Simply put, an insurer must be solvent in order for it to have sufficient funds to meet the obligations it faces under current and future claims that may be made against it. If an insurer has insufficient funds to do this it will be made insolvent which puts the policy holders at risk of reduced payments of claims or potentially no payment in respect of future claims.
If an insurance company is not solvent it may no longer function as insurer for new policies and prospective clients would be unlikely to wish to take policies out with an insurer that couldn’t meet its obligations in the event that they had to make a claim anyway.
How does an insurance company ensure that it remains solvent?
The best way for an insurance company to remain solvent is for it to properly manage the risk that it underwrites so that it is always in a position to be able to make payments to policy holders in any eventuality, though this may not be possible in every circumstance particularly if there is a rush of claims made due to a major natural disaster where the insurer is highly exposed to a particular type of risk.
With this in mind insurers use insurance actuaries to model risk so that they can better understand the risk associated with any individual policy and take positive steps to ensure that the level of premium charges is balanced against the actual level of risk that is being underwritten.
Actuaries are highly trained professionals and understand risk management to a high degree so their job is to mitigate the risks involved for an insurer with regard to specific policies.
Are there external bodies that make sure insurers remain solvent?
Yes and no, there are regulatory bodies in the United States that operate on a state by state basis that try to ensure than an insurer is being financially responsible, and have powers to take action against an insurer if there are areas of concern regarding their solvency.
Similarly there are external auditors and ratings agencies that try and gauge an insurer’s solvency and keep this information in the public domain to encourage the insurer to practice responsible risk management.
However no single body has the power to require an insurer to remain solvent and it depends very much on the risks involved and the number of claims that are made against the insured risks.