and the basic philosophy of the proposal was incorporated in the Omnibus Budget Reconciliation Act of 1987. This article develops probability and severity models for large single-employer defined benefit sponsors. Estimates of the liability that underfunded plans impose on the PBGC are obtained from combining the results of the two models and calculations of insurance premiums are presented. Introduction In 1974, the Employee Retirement Income Security Act (ERISA) established a plan termination insurance program for the majority of defined benefit pension plans in the United States to ensure that at least a certain level of participants' benefits would be paid without regard to the funded status or continued existence of the sponsor's pension plan. The extant literature is replete with articles pointing out the preverse financial incentives created by this program (e.g., Sharpe, 1976; Treynor, Regan and Priest, 1976; Treynor, 1977; and Harrison and Sharpe, 1983) and, since its inception, the deficit generated by the single-employer component of this system had grown to as much as $3.8 billion. In 1986, one of the major defects associated with the original design was corrected when the Single Employer Pension Plan Amendments Act (SEPPAA) changed the insured event from that of, in essence, any plan termination to a termination accompanied by a specified event for the plan sponsor. [1] This change effectively limited the insurable event to an insufficient [2] termination due to bankruptcy by the sponsor, thereby virtually eliminating the opportunity of an ongoing sponsor to exchange the unfunded vested liabilities of the plan for 30 percent of its net worth (an option existing under the original provisions of (ERISA). However, it did nothing to change the premium structure from a flat dollar amount per participant. Congress recently redressed this shortcoming in part by enacting a variable rate premium structure that will relate the sponsor's annual premium to the plan's underfunding (as measured on a termination basis). Although this change will factor the plan's potential severity into the determination of the annual premium, it falls short of a risk-related premium structure that would characterize the insurance if it were written in the private sector. Such a structure would base annual premiums not only on the potential severity but also the probability of an insured event taking place (i.e., bankruptcy of a sponsor with an underfunded plan). The new premium system also differs from a free market approach in that it includes a maximum charge of $50 per participant. The idea of risk-related premiums for the plan termination insurance program is not new. In his seminal work on the establishment of a guaranty fund for pension plan benefits insurance, McGill (1970, p. 76) made a provision to reflect the probability of plan termination in the premium rate if the burden appeared to be consequential. Congress, however, initially set the PBGC premium rates at $1.00 per participant. [1] Although PBGC was provided the opportunity under ERISA Section 4006 to modify this initial premium structure, no action was taken until Congress mandated under SEPPAA that PBGC investigate alternative premium bases upon which some or all projected future program costs could be allocated on a variable rated or risk-related computation. In response, the PBGC (1987, p. 55) produced a proposal for a variable rate premium structure that provided the basic structure of the legislative changes under the Omnibus Budget Reconciliation Act of 1987 (OBRA). [4] The new single-employer plan termination insurance program increased the flat rate premium to $16. …

Risk‐Based Premiums for Insurance Guaranty Funds

ABSTRACTInsurance guaranty funds have been adopted in all states to compensate policyholders for losses resulting from insurance company insolvencies. The guaranty funds charge flat premium rates, usually a percentage of premiums. Flat premiums can induce insurers to adopt high‐risk strategies, a problem that can be avoided through the use of risk‐based premiums. This article develops risk‐based premium formulas for three cases: a) an ongoing insurer with stochastic assets and liabilities, b) an ongoing insurer also subject to jumps in liabilities (catastrophes), and c) a policy cohort, where claims eventually run off to zero. Premium estimates are provided and compared with actual guaranty fund assessment rates.

Risk-Based Premiums for Insurance Guaranty Funds

Risk-Based Premiums for Insurance Guaranty Funds

Guaranty Funds: Consumer's last right: The industry's last rite?

Guaranty Funds: Consumer's last right: The industry's last rite?