Residual Market

Study guides: Exam 6C, Exam 6U

The Residual Market is the mechanism that provides coverage to risks the voluntary market will not write at approved rates. It exists wherever insurance is compulsory — chiefly automobile — because a mandate to buy is meaningless if no insurer will sell. In Canada the residual market is the Facility Association, supplemented by risk sharing pools and Quebec's plan de répartition des risques.

Two structures, and the difference matters:
- A residual market facility (Facility Association) — the risk is written by the facility, which is a separate entity; results are shared among all licensed insurers by market share. The policyholder knows they are in the residual market and pays its rates.
- A risk sharing pool — the risk is written by an ordinary insurer at ordinary rates, and the insurer then cedes it to a pool whose results are shared. The policyholder does not know, and pays the normal rate.
Size is a diagnostic, not a goal. A large or rapidly growing residual market is evidence that approved rates are inadequate for part of the risk spectrum, or that classification restrictions have made some segments unwritable. Regulators watch the trend for exactly this reason.
Every insurer participates in the results whether or not it writes the business, in proportion to its voluntary market share. There is no opting out — which is what makes it a market-wide mechanism rather than a competitive product.
Depopulation is the desired direction: as insurers become able to price and write formerly residual risks, volume returns to the voluntary market. The tools are permitting adequate rates, allowing appropriate classification, and take-out programs.
Actuarial issues: residual market business is adversely selected by construction, so its loss ratios exceed the voluntary market's; the sharing formula determines each insurer's exposure to a business it did not underwrite; and the Take-All-Comers Rule governs which risks are legitimately there rather than being pushed there.

Reading the Residual Market Share A province's residual market share of private passenger auto exposures over five years: $1.2\%$ , $1.5\%$ , $2.4\%$ , $4.1\%$ , $6.8\%$ . Approved rate increases over the same period averaged $2\%$ per year while industry loss costs rose $7\%$ per year.

Diagnose, and say what would reverse it.

Answer The diagnosis is rate inadequacy, and the arithmetic shows it. Over five years, prices rose by $1.02^5 = 1.104$ and costs by $1.07^5 = 1.403$ — a widening gap of roughly $27\%$ . As rates fall below cost for progressively larger parts of the risk spectrum, insurers tighten filed underwriting rules, and the risks those rules exclude go to the Facility Association. The residual share is a thermometer, and it is reading a fever in the rate regime, not a change in drivers.

Note the acceleration: $+0.3$ , $+0.9$ , $+1.7$ , $+2.7$ percentage points. That convexity is expected — each year of suppression makes a wider band of risks unprofitable, so the population crossing the line grows.

What reverses it:

Adequate approved rates. The only durable fix; everything else treats symptoms.

Classification flexibility, so insurers can price the marginal risks rather than decline them. If a restriction is what made them unwritable, the residual market is where the restriction's cost is showing up.

Take-out incentives to move residual business back into voluntary books.

Cost reduction through product reform, which lowers the cost the rate must cover.

What does not work: pressuring insurers to write the business anyway. They are already obliged to write anything their filed rules accept (Take-All-Comers Rule); the risks in the residual market are there because the rules exclude them, and the rules exclude them because the rate does not support them.