Insolvency: What was the actuary’s role?

Time Flies Department: The Reliance Insurance insolvency turned 10 this year, and Best’s Review (sub. req., I think) was all over it.

Reliance was one of three big insurers that went under in a 10-month span ending in March 2002, the others being Legion Insurance and Phico. The accompanying chart, which ranks the largest insolvencies by the net amount they drew from state guaranty funds, gives you some idea how big a mess the three left behind.

Measured this way, they constituted three of the four largest p-c insolvencies in history. And their withdrawal from the market was one of the bigger reasons that prices began rising in late 2001. We tend to forget that because another driver of the hard market, the Sept. 11 attacks, looms much larger in our minds.

Best also reproduces its chart listing the reasons for insolvencies:

I guess I could point out that inadequate pricing/reserving causes 40.3% of insolvencies, note how that means actuaries are super important and be done with it. But this chart nags at me, because I don’t think it’s revealing to say that a company has gone broke because it underpriced or under-reserved.

Pricing a policy and setting loss reserves are what insurance companies do, the same way a restaurant buys beef and sells a steak dinner. Saying an insurer underpriced or under-reserved is like saying a diner paid too much for meat or didn’t sell enough: Well of course it did – that’s why it’s out of business. What you want to know is why policies were too cheap or reserves too low.

The Best article doesn’t say, but the three big 2001-02 insolvencies would seem to fall into that big 40% bucket, but their circumstances were quite different.

Management at Reliance, the article notes, was accused of mismanagement. In lawsuits, company head Saul Steinberg and other executives were accused of draining the insurance operation to drain their lavish life style. The suits were settled for $85 million

But to upstream that money, they needed to show their loss reserves were adequate. So they set reserves that passed muster with outside accountants. Deloitte & Touche ended up settling for $40 million.

To me, that’s not inadequate pricing or reserving. That’s mismanagement with a side helping of weak external controls.

Legion’s downfall was management-driven, too – a flawed business model. It was a front, an insurance operation that bore almost no risk. For that matter, it really didn’t underwrite risks.

Instead, it gave its underwriting authority to outside insurance agencies – managing general agents, usually called MGAs. These are private contractors that both find and underwrite business, but bear little or no risk. A typical agent, of course, finds the risk, but the company decides whether to insure that risk.

When underwriting, MGAs have an inherent conflict of interest. They get paid for each piece of business they write. So they have an incentive to OK every risk they see. The vast majority of MGAs are more honorable than that. Still, the perverse incentive creates a powerful temptation, and the insurer must check that by auditing frequently.

But strong auditing controls weren’t part of Legion’s business model. It accepted all the crud the less-than-honorable MGAs sent.

Instead of auditing, Legion dumped those risks on its reinsurers. Usually, it kept 10% of the risk or less. It ceded the rest to willing reinsurers, who paid Legion handsome commissions that more than covered Legion’s expenses.

So Legion could book profit while seeming to bear trivial risk.

The Legion model worked fine until:

  • A couple of its key reinsurance clients – Trenwick, Scor, Axa were a few – went belly-up or left the market.
  • Other reinsurers saw how poor Legion business was and stopped reinsuring them.

In both cases, they were left holding the crap they wrote. The end came quickly.

I suppose you could call Reliance and Legion failures of pricing or reserving. But I don’t think that captures the situation well at all.

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