In the 1990s, large insurance companies failed in virtually every major market, prompting a fierce and ongoing debate about how to better protect policyholders. Drawing lessons from the failures of four insurance companies, When Insurers Go Bust dramatically advances this debate by arguing that the current approach to insurance regulation should be replaced with mechanisms that replicate the governance of non-financial firms. Rather than immediately addressing the minutiae of supervision, Guillaume Plantin and Jean-Charles Rochet first identify a fundamental economic rationale for supervising the solvency of insurance companies: policyholders are the "bankers" of insurance companies. But because policyholders are too dispersed to effectively monitor insurers, it might be efficient to delegate monitoring to an institution--a prudential authority. Applying recent developments in corporate finance theory and the economic theory of organizations, the authors describe in practical terms how such authorities could be created and given the incentives to behave exactly like bankers behave toward borrowers, as "tough" claimholders.

Foreword vii
Acknowledgements viii


Chapter 1: Introduction 1


Chapter 2: Four Recent Cases of Financially Distressed Insurers 4
2.1 Independent Insurance Company Limited 4
2.2 Groupe des Assurances Nationales 13
2.3 Equitable Life 17
2.4 Europavie 25
2.5 Why Are Insurers Subject to Prudential Regulation? A First Pass 27


Chapter 3: The State of the Art in Prudential Regulation 29
3.1 The Main Features of Prudential Systems 29
3.2 Regulation and Ruin Theory: Controlling the
Probability of Failure 34
3.3 Conclusions 41


Chapter 4: Inversion of the Production Cycle and Capital Structure of Insurance Companies 43
4.1 Inversion of the Production Cycle in the Insurance Industry 43
4.2 An Analogy between Insurance Capital and Deductibles in Insurance Contracts 45
4.3 The Role of Deductibles in Insurance Contracts 47
4.4 The Role of Insurance Capital to Mitigate Informational Problems 50
4.5 Conclusion: The Inversion of the Production Cycle Creates Agency Problems That Can Be Mitigated by Capital Requirements for Insurance Companies 53
4.6 Appendix: Capital Requirements as an Incentive Device 54


Chapter 5: Absence of a Tough Claimholder in the Financial Structure of Insurance Companies and Incomplete Contracts 56
5.1 Absence of a Tough Claimholder 56
5.2 Prudential Regulation and Incomplete Contracts 59
5.3 The "Representation Hypothesis" 61


Chapter 6: How to Organize the Regulation of Insurance Companies 64
6.1 Simple Prudential Ratios 64
6.2 "Double Trigger" 66
6.3 An Independent but Accountable Prudential Authority 68
6.4 Granting Control Rights to the Industry via a Guarantee Fund 69
6.5 A Single Accounting Standard 71
6.6 Limiting the Scope of Prudential Regulation 72
6.7 What if This Is Not Enough? 73


Chapter 7: The Role of Reinsurance 75
7.1 Organization of the Reinsurance Market 75
7.2 Reinsurance and Prudential Supervision 81


Chapter 8: How Does Insurance Regulation Fit within Other Financial Regulations? 83
8.1 Insurance and Financial Conglomerates 83
8.2 The Regulation of Banks and of Insurance
Companies Are Two Different Jobs 90
8.3 Insurance and Systemic Risk 93


Chapter 9: Conclusion: Prudential Regulation as a Substitute for Corporate Governance 97


References 99