U.S. Nonlife Market Exit (2007) Kwon and Kim

A Study of Exit Forms and Insurer Characteristics:

Evidence from the U.S. Property/Liability Insurance Markets

W. Jean Kwon
St. John’s University, USA

Hunsoo Kim
SoonChunHyang University, Korea

DRAFT – DO NOT QUOTE.

American Risk and Insurance Association Conference
August 5- 8, Quebec City, Canada

This paper deals with market exit issues in the insurance industry. It examines how firm specific factors (measured in clusters of profitability, underwriting performance, liquidity, capital adequacy, size, business concentration and business structure) and external factors interact with market exit choices (voluntary liquidation, involuntary liquidation, and merger) in the regulated industry. Using the A.M. Best database of the U.S. property-liability insurance industry for 1999-2004 and a multinomial logit regression approach, we find that normal (non-exiting) firms and merged firms show similar characteristics. Particularly, asset not only significantly affects the probability that a firm continues its operation in the market. It also is a strong indicator of the firm’s preference of voluntary liquidation or merger to involuntary liquidation, when it considers exit from the market. Profitability and capital adequacy are also found to affect the exit forms.

INTRODUCTION

Theory suggests that regulation is costly and prohibits the regulated market from being contestable. A contestable market allows firms to enter it free of cost and, on exiting the market, to liquidate their capital without any loss for an alternative use (Baumol et al., 1982). Nevertheless, insurance markets globally have long been subject to stringent regulation. In the typical insurance market, firms incur sunk costs of operation and the costs are often irrecoverable.[1] A mere presence of regulation thus prohibits any market from achieving a Pareto optimal equilibrium. Besides, an exit barrier can deter potential suppliers’ entry to the market (Ilmakunnas and Topi, 1999; and Europe Economics, 2004).

Insurance regulators commonly believe that they can play a role to minimize problems of information asymmetry (e.g., noise in valuation of insurance contracts), of potential market power (e.g., predatory pricing by a single company or collusively by multiple companies) and of moral hazard (e.g., deviations in consumer behavior). They also believe they can generate some social equity effects (i.e., positive externalities) via, say, compulsory purchase of insurance by affected citizens and mandatory participation of insurers in residual risk pools and guaranty funds in selected lines of business. Paraphrasing it, they believe their activities protect the interests of both the insurance company and the policyholder. Of the two types of interests, regulators tend to emphasize that of the policyholder, thus imposing a number of regulatory measures on insurance companies and their operations.

We can classify regulatory measures in insurance markets into four broad categories (Skipper and Kwon, 2007). First, an applicant of insurance business is commonly subject to market entry regulation, such as initial capital, fit-and-proper person, and license requirements. Second, rate and product regulation (particularly in personal lines) as well as prudential (also known as financial and solvency) regulation affect the operations of incumbent companies. On-going capital regulation via a solvency margin or risk-based capital approach is an example of this type of regulation. Third, market conduct regulation (including regulation of insurance intermediaries) and corporate governance regulation, which is related in part to the regulation of accounting transparency and investment regulation, are observed in insurance markets.

Finally, regulators (should) respond to insurers showing signs of severe financial distress or operational difficulty. On reaching a conclusion that such a firm cannot be rehabilitated, the regulator may locate a buyer of the firm or seek a court order to initiate the liquidation process of the firm. The regulator’s active intervention, including overseeing the completion of the liquidation process, is typically known as (market) exit regulation.

Kwon et al. (2005) conducted a survey of the regulatory environments that govern exit processes of insurance companies in selected countries in Asia, Europe and North America. Their finding confirms that insurers withdrawing from a line of insurance business or completely from the insurance business are subject to the close control of the local regulatory authority. They also find that exit regulation in insurance is a concern from a public policy viewpoint as well as from an economic activity viewpoint.

Market Exit Choices

In typical markets, the exit process of a firm can be initiated by equity-holders or debt-holders. Debt-holders may seek bankruptcy if the debtor company has defaulted on its debt. Even when the company is not on default, equity-holders may decide to sell it via merger or acquisition or voluntarily liquidate it.[2] Of course, they more than often support business continuity and growth. The general bankruptcy act of the country (e.g., U.S. Bankruptcy Code) prescribes the market exit process in those markets.

In insurance markets, two broad types of exit guidelines are observed. In some markets (countries), the governing law is the general bankruptcy code. In some other countries, insurance companies are subject to the market exit procedures stipulated in insurance act and regulations (e.g., the U.S.). In the remaining countries, insurers are subject to both the general code and the specific act. Although the specific rules governing insurer exits differ from state to state, the exit guidelines in the U.S. insurance acts are based mainly on the Uniform Insurers Liquidation Act of 1939 and the Insurers Rehabilitation and Liquidation Model Act of 2003 by the National Association of Insurance Commissioners.

Insurance business is unique in that insurance companies are not much financially leveraged. For example, the U.S. property-liability industry had 0.2 percent of their liabilities in the form of borrowed money (A.M. Best, 2006). Conversely, their liabilities consist mainly of unearned premiums for unexpired risks and loss (future benefit) reserves. This finding implies that the major debt-holders (i.e., policyholders) are not likely to seek bankruptcy in the insurance market. In fact, few countries permit such an action by policyholders.[3] Instead, their agent (i.e., the insurance regulator) is empowered to protect their monetary interests in the non-performing insurers and may even decide the fate of those companies.

Under the normal circumstance, the exit decision of an insurance company is made by equity-holders (or their management agent) or the regulator. Commonly permitted forms of exit in insurance markets are merger/acquisition and involuntary liquidation. Indeed, regulators in all known markets are empowered to take over the management control of insurance companies under severe financial distress or operational difficulty. In an increasing number of countries, the authority may even take over the control of the firm when it has failed to comply with the minimum on-going capital guideline (i.e., minimum solvency margin or risk-based capital).[4] In selected markets, the insurance company may initiate an exit process—what is termed as “voluntary liquidation” in this paper.

Figure 1 illustrates the life cycle in the insurance market. For instance, financially and operationally sound firms—termed as “normal firms” in this paper—usually continue operations, merge with another or be an acquisition target. Voluntary liquidation may occur but occasionally. Involuntary liquidation should be rare.

When an insurer experiences an extreme financial or operational difficulty, its equity-holders may consider other options to business continuation (discussed further in the internal managerial factor section). Ceteris paribus, they first may attempt a merger or acquisition, with which they hope to cash out some franchise value of the firm, and later (and if permitted) initiate voluntary liquidation, with which they forego the entire franchise value of the firm. Two conditions are commonly attached to the “voluntary liquidation” process. First, the insurer firm must acquire prior approval from the regulator of the exit process. Second, the firm is subject to the regulatory oversight until the completion of the process. The regulator may attach similar conditions to voluntary merger/acquisition.

Figure 1: Life Cycle in the Insurance Market

Alternatively, the insurance regulator may intervene with the operations of non-performing companies. It seems that regulators rarely use involuntary liquidation as their first choice of action. Instead, they offer those companies an opportunity to return to normalcy and guide them to do so (e.g., overseeing a corporate restructuring plan). When that attempt fails, they may place the companies under receivership for rehabilitation. On concluding that the rehabilitation attempt has also failed, regulators may arrange acquisition of the companies by unaffiliated insurers. In the case that two insurers experience a similar difficulty, the regulator may propose a merger between them as an alternative. When none of these choices work, regulators may deliver the ultimatum—involuntary liquidation—and dissolve the companies.[5] Hence, the regulator’s choices of action in market exit regulation are: rehabilitation, merger/acquisition, and involuntary liquidation.

The size of run off business—insurance obligations (liabilities) of insurance companies which were liquidated or ceased operations in selected lines or territories—continues to grow. Seventy-one percent of the business is related to insurers’ liabilities, and the rest to reinsurers’. The run-off business is concentrated in the markets in Bermuda, France, Germany, Japan, the U.K. and the U.S. (ARC, 2003). Of which, the U.S. holds the largest share with estimated liabilities of US$150-200 billion (PwC, 2007).[6]


In this study, we examine insurer exits based on the four forms of exits—staying firm, merger/acquisition, voluntary liquidation and involuntary liquidation. With the furtherance of the studies by Schary (1991) and BarNiv and Hathorn (1997), we also investigate by each stage of choice how the permitted set of exit choices is related to the characteristics reflecting the financial environment, internal management and the external environment. The paper is structured as follows. Immediately after this introductory chapter, we review existing theories and literature dealing with market exits in insurance. We then construct models to empirically examine insurer behaviors in the U.S. property-liability market. The final chapter summarizes our findings and policy implications.

REVIEW OF LITERATURE

Several studies examine suppliers’ entry to and entry barriers in a competitive market (e.g., Bain, 1956; Baumol et al., 1982; and Bernheim, 1984) or market exits in a competitive market (e.g., Resnick, 1998; and Peach, 1998). However, studies about market exits in the financial services sector, particularly in the insurance industry, are limited in scope and deal mainly with M&A or insolvency. For example, Altman (1968), Trieschmann and Pinches (1973), Hershbarger (1990) and several other studies examine how to predict insurer insolvency, and Brown et al. (1999) and Carson and Hoyt (2000) causes of insolvency. BarNiv and Hathorn (1997) examine factors affecting bankruptcy, voluntary retirement and merger of financially distressed insurers. Similarly, Schary (1991) explores the determinants of the form of exit in non-insurance markets. However, no study has examined the fuller multiplicity of exit choices—merger and acquisition, voluntary liquidation and involuntary liquidation.

Numerous factors affect the life cycle of the insurance company. We group them broadly into: financial factors, internal management factors and external (political) factors. The financial factors can be further classified into those related to profitability, underwriting performance, liquidity and capital adequacy.

Financial Factors

All other things equal, the owners of the exiting firm would attempt to maximize their own wealth before liquidation as well as the residual value of the firm at liquidation. Similarly, the non-owner management of the firm would attempt to increase not only their economic wealth until liquidation but also their values in the job market they wish to enter after liquidation. In other words, a firm at a declining stage of business life cycle may form an exit strategy instead of, as Resnick (1998) argues, making a further capital commitment to the business. Karakaya (2000) supports the argument such that voluntary liquidation helps shareholders salvage their investment in the liquidated firm. Peach (1998) also suggests that firm owners and their agents have every incentive to recover their investment capital as much as legally permitted. We can observe the strength of the wealth motive of the equity holders and management (i.e., the insurance company) based on profitability, underwriting performance, liquidity, capital adequacy and the capital itself.

Profitability. Several proxy variables have been used to measure insurer profitability. For example, the NAIC uses the ratio of 2-year investment yield average to invested assets for its IRIS analysis. BarNiv and Hathorn (1997) use the ratio of net income to total assets (ROA) to proxy measure the wealth motive.[7] It is assumed that the higher, say, the ROA ratio, the more it is likely that the firm continues operation or becomes an M&A target.

Underwriting Performance. Several conventional financial ratios have been used to measure the underwriting performance of insurance companies. The loss ratio (LR), which often includes loss adjustment expenses, represents the pure cost of insurance coverage (e.g., Angoff, 2005) whereas the expense ratio is related to the non-claims-related activities of the insurer. The sum of these two ratios (i.e., the combined ratio or COMB_R) thus portrays the soundness of underwriting operations (e.g., Berger et al., 1992; Cummins and Danzon, 1997; and Hoyt and Powel, 2005).[8] Ceteris paribus, the lower the loss (or combined) ratio, the healthier the company and the more likely it stays in business or becomes an M&A target.

Liquidity. We find two proxies for the liquidity factor in the insurance business. Carson and Hoyt (1995) employ the ratio of liabilities to liquid assets (LQAST), which represents the insurer’s ability to meet claims.[9] Trieschmann and Pinches (1973) use agent’s balance to surplus (AGBAL), although this seems to reflect more of the intermediaries’ concern about the insurer’s claims paying ability (especially when they capture a signal indicating possible insolvency of the insurer) or merely of the insurer’s account receivable management ability rather than the pure liquidity of the insurer. All other being equal, we expect that normal firms or potential M&A targets reveal a higher LQAST or a lower AGBAL ratio than other firms.

Capital Adequacy. We may safely assume that (highly) adequately capitalized firms prefer staying in business or are attractive M&A targets. Capital adequacy can be proxy measured by the NAIC risk-based capital ratio (e.g., Cox, 2004) or a similar ratio such as the BCAR ratio by A.M. Best Company, although both ratios reflect more about the insurer’s ability to absorb a host of risks (shocks) than purely about its capital adequacy (Pottier and Sommer, 2002). We may also assume that firms with a low ratio of net premiums written to policyholders’ surplus (NPWSUR) is relatively better capitalized (Ambrose and Steward, 1988) and has a strong growth potential. The quality of reinsurance, as measured by the surplus-aid-to-surplus ratio (SURAID), has also been used by the NAIC as an IRIS test element to measure capital adequacy of insurance companies. Given that such surplus aid is generally available in proportional treaty reinsurance, it is not known a priori whether this ratio is powerful enough as a factor affecting the basket of market exit choices.