ICP 23A: Solvency Principles and Structures

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ICP 23ASolvency Principles and Structures
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What are the components of the module?

• Pretest
• Separate bite sized sections
• Practical exercise to work on throughout the
  study
• Exercises to help localize learning
• Post test to validate results

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Units in the module

• Introduction
• Elements of a solvency regime
• Capital adequacy

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Prior Knowledge Requirements

• Module does not require prior knowledge of this
  topic
• But earlier study of other basic modules relating
  to insurance may be useful. For example
• Insurance Accounting
• Financial Analysis

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Key Elements

• Solvency Principles
• The regime of rules that govern the requirement
  that insurance companies hold and manage their
  solvency for the protection of policyholders
• Core Curriculum Module 23A
• Solvency Assessment
• The function of the supervisor and other
  stakeholders to assess the solvency of an
  insurance company
• Core Curriculum Module 23B

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Overview of the Session

• Solvency Concepts
• Elements of a Solvency Regime
• Capital Adequacy Requirements
• Solvency Challenges

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A. Solvency Concepts

• What is solvency?
• Why is adequate capital important?
• Where does capital come from?
• What roles can supervisors play?

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Definition of Solvency IAIS

• 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.

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continued

• In order 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, e.g. is only
  written business (runoff basis, breakup basis)
  to be considered, or is future new business
  (goingconcern 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 probability of becoming
  insolvent should be considered.

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Solvency versus Capital Adequacy

• To remain solvent an insurer must
• Manage its risks
• Ensure asset cash flows are available to meet
  liabilities when payable
• Maintain a safety margin of assets over
  liabilities
• Only the third point is capital adequacy,
  although the terms are often used interchangeably

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Three key distinctions

• The ability of the insurer to meet its
  obligations under all contracts
• Going Concern will continue to have sufficient
  resources to cater for current and expected
  future new commitments
• Run-off Even if no new policies are written,
  it can meet the obligations of existing contracts
  as they fall due
• Wind-up faster than run-off, liquidating
  obligations in the near term.
• Different groups will have different
  perspectives. For example, management will be
  most focused on a going concern measure.

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Another critical concept

• Time horizon

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Short Time Horizons

• May need to consider how long it takes to
• Detect the problem
• Understand the truth about the problem
• Take effective corrective action
• Have the action work

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Why do insurers need adequate capital?

• Finance business activities
• Start-up, growth, diversification
• Provide a safety margin
• Adverse experience, fluctuations
• Promote public confidence
• In a particular company, in the industry

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Where does capital come from?

• Initial capital provided by shareholders or
  founding policyholders (mutual)
• Retained earnings
• Subsequent capital raised from
• Existing shareholders
• New investors in the market
• Ability to raise capital and the cost of doing so
  depend on a companys financial position and
  prospects

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Supervising solvency is essential

• Protecting policyholders is a fundamental
  objective of supervision
• If insurers are insolvent, they cannot make good
  on their promises

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ICP 23 Capital Adequacy and Solvency

• 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.

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What roles can supervisors play?

• Establish a solvency regime
• Monitor compliance
• Take action to resolve problems

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Group Work

• Time available is 45 minutes
• Discuss the assigned question
• Develop a response
• Prepare to report back
• 10 min.

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Questions for Discussion

• How might the interests of an insurers board and
  senior management in solvency coincide with those
  of the supervisor? How might they differ?

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Questions for Discussion

• Consider the most recent instances of insurers in
  your jurisdiction raising additional capital.
  Why did they do so? What were its sources?

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Questions for Discussion

• There is a trend toward broadening solvency
  regimes to include elements such as risk
  management and disclosure requirements. What do
  the ICPs say about this? Comment on the presence
  and relative effectiveness of quantitative and
  qualitative elements in your jurisdictions
  solvency regime.

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First Break
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Elements of a Solvency Regime
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The solvency regime addresses in a consistent
manner

• Valuation of liabilities, including technical
  provisions and the margins contained therein
• Quality, liquidity and valuation of assets
• Matching of assets and liabilities
• Suitable forms of capital
• Capital adequacy requirements.

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Balance Sheet Basics

• Solvency is an assessment of an insurers balance
  sheet
• Currently and, perhaps, prospectively
• A coherent solvency regime cannot exist in the
  absence of reliable and reasonably consistent
  bases for the valuation of assets and liabilities

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• A Model to Illustrate the Approach to the
  Solvency Margin Formula and its oversight

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Liabilities

• Starting with liabilities

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• Need to assess all of the liabilities and
  understand the credibility of their valuation.
• Solvency Margin relies on liability valuations
• Many regimes include some rules or procedures for
  liability valuations especially policyholder
  liabilities.
• For other liabilities, need to understand legal
  priority of claims, particularly in the event
  of a wind up.

Liabilities
Other Liabilities
Policy Liabilities
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Liabilities Technical Provisions

• Technical provisions have to be adequate,
  reliable, objective and allow comparison across
  insurers Principle 1 of Principles on Capital
  Adequacy and Solvency (PCAS)
• They should reflect all risks, to the extent
  possible
• Capital adequacy requirements need to consider
  the level of margins

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• Need to understand how conservative the policy
  liabilities are.
• Also, need to understand various types of
  policies that contribute to the policy liability
  estimates (some are more variable and
  unpredictable than others)

Other Liabilities
Other Liabilities
Policy Liabilities
Margin
Best Estimate or Central Estimate
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Other Liabilities

• Adequate provisions must be made for all other
  liabilities PCAS 2
• Insurers, like other businesses, will have
  liabilities that are not reflected in their
  technical provisions
• The solvency regime should consider the relative
  legal priority of various liabilities
• See ICP 20 Liabilities

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Assets

• Now looking at the assets
• Assume they are at the currently assessable
  market value.

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Assets
Asset Margin

• If they are at book value, it can be argued there
  is a margin on the asset side of the balance
  sheet
• Can the margin be taken into account as part of
  the resources available to meet policyholder
  claims?
• How durable are the margins (going concern versus
  run off versus wind up)?

Book Value of Assets
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• Various assets will have different risks, for
  example
• Credit quality
• Volatility in value (market risks)
• Liquidity
• Concentration risks
• etc
• Some will not be of much value in a wind up or
  run off situation

Asset Margin
Asset Margin
Book Value of Assets
Inadmissible Assets
Fixtures and Equipment
Asset Class 3
Asset Class 2
Asset Class 1
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Assets

• Assets have to be appropriate, sufficiently
  realisable and objectively valued PCAS 3
• Appropriate
• Safety, return, diversification
• Sufficiently realisable
• Marketable, unencumbered, liquid

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Valuation of Assets

• Valuation should be objective, consistent over
  time, consistent across insurers
• The value of some assets may be diminished in
  situations of stress or insolvency
• See ICP 21 Assets and ICP 22 Derivatives

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CAPITAL?
Asset Margin
ALM Risks
Inadmissible Assets
Other Liabilities
Fixtures and Equipment
Margin
Asset Class 3
Best Estimate or Central Estimate
Asset Class 2
Asset Class 1

• Asset and liability Values can behave differently
  as the economic (valuation) environment changes.

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Asset-liability Management

• Capital adequacy and solvency regimes have to
  address the matching of assets with liabilities
  PCAS 4
• Liquidity management is part of ALM
• ALM can reduce an insurers exposure to adverse
  fluctuations

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Reinsurance

• Any allowance for reinsurance should consider
• The effectiveness of the risk transfer
• The likely security of the reinsurance
  counterparty
• PCAS 11 and ICP 23 b
• See ICP 19

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Reinsurance

• Solvency regimes may include provisions
  regarding
• Acceptable reinsurers
• Collateral requirements
• Calculation of credit against technical
  provisions for reinsurance ceded
• Valuation of amounts recoverable from reinsurers

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• The difference between the assets and liabilities
  might be considered capital but there could be
  questions. eg
• Do asset margins provide capital support?
• Are margins in liabilities available as a form of
  capital?
• Etc etc

Asset Margin
CAPITAL?
Inadmissible Assets
Other Liabilities
Fixtures and Equipment
Margin
Asset Class 3
Best Estimate or Central Estimate
Asset Class 2
Asset Class 1
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Capital Actual

• Capital adequacy and solvency regimes have to
  define suitable forms of capital PCAS 9, ICP 23
  c
• Capital must be available to provide support in
  times of adversity
• Even if capital is simply viewed as (Assets less
  Liabilities), its measurement will be affected by
  the ways these elements are valued

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Assessing the Suitability of Capital

• Ability of supervisor to restrict its
  distribution
• Freedom from encumbrances and security interests
• Freedom from requirements or incentives to redeem
  or repay the funds
• Freedom from mandatory fixed charges against
  earnings
• Legal subordination to the rights of
  policyholders and other creditors

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• Many other factors influence whether resources
  are adequate or can be expected to be
  adequate over time horizon.

Economic Environment
Market Environment
Business Strategy
Risk Control Systems
Corporate Governance
Risk Management Policies
Fitness and Propriety
Multiple Control Levels
Group Participation Controls
Capital and Risk Policies
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Second Break
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C. Capital Adequacy Requirements

• Sensitivity to risk
• Risks mitigated by capital
• Minimum requirements
• Providing greater resilience
• Branch and group issues

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Types of capital requirements

• Fixed minimums
• Standards proportional to size
• Risk based standards

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Types of Minimum Requirements

• Fixed amount thresholds
• Provide a minimum assurance of financial capacity
• Especially important for new insurers
• PCAS 8
• Prudential requirements
• Provide reasonable assurance that policyholder
  interests will be protected
• ICP 23 e and f

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Prudential Minimums Alternatives

• Index-based Current EU and others
• Risk-based capital (RBC) used by Australia,
  Canada, USA, Singapore, PNG, Thailand, and
  Solvency II
• Internal models-based
• Emerging practice
• Used in part by Australia, Canada and Singapore

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Index-based Approach (EU)

• Requirements indexed to liabilities and net risk
  (life) premiums or claims (non-life)
• Eligible solvency elements are defined
• Guarantee fund one-third of requirement
  further restricts solvency elements
• Simple, but not very risk-sensitive

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Risk-based Capital Approach

• Requirements vary by nature of assets and
  liabilities
• Usually factor-based
• May include correlation adjustments v
• Sometimes involves the use of models
• More sensitive to an insurers risks, but also
  more complex than index-based

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Sensitivity to Risk

• Capital adequacy requirements are sensitive to
  the size, complexity and risks of an insurers
  operations, as well as the accounting
  requirements that apply to the insurer ICP 23
  d, PCAS 6

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Sensitivity to Risk

• Helps to ensure that capital provides an adequate
  safety margin for each insurer
• Promotes equitable treatment of insurers
• May reduce the opportunities for regulatory
  arbitrage

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Risks Mitigated by Capital

• Underwriting risk
• Credit risk
• Market risk
• Operational risk
• See IAA draft A Global Framework for Insurer
  Solvency Assessment

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Providing Greater Resilience

• Prudential minimum should be met as a condition
  for ongoing operation
• If not, drastic intervention is called for
• Solvency regimes should include mechanisms to
  avoid the breach of minimum requirements
• Solvency control levels ICP 23 g, PCAS 7
• Periodic, forward-looking analyses ICP 23 j

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Solvency Control Levels

• If control levels are breached, supervisor should
  intervene
• Require corrective action
• Impose restrictions
• Often expressed in relation to the minimum, e.g.,
  150
• Insurers should also set targets
• Not less than the control levels

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Stress Testing

• Evaluate the impact of risks and business
  developments on current and future solvency
  position
• Involves the use of models
• Should be part of each insurers risk management
  and business planning
• Some solvency regimes require it

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Branches

• Branch is not a separate legal entity, so has no
  capital of its own
• Some regimes require assets be held in trust
  within the jurisdiction
• Amount equal to liabilities in respect of
  policies written in the jurisdiction, plus a
  margin equivalent to the capital that would be
  required of a local insurer with the same book of
  business

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Groups

• Group issues include
• Contagion risk
• Related-party transactions
• Double- or multiple-gearing of capital
• Solvency regimes need to consider both solo and
  group-wide capital adequacy
• See Joint Forum Supervision of Financial
  Conglomerates, February 1999

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Group Work

• Time available is 45 minutes
• Discuss the assigned question(s)
• Develop a response
• Prepare a presentation (10 min.)

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Questions for Discussion

• In jurisdiction A, insurers value assets at cost
  and liabilities using assumptions fixed by the
  supervisor.
• In jurisdiction B, insurers value assets at
  market and liabilities using their best estimate
  assumptions, plus explicit margins determined by
  their actuaries.
• What aspects of each valuation approach must be
  considered when setting capital adequacy
  requirements?

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Questions for Discussion

• Jurisdiction C has a RBC regime, calculating
  minimum capital by applying these factors
• Assets 0 gov. bonds, 15 equities, 8 other
• Premiums 5 life, 7 motor, 10 other
• Liabilities 2 life, 8 U/E prem., 15 other
• Is this formula sensitive to underwriting,
  credit, market, operational and liquidity risks?
  If so, how? If not, what changes would you
  suggest to make it so?

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Questions for Discussion

• The Insurance Act in jurisdiction D does not
  authorize the supervisor to inspect, obtain
  information from, or regulate the solvency of any
  entities in a corporate group except the
  locally-licensed insurers. Chances that the
  Insurance Act can be amended in the short term
  are slim.
• In this situation, what steps might the
  supervisor take to address the solvency risks
  related to group membership?

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D. Solvency Challenges

• Each of cases describes an insurer that presents
  a serious solvency challenge.
• Why might the situation have occurred?
• What elements of a solvency regime could help
  prevent it from occurring?
• Given that it has occurred, what elements of a
  solvency regime could help protect policyholders
  from excessive loss?
• What corrective actions would you propose?

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Case 1

• A bank has set up a composite insurer to provide
  life, annuity, motor, and property policies to
  its customers. The bank provides centralized
  human resources, investment, and accounting
  services to all group companies. The insurer has
  been growing rapidly in all lines of business.
• Paid claims ratios on the non-life business have
  been much higher than those of competitors. The
  life and annuity lines experienced significant
  losses recently, when interest rates moved
  sharply.

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Case 2

• A large foreign non-life insurer is operating
  locally through a branch. Its book of business
  includes local personal lines and small
  commercial clients, as well as large risks
  arising from its multinational clients.
• Large risks are underwritten at the headquarters,
  where reinsurance is also arranged.
• Losses on a fire that destroyed the factory of a
  multinational client exceed the assets invested
  locally.

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Case 3

• Management of a mutual insurer takes pride in
  serving its members by charging low premium
  rates, providing long term interest rate
  guarantees, and investing in their business
  ventures.
• A downturn in the economy has led to high
  investment defaults, market interest rates lower
  than the policy guarantees, and increased lapses.

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Group Work

• Time available 30 minutes
• Discuss the assigned case
• Develop responses to the questions
• Prepare to report back
• (10 min.)

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Wrap-up

• Any final questions or observations?
• Ideas for using this module in your jurisdiction?

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For further information, questions, discussion,
clarification, or to exchange ideas

• Email cthorburn_at_worldbank.org
• Phone [phone]