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When Insurers Go Bust

When Insurers Go Bust: An Economic Analysis of the Role and Design of Prudential Regulation

Guillaume Plantin
Jean-Charles Rochet
Copyright Date: 2007
Pages: 112
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  • Book Info
    When Insurers Go Bust
    Book Description:

    In the 1990s, large insurance companies failed in virtually every major market, prompting a fierce and ongoing debate about how to better protect policyholders. Drawing lessons from the failures of four insurance companies,When Insurers Go Bustdramatically advances this debate by arguing that the current approach to insurance regulation should be replaced with mechanisms that replicate the governance of non-financial firms.

    Rather than immediately addressing the minutiae of supervision, Guillaume Plantin and Jean-Charles Rochet first identify a fundamental economic rationale for supervising the solvency of insurance companies: policyholders are the "bankers" of insurance companies. But because policyholders are too dispersed to effectively monitor insurers, it might be efficient to delegate monitoring to an institution--a prudential authority. Applying recent developments in corporate finance theory and the economic theory of organizations, the authors describe in practical terms how such authorities could be created and given the incentives to behave exactly like bankers behave toward borrowers, as "tough" claimholders.

    eISBN: 978-1-4008-2777-0
    Subjects: Economics, Business

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-vi)
  3. Foreword
    (pp. vii-vii)
    Hyun Song Shin

    This timely book is a rare, cogent analysis of the regulation of insurance companies from the point of view of economics. The topic of insurance regulation has come right to the fore in the policy debates in financial regulation, and rightly so given the pivotal role of insurance companies in the financial system as direct and indirect claimholders of banks and other leveraged institutions, as well as their long-term role in channeling savings for an aging population. And yet, the current framework for insurance regulation across the advanced economies is a patchwork of rules that have built up over years,...

  4. Acknowledgements
    (pp. viii-x)
  5. 1 Introduction
    (pp. 1-3)

    The insurance industries of several countries have recently experienced periods of stress related to the failure of large, sometimes well-established, insurers. We begin our analysis with a study of four such cases: Independent Insurance and Equitable Life in the United Kingdom, Groupe des Assurances Nationales (GAN) and Europavie in France. These scandals have prompted a general and fierce debate (in the press, in the academic literature, but also in the political arena) about the need to reform the complex regulatory–supervisory systems that most countries have designed. The aim of this book is to offer practical recommendations, backed by rigorous...

  6. 2 Four Recent Cases of Financially Distressed Insurers
    (pp. 4-28)

    In this chapter we analyze four recent scandals, each of them caused by the quasi-failure of a large insurance company. Two of them are life-insurance companies, the third is a property/casualty insurer, and the fourth is a financial conglomerate. Two of them are young firms that started out in the late 1980s, the other two are old, well-established institutions. Two are French, two are British. We emphasize that, in spite of this apparent diversity, these four cases have several salient features in common. Our aim is to shed light on these features. They are the stylized facts upon which our...

  7. 3 The State of the Art in Prudential Regulation
    (pp. 29-42)

    In this chapter, we aim to offer a broad picture of the current dominant views on the prudential regulation of insurance companies. We start by explaining the main features of the prudential system. We go on to describe the main theoretical framework that practitioners have in mind when debating prudential regulation, and finally we emphasize what we consider to be the shortcomings of this theoretical framework.

    Prudential systems basically have two components.

    (i) Prudential regulations stating that insurance companies

    (a) must estimate their outstanding liabilities toward policyholders in a sufficiently conservative fashion;

    (b) must invest in assets whose aggregate liquidity...

  8. 4 Inversion of the Production Cycle and Capital Structure of Insurance Companies
    (pp. 43-55)

    As is particularly clear in the Independent case, the reason insurance companies are likely to suffer from important agency problems¹ is the well-known inversion of the production cycle in the insurance industry. Unlike most other goods and services, insurance services are only producedafterthey are purchased by policyholders. For example, in property/casualty insurance, premiums are typically paid by policy-holders when the contract is signed, but compensation is paid by insurers only after a claim is made and settled, which may take several years. This is so because it would be difficult in practice to collect premiumsex postfrom...

  9. 5 Absence of a Tough Claimholder in the Financial Structure of Insurance Companies and Incomplete Contracts
    (pp. 56-63)

    The inversion of the production cycle may give rise to a chain reaction in which poor governance and value destruction reinforce each other because of the absence of a tough, sophisticated claimholder within insurance companies. A typical nonfinancial firm has two sorts of claimholder who possess financial expertise, or who can afford to hire experts: large shareholders and banks. Banks play an important role if a negative shock hits the firm, because they are concerned by the possibility of not recovering the full value of their loans if the situation deteriorates further. More importantly, unlike share-holders they have less incentive...

  10. 6 How to Organize the Regulation of Insurance Companies
    (pp. 64-74)

    We have argued that the prudential authority should behave as the “banker” of insurance companies. Just as banks screen and monitor their debtors, the prudential authority should screen and monitor insurance firms, without intervening in their ongoing operations as long as simple and easily verifiable financial ratios are met. But it should be committed to making prompt and tough decisions as soon as a company no longer complies with certain prudential rules. When this happens, the only aim of the regulator must be the recovery ofcurrentpolicyholders’ outstanding claims, even if it hurts future business opportunities or is detrimental...

  11. 7 The Role of Reinsurance
    (pp. 75-82)

    While describing the role of capital structure in chapters 4 and 5, we have stressed that corporations design various securities, such as debt and equity, in order to optimally split risks among their various claimholders. Alternatively, they can also insulate their claimholders from some risks by hedging these risks. Namely, they can immunize the cash flows they promise to their claimholders against some risks by purchasing insurance from a third party who has a better ability to bear these risks.

    Insurance companies, like other firms, also have the ability to purchase insurance against the risks generated by their core activities....

  12. 8 How Does Insurance Regulation Fit within Other Financial Regulations?
    (pp. 83-96)

    This chapter examines how the prudential regulation of insurance fits within other financial regulations—the regulation of banks and financial conglomerates, and the management of systemic risk.

    Prudential regulators should be equipped with specific tools for dealing with financial conglomerates. By conglomerate, we mean a group of firms operating in heterogeneous business lines, the heterogeneity being either geographical or operational (e.g., life and non-life insurance, or insurance and banking). These firms have financial links to each other and are controlled by the same top management and/or shareholders. The number of such conglomerates grew during the 1990s, due to the development...

  13. 9 Conclusion: Prudential Regulation as a Substitute for Corporate Governance
    (pp. 97-98)

    Because the customers of insurance companies, that is, policyholders, are their main creditors, their interests should be protected in the very same way as the main creditors of other firms—typically, sophisticated financial institutions such as banks—have their interests protected. Unlike in sophisticated financial institutions, policyholders are dispersed, often-uninformed claimholders, and do not necessarily have the skills to monitor their insurer. This is why the monitoring task is typically delegated to a specific institution: the supervisory authority. The main challenge, when designing the prudential regulation system, is to make this delegation as efficient as possible. Namely, the regulator must...

  14. References
    (pp. 99-101)