When Insurers Go Bust: An Economic Analysis of the Role and Design of Prudential Regulation

When Insurers Go Bust

When Insurers Go Bust

An Economic Analysis of the Role and

Design of Prudential Regulation

Guillaume Plantin

Jean-Charles Rochet

Princeton University Press

Princeton and Oxford

Copyright © 2007 by Princeton University Press

Published by Princeton University Press,

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eISBN: 978-1-40082-777-0

Library of Congress Control Number: 2006936336

A catalogue record for this book is available from the British Library

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10 9 8 7 6 5 4 3 2 1

Contents

Foreword

Acknowledgements

1 Introduction

2 Four Recent Cases of Financially Distressed Insurers

2.1 Independent Insurance Company Limited

2.2 Groupe des Assurances Nationales

2.3 Equitable Life

2.4 Europavie

2.5 Why Are Insurers Subject to Prudential Regulation? A First Pass

3 The State of the Art in Prudential Regulation

3.1 The Main Features of Prudential Systems

3.2 Regulation and Ruin Theory: Controlling the Probability of Failure

3.3 Conclusions

4 Inversion of the Production Cycle and Capital Structure of Insurance Companies

4.1 Inversion of the Production Cycle in the Insurance Industry

4.2 An Analogy between Insurance Capital and Deductibles in Insurance Contracts

4.3 The Role of Deductibles in Insurance Contracts

4.4 The Role of Insurance Capital to Mitigate Informational Problems

4.5 Conclusion: The Inversion of the Production Cycle Creates Agency Problems That Can Be Mitigated by Capital Requirements for Insurance Companies

4.6 Appendix: Capital Requirements as an Incentive Device

5 Absence of a Tough Claim holder in the Financial Structure of Insurance Companies and Incomplete Contracts

5.1 Absence of a Tough Claimholder

5.2 Prudential Regulation and Incomplete Contracts

5.3 The Representation Hypothesis

6 How to Organize the Regulation of Insurance Companies

6.1 Simple Prudential Ratios

6.2 Double Trigger

6.3 An Independent but Accountable Prudential Authority

6.4 Granting Control Rights to the Industry via a Guarantee Fund

6.5 A Single Accounting Standard

6.6 Limiting the Scope of Prudential Regulation

6.7 What if This Is Not Enough?

7 The Role of Reinsurance

7.1 Organization of the Reinsurance Market

7.2 Reinsurance and Prudential Supervision

8 How Does Insurance Regulation Fit within Other Financial Regulations?

8.1 Insurance and Financial Conglomerates

8.2 The Regulation of Banks and of Insurance Companies Are Two Different Jobs

8.3 Insurance and Systemic Risk

9 Conclusion: Prudential Regulation as a Substitute for Corporate Governan

References

Foreword

This timely book is a rare, cogent analysis of the regulation of insurance companies from the point of view of economics. The topic of insurance regulation has come right to the fore in the policy debates in financial regulation, and rightly so given the pivotal role of insurance companies in the financial system as direct and indirect claimholders of banks and other leveraged institutions, as well as their long-term role in channeling savings for an aging population. And yet, the current framework for insurance regulation across the advanced economies is a patchwork of rules that have built up over years, based loosely on actuarial considerations, and which differ substantially from one jurisdiction to another without much rationale. This book sets the standard for debate in this important area. The book surveys the recent episodes of failures of insurance companies, reviews the actuarial basis for insurance regulation and its weaknesses, and proposes an economic rationale for insurance regulation based on capital as a way of mitigating moral hazard. The scholarship backing the book is impeccable, as would be expected from authors of such caliber, but the book has added authority arising from the fact that one of the authors (Plantin) also has first-hand experience as an insurance regulator. The book will be of wide interest to financial economists, and will be essential reading for policy makers in central banks and financial regulatory bodies. In time, this book will gain the status of (and be seen as a natural accompaniment to) Dewatripont and Tirole’s classic on the prudential regulation of banks, and will be widely read and cited.

HYUN SONG SHIN

Professor of Economics, Princeton University

Acknowledgements

This book came out of a research project commissioned by the French Federation of Insurance Companies (FFSA). We are very grateful to Philippe Trainar for his encouragement. Guillaume Plantin has benefited from illuminating discussions with the late Alain Tosetti.

When Insurers Go Bust

1

Introduction

The insurance industries of several countries have recently experienced periods of stress related to the failure of large, sometimes well-established, insurers. We begin our analysis with a study of four such cases: Independent Insurance and Equitable Life in the United Kingdom, Groupe desAssurances Nationales (GAN) and Europavie in France. These scandals have prompted a general and fierce debate (in the press, in the academic literature, but also in the political arena) about the need to reform the complex regulatory–supervisory systems that most countries have designed. The aim of this book is to offer practical recommendations, backed by rigorous economic analysis, for the reform of the prudential regulation of insurance companies.

Insurance companies are heavily regulated within virtually every country with a well-developed financial system. Moreover, insurance regulations endow public authorities with very significant control rights over insurers’ strategic and financial decisions. This is even the case in countries where laissez faire economic policies are the order of the day. The regulator intervenes in the strategy and financial management of insurance companies via three channels:

• tariff restrictions;

•entry and merger restrictions;

• prudential regulation (including insurance schemes that protect against company failures).

The first two types of intervention are rather common tools, used to regulate many other sectors, such as essential facilities. By contrast, prudential regulation is specific to financial institutions. Banks are, indeed, subject to prudential rules that are very similar to those applying to insurance companies. The rationale usually invoked for the prudential regulation of banks does not clearly apply to insurance companies, however. It is commonly asserted that banks have to be regulated because of their crucial role in issuing very liquid claims used as means of payment, namely deposits, while financing projects by means of illiquid loans. Thus banks are by nature illiquid and fragile, and subject to runs. In addition, they finance each other via the interbank market, so that isolated runs may trigger systemic panics, likely to have important real effects on economic growth. Conversely, insurance firms are invested in more liquid and tradable assets that match their liabilities much better than bank loans match bank deposits. Moreover, the organization of the reinsurance market makes it less prone to contagion than the interbank market. Thus, firms seem less fragile, and contagion less likely. Insurance panics have not occurred, to our knowledge, in recent financial history.

So, what is special about insurance? Which achievements are out of range of free insurance markets? How could a prudential regulator do better than them? These are the main questions addressed in this book.

The book is organized as follows. Chapter 2 presents four case studies of insurance companies that went bust during the 1990s.We will draw lessons from these cases throughout the remainder of the book. Chapter 3 describes the practical organization of prudential supervision in the largest insurance markets. It also describes the risk-management tools that are most commonly used to analyze prudential supervision, and stresses what we view as the limits of these tools. Chapter 4 is our first application of modern corporate-finance theory to the insurance industry.We argue that because of the length and the inversion (this notion is explained in chapter 4) of the insurance production cycle, insurance firms are subject to severe agency problems that greatly amplify their operational risks. We show how capital requirements are an appropriate tool to discipline firms and contain these risks. Chapter 5 develops another application of corporate-finance theory to prudential regulation. We discuss the role of the allocation of control rights within firms, and the reasons why it may be desirable to grant such control rights to a supervisory