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Insolvency experience, risk-based capital, and prompt corrective action in property-liability insurance

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  • Cummins, J. David
  • Harrington, Scott E.
  • Klein, Robert

Abstract

In December 1992, the National Association of Insurance Commissioners (NAIC) adopted a life-health insurer risk-based capital (RBC) formula and model law that became effective with the 1993 annual statement filed in March 1994. In principle, well-designed RBC requirements can help achieve an efficient reduction in the expected costs of insolvencies. They can provide incentives for insurers to operate safely in cases where market incentives are weak due to government mandated guarantees of insurer obligations or asymmetries regarding solvency between insurers and buyers. RBC requirements also may facilitate or encourage prompt corrective action by solvency regulators by helping regulators to identify weak insurers and giving regulators legal authority to intervene when capital falls below specified levels. RBC requirements may force regulators to act in amore timely manner when confronted with external pressure to delay action. However, RBC capital requirements have a number ofpotential limitations. Unavoidable imperfections in any meaningful RBC system will likely distort some insurer decisions in undesirable and unintended ways. RBC requirements by themselves will do little or nothing to help regulators determine when an insurer s reported capital (surplus) is overstated due to understatement of liabilities or overstatement of assets. A well-designed RBC system should minimize costs associated with misclassification of insurers. The system should be able to identify a high proportion of troubled companies early enough to permit regulators to take prompt corrective action and should identify as troubled only a minimal proportion of financially sound insurers. This study analyzes data on solvent and insolvent property-liability insurers to determine whether modifications in the NAIC s RBC formula can improve its ability to predict firms that subsequently fail without substantially increasing the proportion of surviving insurers that are incorrectly predicted to fail.
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Suggested Citation

  • Cummins, J. David & Harrington, Scott E. & Klein, Robert, 1995. "Insolvency experience, risk-based capital, and prompt corrective action in property-liability insurance," Journal of Banking & Finance, Elsevier, vol. 19(3-4), pages 511-527, June.
  • Handle: RePEc:eee:jbfina:v:19:y:1995:i:3-4:p:511-527
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    References listed on IDEAS

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    1. Cummins, J David, 1988. " Risk-Based Premiums for Insurance Guaranty Funds," Journal of Finance, American Finance Association, vol. 43(4), pages 823-839, September.
    2. Berger, Lawrence A & Cummins, J David & Tennyson, Sharon, 1992. "Reinsurance and the Liability Insurance Crisis," Journal of Risk and Uncertainty, Springer, vol. 5(3), pages 253-272, July.
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    4. Lamm-Tennant, Joan & Starks, Laura T, 1993. "Stock versus Mutual Ownership Structures: The Risk Implications," The Journal of Business, University of Chicago Press, vol. 66(1), pages 29-46, January.
    5. Harrington, Scott E & Danzon, Patricia M, 1994. "Price Cutting in Liability Insurance Markets," The Journal of Business, University of Chicago Press, vol. 67(4), pages 511-538, October.
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