Lecture 9

Insurance Solvency - EUby Michael Sze, PhD, FSA, CFA

Intensive Actuarial Training for Bulgaria

January 2007

Importance of Solvency Margin

• It is imperative that insurance companies be solvent under most circumstances

• There is much uncertainty in life insurance

• Insurance assets must be greater than insurance liabilities

• An additional layer of assets to cover the contingent uncertainties: solvency margin

Solvency Margin Systems

• Importance of solvency of insurance companies is well recognized

• Different countries come up with different systems to enhance solvency

• Each system has its strength and weakness

• We should study these systems and apply their respective strong points to India

Major Solvency Margin Systems

• EU Solvency Margin

• U.S. Risk Based Capital

• Australian Prudential Standards (No. 3) for Life Insurance

• Canadian Minimum Continuing Capital and Surplus Requirement (MCCSR)

Solvency Margin

-

2,000

4,000

6,000

8,000

10,000

12,000

Liabilities Assets

Ass

et/L

iab

ilit

y V

alu

es

Reserves Solvency Margin Excess Surplus

Impact of Solvency Margin

• Asset of insurance company > or =

insurance reserve + required solvency margin• No amount of the required solvency margin may

be used to pay dividend to shareholders• Only excess surplus may be used to pay dividend• In many countries, investment return on technical

provision is tax exempt– Investment return on solvency margin may not be

Ways to Guarantee Solvency

• Assets not allowed to be depleted below liability reserve

• In fact, assets are required to be substantially in excess of the minimum solvency margin

• Most countries require assets to be in excess of 150% of liability reserve + solvency margin

• Regulatory intervention when assets decrease to close to the solvency margin

Investment Returns on Different Segments of Assets

• Assets covering insurance reserve: tax deductible in most countries

• Excess assets: not tax deductible in most countries

• Assets covering solvency margin: mixed, – Deductible in some countries, – Not deductible in others

Major Risks Covered

• C-1: Risk of loss of asset values• C-2: Pricing or insurance risk• C-3: Disintermediation or asset/liability

mismatch risk• C-4: Business or operation risk• Other related issues:

– Subsidiary or affiliates– Reinsurance

Solvency Margin Systems

• Different jurisdictions have different emphases• Two different categories of solvency margins

– Implicit margin• Conservative method and assumptions in reserve calculations

• Margin provided by higher reserve values

• U.S. and European Union

– Explicit margin• Realistic method and assumptions in reserve calculations

• Explicit margins in solvency reserves

• Canada and Australia

Solvency Margin System in European Union Countries

• European Council solvency margin directives– Protecting the solvency of an insurance company is of

paramount importance

– Solvency I (Council Directive 73/239/EEC) provides regulations on solvency margins

• 3 strategic objectives– A single EU wholesale market

– Open and secure retail market

– State-of-the-art prudential rules and supervision

External Motivation for Refined Solvency Rules

• Increased competition• Pressures to promote “shareholder value”• Convergence between financial and insurance

sectors – Basel I and II of Banking Industry

• Development of risk analysis and control methods• International developments

– IAIS, IAS, IAA

Basic Principles of Solvency Rules

• Aim: Overall solvency

• Qualitative aspects– Management structure– Internal risk control system

• Risk-based approach

• Better measure and control of risk for an insurance company

Solvency I: Council Directive 2002/13/EC

• Amends Council Directive 73/239/EEC

• Provides uniform solvency margin system for all EU countries

• Simple, robust

• Easy to understand and use

• Inexpensive to administer

• Works well in practice

Two Major Aspects of EU Solvency Rules

• Asset rules

• Solvency margins

• Guaranty fund

Assets Covering Insurance Reserve (Technical Provisions)

• Max 10% in one piece of land or building

• Max 5% in single bond, share, debt, etc.

• Max 5% in unsecured loan– 1% in single unsecured loan

• Max 3% in cash

• Max 10% in unregulated market securities

Assets Covering Insurance Reserve (Continued)

• No obligation to invest in particular assets– But Member States may impose own limits

• EU localisation– EU risks should be matched by EU assets

• Currency matching– Max 20% non-currency congruence– Euro always considered congruent

Eligible Solvency Assets

• Paid-up capital (contributions)• 50% of unpaid capital (after 25% paid)• Free reserves• Profit carried forward• Cum. preferred shared / subordinated debt (max

50%)• Less: Intangibles• Unrealised gains• Max 50% future profits ( max 10 years)

Different Lines of Business

1. Accident2. Sickness3. Land vehicles4. Railway rolling stock5. Aircraft6. Ships7. Goods in transit8. Fire & natural forces9. Other damage to

property

10. Motor vehicle liability

11. Aircraft liability

12. Liability for ships

13. General liability

14. Credit

15. Suretyshop

16. Miscellaneous financial losses

17. Legal expenses

Insurance Premium (IP)

• Solvency margin depends on insurance premium (IP) and claim payment (CP)

• IP for business other than classes 11, 12, 13– Higher of gross written premium for insurance and

reinsurance or contributions

• IP for classes 11, 12, 13– Above IP increased 50%

• IP adjusted by premium or contribution cancelled and by premium taxes paid

Claim Payment (CP)

• CP for business other than classes 11, 12, 13– Average of total insurance and reinsurance claims

during the last three years

– Averaging period is increased to seven years for credit, storm, hail or frost risks

• CP for classes 11, 12, 13– Above CP increased 50%

• CP is adjusted by increase in provision for outstanding claims

Solvency Margin (SM)

• SM equals higher of SM1 and SM2• SM1 = (18% IP up to EUR 50 million +

16 % IP in excess of EUR 50 mill) x % claims not covered by reinsurance

• % claims not covered by reinsurance – = 3-year average of remaining claims after deduction

for reinsurance / gross amount of claims

– Each ratio is not less than 50%

SM2

• SM2 = (26% of CP up to EUR 35 million

+ 23% of CP in excess of EUR 35 million) x % claims not covered by reinsurance

• % claims not covered by reinsurance is defined as for SM1

Solvency Margin for Life Insurance

• Sum of two components1. Based on technical provisions

• 4% for policy with investment risk• 1% for policy without investment risk

2. Based on capital at risk• 0.3% of capital at risk• Capital at risk = amount insured – technical provisions

• Reduction due to reinsurance• 15% on 1.• 50% on 2.

Example on Solvency Margin• Data

– Insured amount 10,000– Technical provision with investment risk 2,000– Technical provision without investment risk 2,000

• SM based on technical provisions– 4% x 2000 + 1% x 2000 = 100– Reinsurance reduction = 15% x 100 = 15– Net SM = 100 – 15 = 85

• SM based on capital at risk– Capital at risk = 10,000 – 2,000 – 2,000 = 6,000– SM = 0.3% x 6,000 = 18– Reinsurance reduction = 50% x 18 = 9– Net SM = 18 – 9 = 9

• Total SM = 85 + 9 = 94

Required Solvency Margin• Required solvency margin for any year >

– Solvency margin for previous year– Adjusted proportionally for change in technical

provision

• Technical provision equals the regular reserve liability for the insurance

• Required solvency margin is reviewed annually– Adjusted for CPI increases– If cumulative increase from last adjustment < 5%, then

do not reflect– If policyholders’ rights are threatened, the insurance

authority may require higher SM

Guarantee Fund

• Additional amount over the required solvency margin

• Equal to 1/3 required solvency margin

• Guarantee fund > or = EUR 2 million

• In case classes 10 to 15 are covered & life insurance– Guarantee fund > or = EUR 3 million

Advantages of Solvency I Factors Approach

• Simple and easy to apply

• No significant compliance cost

• Results are easy to understand

• Formula uses factual, historical data

• Avoids subjectivity

Disadvantage of Solvency I Factors Approach

• Difficult to draw up useful capital definition– Only related to objective of prudential supervisor

– Arbitrary

• Focus on certain types of risks only– Mostly on underwriting risks

– Difficult to extend methodology to other risks

• Reinsurance risks not adequate reflected in calculations

Disadvantage of Solvency I Factors Approach (Continued)

• Use of premiums and provisions as exposure bases– Provides incentives for under-provisioning– Does not give credit to companies with prudent

provisions

• Not sensitive to company-specific risk profile• No credit given for company’s internal risk

management process• Inadequate consideration given to diversification

and size effects• Not dynamic (forward-looking)

Push towards Solvency II

• Solvency margins are only one of the three pillars

• Strong insurance supervision is essential

• Transparency and full disclosure are required

• Must also compare the EU factor approach to other solvency methodologies

Objectives of Solvency II

• Enhance policyholder protection– Early warning to supervisors on adverse experience

• Uniform accounting policies– Comparability, transparency and coherency– Level playing field for all insurers

• Solvency margin to match true risks• Avoid undue complexity and not prescriptive• Avoid unnecessary capital costs

– Increase global competitiveness of EU companies

Solvency II: 3-Pillar Approach• Comparable to Basel II of banking industry

– Parallel international development: IAS, IAA, IAIS– Risk based approach to solvency

• 3-pillars– Pillar I: Minimum standards

• Asset and liability valuation rules

– Pillar II: Supervisory review process• Internal controls, sound risk management• Supervisory intervention

– Pillar III: Market discipline• Transparency and disclosure• Frequent, forward-looking, relevant

Expected Timetable

• Solvency I (2004): Current solvency– Yearly solvency rating

– Bulk evaluation for risk management

• Solvency II (2005): Improved solvency– Guidelines on scenario testing,

– Dynamic financial analysis

• More solvency guidelines, 3-pillar concept– Risk assessments, leading to EU regulations

• Qualitative risk supervision, and reporting

Capital Requirement under Pillars I

• Rules relating to capital requirements and quantitative rules to regulate risks– Underwriting, market, credit, operational, A/L

mismatch

• Two fold regulations – Minimum capital requirement (MCR)

• Close to Solvency I• Automatic supervisory intervention upon breach

– Solvency capital requirement (SCR)• Using “standard” or internal model for going-concern basis• May be factor-based, scenarios, dynamic

Pillar II • Presented by European Insurance Supervisory

Authorities (EISA) in 2003• Principles of internal control and administration

by clearly define– “Values” and strategic goals of company– Responsibility of staff at each level

• Principles of risk management in– Company organization, leadership strategy, decision-

making, monitoring, information, corrective measures

• Ongoing review of reinsurance solvency• Appropriate methods of evaluating provisions

Pillar III – Market Discipline• Main contributing factors

– Financial markets– Rating agencies– Greater transparency– Harmonization in accounting rules

• Coordinate with international bodies– IASB, IAIS, IAA

• Public disclosure must strike balance between– Usefulness of information for public– Competitive interests of insurers

Five Risk Categories for Solvency• Underwriting risk

– Premium calculation, reserves, reinsurance

• Market risk– Volatility of capital instruments

• Credit risk– Default debtors in capital market– Default reinsurers

• Operational risk– Technology, personnel, structure, external

• Asset-liability mismatch– Coordination of assets and liabilities

Analysis of Risk Categories• Static or dynamic methods• Current solvency model

– Static RBC models– Easy to implement– Inconvenient for wholesale evaluation– Used in Pillar I to determine MCR

• New supervisory requirement– Scenario analyses and stress tests– Dynamic model, which complements static models– Enhance risk management of companies

• Risk management system must also include– Planning, control, monitoring of associates, internal systems and

control

Reinsurance Companies

• Currently not supervised in some EU countries

• Proposed to require registration like primary insurer

• Fulfilling Solvency I would be precondition for license

• Increase in required capital for some reinsurers