The World Bank Group 1st Contractual Savings Conference

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The World Bank Group 1st Contractual Savings
Conference

• The EU Solvency Margin
• for Life Insurance
• Michael Thom
• Washington, 2 May 2002

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Presentation Outline

• The Europe Union Insurance
• The European Commission and the basic EU
  Prudential Framework
• The EU Solvency Margin Regime
• Solvency I
• Solvency II
• Conclusions

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• The Europe Union Insurance

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• The European Commission and the basic EU
  Prudential Framework

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European Commission

• Key objective
• Creation of a single market
• Classic reasons
• Economic efficiency
• Increased choice and quality,
• lower prices

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Basic Prudential Framework

• Three Generation of Life Non-Life Directives
  
• the single licence
• exclusive home country control for prudential
  matters
• freedom of establishment provision of services
• minimum harmonisation and mutual recognition of
  supervisory / prudential standards

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Basic Prudential Framework

• no economic needs test
• no prior approval of premia or premia changes
• no prior approval of policy conditions
• CONCLUDE
• most open liberal system in world

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Basic Prudential Framework

• Prudential supervision sole responsibility of
  the home Member State, who shall require
• sound administrative and accounting procedures
  and
• adequate internal control mechanisms of the
  company, and

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Basic Prudential Framework

• Respect of common EU financial rules covering
• fit proper managers
• (premiums)
• technical provisions
• investment rules
• solvency margin

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• The EU Solvency Margin Regime

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Rule of Law / Fit proper managers
Liabilities
Assets
Solvency Margin
Investment Rules
Technical Provisions
Adequate premiums
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Fit Proper Managers

• Fitness formal qualifications, experience
• Propriety financial position, absence of
  criminal record, questionable business
  practices
• Very important
• Managers can react long before supervisors

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Technical Provisions

• Meet all liabilities at all times
• (as far as can be reasonably foreseen)
• prudent
• more developed for life

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Technical Provisions- Life

• Must establish sufficient technical provisions
• prospective actuarial basis
• prudent valuation (claims and expenses)
• all options
• - (guaranteed surrender values)
• reference rate of interest
• - (60 state bond portfolio rate)

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Investment Rules (ALM)

• Assets covering technical provisions take account
  of
• type of business
• need to secure safety, yield, marketability
• requirement to be diversified and adequately
  spread

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Investment Rules (ALM)

• Assets covering technical provisions
• list of admissible assets
• (marketable securities, land, buildings, tax
  recoveries, salvage, rent, etc.)
• prudently valued
• derivatives
• only to reduce risk / manage portfolio
• in relation to underlying assets

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Investment Rules (ALM)

• Assets covering technical provisions
• max 10 in one piece of land or building
• max 5 in single bond, share, debt, etc.
• max 5 in unsecured loans,
• 1 single unsecured loan
• max 3 in cash
• max 10 in unregulated market securities

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Investment Rules (ALM)

• Assets covering technical provisions
• no obligation to invest in particular assets (but
  Member States may limit)
• EU localisation
• (EU risks matched by EU assets)
• Currency matching
• max 20 non-currency congruence
• (Euro always congruent)

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• The EU Solvency Margin

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Solvency Margin

• Basic definition
• assets of the undertaking free of any
  foreseeable liabilities less any intangible
  items

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Solvency Margin Eligible Items

• Paid-up share capital (contributions)
• 50 of unpaid capital ( after 25 paid)
• Free reserves
• Profits carried forward
• Cum. pref. Shares / subordinated debt (max 50)
• less
• Intangibles

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Solvency Margin Eligible Items

• Hidden reserves (unrealised gains)
• plus
• Life
• max 50 future profits, max 10 years

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Solvency Margin Requirement- LIFE

• Technical Provisions (TP)
• Investment risk (4 of 2000) 80
• No inv. risk (1 of 2000) 20
• gt5 yr. expense guar. --------
• 100
• reinsurance reduction x85
• Total 85

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Solvency Margin Requirement- LIFE

• Capital at risk
• Sum assured 10 000
• Technical provisions 4 000
• capital at risk 6 000
• (x0.003) 18
• reinsurance reduction x50
• solvency margin requirement 9

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Solvency Margin Requirement- LIFE

• Technical provisions 85
• Capital at risk 9
• Total 94

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The guarantee fund

• Equals a third of solvency margin required
• but subject to a minimum guarantee fund
• class mEURO mEuro
• 9 and 17 0.2 2.0
• 1-8, 16, 18 0.3 2.0
• 10-13, 15 0.4 3.0
• 14 1.4 3.0
• Life 0.8 3.0

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What happens when things go wrong ?

• Staged approach
• If actual solvency margin lt required solvency
  margin
• then company must submit for approval a plan for
  the restoration of a sound financial position

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What happens when things go wrong ?

• If actual solvency margin lt guarantee fund,
• then short-term finance scheme for approval
• supervisor may restrict or prohibit free disposal
  of assets
• supervisor may take all measures necessary to
  protect insured (idem if technical provisions
  not covered)
• must inform other Member States
• who may take the same measures

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What happens when things go wrong ?

• if technical provisions not covered
• supervisor may also take all measures necessary
  to protect insured

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• SOLVENCY I

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• EU solvency margin system is
• Simple
• Robust
• Easy to understand and use
• Inexpensive to administer
• Has worked well in practice

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97 Commission Report

• Present scheme has proved satisfactory
• Certain weaknesses in specific cases
• Main alternatives not demonstrably superior
• Avoid unnecessary cost to industry

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SOLVENCY I Main themes

• Level of harmonisation
• Minimum guarantee fund
• Special supervisory powers
• Reinsurance
• Class enhancement approach
• Miscellaneous

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1. Level of harmonisation

• Minimum or full ?
• Not clear
• Now clearly minimum harmonisation
• in practice
• mirrors banks, investment firms
• subsidiarity principle

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2. Minimum guarantee fund

• Unchanged since 1973 (non-life) 1979 (life)
• Impact of inflation on claims and expenses
• class mEURO mEuro
• 9 and 17 0.2 .0
• 1-8, 16, 18 0.3 2.0
• 10-13, 15 0.4 3. 2 0
• 14 1.4 3.0
• Life 0.8 3.0

2.0
3.0
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3. Special supervisory powers

• When policyholders rights are threatened,
  supervisors may take early intervention
• Supervisors can
• require financial recovery plan
• require higher solvency margin
• revalue downwards all solvency margin items

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4. Reinsurance

• Max. reduction of 50 retained
• Calculated over last 3 years
• Decrease reinsurance reduction if
• nature or quality of reinsurance programme
  changed
• no significant risk transfer

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5. Class enhancement approach

• Problem for long term, long tail risks
• Third index not a solution
• indiscriminate, perverse
• Keep simplicity of current method
• but increase current solvency margin for risky
  classes of business.

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6. Miscellaneous

• Future profits
• Currently max. 50 for max. 10 years
• Propose 50 6
• but
• actuarial report
• no double counting with hidden reserves
• But.only up to 2009

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6. Miscellaneous

• Unit-linked business- Life
• where no investment risk
• where expenses not fixed for more than 5 years
• Required solvency margin 25 of relevant
  overheads

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• Strengthens solvency margin requirement
• Important- more competition in future
• (tariff liberalisation, new distribution
  channels, euro, further consolidation and
  integration, shareholder value)
• (reduced investment profits)

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Implementation Timetable

• 14 Feb 2001 Adoption by Council EP
• 20 March 2002 Publication in OJ
• 20 Sept 2003 In force
• 2002-2007 Transitional period

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• SOLVENCY II

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Solvency II

• Solvency I good, but.
• Size effect (law of large numbers) ?
• Volatility of different risks ?
• Diversification ?
• Quality of internal controls risk management ?

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Solvency II

• Solvency II
• Consider overall financial position of insurer
• examining .

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Solvency II

• Technical provisions
• Assets
• Asset liability management
• reinsurance
• Solvency margin methodology
• Accounting and actuarial
• Internal risk models
• Role for rating agencies ?

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Solvency II

• OBJECTIVES
• Protect policyholders
• Comparability, transparency and coherency
• (creating level playing field)
• Solvency margin better matched to true risks
• Avoid undue complexity

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Solvency II

• OBJECTIVES (cont.)
• Reflect market developments (ART, derivatives,
  ALM
• Establish principles, not excessively
  prescriptive
• Where possible, common accounting policies
• Avoid unnecessary capital costs to industry

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Solvency II WORK ORGANISATION

• Close cooperation with Member States
• Solvency subcommittee of Insurance Committee
• - Two working groups (non-life life)
• EU Conference of Insurance Supervisors
• Working group on insolvencies and near misses
• International Co-operation, IAIS

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Solvency II WORK ORGANISATION

• Commissioned external consultants report on
  Methodologies to assess the overall financial
  position of an insurance undertaking from the
  perspective of prudential supervision
• Regular input from insurance business, actuaries
  and other interested parties
• Visits to major EU insurers and reinsurers
• (Internal Models)

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Solvency II

• TWO STEP APPROACH
• First phase preparatory discussions leading up
  to a decision on the general layout of a future
  EU solvency system.
• Second phase further work to elaborate detailed
  solutions, draft regulatory texts and
  field-testing

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Solvency II

• No decisions yet lots of QUESTIONS
• What risks should be taken into account?
• What rules should apply to technical provisions?
• How to include asset risk more explicitly?
• What about operational risk and other business
  risks? Reinsurance risk?
• What risks can and should be quantified?
• What other risks are better dealt with in a more
  qualitative way second pillar?

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CONCLUSIONS

• Existing solvency margin
• simple, robust, worked well, but
• Solvency I
• significant package of improvements
• Solvency II
• ambitious, long term project reviews overall
  financial position

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Michael THOM, Principal Administrator and
Secretary of the EU Insurance Committee Insuran
ce, Financial Institutions, Internal Market
DG European Commission 200 rue de la Loi,
B-1049 Brussels, Belgium (C107 1/62) ? 32-2-2
96.6068 Fax [phone] E-mail Michae
l.Thom_at_cec.eu.int Internal Market DG
site http//europa.eu.int/comm/dgs/internal_marke
t/index_en.htm
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• The END

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• EXTRA
• INSURANCE GROUPS

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Introduction

• Increasing number of insurance groups
• Mergers and Acquisitions
• Globalisation
• Financial Services Integration
• Supervisory question
• If each part is OK, is the group OK?

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Some problems

• Supervision at level of individual insurance
  company ( solo level)
• Apparently satisfactory situation for
• solvency margin (capital adequacy)
• assets and liabilities
• but..

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Insurer A

• Liability Assets
• 40 cap 1000
• 1000 TP 40 (inv. B)
• 1040 1040
• actual solvency margin 40 required solvency
  margin

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Insurer B

• Liability Assets
• 40 cap
• 1000 TP 1040
• 1040 1040
• actual solvency margin 40 required solvency
  margin

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double gearing problem (B is a 100 subsidiary
of A)

• Insurer A
• Liability Assets Liability Assets
• 40 cap 1000 40 cap
• 1000 TP 40 (inv B) 1000 TP 1040
• 1040 1040 1040 1040
• actual solvency margin 40 required solvency
  margin

Insurer A
Insurer B
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double gearing problem (B is a 100 subsidiary
of A)

• Liability Assets
• 40 cap
• 2000 TP 2040
• 2040 2040
• actual solvency margin 40
• required solvency margin 80 !!!

Consolidated A B
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Intra-Group Transactions

• Similarly can circumvent
• asset or liability rules for insurer A
• by hiding in insurer B
• through intra-group transactions
• e.g. loans or guarantees