Diploma in Insurance M92 Insurance Business and Finance Chapter 10: Financial Strength of Insurance Companies

Learning objectives By the end of this module, you should be able to: Analyse the financial strength of insurance companies Explain the role of rating agencies and the rating process Explain the regulatory solvency requirements

Rating agencies Solvency margins and regulatory requirements

Rating agencies Solvency margins and regulatory requirements

What do large insurers (or reinsurers) pay rating agencies to do? Why pay somebody else to do this? What do large insurers (or reinsurers) pay rating agencies to do? Give an opinion of their financial strength a measure of their ability to pay claims Four main agencies - Standard and Poor’s AM Best Moody’s Fitch Customers are buying a promise Commercial customers/brokers may use financial strength ratings before placing business

For insurers Independently demonstrates to customers its ability to pay claims Allows financial strength comparisons between insurers Allows a very strong insurer (AAA) to charge higher premiums and transact a wider range of business Brokers/customers may decide own risk appetite based on rating (e.g. minimum A rated insurer) https://www.dreamstime.com/koya79_info https://www.dreamstime.com/koya79_info

Rating methodology Qualitative and quantitative data used Objective judgements based on data Takes account of unique dynamics of each insurer Analytical framework is used

Economic and industry risk Competitive position Management and corporate strategy Enterprise risk management (ERM) Operating performance Investments Capital adequacy Liquidity Financial flexibility Analytical framework See Figure 10.1 in text book for Standard and Poor’s insurance ratings framework All interconnected, but weighted according to specific company circumstances. E.G The amount of capital a company has affects strategy, competitive position, etc.

Standard and Poor’s Website

The Ratings – Approximate comparisons What would you think about an insurance company with a rating below the table? What would they have to do about it? http://www.ciihost.co.uk/Study-Texts/GI/M92_Study_text_201819/page_209.html

Typical rating process Insurer/Agency sign contract 2 Analysts – day with senior executives Exhaustive analysis over weeks Lead analyst recommends rating to committee of eight Committee votes Insurer told rating – Accepts or appeals it Regular monitoring and annual review

Rating agencies Solvency margins and regulatory requirements

Overriding regulatory requirement ‘A firm must at all times maintain overall financial resources, including capital resources and liquidity resources, which are adequate, both as to amount and quality, to ensure that there is no significant risk that its liabilities cannot be met as they fall due.’ GENPRU 1.2.26

The board must determine an insurer’s risk appetite Typical risk statement includes: Statement of risks acceptable for the company to bear Risks that are not acceptable Probability of failure that is not acceptable Maximum loss acceptable for one incident Used to set: Risk acceptance criteria An investment policy A reinsurance policy Other financial and risk policy statements PRA Requirement – Probability of failure to be no more than 1 in 200 within a 12 month time scale.

EU Solvency II Directive Established EU-Wide capital requirements, valuation techniques Replaced Solvency I on 1 January 2016 Enhances policyholder protection Aims to create safer and more resilient insurance sector

Four level process Level 1: Framework principles Level 2: Level 3: Solvency II framework directive Lays down essential framework principles Level 1: Framework principles Implementing measures Set out requirements insurers must meet Level 2: European Insurance and Occupational Pensions Authority (EIOPA) set out common standards and guidelines Level 3: Guidance More vigorous enforcement action than before Co-operation between member states regulators and private sector Level 4: Enforcement

The three pillars Pillar 1: Demonstrating adequate financial resources Key quantitative requirements Solvency Capital Requirement (SCR) and Minimum Capital Requirement (MCR) Full or partial approved internal model or based on EU standard formula Pillar 2: Demonstrating adequate governance system Risk identification and management Own Risk and Solvency Assessment (ORSA) Includes overall process by the supervising authority (PRA in UK) Pillar 3: Public disclosure and regulatory reporting Insurers must publish risks they face, capital adequacy and risk management Transparency and openness required

The three pillars Pillar 1: Demonstrating adequate financial resources Key quantitative requirements Solvency capital requirement and Minimum capital requirement Full or partial approved internal model or based on EU standard formula Pillar 2: Demonstrating adequate governance system Risk identification an management Own Risk and Solvency Assessment (ORSA) Includes overall process by the supervising authority (PRA in UK) Pillar 3: Public disclosure and regulatory reporting Insurers must publish risks they face, capital adequacy and risk management Transparency and openness required

Financial Resources (Pillar 1) Balance sheet to be based on market consistent valuations Assets and liabilities must reflect current values at which they would be traded in the market Not their original accounting values Source: https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2015/the-prudential-regulation-of-insurers-under-solvency-2.pdf?la=en&hash=7122450C1347D045A6CF5B33C35BFA04E038D0E0

Solvency II – 3 Tiers of Capital Shareholder’s equity Retained earnings Able to absorb day to day losses – going concern basis Tier 1: Highest quality Subordinated debt Only needs to absorb losses on insolvency Tier 2: Lower quality Only limited loss absorbing capability Unlikely to be significant under Solvency II Tier 3: Lowest quality

Source: https://www. bankofengland. co

Two capital requirements Solvency Capital Requirement (SCR) Amount of capital required to meet unexpected losses over the next year Up to statistical level of 1 in 200 event Robust requirement Aim for insurers to withstand all but most severe shocks Minimum Capital Requirement (MCR) Below this level policyholders are exposed to unacceptable level of risk Corresponds to 85% probability of adequacy in following year

Supervisory ladder intervention Source: https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2015/the-prudential-regulation-of-insurers-under-solvency-2.pdf?la=en&hash=7122450C1347D045A6CF5B33C35BFA04E038D0E0

Inadequate capital – 2 options Raise more regulatory capital Issue new shares New long term debts to meet PRA Tier 1 and Tier 2 requirements Reduce regulatory capital requirement Business volumes – especially long tail Reinsurance Switching from higher risk to lower risk investmentd

Calculating SCR Standard formula used by most European firms Identify the firms market and underwriting risks Prescribed calculation method used to calculate capital needed to cover those risks Calculating SCR

Calculating SCR - Alternative Internal model used Doubles up as firm’s risk management/decision making process PRA take proportionate approach to how complex the modelling should be Calculating SCR - Alternative

Balance required Regulatory Capital Returns on equity ID 2163590 © Stefan Hermans | Dreamstime.com

The three pillars Pillar 1: Demonstrating adequate financial resources Key quantitative requirements Solvency capital requirement and Minimum capital requirement Full or partial approved internal model or based on EU standard formula Pillar 2: Demonstrating adequate governance system Risk identification an management Own Risk and Solvency Assessment (ORSA) Includes overall process by the supervising authority (PRA in UK) Pillar 3: Public disclosure and regulatory reporting Insurers must publish risks they face, capital adequacy and risk management Transparency and openness required

Good governance and risk management required PRA: Senior Insurance Managers Regime (SIMR) Ensure accountability of senior managers Clearly defined responsibilities Honesty, integrity and competence expected

Own Risk and Solvency Assessment (OSRA Regulatory capital requirements may not capture all risks Can be difficult to quantify (e.g. cyber risk) Risks change over time – business plans span many years OSRA requires firms to understand and manage all their risk exposures Can be complex – especially in an insurance group where some activities are not regulated Parent company may have Tier 2 debt but pass to a subsidiary as Tier 1 equity

The three pillars Pillar 1: Demonstrating adequate financial resources Key quantitative requirements Solvency capital requirement and Minimum capital requirement Full or partial approved internal model or based on EU standard formula Pillar 2: Demonstrating adequate governance system Risk identification an management Own Risk and Solvency Assessment (ORSA) Includes overall process by the supervising authority (PRA in UK) Pillar 3: Public disclosure and regulatory reporting Insurers must publish risks they face, capital adequacy and risk management Transparency and openness required

Solvency and Financial Condition Report (SFCR) Must be published annually by firms Quality and standard of report set out in Solvency II Approach to Solvency II (e.g. internal model used) Any non compliance with solvency requirements Reasons and consequences of non compliance Measures taken to resolve non-compliance

Brexit Solvency II legislation piloted in UK UK prominent member of International Association of Insurance Supervisor (IAIS) Likely that Solvency II (or similar) will continue to apply Already part of English Law, so would need to be repealed by parliament Direct delegated EU regulations under Solvency II not directly part of English law Some unpicking needed? ID 84894853 © Elnur | Dreamstime.com

Lloyds – until Brexit Way it conducts business unchanged Continues to be subject to Solvency II Retains its EU rights No existing policies/renewals if existing EU member may be affected by referendum result Policies legally binding and claims will be met Multi year policies remain legally binding even after Brexit Brexit does not affect Lloyd’s trading outside EU Setting up new EU insurance company based in Brussels (trading from 1/1/19)

Stress and scenario testing Important part of planning and risk management Regulatory requirement – robust and effective stress testing Proportionate/relevant to the insurance business PRA conduct own stress tests periodically What would be the result in this scenario? Reverse stress tests also required What scenarios/circumstances would render the business unviable?

Actuary role in Solvency II EU Regulators regard actuarial information as: ‘..indispensable to an adequate system of governance…’ Must be carried out by person with sufficient knowledge of actuarial and financial mathematics (not necessarily qualified actuary) Object is for actuarial function to contribute to effective system of risk management Use internal model to understand reserving volatility and assess firms financial provisions

Rating agencies Solvency margins and regulatory requirements

Economic and industry risk

Competitive position

Management and corporate strategy

Enterprise risk management (ERM)

Operating performance

Investments

Capital adequacy

Liquidity

Financial flexibility