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How the 2023 banking crash reminds us why insurance solvency matters

This post is part of a series sponsored by AgentSync.

How the 2023 banking crash reminds us why insurance solvency matters - from AgentSync

With a spate of financial institution failures in recent times, it is an important time for insurance companies to focus on solvency.

Throughout March 2023, the world watched uneasily as a series of bank failures created more volatility than we have seen since the financial crisis of 2008. While each bank’s problems had different root causes, the highest profile of the recent failures, Silicon Valley Bank, suffered from a liquidity crisis, resulting in its very rapid demise.

Banking and insurance are two closely related industries and both are heavily regulated to protect consumers from devastating losses that can occur when a bank doesn’t have the money to pay its deposits or when an insurance company doesn’t have the money to pay its deposits. claims.

Each industry has its own rules that require institutions to hold a certain amount of liquid funds so they don’t collapse financially under stress. Unfortunately, these rules do not always prevent a worst-case scenario from occurring. With bank failures at the forefront of our collective consciousness, we thought it would be a good time to update everyone on the importance of insurance solvency and how it is similar (and different) to banking solvency.

What is solvency in insurance?

In the most basic sense, solvency is the ability of an insurance company to pay out any claims that occur. This ability is dependent on the insurer having access to sufficient cash at any given time, along with making smart investments with their premium dollars for use in the future. Insurance policies are designed to allow insurers to pay out a small number of claims compared to the total number of policies they write, allowing these companies to invest the premiums they collect and operate without immediate access to that money.

Unfortunately, this working model has worked a little less in recent years as catastrophic events continue to result in large numbers of claims concentrated in the same geographic area and time frame. For a more in-depth look at insurance solvency, check out the solvency series we’ve written before, starting with this introductory installment.

What is bank solvency?

Solvency in banks refers to the institution’s ability to meet all its financial liabilities, both in the short and long term. Just as in the insurance industry, carriers are prepared to pay a certain amount in damages, banks must be prepared for some portion of customers at any given time to ask for a portion of their money. Even if a bank does not have 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 debts and liabilities. On the other hand, a bank’s ability to immediately producing the cash that customers demand is called liquidity.

What is the difference between bank solvency and liquidity?

Financial solvency in banking means that a bank has sufficient total assets to cover its debts and liabilities, whether those assets are immediately available or held in investments or other financial instruments that are more difficult to tap. Bank liquidity specifically refers to the amount of cash a bank has on hand to immediately fulfill its depositors’ requests for their 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 might think of the 1946 classic “It’s a Wonderful Life,” or, more recently, the run on Silicon Valley Bank that precipitated its demise.

Why is solvency important in banking and insurance?

The financial systems of the United States and the world are deeply interconnected. When an institution has a crisis, distrust can quickly spread across global financial markets in a “financial contagion”. If left unchecked, a solvency issue at a bank or insurer can have a domino effect leading to a worldwide economic recession or even depression.

Why insurance solvency is important

Solvency in insurance is critical to consumers who rely on insurance coverage, and as such is also important to keeping the entire world economy running.

To illustrate, imagine an insurer that primarily sells homeowner and auto insurance in the state of Florida. If a massive hurricane destroys an unpredictably large number of homes and cars, the insurer may find itself without the assets to pay all of its claims. This would leave large numbers of residents without homes to live in and cars to drive, which in turn would affect their ability to make a living and pay their other bills. Without an insurance company’s ability to make its customers whole after a catastrophic event, entire communities can be financially affected for years or decades to come.

Help during an insurance solvency crisis

Fortunately, consumers whose insurance companies become insolvent can get help from outside sources. While no one wants to rely on these backstops, government guarantee funds and other government-sponsored programs can be the difference between a complete loss and some degree of recovery for consumers and businesses.

Why bank solvency is important

Within the banking system, liquidity and solvency are important systemic issues. Each bank invests its customers’ deposits in funds around the world, held by other banks. When part of the global economic machinery stops, it can make other institutions unable to honor 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 nothing to mess 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 becomes illiquid or 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 the institutions having enough money to pay their obligations. But how much money is that really? Over time, the government has determined various rules and key figures that banks and insurance companies must follow in order 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 these events. Unfortunately, in recent years the US government has rolled back some protective legislation, allowing banks to operate with lower levels of liquidity than before. A report by Yale’s School of Management attributes some (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 the banking system

Following the 2008 financial crisis, the US Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly known as “Dodd-Frank”. Part of this sweeping legislation was to introduce rules for a bank’s required level of liquidity, known as the liquidity coverage ratio (LCR).

In 2019, regulators revised “the criteria for determining the applicability of regulatory capital and liquidity requirements for large U.S. banking organizations,” effectively removing the LCR from banks with between $50 billion and $250 billion in assets. While the largest US and global banks are still subject to LCR, recent events have shown how damaging it can be when even a relatively small bank (as if $250 billion in assets could be considered small!) fails to maintain sufficient liquidity.

Solvency laws in insurance

Although there is no national insurance industry law equivalent to Dodd-Frank, each state insurance department closely monitors the insurance companies in their state for signs of financial health and solvency. All 50 US states and most of the territories have adopted NAIC model regulations for annual financial reporting, and some states go even further than the model legislation requires.

You can read much more about government audit and annual reporting requirements here.

How bank runs are like catastrophic natural disasters

A massive amount of customers demanding their money from a bank doesn’t seem to have much in common with a Category 5 hurricane hitting Florida. In reality, however, these two events can produce the same result: the failure of a financial or insurance institution.

When a large-scale natural disaster causes everyone to have to replace their homes and cars at the same time, insurers (especially local and regional insurers) may find themselves without the money to pay all the claims that have piled up at once.

Similarly, if the public starts to lose confidence 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 beneficial to banks and insurance companies, their customers, businesses or the public. That’s why both industries use a combination of risk management strategies (such as diversifying the types and placement of policies written or investments) to reduce the risk of a catastrophic natural disaster or insolvent institution taking down the entire company.

Reduce your risk with AgentSync

As you can see, insurance solvency is not something to be taken lightly. And no, AgentSync cannot directly help your insurance company reduce claims losses. What we can do, however, is help insurers operate efficiently by saving costs and employee hours spent on tedious, manual and repetitive license compliance management tasks. We can help you reduce your compliance risk, avoid costly penalties and even help you retain staff who would rather be doing valuable work than spending time on repetitive data entry.

Contact us today to see how we can do all this and more for insurers, MGAs and MGUs looking to reduce their compliance risk and costs.

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