Historical origin of capital as a prudential tool

A continuation of the history of insurance regulation, as per the previous FAnews editions, is covered in this article.

As mentioned previously, the formation of companies was prohibited with the South Sea Bubble saga of 1720. Then in 1844 companies were once again allowed to be formed.

Today, the use of capital plays a pivotal role in the prudential regulation of banks and insurers. In terms of the current system, a short-term insurer has to hold a reserve of 25%; 15% as a ‘solvency’ reserve and 10% as a catastrophe reserve. Solvency Asset Management (SAM), based on Europe’s Solvency II, is a much more elaborate system which also uses capital as a prudential regulatory tool.

In this article we examine the historical origin of this tool.

An uncomfortable feeling

The South Sea saga left an uncomfortable feeling about handing over capital to a company. When companies were again allowed to be formed, there was no requirement to hand over any capital. Shareholders could subscribe to shares and if allocated, they could pay a deposit, and could thereafter be called upon to pay up the outstanding balances.

This could happen if the company needed the capital. The important point is that shareholders did not have to pay over capital to the company. Immediately after companies were allowed to be formed, concerns began to be expressed about companies in general and insurers in particular.

The question arose whether or not there should be only one companies act dealing with all types of companies or at least two acts; an act for general companies and a separate act for insurers, especially life assurance companies.

Standardised recommendations

Parliament was undecided and so, appointed a Select Committee to investigate the matter, in which a report was published in 1853 entitled ‘Report from the Select Committee on Assurance Associations’.

The committee recommended that insurers have a separate act and that accounting principles and reports be standardised. Of particular concern, at the time, was the fact that a large number of companies which were formed after 1844 quickly disappeared.

The committee recommended that it should be compulsory that £10 000 of share capital be paid-up to counter this problem. The capital was not to be used in the insurance business, but invested in public funds. The capital was not to protect policyholders and did not play a prudential role.

It was assumed that the compulsory payment of this capital would reduce the number of short-lived start-up companies. This capital was to play this role during the early period the company.

Leading insurance managers of the day felt there was no need to insist that well established companies hold any capital at all since expenses were paid from premium income, and thereafter profits to shareholders. Capital according to them was not needed. It does not appear as if too much attention was paid to the select committee’s recommendations.

A culminated change

Only in 1869, when the Albert Life Assurance Company collapsed, did this spark a change which culminated in the passing of the UK Life Assurance Act of 1870.

This change required life companies to deposit a sum of £20 000 with the Accountant-General, which could be used for the benefit of policyholders in the case of the collapse of a life company. Accordingly, the requirement of capital for solvency purposes was introduced – for life companies. It is unclear what the purpose of the deposit was.

It is believed the motivation for the deposit came from the Lloyd’s practice where insurance was provided by individuals - known as Lloyd's "Names".

Lloyd’s also initially did not require Names to pay over capital to syndicates. What was necessary however, was the assurance that if called upon to pay for losses, the Names had the resources to do so.

By the mid-1850s it was thought prudent to ask Names to provide security for possible liabilities. In some cases of younger Names, the security was provided on behalf of the Name. In one particular case, a relative was uncomfortable with the idea of standing surety for a new Name and instead, offered to pay a cash deposit of £5 000, which the Lloyd’s Committee reluctantly accepted in lieu of the surety.

Slowly this became the norm. Names lodged a deposit of £5 000 with the Committee at Lloyd’s. The deposit was not for solvency purposes, but a method of obtaining assurance that the Name had some wealth to settle his liabilities.

Institutionalised practice

When the Albert Life Assurance Company collapsed, this practice was institutionalised for life insurance companies and was quickly followed in various parts of the world, including South Africa. In the case of companies, the deposit did not exist for the same reason as Lloyd’s. No system existed to ensure that persons who subscribed to shares could in fact settle the call. Commentators at the time seemed to think the deposit was for solvency purposes. So although the practice for companies was the same, the reason was not.

In 1909, the UK passed the UK British Assurance Act which dealt with both life and short-term insurance, and the deposit was applied to all insurers; not only life companies. Again, this was followed in South Africa with the passing of the 1923 Insurance Act.

Eventually, instead of lodging a deposit with the government, the system changed to the company itself holding capital. This has an important implication since in the case of a company capital; capital is the excess of assets over liabilities.

If a company is forced to hold capital it would mean that all the liabilities would be covered by the assets and a surplus, corporate capital remaining. By forcing companies to hold capital, companies would be forced to be technically solvent.

If the capital was held by a third party, such as the Committee of Lloyd’s, or as a deposit with the government, the company could in fact be insolvent. So, it was not only the holding of the capital which was important, but more importantly the forcing of the company to be technically solvent.

The test of time

It should be noted that even if the capital was a mere R1, the company would then be solvent. The actual amount did not play a significant role in the debate. As companies grew the idea that a fixed amount of £20 000 should be held, it was replaced by a percentage of premiums; 15 + 10 in South Africa. The 15% was referred to as the solvency ratio.

What is more important than capital for prudential regulation is the profitability of the insurer. Capital in a company is built up from retained earnings. As a company grows, the premium income grows, and if the capital grows, the company would have been sufficiently profitable to be able to retain earnings. Capital growth is merely a reflection of a successful insurance company.

The solvency ratio method has stood the test of time. Introduced in 1870, it has worked well for more than 100 years. In South Africa two major insurer collapses have occurred, namely the AA Mutual and IGI, both of which were solvent. As pointed out earlier, if a company has capital this means that the company is solvent. Not surprising, in the end the collapsed insurers could settle all debts and still had capital left over, even after the cost of the liquidation process.

The SAM system places too much emphasis on capital as a prudential tool – executives of yesteryear would find this approach to be quite amusing. After all, they did tell the Select Committee in 1853 that no capital was required to run a successful insurance company. Profit is required.