Chapter 35 - Insolvency and closure

Question 1

Discuss how insolvency and closure are dealt with in the insurance industry

Answer 1

REGULATION

• Normally state regulation
• Goal is for regulator to be able to intervene before company becomes insolvent by:
  1) Required minimum solvency capital
  2) Regular reporting requirements to monitor financial position

INTERVENTION

• Regulator intervenes when minimum solvency capital is breached.
• Regulator may require:

1) Closed to new business
- Last resort
- Unlikely to re-open unless capital levels can be rebuilt quickly
- Existing infrastructure will continue to drain capital resources
- Will need substantially higher capital than minimum requirements to re-open (usually)

2) Develop recovery plan
- Includes. :
> More appropriately matched investment strategy
> Increase reinsurance
> Limit new business sold (why may this not make big difference? - p.3)
> Cost cutting strategies
> Project solvency under recovery conditions (see below)
- Recovery plan will be monitored closely by regulator
- Should factor considerations if closure to new business occurs

3) Sale or merger
- Alternative if closure to new business and recovery plan are infeasible or not ideal
- Ensure critical mass of business in force makes business practicable

PROJECTING SOLVENCY

• Should form part of recovery plan to assess strategy
• Model range of scenarios deterministically or stochastically
• Scenarios should include effect of actions that might be taken
• Factors which need to be modelled
  1) Future surplus/deficit
  2) Current value of surplus assets
  3) Amount and timing of debt redemption
  4) Factors relating to industrial relations and redundancies
• Effect of relationship with employees and unions
  5) Factors relating to staff benefit schemes
  6) Outstanding financial obligations
  7) Minority interests
  8) Tax
• Additional factors to be considered for model in event of sale or merger
  1) Location of operation
  2) Integration of systems platform
  3) Relocation of staff if necessary
  4) Effect on unit costs

COMPENSATION SCHEMES

• Statutory scheme from which some/all of the benefit payments of insolvent company are paid by the scheme
• Usually funded by levy on all providers operating in state’s insurance industry
• Governed by FSA in South Africa

Question 2

Discuss how insolvency and closure are dealt with in the benefit scheme industry.

Answer 2

CLOSURE

• May occur due to insolvency or decision by sponsor to stop financing benefits
• Two main types:

1) Closed to new members but existing members’ benefits accrue
- May need to reduce existing benefits if scheme’s existing funding is insufficient
- Sponsor expects to continue paying contributions, which may increase and become more volatile as membership decreases

2) Closed to new members and no further benefits accrue
- Sponsor essentially expects to make once-off settlement (no further contributions), perhaps over a period of time

DETERMINING LEVEL OF BENEFITS
- Factors to consider concerning beneficiaries:

1) Rights of beneficiaries
- Largely subjective
- Depend on scheme rules and overriding regulation

2) Expectations of beneficiaries
- Likely to be benefits which would have been available had scheme not discontinued
- Decide whether to include things like future accrual, future growth and discretionary benefits

• Factors to consider concerning scheme’s levels of assets and liabilities:

1) Scheme in deficit
- A < L
- Some/all members will have to accept reduced benefit
- Sponsor required to make up deficit if possible
- Accrued benefits may also be reduced if sponsor cannot make up whole deficit
- Legislation and/or scheme rules may indicate:
a) Type of benefits to be reduced and/or
b) Type of beneficiaries to have benefits reduced
- Additional assets may become available to fund discontinuance benefits:
a) Extra funds from solvent sponsor due to legislation or ethical values of sponsor
b) Legislation may enforce extra debt on sponsor to fund discontinuance benefits
c) Insurance
d) State-sponsored compensation scheme which may be funded by levies on solvent schemes
- Expenses for discontinuance process (calculating benefit allocations, communicating to beneficiaries, securing appropriate assets for payment) may further reduce assets available

2) Scheme in surplus
- A > L
- Surplus returns to sponsor after full benefit payments
- Legislation may require surplus funds to be used for increased benefits
- Surplus allocation calculation will use factors which reflect how much member has contributed to scheme surplus, like:
a) length of membership
b) value of member’s benefit
c) contribution level
- Surplus allocation is contentious issue

PROVISION OF BENEFITS
- Several options regarding provision of discontinuance benefits:

1) Scheme operates as closed fund and no more benefits accrue
- Gradual removal of liabilities over time
- Existing fund used to meet benefit outgo subject to adequate funding level
- Sponsor remains liable to finance deficits which arise in order to pay benefits
- Normally a temporary measure until other option become available

2) Transfer liabilities to new scheme with same sponsor
- Only possible if sponsor is still solvent

3) Transfer funds to beneficiaries to remove liability
- Legislation may prohibit this completely
- Alternatively may allow individual to place funds with appropriate insurer or new scheme

4) Transfer of funds to insurance company
- Will then provide individual policies/grouped policies in beneficiaries’ names

5) Transfer liabilities to an insurance company to guarantee benefits
6) Transfer liabilities to central, national/industry-wide discontinuance fund

• Sponsor may prefer last 4 in order to crystallise surplus/deficit and remove uncertainty
• If benefits are transferred to another scheme/insurer, eventual benefit will depend on actual investment experience if no guarantees are offered
• If liabilities are transferred to third party a premium will be charged to compensate for taking on risk of adverse future experience, which will further reduce assets available to pay benefits

Question 3

Discuss how insolvency and closure are dealt with in the banking industry

Answer 3

REGULATION

• Banks subject to national regulation and several legislation
• Requirements include:
  1) Good risk management processes
  2) Capital requirements
  3) Regular reporting standards
  4) Processes and recovery plans for dealing with unfavourable circumstances

INTERVENTION

• Bank failures present large systematic risks for an economy
• Intervention options in South Africa:

1) Place bank under curatorship
- Provides tools and instruments to manage bank’s liquidity and operations
- May include transfer of assets and liabilities to other banks
- May include mergers with other banks

2) Liquidation
- Last resort
- Aim is to maximise value for depositors
- Many countries have explicit deposit insurance scheme
- South Africa has implicit deposit insurance arrangement
- Depositors are compensated on a case by case basis