Solvency Regulation and the Property-Liability "Insurance Cycle"
Winter, Ralph A., Economic Inquiry
The supply of property-liability insurance in the U.S. appears to be extraordinarily cyclical. Liability insurance lines in particular fluctuate between "soft markets" of stable premiums and low returns to insurers, and tight markets or insurance "crises" of rising premiums, cut-backs on availability and tight limits on coverage. The soft markets of the early 1970s and early 1980s were followed in 1975 and late 1984 by sudden premium increases, of hundreds of percent for some policies. (1) In mid-1987--early July according to some reports--the market began to turn around again. Premiums fell by as much as 40 percent and coverage limits increased up to 500 percent compared to the previous year. (2) In a previous paper (Winter ), I addressed the puzzle of why some lines of insurance are apparently so vulnerable to fluctuations, when conventional economic theory predicts that premiums will change only one-for-one with the present value of expected claims.
This paper examines a specific allegation raised during the most recent insurance crisis: that existing regulation of property-liability insurance exacerbates market fluctuations. The principal enforcement role of state insurance commissions is to monitor the financial condition of insurers. Commissioners ensure that financial solvency standards are met so that policyholders are protected from the consequences of bankruptcy; more precisely, the regulations protect state guarantee funds, which assume the liabilities of bankrupt insurers. The regulators examine a number of financial ratios, but the dominant measure of financial leverage is the ratio of the current volume of business to net worth or surplus. Insurers are restricted by state commissioners from writing more insurance than considered justified by their current net worth in order that realized policy claims can be met, even if they turn out to be substantially higher than revenues would cover.
In determining the ratio of quantity of insurance to net worth, regulators face an aggregation problem. A sensible measure of the total quantity of insurance sold by a firm does not exist. The total number of policies sold, for example, is meaningless. Insurance commissioners therefore use premium revenues as a measure of the volume of business. Historically, insurers were allowed a value of two for the ratio of premiums to net worth before attracting the scrutiny of insurance commissioners. According to a standard text on insurance, published in 1982:
For more than 40 years, insurance
commissioners have used the 2-1 rule
as an indicator of the maximum safe
premium volume that property and
liability insurers might write. The
rule is that the premium volume
should not exceed two times policyholder
surplus (that is, net worth).
(Huebner et al. )
The 2:1 rule was referred to as the Kenney rule, after the commissioner who first proposed it. The standard for a "safe" premium-to-net worth ratio has changed over time. Insurers in most states are now considered to meet solvency requirements when the ratio of premiums to net worth does not exceed three or four.
As a measure of financial leverage in solvency regulation, the premiums to net worth ratio has perverse effects. Suppose that demand is inelastic and that a supply shock to the market leads to an increase in premiums and hence revenue. Because the ratio of premiums to net worth has increased, regulatory pressures on insurers to maintain safe solvency standards will lead to even tighter supply. This regulatory pressure will lead to a further increase in premiums and revenue. Instead of signalling a more conservative leverage position, the ratio of premiums to net worth increases, leading to a more negative assessment by the regulator of the insurers' financial viability and hence to further pressure to raise premiums. …