The approach to dealing with failures of financial institutions has witnessed significant changes since the eruption of the financial crisis in 2008, both from the crisis prevention and the crisis management perspective. A changing perspective in the interpretation of the causes, early identification and corrective measures used in the context of (near) failures may create difficulties when trying to compare past failures with current ones, particularly with the advent of recovery and resolution frameworks in finance.
EIOPA has developed its own conceptual approach, which is followed throughout this report. It should be stressed that there is not a conceptual approach which is universally agreed. The aim of the present chapter is to explain the approach followed by EIOPA, in order to achieve a common understanding and support the classification of the different cases of insurance failures and near misses.
This chapter focuses on the following two issues:
- The definition of the concepts of “failure” and “near miss”, which are essential to understanding the database construction process and the scope of the cases to be included.
- The need to have a common understanding of the framework for crisis prevention and management, as well as the recovery and resolution tools to be used.
In terms of crisis prevention and management, the fundamental approach followed by EIOPA can be understood as part of a continuum of supervisory activities. Illustration 1 below summarizes the whole process: During business as usual, and in the normal stages of supervision, an initial problem can be identified, and insurers may seek to implement measures to overcome the problem. Supervisors would, in turn, normally intensify supervision and follow-up more closely on the developments of the insurer. Should the initial problem become a real financial threat (e.g. being in breach of, or about to breach, solvency capital requirements) the insurer enters into a new stage, which is linked to an increased risk of failure, i.e. a near miss situation. In this context, the insurer should trigger certain recovery actions to restore its financial position, while supervisors can intervene more intrusively. In general, there should be a reasonable prospect of recovery if effective and credible measures are implemented. Nevertheless, if the situation of distress is extremely severe and the measures taken do not yield the expected results, the insurer enters into resolution.
Eventually, the insurer (or parts of it) is (are) wound-up and exits the market.
In the context of this report, a near miss is defined as a case where an insurer faces specific financial difficulties (for example, when the solvency requirements are breached or likely to be breached) and the supervisor feels it necessary to intervene or to place the insurer under some form of special measures.
The elements to identify a near miss are the following:
- The insurer is still in operation under its original form;
- Nevertheless it is subject to a severe financial distress to an extent that the supervisory authority deems it necessary to intervene; and
- In the absence of this intervention, the insurer will not survive in its current form and may eventually go into resolution or be wound-up.
Underlying is the idea of success of the measures taken. As such, it should not involve public money or policyholders’ loss.
In other words, a near miss presupposes that the supervisory intervention, either directly (e.g. replacing the management) or indirectly (e.g. request for an increase in capital), contributed in a clear way to overcome the insurer’s financial distress and bring it back to a “business-as-usual” environment. Shareholders generally keep their rights and could potentially oppose any of the measures undertaken.
On a day-to-day basis, insurers and NSAs might have to take different actions that require a certain degree of coordination. A “near miss” in the sense described in this report should be distinguished from these type of situations. Near misses only refer to cases where severe problems were detected or reported and supervisory measures were necessary to ensure the viability of the insurer.
Near misses actually constitute an area of particular interest for this report. In effect, their correct reporting and analysis would allow valuable lessons to be learned from successfully managed distress situations – prospective failure of an insurer and supervisory actions that permitted recovery.
A failure, for the purposes of the present database, exists from the moment when an insurer is no longer viable or likely to be no longer viable, and has no reasonable prospect of becoming so.
The processes of winding-up/liquidation, which are usually initiated after insolvency, either on a balance sheet basis (the insurer’s liabilities are greater than its assets) or cash-flow basis (the insurer is unable to pay its debts as they fall due), are also encompassed within the definition of failure for the purposes of the database. Failure is thus triggered by “non-viability”.
The failed insurer ceases to operate in its current form. Shareholders generally lose some or all of their rights and cannot oppose to the measures taken by the authority in charge of resolution, which has formally taken over the reins from the supervisory authority.
For classification purposes, any case is considered as a failure (regardless of the final result of the intervention) when:
- Private external support (e.g. by means of an insurance guarantee system (IGS)) has been received.
- Public funds by taxpayers were needed for policyholders’ protection or financial stability reasons.
- Policyholders have suffered any type of loss, be it in financial terms or in a deterioration of their insurance coverage.
The following are examples of resolution tools that may be used by authorities in a case of failure:
- Sale of all or part of the insurers’ business to a private purchaser. A particular case is the transfer of an insurers’ portfolio, moving all or part of its business to another insurer without the consent of each and every policyholder.
- Discontinue the writing of new business and continue administering the existing contractual policy obligations for inforce business (run-off).
- Set-up a bridge institution as a temporary public entity to which all or part of the business of the insurer is transferred in order to preserve its critical functions.
- Separate toxic assets from good assets establishing an asset management vehicle (i.e. a “bad insurer” similar to the concept used in banking) wholly owned by one or more public authorities for managing and running-down those assets in an orderly manner.
- Restructure, limit or write down liabilities (including insurance and reinsurance liabilities) and allocate losses following the hierarchy of claims.
This also includes the bail-in of liabilities when they are by converted into equity.
- Closure and orderly liquidation of the whole or part of a failing insurer.
- Withdrawal of authorisation.
Lastly, it should be mentioned that the flow of events shown in Illustration 1 does not necessarily take place in a sequential way. For example, there could be cases in which an insurer goes directly into resolution. Thus, what is relevant for the classification of a particular case is whether the insurer recovers (which would then be considered as a near miss or as a case resolution/return to market if some kind of resolution action/tool is used) or has to be fully resolved and/or liquidated.