Guaranty Funds

Each state has a guaranty fund. Their purpose is to minimize the loss to their citizen policyholders when an insurance company becomes financially impaired or insolvent. Various studies reveal that the following are among the most common reasons for insurance company failure:

  • Fraud (including falsified reports, concealing or altering key information, etc.)
  • Uncontrolled (rapid) expansion
  • Improper assignment of underwriting authority
  • Inadequate pricing
  • Lack of management expertise (especially with new or different lines of business)
  • Improper reserving
  • Insider activity
  • Inadequate or improper Reinsurance Agreements/Reinsurer Failure

Guaranty funds are, typically, mandated by various state laws and they usually focus on helping persons who are considered to be the most vulnerable to insurance carrier instability (such as auto, homeowners and small-sized commercial business).

Guaranty Funds collect assessments from participating insurers (all other insurers operating in a given state) whenever a need for funds is created by an insurer’s serious, financial impairment. The collected funds are used to handle claims suffered by policyholders of a failed insurer as well as pay the creditors and other parties owed money by the failed company. The fund is reimbursed by taking over and liquidating assets that are held by the insolvent insurer.

A state fund is usually called upon to handle payments once that state’s insurance commissioner formally declares that a given insurer is insolvent. Once that declaration is made, the state takes over operations and management of the company.

Most state insurance regulators have a process for monitoring the insurance companies that operate in their state. They require regular financial reporting and use a variety of tools to determine a given insurer’s financial state. If done properly, a vulnerable company should be identified and steps be taken to address the situation. Typically, a well-established set of financial tests are available to assist in evaluating an insurer.

However, regulator efforts in recent years have been undergoing significant change. States have long used benchmarks for measuring an insurer’s status that consist of minimal levels of financial requirements. The problem is that, realistically, the low levels of required capital and surplus bear no resemblance to the actual level of funds insurers need to meet their financial obligations. One unintended result of this traditional approach was that it encouraged companies to engage in practices that might threaten their solvency. So an alternative to the traditional monitoring approach was needed. Fortunately, there is an increasingly used method that more accurately measures an insurer’s vulnerability to failing to maintain adequate resources. It is called the risk-based capital concept (RBC).

Under RBC, regulators consider the business type and mix that a given insurer writes. Property-based business is characterized by predictable losses, so acquiring more business may be fine. However, the situation is different for casualty business which involves unpredictable loss activity, so less business should be held in order to meet possible obligations. While the use of RBC does not guarantee that every dangerous situation will be identified, it does substantially increase the effectiveness of monitoring insurance company solvency.

Sometimes an alternative to the use of guaranty funds is used, called a run off. Under a run off, a company is kept in active operation, but it no longer processes new business or renewals. The goal is to dispose of business in an orderly fashion, without triggering guaranty funds reimbursements or assessments. Run offs are being used more often in handling impaired insurers.


COPYRIGHT: Insurance Publishing Plus, Inc., 2016

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