Protecting Individual and Commercial Policyholders

Over the next year, the Property and Casualty Insurance Compensation Corporation (PACICC) will conduct a comprehensive review of the coverage and benefits it provides to policyholders in the rare circumstances of a member insurer becoming insolvent. PACICC protection currently applies to about 94% of the premiums underwritten by private P&C insurers in Canada. Major lines of business covered include automobile, personal and commercial property, and commercial general liability insurance. PACICC limits compensation payments for indemnity claims to a maximum of $250,000 per policy for each covered occurrence, and a maximum of $700 per policy for the refund of unearned premiums.

RE-EXAMINING PACICC COVERAGE

PACICC undertook the last review of coverage and benefits nine years ago. It is now time to re-examine how well the Corporation’s coverage meets the needs of today’s insurance consumers. PACICC’s research and analysis on coverage is under way. What key factors are most likely to influence future decisions?

PACICC recently took steps to define its mission, focusing on three important goals:

* protecting policyholders from undue financial loss

* minimizing the cost of insurer insolvencies, and

* maintaining a high level of consumer and business confidence in Canada’s P&C insurance industry.

All three goals will figure prominently in PACICC’s review of coverage and benefits. This article will take a closer look at two key issues that relate directly to PACICC’s mission. First, what role does PACICC protection play in maintaining confidence in Canada’s P&C insurance industry? And second, in what lines of business is it most important for PACICC to protect policyholders from undue financial loss?

CONSUMER CONFIDENCE

Let’s start with consumer confidence. Since 1997, the Office of the Superintendent of Financial Institutions (OSFI) has conducted a survey of public confidence in Canadian financial institutions. This national survey of approximately 1,000 Canadians has now been done six times (roughly every other year). The results have been stable over time. The top three confidence-enhancing factors have been:

* the presence of a strong and competent management

* the existence of financial protection (literally, “deposit insurance or similar kinds of protection for your money”), and

* government regulation and oversight of financial institutions.

In fact, more than 80% of Canadians surveyed by OSFI consistently say that financial guarantee protection is important to their confidence in the financial institutions through which they purchase insurance, save or invest. The number has ranged over a nine-year period between a low of 83% to a high of 87%.

The financial protection offered by a guarantee fund like PACICC is therefore an important component in maintaining public confidence in P&C insurance companies. Indeed, such protection has become a modern requirement for doing business and meeting consumer expectations.

WHO NEEDS THE MOST PROTECTION?

With that understanding, let’s consider the second question: which policyholders in what lines of business need protection the most? This is a more complex question; our answer will help clarify the issues PACICC must consider in its review of coverage.

Like most guarantee funds, PACICC has a defined, maximum amount of financial capacity available in a given year to help protect policyholders in the event that their insurer becomes insolvent. To the greatest extent possible, limited financial resources should be directed to policyholders with the greatest need for protection.

A recent study undertaken by the Organization for Economic Co-operation and Development concluded that when an insurance company becomes insolvent, “the primary objective of policyholder protection funds is to protect… individual or non-professional policyholders (Policyholder Protection Funds: Rationale and Structure, OECD, 2001).” OECD says the reason for its conclusion is that individual policyholders “can hardly be expected to verify the credibility of an insurance company sufficiently.” By comparison, “corporations should normally be able to get sufficient information on the [insurance] products and the companies and assess appropriately the risks involved.” Corporations have risk-management capabilities in-house or readily available to them; individual and small-business policyholders typically do not.

The practice of restricting commercial coverage is widespread among P&C insurance guarantee funds around the world. In fact, Canada is one of the few countries not to restrict basic commercial insurance coverage in some way.

RESTRICTING COVERAGE

The types of restrictions used vary considerably – ranging from provisions for net worth and natural persons, to defining what constitutes a small business, to exclusions. To ensure fairness, a good deal of thought must be given to how these restrictions are applied. A key point, however, is that most countries have decided to focus the available protection on individuals and small businesses, with significant restrictions placed on compensation for larger corporate policyholders of an insolvent insurer.

PACICC’s own experience demonstrates that restricting commercial coverage could also improve the fairness of funding insurer insolvencies. For example, in two of the more recent insurer insolvencies overseen by PACICC – Maplex and Markham General – commercial policies accounted for less than 18% of total assessable premiums, but generated 33% of total compensation claims paid.

‘MORAL HAZARD’ PROBLEM

The OECD study of guarantee funds identified two additional fundamental issues that need to be carefully considered when making decisions about coverage and benefits:

* the problem of “moral hazard,” and

* the financial burden of compensation borne by well-managed insurers.

To some extent, both of these issues are inherent drawbacks of any guarantee fund * they can’t be avoided entirely, but they can be mitigated.

The safety net provided by a guarantee fund builds consumer confidence, but it also reduces the incentives of persons or corporations to assess the financial condition of prospective insurers. This is what economists mean by the term “moral hazard.” The evidence indicates that moral hazard effects are greater for corporations than individuals. And as the OECD emphasized, individual policyholders generally lack the knowledge or resources to assess an insurer’s financial health, relative to the capacity of large corporations to identify vulnerable insurers. Accordingly, guarantee funds mitigate moral hazard behaviours through limits on compensation, co-insurance and deductibles, so that policyholders at least bear a portion of the loss.

HELPING INSURERS

To prevent well-managed insurers from bearing too heavy a cost burden for winding up insolvent insurers, PACICC needs to ensure that its coverage and benefits provide fair compensation to those policyholders with the greatest financial needs. To do more unnecessarily increases the risk that a solvent insurer may experience financial difficulty resulting from assessments that need to be paid toward the cost of winding up a failed competitor. This particular risk is heightened if the P&C insurance industry as a whole is experiencing tough financial conditions – circumstances that could increase losses and reduce earnings. Governments and insurance regulators also have a vital role to play in this respect. How? First, by requiring high standards of managerial competence and corporate governance before insurance licenses are granted. And second, by maintaining standards of solvency supervision consistent with international best practices, like
those of OSFI and some provincial supervisors.

In the months ahead, PACICC’s Board of Directors and member companies will consider and debate options that could change the extent and type of coverage offered to policyholders in the rare event that an insurer becomes insolvent. Like most guarantee funds, PACICC has limited financial capacity available to pay the claims of policyholders of an insolvent insurer. The challenge is to ensure that limited resources are used to help maintain high levels of consumer confidence in Canada’s P&C insurance industry, and to compensate policyholders with the greatest financial needs. The evidence reviewed by PACICC shows that in compensating for the effects of insurer insolvencies, strong arguments can be made to favour the financial needs of individual and small business policyholders over those of large corporations.