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ICP 23A: Solvency Principles and Structures

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  • ICP 23A:Solvency Principlesand Structures

    Basic-level Module

    A Core Curriculum for Insurance Supervisors

  • Copyright 2006 International Association of Insurance Supervisors (IAIS).All rights reserved.

    The material in this module is copyrighted. It may be used for training by competent organi-zations with permission. Please contact the IAIS to seek permission.

    This module was prepared by Michael Hafeman and Craig Thorburn. Michael Hafeman is an actuary and independent consultant on financial sector supervision and related issues. He has held senior positions in both private and public sector organizations in the financial services industry in Canada and the United States. Most recently, he was assistant superintendent of the Specialist Support Sector at Canadas Office of the Superintendent of Financial Institutions (OSFI) and served as a member of the Executive Committee and the Technical Committee of the International Association of Insurance Supervisors (IAIS), and chair of its Solvency Subcommit-tee. He is a member of the Public Interest Oversight Board, charged with overseeing the auditing and assurance, ethics, and education standard-setting activities, and the Member Body Compliance Program of the International Federation of Accountants. He serves on the Insurance Program Advisory Committee of the Toronto International Leadership Centre for Financial Sector Supervision. Craig Thorburn qualified as an actuary in 1987 and has worked both in the private sector, in insurance and banking in Australia and New Zealand, and in the public sector. He was appointed Australian government actuary in 1996 and then to various senior supervisory roles for insurance companies and financial conglomerates. As chair of the Solvency Subcommittee of the International Association of Insurance Supervisors (IAIS) between 1999 and 2002, he participated in Joint Forum working groups on capital and risk assessment. He also participated in a number of committees of the International Actuarial Association. His work at the World Bank has included advice and assistance to countries in Latin America, Asia, and Eastern Europe on insurance regulation, supervision, and market de-velopment. He has published numerous research papers.

    This module was reviewed by Mary-Lou Gallegos, Henry Siegel, Alejandro Veiroj, and Jeffery Yong Chin Hui. Mary-Lou Gallegos is head of the Insurance Supervision Division of the Cayman Islands Monetary Authority (CIMA). A graduate of Ottawa University in Kansas, she joined the Civil Service in 1975 and has been with CIMA since its inception. She holds the designation of Associate in Insurance Services from the Insurance Institute of America and has completed the Commissioners Education Program of the NAIC. She has served as Secretary of the Offshore Group of Insurance Supervisors (OGIS) since 1997. She is a former member of the insur-ance fraud sub-committee of the IAIS and the education committee of OGIS. Henry Siegel is vice president of the Office of the Chief Actuary of New York Life. He is a fellow of the Society of Actuaries and a member of the American Academy of Actuaries. He has 36 years of experience in actuarial work in the United States, including a two-year residency in Japan, specializing in financial aspects of insurance, including financial reporting and mergers and acquisitions. He is vice chair of the Financial Reporting Committee of the American Academy of Actuaries, a member of the Financial Reporting Section Council of the Society of Actuaries, and president-elect of the Actuarial Society of Greater New York. Alexander Vieroj has been the executive manager of the Regulation and Research Department of the Uruguayan Central Bank, Superintendency of Insurance, since 1994. He has a wealth of experience in insurance solvency regulation, insurance research, international insurance integration negotiations, actuarial assessment of technical bases, and the financial evaluation of insurance companies. Jeffrey Yong is a senior executive in the Actuarial Section of the Insurance Regulation Department, Bank Negara Malaysia. His actuarial work includes approving insurance products, developing solvency testing guidelines for life insurers, and reviewing the national pension scheme and performance of the life insurance industry. He is a member of the Actuarial Society of Malaysia.

  • iii

    Contents

    About the Core Curriculum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v

    Note to learner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii

    Pretest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .ix

    A. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

    B. Elements of a solvency regime . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

    C. Capital adequacy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

    D. Summary and conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

    E. References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

    Posttest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

    Appendix I. ICP 23 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

    Appendix II. Answer key . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

  • Figures

    Figure 1: Insurers Position vs. Control Levels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29Figure 2: Example of an Insurer within a Corporate Group . . . . . . . . . . . . . . . . . . . . . 32

    Case Studies

    Case Study 1. Diversification by Stagnating Insurers . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3Case Study 2. Liquidity Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13Case Study 3. Effect of Insolvency on a Branch . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

  • v

    About theCore Curriculum

    A financially sound insurance sector contributes to economic growth and well-being by supporting the management of risk, allocation of resources, and mobilization of long-term savings. The insurance core principles (ICPs), developed by the International As-sociation of Insurance Supervisors (IAIS), are key international standards relevant for sound financial systems.

    Effective implementation of the ICPs requires skilled and knowledgeable insurance supervisors. Recognizing this need, the World Bank and the IAIS partnered in 2002 to develop a core curriculum for insurance supervisors. The Core Curriculum Project, funded and supported by various sources, accelerates the learning process of both new and experienced supervisors. The ICPs provide the structure for the core curriculum, which consists of a set of modules that summarize the most relevant aspects of each topic, focus on the practical application of supervisory concepts, and cross-reference existing literature.

    The core curriculum is designed to help those studying it to:

    Recognize the risks that arise from insurance operations Know the techniques and tools used by private and public sector professionals Identify, measure, and manage these risks Operate effectively within a supervisory organization Understand the ICPs and other IAIS principles, standards, and guidance Recommend techniques and tools to help a particular jurisdiction observe the

    ICPs and other IAIS principles, standards, and guidance Identify the constraints and identify and prioritize supervisory techniques and

    tools to best manage the existing risks in light of these constraints.

  • vii

    Note to learner

    Welcome to ICP Module 23A: Solvency Principles and Structures! This is a basic-level module on solvency that does not require specific prior knowledge of this topic. The module should be useful to either new insurance supervisors or experienced supervi-sors who have not dealt extensively with the topic or are simply seeking to refresh and update their knowledge.

    Start by reviewing the objectives, which will give you an idea of what a person will learn as a result of studying the module, and answer the questions in the pretest to help gauge your prior knowledge of the topic. Then proceed to study the module either on an independent, self-study basis or in the context of a seminar or workshop. The amount of time required to study the module on a self-study basis will vary, but it is best addressed over a short period of time, broken into sessions on sections if desired.

    To help you engage and involve yourself in the topic, we have interspersed the module with a number of hands-on activities for you to complete. These exercises are intended to provide a checkpoint from time to time so that you can absorb and under-stand the material more readily and can apply the material to your local circumstances. You are encouraged to complete each of these activities before proceeding with the next section of the module. If you are working with others on this module, develop the an-swers through discussion and cooperative work methods. An answer key in appendix III sets out some of the points that you might consider when tackling the exercises and suggests where you might look for the answers.

    As a result of studying the material in this module, you will be able to do the fol-lowing:

  • Insurance Supervision Core Curriculum

    viii

    1. Describe what is meant by the terms capital adequacy and solvency and ex-plain the difference

    2. Explain the differences among going concern, run-off, and break up concepts of solvency

    3. Explain each of the following reasons for which insurers need capital: (a) fi-nancing start-up, (b) financing growth and diversification, (c) liquidity, (d) pre-caution against fluctuation of asset and liability values, (e) precaution against adverse experience, (f) public confidence, and (g) salutary incentives

    4. Describe the sources of capital for an insurer

    5. Summarize steps commonly taken by supervisors to guard against insolvency

    6. Describe the essential elements of a solvency regime

    7. Explain the difficulties in measuring capital

    8. Describe the criteria used to assess the suitability of potential forms of capital

    9. Explain which risks of insurers are more amenable to being mitigated with capi-tal and which are not

    10. Compare the following types of capital requirements: (a) fixed minimum stan-dards, (b) standards proportional to size, and (c) risk-based standards

    11. Explain the purpose of solvency control levels

    12. Explain why a solvency regime may place different requirements on an insurer operating through a branch and describe some commonly used requirements

    13. Describe steps that may be taken to prevent the inflation of capital through dou-ble or multiple gearing, intragroup transactions, or other financing techniques available as a result of an insurers membership in a corporate group

    14. Summarize the requirements of ICP 23

    15. Explain the linkages between ICP 23 and the other principles in the Prudential Requirements section of the ICPs.

  • ix

    Pretest

    Before studying this module on solvency, answer the questions below. The questions are designed to help you gauge your existing knowledge of this topic. An answer key is presented in appendix II at the end of the module.

    For each of the following questions, circle the response that is correct or most relevant.

    1. Aninsurercanbeconsideredsolventifit:

    a. Hasenoughcashtopayallclaimsthatarecurrentlyoutstanding

    b. Isabletomeetitsobligationsunderallcontractsatanytime

    c. Hasassetsatleastequaltoitsliabilities

    d. IspartofaconglomeratethatisratedB+orhigherbyaratingagency.

    2. Ashareholder-ownedinsurermaybeabletoobtainadditionalcapitalby:

    a. Drawingonalineofcreditwithitsbank

    b. Issuingsharesandsellingthemtoinvestors

    c. Makingspecialcapitalassessmentsagainstitspolicyholders

    d.Borrowingmoneyfromitscorporateparent.

  • Insurance Supervision Core Curriculum

    x

    3. InICP23,theIAIShasdefined:

    a. Allofthecapitaladequacyrequirementsthataninsurermustfollow

    b.Theneedforasolvencyregimetoaddressassets,liabilities,andcapitaladequacyrequirementsinaconsistentmanner

    c. Theminimumsolvencymarginthatshouldbeincorporatedinasolvencyregime

    d.Suitableformsofcapital.

    4. Suitableformsofcapitalinclude:

    a. Allassetsinexcessofaninsurerstechnicalprovisions

    b.Marginsofconservatisminthetechnicalprovisionsduetothespecificationofalowdiscountratebythesupervisor

    c. Retainedearningsavailabletocoveranyunexpectedlosses

    d.Theproceedsobtainedbyissuingshort-termdebtsecurities

    e.Theamountindicatedinaletterfromtheboardofdirectorsofaninsurerscorporateparentexpressingtheintenttocontributeadditionalfunds.

    5. InsurerAoperatesinajurisdictionthathasanindex-basedsolvencyregime.Theminimumsolvencymarginisbasedon3indices:15percentofpremiums;25percentofclaimscosts;and10percentoftechnicalprovisions.Theregimealsoincludesanabsoluteminimumsolvencymarginof$10million.ThefinancialstatementsofInsurerAshowpremiumsof$100million,claimscostsof$80million,andtechnicalprovisionsof$200million.

    WhatistheminimumsolvencymarginthatmustbemaintainedbyInsurerA?

    a. $10million

    b.$20million

    c. $25million

    d.$30million

    e.$55million

    f. $65million.

    6.Risk-basedcapitaladequacyregimesgenerallyrequirethe:

    a. Applicationoffactorstoaninsurerstechnicalprovisionsbutnottoitsassets

    b.Useofinternalmodelstodeterminethecapitalrequiredforoperationalrisk

  • ICP 23A: Solvency Principles and Structures

    xi

    c. Additionoftheamountscapitalrequiredinrespectofvarioustypesofriskstocalculatethetotalminimumrequirement

    d.Servicesofactuariestomakethecalculations.

    7. Theprimarypurposeofsolvencycontrollevelsisto:

    a. Establishatriggerforearlyinterventionbythesupervisor

    b.Ensurethataninsurerdoesnotinvestanexcessiveproportionofitsassetsinspeculativeventures

    c. Determinetheportionofaninsurersassetsthatshouldbeinvestedinlocalcurrencytomeetobligationstolocalpolicyholders

    d. Indicatewhenanon-siteinspectionmayberequired.

    8. Asolvencyregimeappropriatelymayplacedifferentrequirementsonaninsureroperatinginthejurisdictionthroughabranchthanonadomesticinsurerbecause:

    a. Brancheshavenocapitalthatislegallytheirown

    b.Domesticinsurersmaybemorehighlytaxedthanbranches,sothecompetitiveplayingfieldmustbeleveled

    c. Assetsofabrancharelikelytobeinvestedinforeigncurrencies

    d. Investmentwithinthejurisdictionshouldberequiredtopromoteeconomicdevelopment.

    9. Techniquesforpreventingtheinflationofcapitalthatmightotherwiseoccurinthecaseofaninsurerthatisamemberofacorporategroupinclude:

    a. Calculatingcapitaladequacyonaconsolidatedbasis

    b.Valuinginvestmentsinaffiliatesatbookvalue

    c. Closelyexaminingthenatureandfinancialimpactofreinsuranceplacedwithunrelatedreinsurersbyothercompaniesinthegroup

    d.Prohibitingtheissuanceofinsurancepoliciestoaninsurersparent.

    10.Itisreasonabletoexpectaninsurertomaintainsufficientcapitaltofullymitigatethepotentialeffectsofinadequateriskmanagement.

    a. True

    b.False.

  • ICP 23A: Solvency Principlesand Structures

    Basic-level Module

    A. Introduction

    In exchange for the receipt of premiums from their policyholders, insurers take on obli-gations to pay benefits under the terms of the policies. Whether they meet these obliga-tions satisfactorily depends not only on the fairness with which they conduct business but also on their having adequate financial resources to pay benefits as they come due. The closely-relatedbut not synonymoustopics of capital adequacy and solvency re-late to the latter of these two issues.

    What is solvency?

    All insurance supervisors certainly would agree that solvent insurers are much better than insolvent insurers and that those with adequate capital are much better than those without adequate capital. Solvent insurers with adequate capital should have the finan-cial means to make good on their obligations to policyholders in both the short and long terms. Those that are financially weak often present a range of supervisory chal-lenges and pose a greater risk of defaulting on their obligations. Nevertheless, achiev-ing a common understanding of what is meant by the terms solvency and capital adequacy can be somewhat elusive.

    The Glossary defines solvency as the ability of an insurer to meet its obligations (liabilities) under all contracts at any time. However, as it goes on to note, due to the very nature of insurance business, it is impossible to guarantee solvency with certainty. No matter how financially strong an insurer might be, one could always imagine an

  • Insurance Supervision Core Curriculum

    2

    economic scenario, natural disaster, or human-made catastrophic event_however un-likelythat would cause the insurer to be unable to meet its obligations. To achieve a clearer understanding of solvency, it may be useful to consider separately some of the issues touched on above.

    The first of these is the business circumstances under which an insurers ability to meet its obligations are to be considered. Insurers ordinarily seek to operate as going concerns, continually writing new business to grow larger and more profitable. For an insurer to be considered solvent on a going-concern basis, it should have adequate fi-nancial resources to meet obligations both to existing policyholders and to those who will become policyholders in the future. Clearly, supervisors, shareholders, and credi-tors share the insurers interest in maintaining going-concern solvency.

    However, solvency could focus strictly on an insurers ability to meet its obligations to existing policyholders. This focus would be relevant if business circumstances were such that the insurer stopped writing new business, either voluntarily or at the direction of the supervisor. In this case, solvency could be considered on the basis that the insurer would remain in operation, collecting premiums and paying benefits, until all existing policies had expired or matured and obligations under those policies had been settled. For some lines of business, such as life insurance, the run-off of business could take many years. Alternatively, solvency could be considered on a break-up, or winding-up, basis. In these circumstances, the insurer not only would stop writing new business but also its existing obligations would either be settled or transferred to another insurer as soon as possible. A supervisors interest in run-off or break-up solvency likely will be greater than that of an insurers shareholders, board of directors, and senior manage-ment, who understandably focus on the viability of the business as a going concern (see IAA 2004).

    The second issue relevant to understand the concept of solvency is its time horizon. An insurers obligations at a particular point in time, even to existing policyholders and claimants, generally will be influenced by future events. Therefore, the obligations can only be estimated. While the Glossary definition may be taken to imply an unlimited time horizon, whether an insurer that currently appears able to meet its obligations will still be able to do so many years from now is impossible to know. At the other extreme, if an insurer appears able to meet its obligations today but is subject to a high risk such that it may be unable to do so tomorrow, it could not usefully be considered solvent. A practical compromise employed by many supervisors and suggested by the IAA is the use of a one-year time horizon IAA, 2004). This compromise considers an insurer to be solvent only if it seems very likely that it will continue to be solvent one year hence.

    A third issue suggested by the definition is the degree of certainty that an insurer will be able to meet its obligations. As mentioned above, complete certainty is impos-sible. The issue of how much certainty is necessary or appropriate is a matter of judg-ment. This topic will be discussed more fully later in this module.

  • ICP 23A: Solvency Principles and Structures

    3

    Why is adequate capital important?

    Solvency not only is difficult to define but also can be difficult to maintain. A working group of the EU Insurance Supervisors Conference analyzed cases of insurer insolven-cies or near misses to identify the causes of solvency problems (see Conference of the Insurance Supervisory Services of the Member States of the European Union 2002). They found that, in each case, the solvency difficulties could be traced back to internal causes such as problems with management, shareholders, or other external control-lers of the insurers. The problems included incompetence, operating outside areas of expertise, lack of integrity or conflicting objectives, or weakness in the face of inap-propriate group decisions. These internal weaknesses led to inadequate decisionmaking processes, internal controls, and risk decisions that, in turn, left the insurers vulnerable to external trigger events. Case study 1 provides examples cited in the working groups report. Clearly, good governance and risk management are essential to the maintenance of solvency.

    However, the vulnerability of insurers to financial difficulties can be further re-duced by ensuring that asset cash flows are available to meet liabilities when they come due, for example, through asset-liability management (ALM) and liquidity manage-ment; and by maintaining a safety margin of assets over liabilities (see Institute of Actu-aries of Australia 2001). Such a safety margin is provided by an insurers capital.

    What is capital? One, somewhat old, dictionary defines it as money or property owned or used in business (see The World Publishing Co. 1963). This definition seems simple and straightforward; perhaps, that is why neither the IAIS Glossary nor many financial textbooks bother to define capital. Another explanation for not defining the term might be that the topic of capital is so complex that the word defies a more com-

    Thestagnatingfirmssoughttogrowand

    movedintonon-corebusiness.Theprob-

    lem,particularlyfornichefirms,wasthat

    managershadlittlewiderexperienceand

    movedoutsidetheirfieldofexpertise.Ar-

    eastheymovedintowere:

    Non-insuranceactivitiesundershoot

    businesstargetsandovershootex-

    pensebudgets,leadingtolossesthat

    threatensolvency.

    Illiquid,risky,concentratedinvest-

    mentsperformpoorly,andadditional

    lossesthathadnotbeenprovidedfor

    ariseonsale.Or,

    Newclassesofinsurance(forin-

    stance,specialistlinesornew

    geographicalareas):Systemsand

    controlsoverunderwritingarepoor,

    sothefirmisunabletoassessrisks

    properly,leadingbothtoincorrect

    pricingandtoareinsuranceprogram

    poorlymatchedtotheclaimsprofile

    ofthebusiness.Lossesaresuchthat

    thesolvencyrequirementisbreached.

    Case Study 1. Diversification by Stagnating Insurers

  • Insurance Supervision Core Curriculum

    plete, yet concise, definition. The Glossary provides a hint of this complexity in its defi-nition of eligible capital element:

    [an] on- or off-balance-sheet element that, in accordance with domestic regula-tions, is suitable to cover the required solvency margin (that is, eligible for inclu-sion in the available solvency or regulatory capital, that is, allowable for solvency purposes). As a general rule, these elements are either assets free of all foreseeable liabilities, or, if they represent liabilities, the latter should be subordinated to any other liabilities, that is, in the event of a winding-up or bankruptcy, they are to be paid only after the claims of all other creditors have been satisfied. [end quote]

    Capital serves as a cushion against adverse experience and financial fluctuations, helping an insurer to maintain solvency while it deals with the many risks to which it is subject. The manner in which capital adequacy requirements can recognize these risks, which may be categorized as underwriting, credit, market, operational, and liquidity risk (see IAA 2004), is discussed in section C. Many of these risks arise from the risk-taking and financial intermediation aspects of the insurance business itself.

    However, capital is also essential in enabling insurers to meet the types of strate-gic and operational needs that it shares with any business. A new insurer needs cash, sometimes referred to as working capital, to finance its start-up expenses. Established insurers need capital to finance the expenses of, and provide a buffer against the risks posed by, diversification into new products, market segments, or geographic territories. As a companys business grows, the amount of capital needed to provide an adequate safety margin also will grow, although perhaps less than proportionally, if the company is successful in diversifying its risks. At the same time, however, the costs of acquiring new businessparticularly in the case of life insurancemay depress an insurers profits or even create losses. In addition, the nature of long-term life insurance contracts with relatively high initial expenses can imply that it may take a number of years before a new company starts reporting overall profits.

    In light of the fiduciary nature of the insurance business, a strong capital posi-tion can increase the confidence of current or prospective policyholders that an insurer will be able to meet its obligations to them. In fact, some insurance consumers, for example, large corporations or insurers seeking reinsurance, may refuse to do business with insurers that lack enough capital to qualify for a high rating from a rating agency. Viewed from a broader perspective, an insurance sector comprised of well-capitalized companies contributes to public confidence and the effective functioning of the insur-ance market.

    Thus, the existence of capital may provide a number of benefits beyond keeping an insurer financially solvent. Determining how much capital will be adequate to respond to these various needs can be a complicated process, and, to some extent, a judgment

  • ICP 23A: Solvency Principles and Structures

    call. The IAIS Glossary does not include even a definition of capital adequacy. Never-theless, the topic will be further explored in section C.

    Where does capital come from?

    Adequate capital, however it may be defined and determined, is essential to an insurer, but from whence does this capital come? While there are a number of possible sources of capital for an insurer, the relevance of each to a particular insurer will depend on such factors as its corporate legal form, who owns it, its stage of development, and its financial position and performance.

    Most insurers are constituted as shareholder-owned corporations. The initial capi-tal for such an insurer is obtained by issuing and selling common shares (stock), which provide their purchasers with shares in the ownership of the insurer. Shareholders make this investment in the expectation that the insurer will be successful, that is, profitable and growing. Shareholders may then benefit through the distribution of a portion of these profits to them as dividends, through their ability to sell their shares at a higher price, or both. A shareholder-owned corporation may be either widely held, that is, hav-ing many shareholders, or closely held, with few shareholders. For example, the shares of an insurer that is part of a financial conglomerate may be wholly owned by its cor-porate parent.

    Some insurers, for example, mutuals, fraternals, friendly societies, and coopera-tives, have no shareholders but are owned by some or all of their policyholders. The ini-tial capital for such insurers is obtained from a founding group of policyholders. While their initial capital contributions will be returned to them once the insurer becomes well established, their claim against the insurer is not a transferable right of ownership that can be sold to a third party, such as that of a shareholder in a shareholder-owned insurer.

    Finally, some insurers may be state-owned. In such cases, their initial capital is ob-tained from the government. Once an insurer is through its start-up period, its primary source of capital typically will be retained earnings. Retained earnings are the profits that have been earned by the insurer but have not been distributed to policyholders or shareholders. Both shareholder-owned and policyholder-owned insurers may issue policies, called participating or with-profits policies, which provide for sharing the in-surers profits with the policyholders. In the case of policyholder-owned insurers, such policies also confer rights of ownership, such as the right to elect directors to the board. As mentioned above, shareholders expect to share in the insurers profits, and the board of a profitable shareholder-owned insurer would typically declare dividends payable to shareholders. However, the board of directors of any type of insurer usually will decide to add a portion of its profits to its capital base.

    If an insurer is growing rapidly or has adverse experience, it may need more capital than can be generated, at least in the short term, by profits on its existing policies. Share-

  • Insurance Supervision Core Curriculum

    holder-owned insurers may be able to raise additional capital by selling more shares to either existing shareholders or new investors. If the insurer is closely held, it most often will look to existing shareholders for additional capital. Additionally, as discussed in section B, some of the capital raised may be in forms other than common shares, for example, preference shares. In any case, the willingness of investors to provide capital and the terms on which they are prepared to do so will depend on their assessment of the insurers future prospects.

    Policyholder-owned insurers are at a distinct disadvantage when it comes to rais-ing capital, as they are unable to sell shares to investors. To overcome this constraint on their ability to grow and compete effectively, many mutual insurers have in recent years converted to shareholder-owned insurers, that is, demutualized. In a demutualization, participating policyholders receive shares or cash in exchange for the company owner-ship rights inherent in their policies. Subsequently, the demutualized insurer can raise capital in the same manner as any other shareholder-owned insurer.

    Another technique used by insurers to cope with a shortfall in capital is to reinsure some of their business. Some of the risk is assumed by the reinsurer, thereby reducing the amount of capital needed by the insurer as a safety margin. Reinsurance arrange-ments also might be structured to provide for the up-front payment by the reinsurer of some of the expected future profits of the business reinsured, thereby providing the insurer with immediate additional capital.

    An insurer also might decide to borrow money to help meet its needs, for example, by obtaining a loan or by issuing bonds. However, since borrowed money must be re-paid together with interest, supervisors normally do not treat it as an eligible capital ele-ment. Section B includes a discussion of the criteria that might be applied to determine the suitability of different forms of capital.

    What roles can supervisors play?

    A fundamental objective of insurance supervision is protecting the interests of current and prospective policyholders. If they are to be protected, insurers must be able to make good on their promises. Those that become insolvent quite likely will be unable to meet their obligations in full and on time. Accordingly, solvency typically is a major focus of insurance legislation, regulation, and supervision.

    The IAIS Insurance Core Principles (ICPs) explicitly address the topic of solvency in ICP 23, Capital Adequacy and Solvency, which states: The supervisory authority requires insurers to comply with the prescribed solvency regime. This regime includes capital adequacy requirements and requires suitable forms of capital that enable the insurer to absorb significant unforeseen losses. This principle is supported by various criteria that a solvency regime and capital adequacy requirements should meet; these are addressed by parts B and C, respectively, of this paper. The full text of ICP 23, in-cluding its explanatory note and criteria, is included as appendix I.

  • ICP 23A: Solvency Principles and Structures

    Many other ICPs also are relevant to solvency. In particular, the other principles in the prudential requirements section (ICPs 1823) cover such topics as the assessment and management of risks and the assets and liabilities of insurers. As noted above, many solvency problems can be traced back to incompetence, corporate control problems, weak corporate governance, or inadequate internal controls. All of these are addressed by principles in the supervised entity section (ICPs 610). The principles in the on-going supervision section (ICPs 1117) provide important guidance in the monitor-ing of solvency and the supervisory intervention that may be necessary to deal with solvency problems.

    Both ICP 23 and the ICPs taken as a whole reinforce the fact that, while the es-tablishment of solvency requirements is essential, the work of supervisors cannot stop there. Solvency must be regularly monitored and assessed, through both off-site and on-site activities.1 When solvency problems are noted, supervisors must intervene. As the EU Insurance Supervisors concluded from examining actual failures, firms rarely recover from a difficult situation without fresh capital, either as a capital injection by a parent or partner, or by a better-capitalised firm taking over the portfolio (see Con-ference of the Insurance Supervisory Services of the Member States of the European Union, 2002, 62). To protect policyholders, a supervisor needs to ensure that an insurer is taking adequate steps to recover from any solvency difficulties or, when an insurer is no longer viable, take supervisory action to achieve its orderly exit from the market-place.

    1. Core Curriculum module 23B deals specifically with solvency assessment.

    Exercises

    Answer the following questions considering, where indicated, the practices in your jurisdiction. If you are working with others on this module, develop the answers through discussion and cooperative work methods.

    1. Howmighttheinterestsofaninsurersboardandseniormanagementinsolvencycoincidewiththoseofthesupervisor?Howmighttheydiffer?

    2. Considerthemostrecentinstancesofinsurersinyourjurisdictionraisingadditionalcapital.Whydidtheydoso?Whatwereitssources?

    3. Thereisatrendtowardbroadeningsolvencyregimestoincludeelementssuchasriskmanagementanddisclosurerequirements.WhatdotheICPssayaboutthis?Commentonthepresenceandrelativeeffectivenessofquantitativeandqualitativeelementsinyourjurisdictionssolvencyregime.

  • Insurance Supervision Core Curriculum

    Commonly used terms

    Before delving into the topic, it is important to define some commonly used terms. The following definitions are taken from the Glossary (see IAIS 2006).

    Available solvency: Surplus of assets over liabilities. The first sense of the term is the sur-plus evaluated in accordance with domestic regulationeither rules of public account-ing or special supervisory rules. The second sense is of the surplus, taking into account domestic requirements as regards eligible capital elements. In other words, the second sense is surplus as the amount of capital appropriate to cover the required solvency margin in accordance with domestic law or supervisory regulations.

    Control level: A threshold value that requires intervention of the supervisor or impos-es certain restrictions on the insurer if its available solvency margin falls short of this amount. A system of solvency requirements may have more than one control level for different types of regulatory action.

    Equalization provision: Amount set aside on the balance sheet in compliance with legal or administrative requirements to equalize fluctuations in loss ratios in future years or to provide for special risks. Whether the term reserve or provision is used depends on the purpose of this amount. Amounts set aside for specified types of business (for example, hail, pollution liability or credit insurance) may be referred to as provisions, whereas amounts set aside to cover fluctuations of the entire portfolio may be referred to as reserve. Reserve may include catastrophe provisions.

    Going-concern basis: A method of considering the financial situation that assumes that the company will continue to operate and that future business will be written.

    Liability: A debt or responsibility; an obligation that may arise by a contract made or by a tort committed.

    Required solvency margin: Minimum amount of solvency margin as defined above, stip-ulated by domestic law.

    Reserve: Amounts set aside to meet unforeseeable liabilities (that is, obligations that have not yet materialized) or statutory requirements. Reserves stemming either from shareholders capital or, in the case of mutuals, members contributions and from ac-cumulated surplus. Reserves are part of the own funds (in contrast to provisions that support liabilities to parties other than shareholders or other owners).2

    2. The terms provisions or technical provisions are used here to denote liabilities arising from insurance contracts, al-though some jurisdictions use the term reserves for this purpose. Reserve as used here relates more to general reserves.

  • ICP 23A: Solvency Principles and Structures

    Run-off basis: A method of considering the financial situation that assumes that no new business will be written but that the company will continue to operate with underwrit-ten insurance contracts until the end of the term set by the policy conditions (for ex-ample, the renewal date, end of a fixed term, death of the insured person) and will settle any claims eventually arising during this period.

    Solvency: Ability of an insurer to meet its obligations (liabilities) under all contracts at any time. Due to the very nature of insurance business, it is impossible to guarantee solvency with certainty. To come to a practicable definition, it is necessary to make clear under which circumstances the appropriateness of the assets to cover claims is to be considered. For example, is only written business (run-off basis, break-up basis) to be considered, or is future new business (going-concern basis) also to be considered? In addition, questions regarding the volume and the nature of an insurance companys business, which time horizon is to be adopted, and what is an acceptable degree of prob-ability of becoming insolvent should be considered.

    Stress testing: Method of solvency assessment that provides for the consideration of the impact (current and prospective) of a particular defined set of alternative assumptions or outcomes that are adverse. Consideration is given to the effect on the insurance com-pany assets, liabilities, and operations of a defined adverse scenario.

    Technical provision: Amount set aside on the balance sheet to meet liabilities arising out of insurance contracts, including claims provision (whether reported or not), provision for unearned premiums, provision for unexpired risks, life assurance provision, and other liabilities related to life insurance contracts (for example, premium deposits, sav-ings accumulated over the term of withprofit policies).

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    0

    B. Elements of a solvency regime

    Overview

    ICP 23 states that a solvency regime must be prescribed and an essential criterion (EC) describes the fundamental elements of a solvency regime as follows:

    a. The solvency regime addresses in a consistent manner:

    Valuation of liabilities, including technical provisions and the margins con-tained therein

    Quality, liquidity and valuation of assets Matching of assets and liabilities Suitable forms of capital Capital adequacy requirements.

    Later in section B, each of these elements will be examined in turn, with the ex-ception of capital adequacy requirements (the subject of section C). Before doing so, it is important to note that while these largely quantitative elements are necessary, their existence alone will not necessarily ensure solvency.

    The board of directors and senior management of an insurer are responsible for its prudent operation and, therefore, must take primary responsibility for ensuring its solvency. As highlighted by ICP 18, they need to recognize the range of risks that the insurer faces and manage them effectively. Both the insurers and their supervisors need to understand that not all risks can be mitigated solely with capital. For example, capital can provide an effective safety margin against adverse claims experience on a portfo-lio of insurance policies that has been prudently designed, adequately priced, carefully underwritten, and appropriately protected by reinsurance. However, weaknesses in any one of these areas might make it impossible, or at the very least economically unfeasible, to maintain enough capital to provide an effective safety margin. Taken to an extreme, consider how much capital might be needed to secure the solvency of a small insurer that operates in a coastal region prone to hurricanes, writes only property insurance on large risks, applies limited underwriting, and has purchased no reinsurance coverage.

    ICP 26 highlights the need for various stakeholders of an insurer, such as investors, creditors, policyholders, and intermediaries to have access to information on the risks it has undertaken and its financial capacity to bear these risks. Such disclosure by insurers enables markets to act efficiently, and the discipline it engenders serves as an adjunct to supervision.

    Supervisors and others have responded to these issues by recognizing that capital adequacy and other quantitative requirements should be integrated into broader sol-vency regimes. For example, the EU Solvency II project, the IAA recommendations, and the Basel II Capital Accord for banks each identify quantitative capital adequacy

  • ICP 23A: Solvency Principles and Structures

    requirements, supervisory assessment of risk management, and disclosure of informa-tion as key elements, or pillars, of a broader solvency regime. The relative emphasis on each of these elements may vary by jurisdiction, reflecting differences in such things as supervisory philosophy, market development, and technical capabilities of the insurers. For example, supervisory assessment of risk management might be emphasized in a ju-risdiction in which relatively little statistical information exists to support the develop-ment of risk weights for a capital adequacy test and few of the insurers are widely held, that is, accustomed to providing extensive public disclosures.

    Liabilities and assets

    Solvency is fundamentally an assessment of an insurers balance sheetcurrently and, perhaps, prospectively. Therefore, it is impossible to make an adequate assessment of solvency unless the liabilities and assets in the balance sheet are valued appropriately. While opinions may differ on what is appropriate, a coherent solvency regime can-not exist in the absence of reliable and reasonably consistent bases of asset and liability valuation.

    To the extent possible, the valuation bases should provide a clear picture of in-surers financial situations, reflecting their economic viability. Distortions should be avoided, as should volatility that is unrelated to the true economics of the business. For example, if assets are valued at historical cost but liabilities are valued based on current market conditions, an insurers financial results could well be both volatile and distorted. The valuation bases should not only produce results that are comparable from one period to the next for any particular insurer but also facilitate comparisons of one insurer to another.

    Supervisors have responded to these measurement challenges in various ways. In some jurisdictions, accounting and actuarial standards provide the bases for the valu-ations used for both shareholder and supervisory reporting purposes. In other juris-dictions, insurance supervisors specify the valuation bases to be used for reporting to the supervisory authority, which may differ from that used for shareholder reporting. Still others take intermediate approaches, such as requiring specific adjustments to the valuation bases used for shareholder reporting. Regardless of the approach taken, it is essential that the solvency regime be sensitive to the valuation and accounting require-ments that apply to the insurers.

    Technical provis ions

    Technical provisions are the liabilities on an insurers balance sheet in regard to its obli-gations arising out of insurance contracts. Since technical provisions typically account for the vast majority of an insurers liabilities, it is essential that these provisions ad-

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    2

    equately reflect these obligations. ICP 20 states that supervisors should require insurers to comply with standards for establishing technical provisions, assess their adequacy, and require that they be increased if necessary.

    Technical provisions, particularly those of life insurers, often are calculated by ac-tuaries. The techniques for doing so are varied and sometimes complex. An IAIS dis-cussion paper (see IAIS 2003a) provides an overview of some current practices and issues in this area. Regardless of the techniques employed, to the extent possible, techni-cal provisions should reflect all of the risks related to the policies written by the insurer. They should be sufficient to cover not only claims and other policy benefits but also any related administration expenses, taxes, embedded options, and policyholder dividends or bonuses.

    Since the technical provisions are only estimates of an insurers ultimate obliga-tions under its policies, whether or not these estimates are adequate can only be known in retrospect, once the obligations have been settled. However, EC c of ICP 20 provides some guidance on what might be considered adequate, technical provisions to cover all expected and some unexpected claims and expenses. These words mean that some margin for adverse experience should be included in the technical provisions.

    Unsurprisingly, the supervisors, actuaries, and accountants in various jurisdictions have different ideas about how much margin there should be and how it should be cal-culated. For example, in some jurisdictions, such as Canada, technical provisions are calculated using assumptions that are best estimates plus explicit margins for adverse deviation in each assumption; the actuarial profession provides guidance on the size of these margins. In other jurisdictions, such as in the United States, supervisors may limit or specify values for particular assumptions, which, although sometimes intended to be quite conservative, generally do not facilitate identification of the amount of the margin. Finally, some jurisdictions, such as Australia, have begun to explicitly state the level of the margin should be to provide a particular level of confidence that the techni-cal provisions will be adequate, as determined through stochastic modeling of multiple scenarios.

    It is important that capital adequacy requirements be sensitive to the level of mar-gin in the technical provisions and how it may (or may not) change in response to changes in economic conditions and other factors. All else being equal, the supervisor in a jurisdiction in which the technical provisions include explicit margins that vary in accordance with changing conditions may require its insurers to maintain less capital than the supervisor in a jurisdiction that specifies particular assumptions, whose initial conservatism may erode as conditions change.

    oTher liabiliTies

    An insurer, like any other business, will have liabilities apart from its obligations un-der insurance contracts. These liabilities may include amounts borrowed from banks,

  • ICP 23A: Solvency Principles and Structures

    3

    equipment leases, accrued wages of its employees, pension obligations to both retired and currently active employees, taxes payable, accrued interest, and contingent obliga-tions under derivative contracts. Typically, insurers will account for such liabilities in the same manner as other businesses in their jurisdiction.

    Supervisors need to understand how such liabilities are being accounted for by insurers and ensure that the provisions established are adequate. Furthermore, when designing and enforcing a solvency regime, it is essential that supervisors understand the relative legal priority of liabilities to policyholders and those to other parties in the case of insolvency. In recognition of the fiduciary nature of the insurance business, in-surance laws in many jurisdictions rank obligations to policyholders above some, but not necessarily all, other liabilities of an insolvent insurer.

    as s eTs

    It is important that assets be realizable to meet obligations to policyholders at any time. Therefore, as mentioned in EC a, solvency regimes must address the quality, liquidity, and valuation of assets. ICP 21 provides guidance on what supervisors and insurers need to do to ensure that insurers investments are managed in a sound and prudent manner. Likewise, ICP 22 provides guidance with respect to insurers use of derivatives and similar commitments, which may be either assets or liabilities.

    A diversified portfolio of high-quality assets is more likely to maintain its value than one whose assets are speculative in nature. Accordingly, solvency regimes typi-cally include restrictions on the types and mix of assets in which insurers may invest. As discussed in section C, risk-based capital adequacy requirements also provide an incen-tive to invest in high quality assets by requiring insurers to hold less capital as a margin against potential losses on such assets than on lower quality assets.

    Since the amount and timing of obligations to policyholders are seldom certain and, in fact, may fluctuate significantly, insurers need to maintain enough cash or liq-uid assets to meet these obligations on short notice. Liquid assets are those that can

    In1999anAmericaninsurerscreditrat-ing was downgraded by a major ratingagency. Shortly thereafter, many inves-tors invoked the seven-day redemptionclause in theshort-term fundingagree-ments issued by the insurer. Althoughthese agreements suddenly behavedlikeshort-termliabilities,thesupportingassetswere invested for longer terms.

    The insurer was unable to sell assetsquicklyenoughtomeet the redemptionrequests. The combination of a mis-matchinthetermsoftheliabilitiesandassetsandtheratingdowngradeledtoa liquiditycrisis,causing the insurer tovoluntarilyseekstateinsurancedepart-mentsupervision.

    Case Study 2. Liquidity Crisis

  • Insurance Supervision Core Curriculum

    be quickly converted to cash in an amount equal or very close to their value on the insurers books. In normal circumstances, cash flows from premium payments and in-terest on invested assets often are sufficient to enable an insurer to meet its obligations, without the need to realize any assets. However, insufficient liquidity to cope with ab-normal circumstances can lead an insurer to solvency difficulties; see case study 2 for an example.

    Appropriate valuation of assets is also essential to the determination of an insurers solvency. EC b of ICP 21 requires that investments be valued according to a method prescribed by or acceptable to the supervisory authority. Valuation methods should be prudent, transparent, objective as possible, and produce consistent results. Some assets easily can be valued, for example, cash, government bonds, and shares that are regularly traded on an established exchange. The valuation of other assets may be more complex or subjective, for example, real estate, which may require periodic assessment by ex-perts; and derivatives, which may require the use of models.

    To provide greater assurance that the asset values in insurers balance sheets are prudent, some solvency regimes incorporate mechanisms for deferring recognition of increases in the values of certain assets. For example, increases in the market values of investments in common shares might not be reflected in the balance sheet until the shares are sold, or only a portion of the previously unrecognized increases might be recognized each year. On the other hand, assets that have declined in value, perhaps due to the financial troubles of their issuers, might have to be held at their reduced market values, which are all that could be realized if the insurer were to become insolvent.

    The values of some types of assets may diminish, or even vanish, in situations of stress or insolvency. For example, an insurer that has had some unprofitable years may be entitled to apply its losses against future years profits, thereby reducing or eliminat-ing the taxes payable on those profits. The insurer may carry an asset on its balance sheet in respect of this entitlement. However, if the insurer becomes insolvent, there is no prospect of future profits (or tax savings), thereby rendering this asset worthless unless, perhaps, the insolvent insurer can be merged with a profitable one. Other as-sets that might be of limited value in meeting policyholder obligations in the event of insolvency include the furniture and equipment used by an insurer in its operations, amounts due from insurance intermediaries, and investments in subsidiaries or affili-ated companies. Not only are these assets illiquid, but enforcing the repayment of such amounts in an insolvency situation would likely be very difficult, if not impossible.

    Solvency regimes respond to this risk in various ways. One approach is to disallow certain assets entirely, either on the balance sheet that insurers submit to the supervi-sor or for purposes of the capital adequacy test; such assets are called non-admitted. Another approach is to limit the recognition of such assets, for example, by ignoring the portion of their value in excess of a defined percentage of the insurers assets or by rec-ognizing only a certain percentage of their value (sometimes known as haircutting). Yet another technique is to apply a high-risk weight to such assets when calculating required capital under a risk-based capital adequacy test.

  • ICP 23A: Solvency Principles and Structures

    as s eT-liabiliTy managemenT

    As the case study 2 demonstrates, a mismatch between the term of an insurers liabilities and that of its assets can create liquidity problems that are serious enough to threaten its solvency. However, the need for an insurer to align its assets with its liabilities is im-portant for more reasons than just ensuring adequate liquidity. An insurers results can be subject to adverse fluctuations or trends, perhaps threatening its solvency, if its assets and liabilities are mismatched in terms of currency or the timing or amount of the cash flows. The risks may be particularly high in the case of long-term life insurance, annuity, or savings products that provide various guarantees or embedded options.

    As noted in EC a of ICP 23, solvency regimes need to address the matching of as-sets and liabilities. One way to do this is to require that insurers develop and implement programs of asset-liability management (ALM). What is ALM? According to the Soci-ety of Actuaries (see Society of Actuaries 2003, 2):

    ALM is the practice of managing a business so that decisions and actions taken with respect to assets and liabilities are coordinated. ALM can be defined as the ongoing process of formulating, implementing, monitoring and revising strategies related to assets and liabilities to achieve an organizations financial objectives, giv-en the organizations risk tolerances and other constraints. ALM is relevant to, and critical for, the sound management of the finances of any organization that invests to meet its future cash flow needs and capital requirements.

    A wide range of techniques can be used in an ALM program, for example, sto-chastic modeling of asset and liability cash flows, value at risk (VaR) calculations, and hedging with derivatives. A more substantive discussion of ALM is beyond the scope of this module.

    The mitigating influence of a well-executed program of ALM might be explicitly recognized in a solvency regime. For example, one supervisor (see Office of the Super-intendent of Financial Institutions Canada 2003, 3.6.1) requires life insurers to hold an amount capital in respect of the assets backing index-linked products in inverse relation to the correlation between the rates of return credited to policyholders funds and the returns earned on the underlying assets. For example, if the returns are shown to be perfectly correlated, this component of required capital is nil. If the returns are only 85 percent correlated, required capital is 15 percent of assets.

  • Insurance Supervision Core Curriculum

    reins urance

    EC b of ICP 23 requires that, Any allowance for risk mitigation or transfer considers both its effectiveness and the security of any counterparty. Reinsurance is one of the techniques most commonly used by insurers to mitigate or transfer some of the risk that they have assumed. Its use has a number of implications that must be addressed by a solvency regime.

    It is important to note that the purchase of reinsurance protection does not extin-guish or diminish an insurers ultimate obligations to its policyholders. Insurers en-ter into reinsurance arrangements with the expectation that their reinsurers will make good on their own obligations when they come due. While this expectation usually manifests, it is not a certainty. For example, a reinsurer may become insolvent or an insurer may have entered into an agreement with a disreputable reinsurer that refuses to pay claims promptly or in full. In the case of such a default, the insurer must neverthe-less meet its obligations to policyholders out of its own resources.

    Solvency regimes seek to limit this reinsurance counterparty credit risk in various ways. One way is to encourage insurers to deal with reputable, financially strong rein-surers. Insurers should be expected to perform due diligence on prospective reinsurers before entering into agreements with them. Some jurisdictions license and supervise reinsurers and may not allow insurers to deal with unlicensed reinsurers; or if such deal-ings are allowed, to take credit on their balance sheet for amounts due from unlicensed reinsurers. Others may apply haircuts to the credits that may be taken for amounts due from reinsurers that have lower ratings from ratings agencies, or allow credits only if the reinsurer posts collateral in a trust. Some jurisdictions establish limits to prevent excessive concentration of an insurers reinsurance program with a single reinsurer.

    Credits for reinsurance on an insurers balance sheet may take the form of assets, for example, amounts receivable from reinsurers; or of reductions in liabilities, for ex-ample, lowering the technical provisions in proportion to the amount of coverage pur-chased. The precise treatment will depend on the accounting standards applied in the jurisdiction, perhaps supplemented by supervisory requirements.

    The above discussion of taking credit for reinsurance on the balance sheet is pre-mised on the assumption that there has actually been a meaningful transfer of risk from the insurer to the reinsurer. This assumption may not always be valid. Some reinsur-ance arrangements, for example, financial reinsurance, are designed primarily to assist insurers in meeting prudential requirements with little or no transfer of risk. Solvency regimes may include criteria for assessing the effectiveness of the risk transfer and pro-vide no balance sheet credit unless the criteria have been met. Supervisors may need to review not only the financial records of a reinsurance arrangement but also the rein-surance contract itselfalong with any side letters that may existto make such an assessment.

  • ICP 23A: Solvency Principles and Structures

    Capital

    Finally, before turning to a discussion of how much capital might be required, it will be useful to consider what forms of capital might be suitable to meet such requirements and how the amount of capital available might be measured.

    From a simple accounting perspective, the amount of capital available might be calculated by taking the arithmetic difference between an insurers assets and its li-abilities. This measurement will obviously be affected by the ways these elements of the balance sheet have been valued. As noted above, the valuation bases vary from jurisdic-tion to jurisdiction, reflecting differences in accounting and actuarial standards and regulatory requirements. For example, in one jurisdiction, assets may be valued using current market values, while in another jurisdiction they are valued at historical cost. In either case, there may or may not be a mechanism for smoothing the changes in reported values. To the extent that the reported values of assets or liabilities differ from best-estimate or fair market values, hidden reserves are created; such reserves may be positive or negative.

    Within a particular jurisdiction, the valuation bases may also vary from insurer to insureralthough, hopefully, not too muchreflecting the choices each insurer has made within the confines of the local regime. One insurer may follow an aggressive ac-counting approach to show more favorable financial results by, for example, minimizing the margins in its technical provisions and seeking optimistic appraisals of its real estate investments. Another insurer may elect to include extra margins in its technical provi-sions and use conservative appraisers in valuing its real estate.

    The foregoing highlights the need for supervisors to be fully aware of the valuation and accounting practices being applied by insurers when examining their reported cap-ital. Such awareness may be especially challenging when the examination involves the financial reporting done in the context of another jurisdictions requirements. However, simple balance sheet comparisons easily can lead to inappropriate conclusions.

    Another way to look at capital is to consider the sources of an insurers assets and the nature of any claims against those assets. Predominantly, insurers assets come from the premiums paid by policyholders and the returns earned through the investment of those premiums prior to the payment of policy benefits. Likewise, the claims against insurers assets consist primarily of its obligations to policyholders. However, as men-tioned in section A, some assets come from sources other than policyholders, for ex-ample, the sale of shares. Other assets may arise from policyholders, but exceed the remaining obligation to them, that is, retained earnings. From this perspective, capital can be viewed as the claims against an insurers net assets, roughly, assets minus tech-nical provisions and other liabilities. Capital instruments define the nature of those claims.

    The capital shown on an insurers balance sheet may represent either equity claims or debt claims. Equity claims are defined by instruments such as shares of stock, contri-bution certificates in respect of the initial capital of a mutual insurer, and participating

  • Insurance Supervision Core Curriculum

    policies. Debt claims are defined by instruments such as bonds or commercial paper. The precise nature of the claims evidenced by these instruments must be evaluated in determining whether the corresponding amounts of reported capital are of suitable quality to be recognized in the context of a solvency regime.

    Solvency regimes should either clearly define the forms of capital that will be recog-nized as suitable or set out criteria that can be used to assess the suitability of particular capital instruments. In a draft standard on this topic, the IAIS Solvency Subcommittee (see IAIS 2004, 3), comments:

    [the] quality of an insurers capital should be assessed in terms of its availability to cover unexpected losses, both currently and prospectively. The highest quality capital is that which is both presently available and permanent. Specifically, criteria against which the quality of capital may be assessed include:

    1. Whether the supervisor can control or restrict the distribution of the capital, whether via repayment/redemption or payment of dividends;

    2. Whether net assets are free and clear of encumbrances and perfected secu-rity interests3;

    and from the perspective of the capital instruments,

    3. Whether the capital instrument is free from requirements or incentives to redeem or repay the funds;

    4. Whether the capital is free from mandatory fixed charges against earnings; and

    5. Whether the capital instrument is legally subordinated to the rights of poli-cyholders and other creditors of the insurer.

    Solvency regimes deal with any differences in the potential capital elements avail-ability to cover unexpected losses and their permanence in various manners. Some ju-risdictions define one or more categories, or tiers, of capital quality. For example, tier 1 would consist of the highest quality capital, such as common shares, retained earn-ings and perpetual noncumulative preferred shares. Tier 2 capital, which falls short in meeting one or both of the quality criteria but still contributes to the overall financial strength of an insurer, might include goodwill and intangible assets, future income tax credits, and hidden reserves. Whether or not a tiered approach is employed, supervisors generally will specify additions or reductions to reported capital for purposes of assess-ing capital adequacy, for example, nonadmitted assets, reinsurance with unregistered reinsurers, and market value smoothing reserves.

    3. Authors note: Basically, no other party should have a claim to assets that would prevent their use to meet obligations to policyholders.

  • ICP 23A: Solvency Principles and Structures

    Exercises

    Answer the following questions considering, where indicated, the practices in your jurisdiction. If you are working with others on this module, develop the answers through discussion and cooperative work methods.

    4. Inyourjurisdiction,whoestablishesstandardsforthevaluationoftheassetsandliabilitiesofinsurersthatarereportedinthefinancialstatementspreparedfortheirshareholders?Arethesesamevaluesusedintheregulatoryreturns?Ifnot,howdotheydiffer?

    5. Technicalprovisionsmaybecalculatedusingassumptionsthatareintendedtobeconservative,whichmethodprovidesimplicitmargins.Alternatively,theymaybecalculatedusingbestestimateassumptionstowhichexplicitmarginsthenareadded.Whataretheadvantagesanddisadvantagesofeachinthecontextofestablishingsolvencyrequirements?Whichapproachtocalculatingtechnicalprovisionsisusedinyourjurisdiction?

    6. WhataresomeoftheALMtechniquesusedbyinsurersinyourjurisdiction?HowdoesyoursolvencyregimerecognizethepresenceorabsenceofALM?

    7. Solvencyregimessometimesseektolimitreinsurancecounterpartyriskbyallowinginsurerstotakecreditontheirbalancesheetsonlyforreinsurancewithhighly-ratedreinsurers.However,iffewhighly-ratedreinsurersareoperatinginajurisdiction,insurersthatwanttoobtaincreditmaybesubjecttoconcentrationrisk.Howmightasolvencyregimeaddressthisdilemma?Whatapproachisusedinyourjurisdiction?

    8. Whatformsofcapitalarerecognizedforregulatorypurposesinyourjurisdiction?Howdoesregulatorycapitalinyourjurisdictiondifferfromtheresultofsimplysubtractinganinsurersliabilitiesfromitsassets?

    9. Thehighestqualitycapitalisbothpresentlyavailableandpermanent.Towhatextentwouldyouconsidereachoftheelementsofcapitalrecognizedforregulatorypurposesinyourjurisdictiontobepresentlyavailable?Towhatextentiseachpermanent?

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    C. Capital adequacy

    Capital adequacy is a concept that considers the interaction of the available resources and compares them to the potential for an adverse outcome that may erode these re-sources. To the extent that an insurer has sufficient resources to withstand a particular adverse event, it would be capitalized adequately if that event happens. The difficulty, however, is that there are many potential adverse events, and they have different likeli-hoods of occurring and different magnitudes of effects when they do occur. Further-more, more than one adverse event may occur at the same time; they may be linked in cause and effect creating a correlation effect; or they may magnify (or reduce) the size of the resources required to withstand them if they occur together rather than separately.

    The ICPs indicate that an insurer should be able to recognize, measure, manage, and mitigate the risks that it faces. Capital is one way of providing resources against such risks and is, therefore, a form of risk mitigation. Other forms of risk mitigation include reinsurance and underwriting controls. (For further discussion of this topic, see ICP 18 on risk assessment and management and ICP 19 on insurance activity.)

    The regulation of capital has two basic objectives. The first is to provide a minimum level of resources considered prudent for supervisory purposes. This requirement can provide an element of capital over and above that considered necessary by the company itself to meet its business needs. The second is to provide a trigger for intervention.

    The IAIS has established a number of features of a solvency regime. These are dis-cussed above. Using the minimum solvency margin as a measure of the capital ad-equacy of an insurance company means that it should be a measure of the level of risk that the company is carrying. It is not possible to have a perfect measure under any circumstance. The best measurements require considerable data collection and infor-mation, something usually practical only in the company itself. Therefore, the mini-mum solvency margin necessarily must be an approximation and be capable of broad, practical application.

    The ICPs note that it is useful to establish solvency control levels above the mini-mum solvency margin. As such, the validity of a point of intervention at, for example, 1.5 times the minimum solvency margin will represent different levels of risk for dif-ferent companies. This distinction will be more consistent if the solvency margin itself reasonably approximates, or follows in broad terms at least, the level of risk in the com-pany itself.

    This section considers the nature of risk, the relevance of capital as a risk mitigation tool, sample structures for a solvency margin, and the use of control levels and stress tests as tools for greater resilience. It briefly comments on issues relating to branches and insurance companies that are part of conglomerates.

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    2

    Risks mitigated by capital

    There are many ways to break down the various risks that are faced by insurers and other financial institutions. Several risk taxonomies have been published. The differ-ences among them tend to reflect the preferences of those who prepared them and the level of detail at which individual risks are identified. This module outlines a relatively simple taxonomy.

    Ultimately, risk is considered to be the potential for variability in outcome, particu-larly adverse outcomes. If a particular outcome is known with certainty, there is no risk. In reality, even in cases in which the certainty is high, it is rare that a business operation of any sort does not face some uncertainty of outcome. For example, if an enterprise holds notes and coins as an asset, it may feel that their value is certain. However, the value may be reduced in the case of losses due to inadequate storage, misadventure, or theft when insufficiently insured.

    More practically, in the case of an insurance company, consider the liability side of the balance sheet. The majority of the liabilities consist of provisions for obligations under insurance policies. Depending on the types of insurance, the outcome in terms of claims and their cost will be more or less certain. For non-life-insurance policies, both the likelihood of a claim and its size are usually uncertain, whereas the timing of life insurance claims is always uncertain even if the amount of the payment is defined in the contract.

    The uncertainty in the financial outcome of an insurance portfolio often is referred to as technical risk or underwriting risk. Such risk relates to the uncertainty of the outcomes in policies, whether they are in force or have expired but for which claims either remain outstanding or could still be reported.

    Considering the assets in which an insurer invests, the risks are similar to those faced by other investors. Credit risk generally refers to the potential that a counterparty may (by choice or inability) fail to repay its commitments to an investor. Concentration risk reflects the level of exposure to a single counterparty and should consider all types of commitments made from the counterparty together. Liquidity risk is the risk that an insurer will be unable to realize the value of an investment in a timely manner consis-tent with its needs. Market risk reflects the possibility that, even if an asset may be able to be realized, its value may have fluctuated adversely.

    As discussed in section B, for many types of insurance risks, it is possible to man-age the assets and the liabilities so that fluctuations on the asset side of the balance sheet are matched by fluctuations on the liability side. However, this ideal is not always pos-sible. The extent to which risk may arise from mismatching should be considered in the capital adequacy requirements.

    Efforts to measure most of these risks have led to a desire to apply risk mitigation techniques. A particular risk mitigation technique for insurance companies is to take out reinsurance, that is, transfer the risk to another party. However, transfer risk can lead to its own risk, because the mitigation may not be perfect. For example, if the defi-

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    nition of claims in the reinsurance policy differs from the definition in the insurance policies issued by the company, the cover may not be perfect in all circumstances. This discrepancy is referred to as basis risk, because the reinsurance claims are paid on a different basis than that of claims under the reinsured policies. In addition, reinsurers can become a critical counterparty for an insurer if there is a large claim on the reinsur-ance policies.

    Conventional wisdom has been that liquidity risk should not be a major concern for insurers. Normally, premiums exceed claim payments, and insurers are net inves-tors. Similarly, if claims were to increase sharply, insurers usually can find mechanisms to make the payments progressively to avoid distress. In some cases, these mechanisms can include invoking clauses in contracts that enable the deferred payment of surren-der values, or recognizing that insurers do not have funds on call from the customer in the same way that a bank would. Nevertheless, liquidity risk can have a significant impact on an insurer (see case study 2). In the event of an adverse outcome, the addi-tional financial resources of capital can be available to meet most risks. However, the extent to which these resources can assist in dealing with a liquidity problem depends on whether these additional assets themselves are liquid. Recognizing the difficulties inherent in quantifying liquidity risk, the IAA recommends that its solvency implica-tions be addressed through supervisory assessment rather than through quantitative capital adequacy requirements (see IAA 2004).

    One additional risk that increasingly has been recognized is operational risk. This risk often is defined as all other risks but may be defined more explicitly. In particular, operational risk focuses on the adversity that can result from failures in the operations of the company. Examples of operational risk include a breakdown of procedures, fail-ures in management, computer failure, poor recordkeeping, events that make it impos-sible for the insurer to operate from its regular offices, or even fraud. Operational risks vary widely and may be difficult to anticipate. While capital can mitigate operational risk, this type of risk also must be addressed effectively through good corporate gover-nance, internal controls, and risk management practices.

    Usually, consistent with the ICPs and the Principles on Capital Adequacy and Sol-vency (see IAIS 2002), there is a fixed minimum level of capital or solvency margin. The reason is that, regardless of the size of the insurer, some risks exist, and new insur-ance companies face particular risks. These challenges include difficulties in manag-ing a start-up operation that do not exist in an ongoing business. An example would be not having adequate existing data to estimate the claims experience from policies, compared to an established company that has good data. In addition, to quickly build their book of business to a viable size, new companies may tend to accept riskier or less profitable business that an established company would pass up.

    Absolute minimums also ensure that only operations of some substance are per-mitted to enter the insurance market. This standard is important in light of the unique nature of insurance, which requires an insurer to deliver on long-term and important promises.

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    Minimum requirements

    Minimum solvency requirements must be clearly defined. The reason is that they iden-tify the point at which final intervention occurs, that is, when the supervisor takes over the company and relieves senior management and owners of their rights. A require-ment that is open to interpretation can hold up intervention in legal disputes. Such disputes can impede the important need to protect the interests of the policyholders. Thus, the minimum solvency requirement usually is defined in terms that enable it to be determined more precisely than the assessment of solvency (a matter of judgment) would suggest. To achieve more legal certainty, some matters of judgment need to be set aside.

    Two main approaches are taken to define the minimum solvency requirement: (1) the index-based method and (2) the risk-based capital (RBC) method. However, an approach that reflects a middle ground seems to be emerging.

    i ndex-bas ed requiremenTs

    This section summarizes a standard index-based solvency regime. While all regimes in-volve a range of elements, an index-based regime is characterized by a solvency margin that is expressed as the greatest of a range of balance sheet or income statement indexes. The most copied example of such a regime is in place in the European Union.

    The European Economic Area has developed an EU framework, which includes common rules on insurance. Directives are drafted and revised by the European Commission and the supervisory authorities of member states. Industry consultation is a feature of this drafting process. Ultimately, these directives are adopted by the EU through the political processes of the European Parliament and then are implemented by each member state in its own legal system.

    An EU directive on annual accounts and consolidated accounts for insurance un-dertakings has been in force since 199596. This directive does not provide for a full harmonization of public accounting, but it does fix terminology and structure to a large extent. This directive offers options for many points, notably, the choice between his-torical cost and more market-based values for assets, although the result of applying the complementary principle must be disclosed in a note. It also mandates notes to the annual accounts, mainly for providing information on premiums, claims, and expenses for 10 groups of non-life-insurance classes and some premium data for life insurance. However, as prescribed in the respective national laws, public accounts are comple-mented by annual and more frequent returns to the supervisory authorities.

    As to technical provisions, most local traditions can be accommodated within the system. Some member states with mandatory equalization provisions count them as part of technical provisions, whereas others count equalization provisions as reserves and thus as part of the resources for covering losses. In non-life insurance, the predomi-

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    nant practice is to show undiscounted provisions for outstanding claims. However, the directive allows member states to permit discounting of such provisions, within a cer-tain framework. The directive also addresses incurred but not reported (IBNR) provi-sions. In life insurance, reference is made to actuarial principles.

    To achieve sufficient harmonization to support a system of mutual trust in sol-vency supervision among the member states, the required solvency margin is based on a relatively simple formula. One part is the minimum capital requirement, called minimum solvency margin, which uses fractions of various indices of risk exposure. In other words, factors are applied to various figures taken from the balance sheet of the insurer, and the minimum solvency margin is taken to be the greatest of the calculated results.

    Certain scale effects are recognized. In particular, as the portfolio grows, the vol-atility of total claims in a portfolio of independent or negatively correlated insured risks increases at a slower pace than the average claim. These scale effects are reflected through the application of lower factors for the part of the exposure that exceeds a cer-tain threshold. For small volumes, the minimum solvency margin as defined is consid-ered insufficient and is reinforced by a requirement expressed in an absolute number of euros, called the minimum guarantee fund.

    The premium index uses gross premium income as a measure of exposure. The factors applied are 18 percent for the part of the premium up to 10 million, and 16 per-cent for the excess, if any. The corresponding formula for the claims index is 26 percent of the average claims cost up to 7 million, and 23 percent of any excess. The average claims cost is defined as the claims incurred, in contrast with claims paid, over the last three years. The various percentages originally were determined using a mathematical approach called ruin theory. Ruin theory estimates the probability that an insurer will face financial ruin during a period of time, taking into account its risk profile and level of solvency margin. The greater of the various calculations constitutes the solvency margin requirement.

    Risk limitations and the credit given for reinsurance cover are additional features of the system. If a member state chooses to do so, the effect of reinsurance may be re-flected in calculating the required solvency margin. However, the reduction must not exceed 50 percent for non-life-insurance and 15 percent for life insurance. Some mem-ber states do not give credit for reinsurance at all, or give credit only if a corresponding deposit of assets is made as security for future claims on the reinsurer.

    During the last few years, the EU solvency regulation has been under review by supervisory authorities and the EC. Looking back on nearly 20 years of experience, the member states generally consider that the system has worked reasonably well. Never-theless, the changes that are being discussed are expected to lead to considerable re-working of the current system.

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    In summary, the index-based method broadly relates risk to various index mea-sures. The larger the premium or the claims provisions, the greater the overall risk that the company is carrying. Some observers argue that this index-based approach has been widely used and has shown relatively good empirical results. However, it focuses on the liability side of the balance sheet and thus does not reflect all the risks faced by an insurer. Others contend that the indexes selected are a proxy for the overall risk of the enterprise.

    r is k-bas ed capiTal requiremenTs

    Risk-based capital (RBC) solvency regimes, such as those used in the United States, Canada, and other countries, attempt to more closely reflect the risks assumed by each insurer in the calculation of its required capital. They use more complex formulas and statistical techniques than those employed in an index-based solvency regime.

    In the United States, the insurance industry is regulated by the individual states. To coordinate and pool their efforts, regulators in 55 jurisdictions, including the 50 states, have formed the National Association of Insurance Commissioners (NAIC). One result of NAICs activities has been the development of statutory financial accounting and reporting standards. These are used for regulatory reporting and differ from the accounting standards used for other purposes. Statutory accounts are conservative in their definition of technical provisions and asset valuation.

    The NAIC has developed a comprehensive and detailed solvency regime, includ-ing solvency requirements that cover each risk within a defined taxonomy. Under this regime, there are two types of capital requirements: (1) statutory minimum capital and surplus requirements, and (2) risk-based capital requirements. Insurers must meet the higher of the two requirements. Statutory minimum capital and surplus requirements represent the minimum required solvency margin. If a company drops below the re-quired minimum level of capital and surplus, intervention is triggered.

    Risk-based capital computations specify the minimum amount of capital required based on a companys size and risk profile. The formulas used depend on whether the company is a life insurer or a non-life-insurer. Major risk categories are:

    Asset risk4

    Interest rate risk (life insurance) and health credit risk (accident and health in-surance)

    Underwriting risk5

    4. asset risk, the individual groups of assets are examined separately. The contribution to RBC is expressed as a percentage of balance sheet value, with the percentage typically ranging from 0 to 30. The assigned percentages or factors increase in rela-tion to the perceived risk of the asset, based on such considerations as potential for default or decline in market value. United States Treasury Bonds, for instance, receive a 0% factor, whereas common shares receive a 30% factor and real property a 10% factor. Concentration of risk by issuer may incur additional RBC penalties.5. For underwriting risk in property and casualty insurance, each line of business is examined separately. Moreover, under-writing risk is assessed using two RBC components, based on written premiums and provisions (reserves) respectively. The premium-based component, with the contribution to RBC expressed as a percentage of net written premiums, reflects the risk

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    Credit risk (especially with respect to reinsurance) Other business risk.

    The computation of RBC includes adjustments for correlation among risks and additional risks inherent in certain types of activity. These adjustments are reflected mathematically through the use of a square root sign in the formula. I

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ICP 23A: Solvency Principles and Structures Basic-level Module A Core Curriculum for Insurance Supervisors
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