Strict rate regulation contributes to solvency risk: PACICC report

Inadequate pricing is the primary reason why insurers fail, and strict rate regulation is among several contributors to inadequate pricing, the Property and Casualty Insurance Compensation Corporation (PACICC) says in its recently released report, Why Insurers Fail: Inadequately Pricing the Promise of Insurance.
PACICC’s most recent publication, the third in a series of reports on why insurers fail, identifies several factors leading to inadequate pricing. Among them, strict rate regulation threatens to de-link the relationship between insurance premium pricing and the insurers’ claims costs.
The PACICC report clarifies that rate regulation is not in itself a direct cause of inadequate pricing. Rather, rate regulation can adversely affect an insurer’s ability to respond to changes in claims trends.
“Risk increases if claims costs increase at a rate faster than can be accommodated under the rate regime, requiring an insurer to draw down its capital,” the report says. “Insurers with less capital and/or greater rate inadequacy are therefore less likely to achieve rate adequacy before the onset of financial distress…
“Put simply, price controls that de-link prices from claims costs for an already stressed insurer can have a detrimental effect on the company’s solvency.”
The report notes that five insurer bankruptcies occurring after rate regulation was introduced in Ontario in 1989 generated Cdn$115 million in claims for the guarantee fund.
PACICC’s report lists several other reasons for inadequate pricing. They include:
•    An inverted production cycle, in which the price of an insurance product is established prior to the final determination of its cost in the event of a claim (which isn’t resolved until years after the product is sold);
•    Inadequate information management. This, in turn, could be the result of poor internal information systems, weakness of claims history and/or poor management systems.
•    The inexperience of new entrants. Thirty per cent of companies fail within the first 10 years; there is a significant risk of failure among companies between five and seven years old.
•    Pricing under duress, or what is also known as a “spiral of decline.” Companies in danger of failing will often lower their price to sell more policies, thereby trying to stay alive through rapid growth and the quick generation of cash flow. For example, one year before Markham General became insolvent, they were selling one-year auto policies at about Cdn$800; a week before the insurer went bankrupt, the same policies were selling for just under Cdn$250.