With a slew of recent financial institution failures, it’s an important time for insurers to put solvency front of mind.
Throughout March of 2023, the world anxiously watched as a series of bank failures created more volatility than we’ve seen since the 2008 financial crisis. While each bank’s trouble had a different root cause, the highest-profile of the recent failures, Silicon Valley Bank, suffered from a liquidity crisis, resulting in its very quick demise.
Banking and insurance are two closely related industries and both are heavily regulated to protect consumers from devastating losses that can occur when a bank doesn’t have the funds to honor its deposits, or when an insurance company doesn’t have the funds to pay its claims.
Each industry has its own regulations that require institutions to hold a certain amount of liquid funds so they don’t financially collapse under stress. Unfortunately, these regulations don’t always prevent a worst-case scenario from happening. With bank failures at the forefront of our collective consciousness, we thought it would be a good time to refresh everyone on the importance of insurance solvency and how it’s similar (and different) to solvency in banking.
What is solvency in insurance?
In the most basic sense, solvency is the ability of an insurance carrier to pay out any claims that occur. This ability relies on the insurer having access to enough cash at any given time, along with making smart investments with their premium dollars for use in the future. Insurance is designed for insurers to pay out a small number of claims compared to the total number of policies they write, which allows those companies to invest the premiums they collect and function without immediate access to that cash.
Unfortunately, this working model has been working a bit less in recent years as catastrophic events continue to result in large numbers of claims concentrated in the same geographic area and time frame. For a more in-depth look at solvency in insurance, check out the solvency series we’ve written previously, starting with this introductory piece.
What is bank solvency?
Solvency in banking refers to the institution’s ability to meet all of its financial liabilities, both short and long term. Just like how in the insurance industry, carriers are prepared to pay a certain amount in claims, banks have to be prepared for some portion of customers to ask for some portion of their money at any given time. Even if a bank doesn’t have the cash on hand to pay all of its obligations immediately, it can still be considered solvent if it has enough assets to more-than-cover any debts and liabilities. On the other hand, a bank’s ability to immediately produce the cash its customers demand is called liquidity.
What’s the difference between bank solvency and liquidity?
Financial solvency in banking means that a bank has enough total assets to cover its liabilities and debts, regardless of whether those assets are immediately available or are being held in investments or other financial instruments that are harder to tap into. Bank liquidity refers specifically to the amount of cash a bank has on hand to immediately honor its depositors’ requests for their money.
A bank can be solvent but still have a liquidity crisis if too many customers ask for too much money in a short period of time. When this happens, it’s known as a “bank run.” And if this sounds familiar, you might be thinking of the 1946 classic “It’s a Wonderful Life,” or, more recently, the run on Silicon Valley Bank that fueled its demise.
Why is solvency important in banking and insurance?
The financial systems of the U.S. and the world are deeply interconnected. When one institution has a crisis, distrust can quickly spread across global financial markets in a “financial contagion.” If not contained, a solvency issue at one bank or insurer can have a domino effect that leads to worldwide economic recession or even depression.
Why insurance solvency matters
Solvency in insurance is vital to consumers who rely on insurance protections, and as such, it’s also vital to keeping the entire world economy running.
To illustrate, imagine an insurer who primarily sells homeowners and auto insurance in the state of Florida. If a massive hurricane destroys an unforeseeably large number of homes and cars, the insurer might find itself without the assets to pay all of its claims. This would leave large numbers of residents without homes to live in and cars to drive, which in turn would impact their ability to earn a living and pay their other bills. Without an insurance company’s ability to make its customers whole after a catastrophic event, entire communities can be economically impacted for years or decades to come.
Help during an insurance solvency crisis
Luckily, consumers whose insurance companies become insolvent may have some help from outside sources. While no one wants to rely on these backstops, state guaranty funds and other state-sponsored programs may be the difference between a complete loss and some degree of recovery for consumers and businesses.
Why banking solvency matters
In banking, liquidity and solvency are important systemic issues. Any given bank invests its customers’ deposits in funds around the world, held by other banks. When one piece of global economic machinery comes to a grinding halt, it can cause other institutions to be unable to honor their own deposits: and the cycle continues. While we’re not economists, we can say that the complicated interplay between bank liquidity, the stock market, private businesses, and consumers is not something to mess around with.
Help during a banking solvency crisis
After the Great Depression, the Banking Act of 1933 created the Federal Deposit Insurance Corporation (FDIC). Since then, consumers and businesses with money in U.S. banks have the assurance that up to $250,000 of their money (per insured account) will be available, backed by the U.S. government even if their bank becomes illiquid or insolvent. Congress later created the National Credit Union Association (NCUA) in 1970 to perform a similar function for credit unions, which aren’t technically banks.
Laws governing bank and insurance solvency and liquidity
Both banking and insurance rely on institutions having enough money to pay their obligations. But how much money is that, exactly? Over time, the government has determined different rules and ratios that banks and insurers must adhere to in order to reduce the risk of insolvency or illiquidity.
While sticking to these rules isn’t a foolproof guarantee that a bank or insurer won’t ever experience a solvency crisis or a liquidity crisis, they’re certainly a part of reducing the risk of those events. Unfortunately, in recent years, the U.S. government has rolled back some protective legislation, allowing banks to operate with lower levels of liquidity than before. A report from Yale’s School of Management attributes some (though not all) of the run on Silicon Valley Bank and its subsequent closure to how the bank was allowed to operate under less strict laws.
Solvency laws in banking
After the 2008 financial crisis, the U.S. Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly known as “Dodd-Frank.” One component of this sweeping legislation was to put rules in place for a bank’s required level of liquidity, known as the liquidity coverage ratio (LCR).
In 2019, regulatory agencies revised “the criteria for determining the applicability of regulatory capital and liquidity requirements for large U.S. banking organizations,” in effect, removing the LCR from banks with between $50 billion and $250 billion in assets. While the largest U.S. and global banks are still subject to the LCR, recent events have shown just how damaging it can be when even a relatively small bank (as if $250 billion in assets could be considered small!) fails to keep adequate liquidity.
Solvency laws in insurance
While there’s no national law for the insurance industry equivalent to Dodd-Frank, each state department of insurance closely monitors the insurance carriers in their state for signs of financial health and solvency. All 50 U.S. states and most of the territories have adopted NAIC model regulation on annual financial reporting, and some states go even further than the model legislation requires.
You can read much more about state audit and annual reporting requirements here.
How bank runs are like catastrophic natural disasters
A massive horde of customers demanding their money from a bank may not seem to have much in common with a Category 5 hurricane hitting Florida. In reality, though, these two events can bring about the same results: the failure of a financial or insurance institution.
When a large-scale natural disaster leaves everyone needing their homes and cars replaced at the same time, insurers (especially local and regional insurers) can find themselves without the money to pay all the claims that’ve piled up at once.
Similarly, if the general public starts to lose confidence in a bank and everyone starts trying to withdraw their money at the same time, banks can quickly be in a position of not having money to give.
Neither situation is beneficial to banks and insurers, their customers, businesses, or the general public. That’s why both industries use a combination of risk management strategies (such as diversifying the types and locations of policies written, or investments held) to reduce the chances of one catastrophic natural disaster or one insolvent institution from taking down their entire firm.
Reduce your risk with AgentSync
As you can see, insurance solvency is nothing to be taken lightly. And no, AgentSync can’t directly help your insurance carrier business reduce claims losses. What we can do, however, is help insurers run efficiently by saving costs and employee-hours spent on tedious, manual, and repetitive license compliance management tasks. We can help you lower your compliance risk, avoid costly penalties, and even help retain staff who would rather be doing valuable work and not spending time on repeat data entry.
Contact us today to see how we can do all this and more for insurance carriers, MGAs, and MGUs looking to reduce their compliance risk and costs.