Guaranteeing Public Confidence

A good name, like goodwill, is got by many actions and lost by one.” This quote by Lord Jeffery, the 19th century founder of the distinguished Edinburgh Review, characterizes the ambiguous and sometimes fragile perception of reputation or public confidence.

Few things are more certain to shake consumer confidence than the insolvency of their financial institution. Data on business insolvency from Industry Canada’s Office of Bankruptcy and consumer confidence measures from Statistics Canada highlight this relationship (see Figure 1). Insolvency is highly and inversely correlated with consumer confidence (a correlation coefficient of -80%) indicating that when more companies fail, consumers lose confidence in the economy. While the data represents insolvency and public confidence across all business sectors, we expect the results are even stronger among financial institutions such as the property and casualty (P&C) insurance industry. Analysis of media stories and circulation data estimate that stories of P&C insurance insolvencies in Canada’s major daily newspapers have reached more than 50 million readers in the past two decades.

REPUTATIONAL RISKS

A Royal Bank of Canada survey highlights the importance of reputation. It found image and/or reputation to be the largest driver of consumer perceptions. In the P&C insurance industry in particular, policyholder confidence is fundamentally based on the belief that insurance contracts will be fulfilled and eligible claims paid. Other factors may influence an institution’s or the industry’s reputation, but financial soundness is the core of public confidence in the P&C industry.

Several research studies have found a relationship between financial strength and reputation effects. For example, as the likelihood increases that an insurer will not be able to pay out loss claims, fewer policyholders wish to have policies with that insurer. Guarantee funds like PACICC add to consumer confidence because they remove the risk of claims default (at amounts below the guarantee fund limits). This in turn reduces the incentive for policyholders to consider financial soundness when they purchase a policy. Nevertheless, evidence from past insolvencies indicates that policyholders do rush to switch insurers if they feel there is a risk of default. In addition to demand for policies, research has found that insurers with higher financial strength ratings (i.e. safer firms) have better revenue growth and are able to command higher premiums, particularly in markets where insolvency or the risk of insolvency is higher.

Despite its core relevance to the industry, reputation is an intangible asset: losses are apparent only after the reputation has already been damaged. If public confidence is lost in the P&C industry, then insurers might see their client numbers decrease as brokers and policyholders move their coverage over to other insurers. New regulatory burdens may result from the projected loss of consumer confidence.

Broadly speaking, there are three potential sources of reputation risk for either a P&C insurer or the overall industry. These include inherent, governance and control and environmental risks.

Inherent Risk

Inherent risks arise from or are a built-in feature of, products and services (or their delivery) and negatively impact market and customer satisfaction. For example, ambiguous policy wordings and inconsistent claims services may be a source of reputation risk if they generate a significant number of disputes.

Governance and Control Risks

Governance and control risks result from inadequate or failed internal processes, people and systems, as well as from losses caused by an organization’s failure to adopt or adhere to applicable laws, regulation rules, codes, industry standards or practices. Governance and control risks impair the market and customer’s perception of institutional integrity.

Environmental Risks

Environmental risks arise from the operating environment. They are largely unrelated to the quality of the products or services of an insurer, but can negatively impact market and customer brand or franchise acceptance. For example, insolvencies in the early and late 1980s created significant environmental risk for the industry, resulting in new regulatory environments and changes in the industry.

GUARANTEE FUND

Inherent risks and governance and control risks are specific to each financial institution. Such risks affect reputation and public confidence, but individual insurers can manage them internally. The environmental component of reputation risk is largely beyond individual insurer control; it must be addressed at an industry level by supervisory authorities and organizations like PACICC, the Insurance Bureau of Canada, the General Insurance Ombudservice and Facility Association.

As noted, the core of policyholder confidence is fundamentally based on the belief that insurance contracts will be fulfilled and eligible claims paid. Insolvency threatens this core foundation of confidence in the industry. Guarantee funds such as PACICC are the final safety net (the supervisory system representing the primary protection mechanism) for consumers in the event a financial institution fails.

Highlighting the importance of PACICC’s role in mitigating reputation risk and maintaining public confidence in the industry, OSFI’s annual polling has found that sound governance and the existence of a guarantee fund are two of the strongest contributors to public confidence in the soundness of the financial sector. Since 1997, 85% of respondents have said a guarantee fund (PACICC) contributed to their confidence in the P&C industry.

GUARANTEE FUND EFFECT

Media coverage of events may influence public confidence. This is not only because the media can choose the slant of a particular report, but also because the media can affect evaluations of the importance of different issues by choosing what to report. Since insurance is all about trust, the amount of media coverage of insolvency in the industry can be critical to the development of public opinion. In this context, the reduction in the quantity of media coverage of insolvencies since the founding of PACICC is striking.

PACICC has reviewed print media coverage since 1980 (see Figure 2). Since 1980, there has been a total of 23 insolvent P&C insurance companies – 10 prior to 1989, when PACICC was established, and 13 (or 57%) since the industry put in place a guarantee fund. Insolvencies occurring prior to PACICC accounted for 59% of all media coverage. Following the establishment of PACICC, the annual estimated coverage (in terms of readership reach) of P&C insurance insolvency-related media stories declined substantially.

PACICC also constructed an index of media coverage that takes into account insurer size and circulation trends (see Figure 3). Again, the results are quite striking: following the establishment of PACICC, the volume of media stories per insolvency of any given size of insurer fell by 84%. The introduction of unearned premium protection in 1997 appears to have further reduced the industry’s post-insolvency media exposure by half. Insolvencies now only generate about 8% of the media coverage they did prior to PACICC’s establishment.

Qualitative analysis of media coverage followed the same pattern PACICC witnessed in its quantitative studies. For example, prior to 1989, media coverage largely focused on the implications for claimants and policyholders. Following each insolvency, various media outlets called for the establishment of a mechanism to protect the insureds. After the creation of PACICC, media coverage of insolvencies declined; coverage generally focused on the loss of unearned premiums by policyholders. The partial return of unearned premiums accounts for 81% of the number of policyholder claims paid by PACICC, even though they only rep
resent an 11% value of claims paid. As Lord Jeffery noted, public confidence is got by a number of small actions similar to these. Since the introduction of PACICC’s unearned premium coverage, media stories became largely restricted to brief notes in the business pages stating a particular insurance company will be wound-up and that policyholders would be protected by PACICC.

CURRENT CONTEXT

As PACICC reviews its current coverages, a key objective is to ensure that policyholders remain well-protected should their insurer become insolvent. PACICC’s current levels of coverage have been in place for nearly a decade and have done a good job of protecting policyholders against undue financial loss. At the same time PACICC’s coverage has not encouraged excessive risk-taking behaviour. A successful outcome to the current coverage review will be to maintain this balance and continued public confidence that Canada’s P&C insurers will pay policyholder claims.