What is Early Warning Tests

Early warning tests are 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

Early warning tests are used to identify failing insurance companies before they become a problem for their customers and other interests. 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.

NAIC's Risk-Based Capital Early Warning Tests

The NAIC’s Risk-Based Capital (RBC) regime began in the early 1990s as an early warning system for U.S. insurance regulators. The adoption of the U.S. RBC regime was driven by a string of large-company insolvencies that occurred in late 1980s and early 1990s.

The NAIC's RBC early warning tests have two primary components:

  1. The risk-based capital formula that established a hypothetical minimum capital level that is compared to a company’s actual capital level
  2. A risk-based capital model law that grants automatic authority to the state insurance regulator to take specific actions based on the level of impairment