Risk Management and Financial Institutions. Hull John C.

with the maturity of liabilities. However, it takes on credit risk because the default rate on the bonds may be higher than expected.

TABLE 3.3 Abbreviated Balance Sheet for Life Insurance Company

      Unlike a bank, an insurance company has exposure on the liability side of the balance sheet as well as on the asset side. The policy reserves (80 % of assets in this case) are estimates (usually conservative) of actuaries for the present value of payouts on the policies that have been written. The estimates may prove to be low if the holders of life insurance policies die earlier than expected or the holders of annuity contracts live longer than expected. The 10 % equity on the balance sheet includes the original equity contributed and retained earnings and provides a cushion. If payouts are greater than loss reserves by an amount equal to 5 % of assets, equity will decline, but the life insurance company will survive.

      Property-Casualty Insurance Companies

Table 3.4 shows an abbreviated balance sheet for a property-casualty life insurance company. A key difference between Table 3.3 and Table 3.4 is that the equity in Table 3.4 is much higher. This reflects the differences in the risks taken by the two sorts of insurance companies. The payouts for a property-casualty company are much less easy to predict than those for a life insurance company. Who knows when a hurricane will hit Miami or how large payouts will be for the next asbestos-like liability problem? The unearned premiums item on the liability side represents premiums that have been received, but apply to future time periods. If a policyholder pays $2,500 for house insurance on June 30 of a year, only $1,250 has been earned by December 31 of the year. The investments in Table 3.4 consist largely of liquid bonds with shorter maturities than the bonds in Table 3.3.

TABLE 3.4 Abbreviated Balance Sheet for Property-Casualty Insurance Company

      3.10 THE RISKS FACING INSURANCE COMPANIES

      The most obvious risk for an insurance company is that the policy reserves are not sufficient to meet the claims of policyholders. Although the calculations of actuaries are usually fairly conservative, there is always the chance that payouts much higher than anticipated will be required. Insurance companies also face risks concerned with the performance of their investments. Many of these investments are in corporate bonds. If defaults on corporate bonds are above average, the profitability of the insurance company will suffer. It is important that an insurance company's bond portfolio be diversified by business sector and geographical region. An insurance company also needs to monitor the liquidity risks associated with its investments. Illiquid bonds (e.g., those the insurance company might buy in a private placement) tend to provide higher yields than bonds that are publicly owned and actively traded. However, they cannot be as readily converted into cash to meet unexpectedly high claims. Insurance companies enter into transactions with banks and reinsurance companies. This exposes them to credit risk. Like banks, insurance companies are also exposed to operational risks and business risks.

      Regulators specify minimum capital requirements for an insurance company to provide a cushion against losses. Insurance companies, like banks, have also developed their own procedures for calculating economic capital. This is their own internal estimate of required capital (see Chapter 26).

      3.11 REGULATION

      The ways in which insurance companies are regulated in the United States and Europe are quite different.

      United States

      In the United States, the McCarran-Ferguson Act of 1945 confirmed that insurance companies are regulated at the state level rather than the federal level. (Banks, by contrast, are regulated at the federal level.) State regulators are concerned with the solvency of insurance companies and their ability to satisfy policyholders' claims. They are also concerned with business conduct (i.e., how premiums are set, advertising, contract terms, the licensing of insurance agents and brokers, and so on).

      The National Association of Insurance Commissioners (NAIC) is an organization consisting of the chief insurance regulatory officials from all 50 states. It provides a national forum for insurance regulators to discuss common issues and interests. It also provides some services to state regulatory commissions. For example, it provides statistics on the loss ratios of property-casualty insurers. This helps state regulators identify those insurers for which the ratios are outside normal ranges.

      Insurance companies are required to file detailed annual financial statements with state regulators, and the state regulators conduct periodic on-site reviews. Capital requirements are determined by regulators using risk-based capital standards determined by NAIC. These capital levels reflect the risk that policy reserves are inadequate, that counterparties in transactions default, and that the return from investments is less than expected.

      The policyholder is protected against an insurance company becoming insolvent (and therefore unable to make payouts on claims) by insurance guaranty associations. An insurer is required to be a member of the guaranty association in a state as a condition of being licensed to conduct business in the state. When there is an insolvency by another insurance company operating in the state, each insurance company operating in the state has to contribute an amount to the state guaranty fund that is dependent on the premium income it collects in the state. The fund is used to pay the small policyholders of the insolvent insurance company. (The definition of a small policyholder varies from state to state.) There may be a cap on the amount the insurance company has to contribute to the state guaranty fund in a year. This can lead to the policyholder having to wait several years before the guaranty fund is in a position to make a full payout on its claims. In the case of life insurance, where policies last for many years, the policyholders of insolvent companies are usually taken over by other insurance companies. However, there may be some change to the terms of the policy so that the policyholder is somewhat worse off than before.

      The guaranty system for insurance companies in the United States is therefore different from that for banks. In the case of banks, there is a permanent fund created from premiums paid by banks to the FDIC to protect depositors. In the case of insurance companies, there is no permanent fund. Insurance companies have to make contributions after an insolvency has occurred. An exception to this is property-casualty companies in New York State, where a permanent fund does exist.

      Regulating insurance companies at the state level is unsatisfactory in some respects. Regulations are not uniform across the different states. A large insurance company that operates throughout the United States has to deal with a large number of different regulatory authorities. Some insurance companies trade derivatives in the same way as banks, but are not subject to the same regulations as banks. This can create problems. In 2008, it transpired that a large insurance company, American International Group (AIG), had incurred huge losses trading credit derivatives and had to be bailed out by the federal government.

      The Dodd–Frank Act of 2010 set up the Federal Insurance Office (FIO), which is housed in the Department of the Treasury. It is tasked with monitoring the insurance industry and identifying gaps in regulation. It can recommend to the Financial Stability Oversight Council that a large insurance company (such as AIG) be designated as a nonbank financial company supervised by the Federal Reserve. It also liaises with regulators in other parts of the world (particularly, those in the European Union) to foster the convergence of regulatory standards. The Dodd–Frank Act required the FIO to “conduct a study and submit a report to Congress on how to modernize and improve the system of insurance regulation in the United States.” The FIO submitted its report in December 2013.6 It identified changes necessary to improve the U.S. system of insurance regulation. It seems likely that the United States will either (a) move to a system where regulations are determined federally and administered at the state level or (b) move