The Impact of Regulation
While portfolio and cost management are important determinants of the viability of insurance companies, the US experience indicates that th nature and extent of regulation too plays a key role in determining the viability of these companies. The insurance industry in the US has histori¬cally been one of the most regulated financial industries. The nature of regulation of life insurance companies, however, has differed significantly from the nature of regulation of property liability companies.
Regulation of the former has typically emphasised asset quality, while the regulation of the latter has largely concerned itself with policyholder's "welfare."
The regulations had impact on the quality of bonds held by the life insurance companies. New York's insurance regulatory laws require that life insurance companies ensure that, for all bonds purchased by them, the companies issuing the bonds have had enough earnings to meet debt obligations for the previous five years.
The bond issuing companies are also required to have net earnings 25 per cent in excess of the annual fixed charges, and they should not be in default with respect to either principal or interest payments. Further, regulation of various states impose quantitative restrictions on the amount of "risky" bonds that can be purchased by the insurance companies. Finally, regulations of all states are subject to the life insurance asset portfolios to the Mandatory Security Valuation Reserve (MSVR) require¬ment.
According to this requirement, which came into effect in June 1990, life insurance companies are required to make mandatory provisions for all corporate securities. The minimum provisioning, for A rated and higher quality bonds, is 0.1 per cent of par value, and the maximum provisioning of 5 per cent is required for Caa rated (or equivalent) and lower quality bonds. If the issuer of a bond goes into default, the relevant loss is adjusted against the MSVR account rather than against the company's surplus.
Further, the non life industry has suffered significantly as a conse¬quence of changing legal ethos. In the recent past, the US courts have retroactively granted citizen policyholders coverage against hazards, like those from use of asbestos, that were not factored into the actual insurance contract. As a consequence, the premia actually earned by the property ¬liability companies fell short of the "fair" prices of these contracts, and hence these companies had to bear huge losses on account of these poli¬cies.
However, while politics and changing ethos might together have dealt an unfair blow to the non life insurance companies, the importance of regulation cannot be overemphasised. The cyclical nature of the firms' profitability requires that they be monitored/regulated such that they are not in default during the unfavourable phases of the cycle. The property liability cycle is typically initiated by an exogenous shock which increases the industry's profits. The higher profits enable the compa¬nies to underwrite more policies at a lower price. During this phase, the insurance market is believed to be "soft."
The decrease in price during the soft phase, in turn, reduces the profitability of the companies, and initiates the downturn in the cycle leading to the "hard" phase. Hard markets are characterised by higher prices and reduced volumes. Once the higher prices restore the industry's profitability, the market softens again and the cycle starts again.
While portfolio and cost management are important determinants of the viability of insurance companies, the US experience indicates that th nature and extent of regulation too plays a key role in determining the viability of these companies. The insurance industry in the US has histori¬cally been one of the most regulated financial industries. The nature of regulation of life insurance companies, however, has differed significantly from the nature of regulation of property liability companies.
Regulation of the former has typically emphasised asset quality, while the regulation of the latter has largely concerned itself with policyholder's "welfare."
The regulations had impact on the quality of bonds held by the life insurance companies. New York's insurance regulatory laws require that life insurance companies ensure that, for all bonds purchased by them, the companies issuing the bonds have had enough earnings to meet debt obligations for the previous five years.
The bond issuing companies are also required to have net earnings 25 per cent in excess of the annual fixed charges, and they should not be in default with respect to either principal or interest payments. Further, regulation of various states impose quantitative restrictions on the amount of "risky" bonds that can be purchased by the insurance companies. Finally, regulations of all states are subject to the life insurance asset portfolios to the Mandatory Security Valuation Reserve (MSVR) require¬ment.
According to this requirement, which came into effect in June 1990, life insurance companies are required to make mandatory provisions for all corporate securities. The minimum provisioning, for A rated and higher quality bonds, is 0.1 per cent of par value, and the maximum provisioning of 5 per cent is required for Caa rated (or equivalent) and lower quality bonds. If the issuer of a bond goes into default, the relevant loss is adjusted against the MSVR account rather than against the company's surplus.
Further, the non life industry has suffered significantly as a conse¬quence of changing legal ethos. In the recent past, the US courts have retroactively granted citizen policyholders coverage against hazards, like those from use of asbestos, that were not factored into the actual insurance contract. As a consequence, the premia actually earned by the property ¬liability companies fell short of the "fair" prices of these contracts, and hence these companies had to bear huge losses on account of these poli¬cies.
However, while politics and changing ethos might together have dealt an unfair blow to the non life insurance companies, the importance of regulation cannot be overemphasised. The cyclical nature of the firms' profitability requires that they be monitored/regulated such that they are not in default during the unfavourable phases of the cycle. The property liability cycle is typically initiated by an exogenous shock which increases the industry's profits. The higher profits enable the compa¬nies to underwrite more policies at a lower price. During this phase, the insurance market is believed to be "soft."
The decrease in price during the soft phase, in turn, reduces the profitability of the companies, and initiates the downturn in the cycle leading to the "hard" phase. Hard markets are characterised by higher prices and reduced volumes. Once the higher prices restore the industry's profitability, the market softens again and the cycle starts again.