Guaranty Funds

Study guides: Exam 6C, Exam 6U, Exam CP-321

Guaranty Funds are industry-financed arrangements that pay the claims of an insolvent insurer's policyholders, up to defined limits, so that a failure does not leave claimants uncompensated. Canada's property and casualty fund is PACICC; membership is a condition of licensing in every province.

\text{Assessment}_i = \text{Shortfall} \times \frac{\text{Premium}_i}{\sum_j \text{Premium}_j}

• Post-assessment funding is the Canadian model: the fund holds only modest standing resources and levies surviving insurers after a failure, in proportion to their market share in the affected jurisdiction and lines. Pre-funded models (as in some other countries) hold capital in advance instead.
• Coverage is capped and partial. PACICC pays defined maximums per claim and per policy and refunds a portion of unearned premium; large commercial claims above the cap, and claims of a kind excluded from coverage, are not made whole. A guaranty fund is a safety net, not a substitute for solvency.
• The moral hazard problem is structural. Assessments are based on market share, not on the assessed insurer's own risk, so a prudently capitalised insurer pays for a reckless one's failure and the reckless one's policyholders were protected all along. This is the standard criticism, and it is the argument for risk-based assessment — which no Canadian fund uses.
• Capacity is finite. The fund can absorb the failure of small and medium insurers; the failure of a very large one, or several at once after a catastrophe, would exceed what the survivors can be assessed without threatening their solvency. This is why Solvency Regulation does the real work and the fund handles the residual.
• Interaction with the regulator. OSFI and PACICC share information, and OSFI's early-intervention ladder exists partly to give the fund an orderly wind-up rather than a disorderly failure — an insurer resolved early costs the fund far less.
• Life and health insurers have a separate fund (Assuris); the two are distinct in coverage, funding and limits.

Sizing an Assessment An insurer with \$180 million of premium fails, leaving a shortfall of \$95 million after its assets are applied. Guaranty fund coverage limits reduce eligible claims to \$78 million. Industry premium in the affected jurisdiction is \$14 billion, and a surviving insurer writes \$420 million there.

Compute the surviving insurer's assessment, and comment on the framework's limits.

Answer

\begin{align*}
\text{Market share} &= \frac{\$420\text{M}}{\$14{,}000\text{M}} = 3.0\% \\[6pt]
\text{Assessment} &= 0.030 \times \$78\text{M} \\
&= \$2{,}340{,}000
\end{align*}

Manageable — which is the point of a post-assessment fund for a failure of this size.

Three things the calculation exposes:

• \$17 million of claims are not paid at all (\$95M less \$78M), being above coverage limits or outside covered classes. Those policyholders rank as unsecured creditors in the liquidation. A guaranty fund does not make the market whole.
• The assessment is unrelated to prudence. The surviving insurer pays \$2.34 million because it is large, not because it took risk. Had assessments been risk-based, the failed insurer would have paid more in advance — the reform repeatedly proposed and not adopted.
• Scale it up. Had the failure been ten times larger, the same insurer's assessment would be \$23.4 million, and an industry already weakened by whatever caused the failure — a catastrophe, a reserve deficiency common to the market — would be absorbing it at the worst moment. That correlation between the cause of failure and the assessors' own weakness is the fund's real capacity constraint.