DEFINITION of 'Early Warning Tests'

A series of financial ratios and other performance criteria used to identify insurance companies that may require additional monitoring by state insurance regulators. Early warning tests are designed by the National Association of Insurance Commissioners (NAIC) and help regulators reduce the risk of insurance companies becoming insolvent.

BREAKING DOWN 'Early Warning Tests'

Insurance companies are primarily regulated by state agencies rather than the federal government, and regulations may vary from state to state. Despite the varying regulations, all states have a common interest: limiting the possibility that an insurance company will become insolvent. This is for several reasons. First, insolvent insurers cannot pay claims made by policyholders, which hurts consumers and businesses that have experienced losses. Second, a few failing insurers can erode confidence in the wider insurance industry. Third, state regulators may be forced to step in and use resources to wind down the insurer.

Insurance companies are not allowed to declare bankruptcy, and must instead go through a protracted resolution process. Rather than discover that an insurer is in financial trouble after it is unable to make claims, regulators use early warning tests to monitor the financials of insurance companies and catch problems before they get out of hand. In some ways early warning tests are similar to the tests employed by bank regulators to determine if a bank has enough capital.

Early warning tests focus on how an insurer’s financials have changed from year to year. For example, tests look at increases or decreases in surplus, commissions and expenses, and premiums. Tests may also examine how an insurer invests its premiums, as well as how the insurer’s product mix has changed.

In most cases, state regulators do not make the results of early warning tests public, and only share the information with the companies involved. This approach is taken because the public may flee an insurer if they find out that the insurer has received a poor test score, which can exacerbate the insurer’s financial problems.

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