Dibra.Fail

If OSFI's mission is to minimize the probability of insolvencies, then Dibra & Leadbetter's paper on why insurance companies fail should be required reading. There are well-known risk factors, both internal and external, and insolvency is rarely a surprise.   Forum

Pop Quiz

One reason an insurance company may fail is exposure to a devastating flood. Do you remember the 4 preconditions for a strong flood risk management culture. [Hint: maps.IA$] (This was discussed in the reading on flood insurance, IBC.Flood.)

BattleTable

Based on past exams, the main things you need to know (in rough order of importance) are:

• internal causes of insurer insolvency
• how to analyze a scenario for insolvency risk
• external causes of insurer insolvency
• proximate causes of insurer insolvency
• miscellaneous facts regarding winding-up of an insurer and PACICC (See PACICC.Comp)

If you only have 20 minutes to study this paper, then do the following (and skip the rest):

• memorize the internal causes of insurer insolvency [Hint: GoNGS]
• review the exam problems with a SCENARIO where you have to evaluate insolvency risk

If you have 2 hours to study this paper, then you can cover all of it, including looking at selected portions of the source paper.

Top Questions ← Questions you absolutely need to know!

reference	part (a)	part (b)	part (c)	part (d)
E (2018.Fall #13)	insolvency causes: - proximate causes	PACICC.Comp
E (2018.Fall #11)	SCENARIO: - evaluate insolvency risk
E (2017.Fall #12)	insolvency causes: - INTERNAL causes
E (2016.Fall #12)	definition: - insolvency & liquidity risk	insolvency causes: - proximate causes	insolvency causes: - INTERNAL causes
E (2015.Fall #8)	PACICC: - purpose	PACICC: - treatment of dividends	insolvency causes: - INTERNAL causes
E (2014.Fall #11)	winding-up: - measurement of costs
E (2013.Fall #12)	winding-up: - issuance of order	SCENARIO: - evaluate insolvency risk
E (2012.Fall #17)	insolvency causes: - INTERNAL causes

In Plain English!

Intro

Alice the Actuary told me that insolvency is rarely a surprise. Her theory is that executives sometimes willfully ignore obvious signs of trouble because to admit there are problems is to admit they managed the company poorly. (Their egos can't handle that!)

This is a pretty easy paper to study, and old exam questions are usually easy as well. Once exception is (2015.Fall #8b) and we'll specifically cover that later in this article.

The reading is organized around external and internal causes of insolvency.

Question: define the term insolvency

• an involuntary market exit due to a winding-up order being issued by a supervisory authority

This definition has never been asked on the exam, but it seems like a good potential question. In any case, we can't discuss something without first agreeing on what it is.

The next logical question is then:

Question: when is a wind-up order issued

• a wind-up order may be issued when the regulator decides the insurer is no longer viable:

• (capital available) < (minimum capital required) due to unacceptable level of risk in 1 or more risk categories IMCO (See OSFI.MCT)

- in other words, the MCT ratio < 100%

• excessive liquidity risk or insolvency risk

You can google the terms liquidity risk and insolvency risk or look in the BattleCards in the next mini BattleQuiz

The paper has a graph showing the numbers of insurer insolvencies from 1960-2005, and there is a big jump in the early 1990s. Reasons for this jump might include:

economic volatility: increased volatility in U/W cycles (This is at least somewhat within the control of insurers.)

catastrophes: exposure is increasing (This relates to climate change and increasing population density. See IBC.Flood.)

The above reasons are external causes of insolvency and are discussed in the next section. Note that the Dibra paper was published way back in 2007 - it appears they were right about increasing cat exposures.

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External Causes

An external cause of insolvency is something that potentially affects all insurers, like a catastrophe. Conversely, an internal cause would something like poor management, something that's specific to a single insurer. In this section, we'll look at common external causes of insolvency.

Question: describe some external causes of insurer insolvency [Hint: U/W.cats.eco.iX]

U/W: U/W cycle and profitability - in a soft market, prices and profits are lower, so insurers are less able to absorb unexpected losses.

cats: Catastrophes - includes natural and industrial disasters

eco: Economic Cycles - can be related to U/W cycles, but they aren't the same thing (stock prices, inflation,...)

iX: International Exposure - 2/3 of Canadian P&C insurers are foreign-owned, but this is not actually considered a strong risk factor for insolvencies

For the 3rd point above, eco, the BattleCards drill down to more detail. For example, it isn't the level of economic indicators that's correlated with insolvencies, it's the volatility. In other words, if the stock market stays at a consistent level, that's predictable, and we can plan around that. The real problem is if the market is volatile, meaning that it goes up and down in an unpredictable way.

Take a look at the relevant sections in the reading, pages 16-21. It's well-written - easy bedtime reading.

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Internal Causes

In the previous section, we listed poor management as an internal cause of insolvency. Here we list a few more.

Question: describe some internal causes of insurer insolvency [Hint: GoNGS]

Governance & internal controls (poor management and oversight)

New entrants (subject to competition & inexperience)

Growth (too rapid & loss ratios tend to be higher for new business)

Size (too small to absorb losses)

This question has been asked at least 4 times on past exams, including on part (c) of:

E (2016.Fall #12c)

It was worth 2 points, and there aren't many 2-point questions that are this easy. For 0.5 points each, you may have to write a little more than what I've given above for full credit, but the BattleCards have extra details. Or you can go back to the source paper. You could read that section and make a few notes in about 20 minutes.

Before moving on, let's consider a related but slightly different question that has appeared on the exam. See part (b) of E (2016.Fall #12b)

Question: identify 4 proximate causes of insurer insolvency in the Canadian P&C industry

Now, the paper says there is often no single cause of insolvency, that it's a mixture of external and internal causes. That's true, but often there is a single proximate cause, the last straw so to speak. This would be the final trigger that took a troubled insurer over the brink into actual insolvency. There is a table on page 7 that lists 9 proximate causes in order of frequency. Here are the top 4:

• inadequate pricing, deficient loss reserves
• foreign parent
• rapid growth
• alleged fraud

I don't think it was a good exam question. It tests only whether you memorized that table from the paper. Whoever created that question was just being lazy. The main ideas in this reading are the external and internal causes of insolvency. I can understand the reason for memorizing those, but you can't be expected to memorize every list & table in every reading. You have to use your judgment in this regard.

A much better question is reference below. It describes a scenario and asks you to apply your knowledge.

E 2013.Fall #12b

Note that a similar question from 2018 requires you to know what surety insurance is. A simple example is a plumber:

A province may require a plumber to obtain a surety bond as part of the licensing process. If the plumber doesn't comply with building regulations when performing his work, the plumber's customer is protected from financial loss by the surety bond.

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2015.Fall #8b

I mentioned in the intro that part (b) of this question was pretty hard:

E (2015.Fall #8b)

The first time I read this paper, I glossed over that part. Apparently the following item is important:

• treatment of dividends paid to a guarantee fund as a creditor of the estate

Of course, I can see why this is important. It just seemed too detailed relative to typical exam questions on this topic. This was from 2015.Fall and since then, the questions have been straightforward and mainly about the causes of insurer insolvency. Anyway, the question was: (See PACICC.Comp for more information about PACICC.)

Question: regarding treatment of dividends how is PACICC different from other guarantee funds in the U.S. or U.K.

PACICC: liquidated dividends are returned to solvent members

US/UK: liquidated dividends reduce current & future assessments

Given the volume of material on this exam, you always have to make judgment calls on what to memorize and what to skip. A tip-off that this might appear on an exam is that there is a graph illustrating the concept on page 15.

The mini BattleQuiz contains this and a few other miscellaneous facts about PACICC. See PACICC.Comp#Funding_and_Assessment.

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Theoretical Models (OUT OF SYLLABUS!!)

There is a fascinating discussion starting on page 9 called Literature Review. It discusses theoretical models to assess the probability of a firm's survival. This could be a great research project, but it doesn't seem like something that's easily testable. Also, the models are not specific to the insurance industry, but were designed for manufacturing sectors.

The 2 models are:

Dynamic Equilibrium Model: considers the effect of environmental factors on a firm's entry & exit

Hazard Model: considers factors that move the market to a new equilibrium

BattleCodes

Memorize:

• definition of insolvency
• 4 external causes of insolvency
• 4 internal causes of insolvency
• 4 proximate causes of insolvency for Canadian P&C insurers
• treatment of dividends by PACICC versus U.S./U.K. guarantee funds

Conceptual:

• Who is the audience for this information? Executives of a company? Regulators?
  • Obviously, both can benefit from greater knowledge of the causes of failure, but I suspect that regulators are the main beneficiary. Executives of a troubled company probably know they're in trouble long before it becomes obvious to outside parties. The causes listed here could be high-level warning signs of impending trouble. (Note that regulators would also have access to more detailed information like the MCT ratio, MSA ratios, DCAT analysis, Appointed Actuary's report.)
• Given specific information about an insurer, can you evaluate the probability of insolvency? (As in 2013.Fa11 #12b)

Calculational:

• none (although the paper PACICC.Comp is related and there is a calculation problem there)

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  Forum

POP QUIZ ANSWERS

If you knew the answer without having to look it up, then you're doing very well!!

Note that in the BattleCards for IBC.FLood, the mnemonic hint for remembering this list is: maps.IA$ where

• maps = FldMaps
• I = Infrastructure
• A = Awareness
• $ = incentivize policyholder by limiting Govt $s for compensation

A slightly more detailed answer is:

• need FldMaps (for planning & RskMgmt)
• good Infrastructure (levies, sewers)
• policyholder Awareness of risk, methods of risk mitigation, and FinMgmt for floods
• Incentives for individual RskMgmt (by limiting Govt $s for compensation)