This post is part of a series sponsored by AgentSync.
With a spate of recent bankruptcies at financial institutions, this is an important time for insurers to put solvency at the forefront.
Throughout March 2023, the world watched anxiously as a series of bank failures created more volatility than we have seen since the 2008 financial crisis. While each bank’s problems had a different root cause, the highest profile of recent failures, Silicon Valley Bank, suffered a liquidity crisis that resulted in its very fast disappearance
Banking and insurance are two closely related industries and both are heavily regulated to protect consumers from the devastating losses that can occur when a bank does not have the funds to honor their deposits, or when an insurance company does not have the funds to pay your claims.
Each industry has its own regulations that require institutions to maintain a certain amount of liquid funds so that they do not collapse financially under stress. Unfortunately, these regulations do not always prevent the worst case scenario from occurring. With bank failures at the forefront of our collective conscience, we thought it would be a good time to refresh everyone on the importance of insurance solvency and how it is similar (and different) to solvency in banking.
What is insurance solvency?
In the most basic sense, solvency is the ability of an insurance company to pay any claims that occur. This ability relies on the insurer having access to enough cash at any given time, as well as making smart investments with the insurer’s premium dollars for future use. The insurance is designed so that insurers pay out a small number of claims compared to the total number of policies they write, allowing those companies to invest the premiums they charge and operate without immediate access to that cash.
Unfortunately, this working model has been working a little less in recent years as catastrophic events continue to give rise to a large number of claims concentrated in the same geographic area and time period. For a more in-depth look at solvency in insurance, check out the solvency series we’ve written above, starting with this introductory piece.
What is bank solvency?
Solvency in banking refers to the institution’s ability to meet all its financial liabilities, both short and long term. Just like in the insurance industry, insurers are prepared to pay a certain amount on claims, banks must be prepared for a portion of customers to request a portion of their money at any given time. Even if a bank does not have the cash on hand to pay all of its obligations immediately, it can still be considered solvent if it has enough assets to more than cover any debt and liabilities. On the other hand, the ability of a bank to immediately Producing the cash that your customers demand is called liquidity.
What is the difference between bank solvency and liquidity?
Financial solvency in banking means that a bank has enough total assets to cover its liabilities and debts, regardless of whether those assets are readily available or held in investments or other financial instruments that are more difficult to tap into. Bank liquidity specifically refers to the amount of cash a bank has available to immediately meet depositors’ requests for money.
A bank can be solvent but still have a liquidity crisis if too many customers ask for too much money in a short period of time. When this happens, it is known as a “bank run.” And if this sounds familiar, you may be thinking about the 1946 classic “It’s a Wonderful Lifeor, more recently, the run at Silicon Valley Bank that fueled his demise.
Why is solvency important in banking and insurance?
The financial systems of the US and the world are deeply interconnected. When an institution has a crisis, mistrust can spread rapidly through global financial markets in “financial contagion.” Left unchecked, a solvency problem at a bank or insurer can have a ripple effect leading to a global economic recession or even depression.
Why insurance solvency is important
Insurance solvency is vital to consumers who rely on insurance protections, and as such, it is also vital to keeping the global economy running.
To illustrate, imagine an insurer that primarily sells auto and homeowners insurance in the state of Florida. If a massive hurricane destroys an unpredictably large number of homes and cars, the insurer could find itself without the assets to pay all of its claims. This would leave large numbers of residents without a home to live in or a car to drive, which in turn would affect their ability to earn a living and pay their other bills. Without an insurance company’s ability to get their clients back on their feet after a catastrophic event, entire communities can be financially impacted for years or decades to come.
Help during an insurance solvency crisis
Fortunately, consumers whose insurance companies become insolvent can receive help from outside sources. While no one wants to depend on these endorsements, state warranty funds and other state-sponsored programs it can be the difference between a total loss and some degree of recovery for consumers and businesses.
Why bank solvency matters
In banking, liquidity and solvency are important systemic issues. Any bank invests its clients’ deposits in funds from all over the world, held by other banks. When a piece of the global economic machine comes to a complete halt, it can cause other institutions to be unable to pay their own deposits – and the cycle continues. Although we are not economists, we can say that the complicated interaction between bank liquidity, the stock market, private companies and consumers is not something to be trifled with.
Help during a bank solvency crisis
After the Great Depression, the Banking Act of 1933 created the Federal Deposit Insurance Corporation (FDIC). Since then, consumers and businesses with money in US banks have been assured that up to $250,000 of their money (per insured account) will be available, backed by the US government, even if their bank loses. liquidity or is insolvent. Congress later created the National Credit Union Association (NCUA) in 1970 to perform a similar function for credit unions, which are not technically banks.
Laws governing banking and insurance solvency and liquidity
Both banking and insurance depend on institutions having enough money to pay their obligations. But how much money is that, exactly? Over time, the government has determined different rules and ratios that banks and insurers must meet to reduce the risk of insolvency or illiquidity.
While adhering to these rules is not a foolproof guarantee that a bank or insurer will never experience a solvency crisis or a liquidity crisis, they are certainly part of reducing the risk of those events. Unfortunately, in recent years, the US government has repealed some protective laws, allowing banks to operate with lower levels of liquidity than before. A report from the Yale School of Management attributes part (but not all) of the run on Silicon Valley Bank and its subsequent closure to how the bank was allowed to operate under less stringent laws.
Solvency laws in banking
After the 2008 financial crisis, The United States Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act., commonly known as “Dodd-Frank”. One component of this sweeping legislation was to set rules for a bank’s required level of liquidity, known as a liquidity coverage ratio (LCR).
In 2019, regulatory agencies revised “the criteria for determining the applicability of regulatory capital and liquidity requirements for large US banking organizations.” in effect, eliminating the LCR of banks with between $50 billion and $250 billion in assets. While the largest banks in the US and the world are still subject to the LCR, recent events have shown just how damaging it can be when even a relatively small bank (as if $250 billion in assets could be considered small!) It fails to maintain adequate liquidity.
Solvency laws in insurance
While there is no national insurance industry law equivalent to Dodd-Frank, each state department of insurance closely monitors insurance companies in its state for signs of solvency and financial health. All 50 US states and most territories have adopted the NAIC model regulation on annual financial reportsand some states go even further than the model legislation requires.
You can read much more about state audit requirements and annual reporting here.
How Bank Runs Are Like Catastrophic Natural Disasters
A massive crowd of customers demanding their money from a bank may not seem to have much in common with a Category 5 hurricane hitting Florida. In reality, however, these two events can bring the same results: the bankruptcy of a financial or insurance institution.
When a large-scale natural disaster causes everyone to need to replace their homes and cars at the same time, insurers (especially local and regional insurers) can find themselves without the money to pay all the claims that have accumulated at once.
Similarly, if the general public begins to lose trust in a bank and everyone starts trying to withdraw their money at the same time, the banks can quickly find themselves in a position where they have no money to give.
Neither situation is win-win for banks and insurers, their customers, businesses or the general public. That’s why both industries use a combination of risk management strategies (such as diversifying the types and locations of policies written or investments held) to reduce the chances that a catastrophic natural disaster or insolvent institution will bring down their entire business.
Reduce your risk with AgentSync
As you can see, insurance solvency is nothing to be taken lightly. And no, AgentSync can’t directly help your insurance company reduce claims losses. What we can do, however, is help insurers run efficiently by saving costs and employee hours on tedious, manual, and repetitive leave compliance management tasks. We can help you reduce your compliance risk, avoid costly fines, and even help you retain staff who would rather do valuable work than waste time on repetitive data entry.
Contact Contact us today to see how we can do all of this and more for insurers, MGAs and MGUs looking to reduce their risk and compliance costs.