Riding the escalator to nowhere

01 February 2017 University of the Witwatersrand

On 12th October 2016, the Registrar of Short Term Insurance – the Chief Executive Officer of the Financial Services Board (FSB) – made an application to the North Gauteng High Court to liquidate Saxum Insurance.


It is a rare event for a South African insurer to be liquidated at the behest of the regulator.


In the 1960s, there were a number of insurers which got into difficulties in the UK. During the same time, a similar experience happened in South Africa. The most famous South African example was Parity in 1966. Subsequently, the businesses of two well-known insurers – AA Mutual and IGI – were liquidated, but in both cases, all liabilities were discharged and a surplus remained.    More recently in the First Central was handed over to curators but was eventually handed back with a small surplus.   In these three cases policyholders were paid out.


Insufficient assets

Thus in the South African context, an unusual feature of the Saxum liquidation is that it apparently (according to the Financial Services Board) will not have sufficient assets to settle the claims made against it.


This distinguishes Saxum from the AA Mutual, IGI and First Central. On 10 December 2016 the FSB approached the South African Insurance Association (SAIA) asking it to make an approach to its members to see if they would consider contributing towards the Saxum shortfall, which was estimated at some R15 million.


If the short-fall does not materialize, the insurers will be refunded their contribution to the Saxum fund.


The FSB’s approach to SAIA contained a hint that the industry in future will be required to contribute to a fund to be used to cover future losses resulting from insurer failures.  This is an extraordinary state of affairs. The financial services industry is paying billions every year towards regulation, and in addition, a fund is to be established to pay uncovered claims when the regulation fails.


If a fund is established, consideration should be given to disbanding regulators and taking the billions spent on regulation to establish the fund set up to compensate the public for the losses suffered because of insurer failures. It is a bit odd to have both expensive regulators and an expensive fund at the same time to bailout insurer failures. If a fund is to be established, then the current intrusive and expensive regulatory system should be dismantled.


The difference being…

Of course a major difference between the past and the present is indeed the billions currently spent each year on regulation. Looking at the Saxum incident, have these billions improved matters at all?


There is no evidence that the billions have produced any benefits when looking at the Saxum matter. The complex solvency asset management (SAM) system will not make any difference to the Saxum matter.


As we have indicated in earlier articles dealing with prudential regulation of insurers, the prudential system was based on two fundamental requirements:

  • First maintaining a proper transparent insurance accounting system – which had to be open to public scrutiny – and second maintaining a surplus, a reserve, on the balance sheet. Lloyd’s treated premiums as amounts contributed to a trust fund with only clearly defined withdrawals from the trust fund; and

premiums are paid into a bank account and become the assets of the insurer. From these assets, claims are paid. If insurance is priced correctly then the assets of an insurance company should always exceed its liabilities. To be on the safe side the assets of insurance company need to exceed the liabilities by an additional amount. That additional amount, the reserve, ensured policy holders would always be covered. The entire system is funded out of premiums. Capital plays a minor role in the system.  


The historical position was that the insurer had to have a reserve equal to 25% of premiums. Fifteen percent was a normal reserve, and after the liquidation of the business of AA Mutual, an additional 10% was required as a catastrophic reserve.


So what is important is for the regulator to keep an eye on the reserve. If it was above 25%, then policyholders are not at risk.


Meaningless changes

One of the recent meaningless changes was to do away with the simple 25% of premiums as a reserve, and replace it with a much more complex Capital Adequacy Ratio (CAR).


So instead of a simple reserve sufficient assets to cover liabilities rule, a complex risk based capital (RBC) method was introduced.


If an insurer cannot maintain a simple assets to cover its liabilities plus a reserve rule, giving it a much more complicated system does not help at all.


The focus has moved from ensuring that premiums are sufficient to cover claims to a complex belief that capital is somehow important. It should also be noted that the liabilities are covered by premiums, and premiums constitute revenue not capital. Moving the solvency focus to capital does not help.


A tangled web

The CA replaces the solvency ratio. In the FSB’s founding affidavit against Saxum, CAR is defined as (Assets – Liabilities)/CAR.   It is of course confusing to have CAR mean Capital Adequacy Ratio and Capital Adequacy Requirement.  Let us rather use SCR; solvency capital requirement.


Assuming a company has assets of R1.25 billion, liabilities of R1 billion and it has been determined its SCR is R250 million, then its CAR would be R250 million/R250 million = 1.


If we then assume the company’s premiums equaled R1 billion, then the solvency ratio would be 25%. If the liabilities causing the reserve to decrease to R150 million, then the company would still be solvent but its CAR would be down to 0.6.


A CAR does not convey the same information that the solvency ratio did.


Expressing concern

The registrar advised in its affidavit that its concern about Saxum went back to 2015 where from January to May, the CA Ratios were 1.24, 1.22, 1.04, 1.01 and 1.14. Since in January and February these ratios were well in excess of 1, it is not clear why the FSB was concerned. In May 2016 the ratio had declined to 0.97 decreasing to 37.2 in April.


On 8 September 2016, the FSB issued a notice that Saxum desists from carrying on any new business, by which time the insurer was technically insolvent.


We cannot see anything in the new Twin Peaks regulation which would have changed the Saxum outcome. The CA Ratio is less clear than the solvency ratio. Having a different even higher capital requirement would not have changed the outcome since Saxum was not able to raise the lower capital amount.


When the financial statements of Saxum are examined, matters of concern appear.


The company had a net premium income plus net commissions earned of R74 m. Its expenses were R 70.2 m (Management expenses R42.5 m + Underwriting management fees R27.7 m) leaving a mere R3.8 million to pay claims of R33 m.


The rationale for the existence of an insurance company is to pay claims. If only 5.1 % of its income is devoted to paying claims, it is unlikely the company can or indeed should or will exist. It is also noted that in the final year management expenses increased by more than 100% without an explanatory note. One wonders how the FSB let the situation escalate to this point.


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