From underwriting to guaranty funds, the legacy machine that is the insurance industry is built on a series of private and public entities and partnerships, most with redundancies and failsafes, all working on the premise that a guarantee should be that: guaranteed.
Solvency essentially is the ability to pay what you owe. In the case of insurers, it’s the ability to pay for claims. From the consumer side of things, solvency is knowing that, if something unfortunate happens to your life, health, property, business, etc., that the insurance company will hold up its side of the contract.
A solvency ratio is the ticky-tacky method of calculating solvency – essentially, it’s the ratio of a company’s capital divided by its contractual obligations, sort of an assets-to-debt ratio.
Determining an insurance carrier’s solvency ratio includes:
And, of course, even the most sturdy companies can be rocked by conditions unforeseen by underwriters, such as in the event of a particularly concentrated disaster. In these cases, reinsurance and guaranty associations provide broader solutions to maintain the assurance that, beyond an individual company, the insurance industry is sound.
While top to bottom, insurance is meant to be a sure bet, fullstop, our solvency series covers some of the often-unseen or misunderstood pieces that contribute to the “sure” part of insurance.
The first foundation of surety for insurers is in the underwriting process. This unglamorous bedrock is where actuaries use massive amounts of data to calculate the likelihood of particular risks occurring, the variables that matter, and, ultimately, the cost associated with insuring against that risk and how many people they need to purchase the insurance to be able to pay claims while maintaining profit.
Of course, insurers are not omnipotent and even the best-assessed risks may be off base. Using historical likelihoods to inform your decisions can only get you so far.
Insurers invest their capital – profitability and sustainability go hand in hand. Yet, regardless of market performance, an insurance carrier needs to have enough money available to reasonably pay their contractual obligations. It’s also true that, barring catastrophic events, it’s unlikely that all policyholders will submit claims all at once.
States have requirements about how much reserve a carrier must maintain in order to fit a legal definition of being able to pay claims. This definition may shift somewhat depending on the nature of the line of insurance.
To back up their guarantees, insurance companies often have contracts with reinsurers that provide two real services: allowing insurers to “cede” their risks, and pooling risk amongst a larger industry or geographic region.
Ceding risk essentially means the insurance carriers are giving some of the risk of their contracts to the reinsurer. This allows insurers to provide more coverage without increasing premiums, while also providing safety measures in the case of catastrophic events.
While a lot of effort and regulation goes into making sure insurance carriers are capable of meeting their financial obligations, the truth is that not all insurers are created equally. Ratings agencies compose a private segment of the industry that bolsters the solvency system. By obtaining a rating from one of the top ratings agencies, carriers broadcast their financial health – and sometimes lack thereof – to consumers in a report card style that is more easily understood in lay terms.
By checking a carrier’s published rating, consumers have heightened abilities to judge for themselves whether a carrier – and, by extension, a policy – is really as sound as it seems.
Trust but verify: States require insurers to file annual reports on their financial standings. Verifying cash reserves, explaining significant balance changes, and generally being transparent about bookkeeping – these are all advantages of insurer self-reporting. Yet, just in case, states also require larger insurers or insurers whose solvency is in any doubt to validate their report through an independent auditor.
This process ensures a higher standard for insurance transparency and guards against dangerously optimistic or intentionally vague financial statements.
When a company’s solvency is called into question in a big way, a state may put the troubled carrier into a legal situation called a receivership. The receivership mechanism puts a carrier under state control, and seeks first to reorganize the company into a more financially stable condition. However, if minor or even major changes won’t be enough to maintain the troubled insurer’s capability of paying claims into the future, the state will take more drastic measures.
Liquidation = drastic measures. A state liquidates a company as a last resort to maintain as much of the contract guarantees as possible, using a guaranty fund to pay immediate claims but generally selling lots of contracts off to more solvent companies.
The safety net under the system is the guaranty association. While details vary by state and line of authority, a guaranty association is a state-mandated association that insurers are required to be members of and pay into. The guaranty fund, maintained by a board of directors, serves as a final payment option in case of total carrier failure.
Guaranty funds pay claims while a carrier is moved from receivership into liquidation, and will pay to settle outstanding claims or partial premium returns for contracts that can’t be resold in liquidation.
Guaranty associations and guaranty funds underpin the entire insurance industry and its contractual obligations, but they are so far removed from the public eye that they often go unnoticed and undiscussed.
It may be easy to view the insurance industry as one stilted by regulation, and sometimes that is the case. Yet, the complex system of rules, norms, regulations, and overlapping redundant failsafes composes a truth of the social contract: that the guarantees of a contract are guaranteed.
If that still sounds boring, we’ll put it in slightly more starry-eyed terms. The doublechecks on solvency help us all believe in insurance and the promises of our contracts. They give us hope that, despite occasional insurer failure, or even in the face of natural catastrophes, someone will show up to fulfill those contract guarantees.
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