Journal of Financial Services Research 21:1/2 101±116, 2002 # 2002 Kluwer Academic Publishers. Manufactured in The Netherlands. The Effectiveness of Public and Private Sector Summary Risk Measures in Predicting Insurer Insolvencies STEVEN W. POTTIER AND DAVID W. SOMMER University of Georgia, Athens, GA Abstract This article investigates the abilities of four key summary risk measures to predict property-liability insurer insolvencies. The four summary risk measures studied are the NAIC's risk-based capital ratios, the NAIC's ®nancial analysis solvency tools (FAST) scores, A.M. Best's Capital Adequacy Relativity ratios, and A.M. Best's ratings. The empirical tests ®nd that the risk measures produced by the private sector are superior in predictive ability to the measures produced by regulators, perhaps because of the qualitative adjustments made by private sector analysts. The results also demonstrate that overall measures of risk are substantially better than risk-based capital measures in predicting insolvencies. Another ®nding is that the predictive ability of the NAIC's RBC ratios can be improved substantially if ranks are used rather than the ratios themselves. Key words: Risk-based capital, insolvencies, insurance regulation. 1. Introduction Both the public and private sectors are actively involved in assessing the ®nancial strength of insurance companies. Ideally, insurance regulators should be interested in insolvency detection systems that identify troubled insurers for appropriate regulatory action, while minimizing the number of cases in which ®nancially sound insurers are incorrectly identi®ed as troubled, with the ultimate goal of minimizing the social costs of insolvencies in the context of a competitive insurance market. Private rating organizations are also vitally interested in the ®nancial condition of insurers. The focus of their business is the provision of information relating to the ®nancial soundness of insurance companies, so the success of their business is closely tied to the accuracy of their assessments of ®nancial strength. Both regulators and rating agencies made signi®cant efforts in the 1990s to improve the methods by which the ®nancial condition of insurers is assessed. Regulators, through the National Association of Insurance Commissioners (NAIC), adopted both the ®nancial analysis solvency tools (FAST) solvency monitoring system as well as the risk-based capital (RBC) system as part of the NAIC's ``solvency policing agenda.'' During the same period, the primary private insurer rating organization, A.M. Best, enhanced its arsenal of ®nancial strength monitoring tools with the development of its own risk-based capital measure, Best's Capital Adequacy Relativity (BCAR) ratio, which it declared to be the single most important quantitative factor in its rating system.