Do insurers use internal capital markets to manage regulatory scrutiny risk?

• Published date: 01 December 2023
• Author: Stephen G. Fier,Andre P. Liebenberg
• Date: 01 December 2023
• DOI: http://doi.org/10.1111/jori.12438

Received: 29 November 2021

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Revised: 21 June 2023

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Accepted: 30 June 2023

DOI: 10.1111/jori.12438

ORIGINAL ARTICLE

Do insurers use internal capital markets

to manage regulatory scrutiny risk?

Stephen G. Fier

1

|Andre P. Liebenberg

2

1

Department of Finance, Insurance and

Real Estate, School of Business, Virginia

Commonwealth University, Richmond,

Virginia, USA

2

Department of Finance, School of

Business Administration, University of

Mississippi, University, Mississippi, USA

Correspondence

Stephen G. Fier, Department of Finance,

Insurance and Real Estate, School of

Business, Virginia Commonwealth

University, Snead Hall, 301 W. Main St.,

Richmond, VA 23284, USA.

Email: fiersg@vcu.edu

Abstract

Empirical evidence suggests that insurance groups

allocate capital to members with better performance or

growth prospects and use internal capital markets

(ICMs) to protect the franchise value of less capitalized

members. We propose and test an additional motiva-

tion for the use of ICMs—to manage regulatory

scrutiny risk. We show that almost 50% of insurers at

risk of facing additional regulatory scrutiny due to

failing four Insurance Regulatory Information System

(IRIS) ratios received sufficient internal capital to avoid

enhanced regulation. Moreover, the likelihood and

extent of internal capital allocation are related to

regulatory scrutiny risk and the amount of capital

allocated is typically just enough to avoid regulatory

scrutiny. Time series evidence indicates that groups

manage regulatory scrutiny risk by allocating capital

toward affiliates when their pre‐capital contribution

IRIS ratio failures exceed three, and away from

affiliates when they are no longer at risk of additional

regulatory scrutiny.

KEYWORDS

internal capital markets, property‐casualty insurance, regulation,

regulatory scrutiny risk

JEL CLASSIFICATION

G22, G31, G32, G38, K20

Journal of Risk and Insurance. 2023;90:861–897. wileyonlinelibrary.com/journal/JORI

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861

© 2023 American Risk and Insurance Association.

1|INTRODUCTION

A vast body of literature examines the use of internal capital markets (ICMs) in conglomerate

firms. One strand of research examines the efficiency of ICMs and argues that capital should

optimally be allocated toward better performing group members. However, recent studies of

banks and insurers show that these financial institutions also use ICMs to support weak group

members. For example, Cremers et al. (2011) find that capital is allocated toward less solvent

banking group members and Gopalan et al. (2007) show that capital is transferred to weaker

group members via intragroup loans to avoid default. Niehaus (2018) predicts that life insurers

optimally allocate capital towards less capitalized group members to preserve franchise value

and reduce the potential for declines in demand. Most recently, Ge (2022) finds that life

insurance affiliates make more financial transfers to their group following large losses by

property‐casualty affiliates.

In this paper we propose and test an additional motivation for the use of ICMs in insurance

groups—the management of regulatory scrutiny risk. We use Insurance Regulatory Information

System (IRIS) ratio violations as an indicator of regulatory scrutiny risk. The National Association of

Insurance Commissioners (NAIC) states that IRIS is “… intended to assist state insurance

departments in targeting resources to those insurers in greatest need of regulatory attention”

(NAIC, 2017). IRIS ratios capture various aspects of insurer financial health but eight of the thirteen

ratios are directly affected by policyholders' surplus—which can be increased via internal capital

allocations.

1

Having four or more IRIS ratios outside of the acceptable bounds typically triggers

greater state‐level regulatory scrutiny (e.g., Adiel, 1996; Gaver & Paterson, 2000;Petroni,1992),

which we refer to as “regulatory scrutiny risk.”

2

This potential for increased regulatory scrutiny once

four or more IRIS ratios fall outside of the appropriate bounds is not simply a matter of conjecture in

academic literature, but is recognized by insurers and regulators as evidenced by annual disclosures

and required state filings, suggesting that this four‐ratio threshold serves as a meaningful value for

insurers in practice.

3

Given the effect IRIS can have on the degree to which firms are regulated in the insurance

industry, we test how internal capital allocations among group members may be used to avoid

additional regulatory scrutiny by way of managing their IRIS ratios (holding constant risk‐

based capital [RBC] and other internal capital allocation determinants).

The insurance industry is an ideal setting to investigate the potential role that the

management of regulatory scrutiny risk can have on internal capital allocation decisions. Given

the unique nature of statutory reporting in the insurance industry, we are able to directly

observe internal capital allocations among group members and use that information to

calculate pre‐capital contribution IRIS ratios.

4

Because IRIS ratios are largely affected by the

amount of surplus carried by an insurer, we are able to calculate IRIS ratios before

1

Policyholders' surplus represents the difference between assets and liabilities and is equivalent to owners' equity.

2

The ranges are determined by the NAIC and the ratios, their individual components, and the acceptable ranges are

disclosed to the insurers. Detail regarding the calculation of each of the IRIS ratios is provided in Appendix Awhile

acceptable ranges and an overview of the System are reported in Appendix B.

3

For instance, it is not uncommon for insurers to reference the four‐violation threshold in their annual statements,

while some state regulators require insurers to provide an explanation for why they had four or more IRIS ratios that

were outside of the acceptable range. A detailed discussion of the relevance of the four‐violation threshold is provided

in Appendix C.

4

As discussed by Powell et al. (2008), capital contributions include any transfer of capital among affiliated firms,

including cash, securities, real estate, and surplus notes.

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FIER and LIEBENBERG

consideration of net capital contributions and use that information to test the influence of

regulatory scrutiny risk on capital allocation.

The purpose of this study is twofold. First, we test whether the management of

potential regulatory scrutiny impacts the amount of internal capital received or provided

by a given affiliate. If firms do attempt to manage the risk of increased regulatory scrutiny

through the use of internal capital allocation, we posit that firms with at least four IRIS

ratios outside of the appropriate ranges before receiving capital contributions will likely

receive greater amounts of internal capital than other group members. Second, we test

whether a change in regulatory scrutiny risk influences the amount of internal capital

received by a given firm. If insurance groups use internal capital for the purpose of

managing regulatory scrutiny risk, we anticipate that a positive (negative) change in

regulatory scrutiny risk should result in an increase (decrease) in the amount of capital

received from group members.

We show that almost one‐half of firms with four IRIS ratio violations receive sufficient

internal capital to manage regulatory scrutiny risk. Further, our results suggest that

regulatory scrutiny risk is related to both the likelihood of receiving capital contributions

and the amount that is received. Specifically, we find that firms with at least four pre‐

capital contribution violations are 17% more likely to receive internal capital relative to

firms below the four violation threshold. Our results also indicate that firms with at least

four pre‐capital contribution IRIS ratio violations ultimately receive 2.4% more internal

capital relative to assets than firms with fewer than four violations. The capital allocation

appears efficient as the vast majority of internal capital recipients that face the potential

for greater regulatory scrutiny are allocated just enough capital to avoid the four‐ratio

failure threshold.

Finally, we find that changes in capital allocations are influenced by changes in the risk of

potential regulatory scrutiny. In particular, we find that firms that did not face greater

regulatory scrutiny in the prior year (i.e., those with fewer than four pre‐capital contribution

IRIS ratio violations) but do face the potential for increased regulatory monitoring in the

current year receive an increase in internal capital contributions. Likewise, firms with more

than three pre‐capital contribution IRIS ratio violations in the prior year but with fewer than

four in the current year experience a reduction in the amount of internal capital received.

Overall, these results indicate that the management of regulatory scrutiny risk plays a crucial

role in capital allocation decisions.

It is important to distinguish between the avoidance of regulatory scrutiny motivation

for capital allocation and other motivations, such as the protection of franchise value,

avoidance of a costly ratings downgrade, or unresolved agency conflicts. Accordingly, our

identification strategy involves several approaches that aim to isolate the impact of

potential regulatory scrutiny on capital allocation from these other motivations. First, we

control for the incentive to protect franchise value by including a range of RBC variables

in our models. We find that the inclusion of alternative RBC controls has a negligible

impact on the effect that being at risk of failing four or more IRIS ratios has on capital

allocation. Second, we test whether capital allocation changes as affiliates move in and

out of regulatory scrutiny risk over time. We find that capital allocation is highly sensitive

to changes in regulatory scrutiny risk. Third, we condition on the subsample of firm‐years

where RBC is sufficiently high that it is not binding, and find that all of our general results

persist in a setting that eliminates the franchise value protection incentive. Fourth, we

show that our results are robust to the inclusion of variables that control for potential

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