Trends in Solvency Regulation CAIR Conference December 2008 Montego Bay, Jamaica. Craig Thorburn

Agenda The old world is passing away The new world of risk based approaches Control levels and own solvency assessments Internal models Stress testing

THE OLD WORLD IS PASSING AWAY Trends in solvency regulation

Original idea – Mark 1 Minimum Solvency requirements started as –leverage rules / a percentage of premium –based on famous ‘kenny ratio’ –scientific basis in statistical risk theory Solvency I widely copied

Original idea – Mark 2 Allowance for reinsurance –Net premium –Gives full credit for reinsurance Some adjustment –Limit credit taking account of recoverability reflected in some or other of Local registration of reinsurers Credit ratings of reinsurers Official list of acceptable reinsurers Collateral

Original idea – Mark 3 There should be an absolute minimum –a test of means at entry and ongoing stability Ultimately a political trade-off or balance Variation over the world is wide from low figures (under $US1million) to high figures ($US100 million) Reinsurance companies often face higher minima.

Original idea – Mark 4 Companies in run-off or those dominated by longer tail business might not be adequately capitalized based solely on premium income measures “Greater of” approach –Fixed value –Percentage of premiums –Percentage of claims provisions With allowance for reinsurance.

Original idea – Life insurance More complex but can use actuaries Treat all as long term and apply proportion of liabilities as premiums are even less relevant Some innovation –minimum basis for valuation is a form of stress test or dynamic capital adequacy test –run the valuation on particular conservative assumptions and reflect the difference between the economic valuation and the conservative valuation in capital (embedded value) Company management / actuarial practice reflected approach over time as computing power and actuarial skills developed –quantify new business strain. –find the economic embedded value

THE NEW WORLD OF RISK BASED APPROACHES Trends in solvency regulation

Solvency I is out of date IAIS produced Solvency Principles in 2002 EU reviewed Solvency I –found shortcomings against IAIS benchmark. –noted all EU countries implement Solvency I+ –served well but market has moved on For those jurisdictions outside the EU, do the same conclusions apply?

Other countries had worked on approaches USA – RBC Canada – MSCR and DCAT Australia – Margin on Services

Move to a more risk sensitive approach Methods emerge between RBC and Solvency I “Factor based” approaches that are more sensitive to risk compared to Solvency I –Asset side risks (credit, liquidity, market volatility) –More refined liability side risks Solvency II standard approach Promise of internal models mean standard approach does not have to be as risk sensitive as RBC –Especially the square root sign (allowing for diversification & lack of correlation of risks)

Our generic model Apply factors to balance sheet items Liabilities by broad class of business –Claims provisions –Premiums (usually premium liabilities at 150% of claims based factors) Assets by class May add additional items –Catastrophe risk based on PMLs –Mismatch risk based on a defined stress test Consistent with Solvency II, Canada, Australia, US principles based project, Malaysia, Philippines, Singapore, Chile, PNG, Basel II

The formula K is the total capital requirement subject to a fixed nominal minimum; L is the liability risk charge A is the asset risk charge C is the catastrophic event risk charge –Other events relating to significant risk could be added here.

Liabilities RiskItemPremium Charge Claim Charge LowComprehensive Motor, Home Owners 139 MediumFire, Marine, Other1611 HighCompulsory Third Party Motor, Liability, Contractors All Risks, Workers Compensation 2215 Where P values are premium liabilities with their corresponding j capital charges; and C values are claims liabilities with their corresponding k capital charges.

Assets ItemAsset Charge Cash1% Government Debt2% Other Debt8% Listed Equities8% Other Equities10% Direct Property (Direct and Other)10% Premiums Receivable6% Reinsurance Recoveries4% Loans to Directors100% Deferred Acquisition Costs0% Future Income Tax Benefits100% Other Intangibles100% Other Assets10% Where A values are asset market values with their corresponding j capital charges; and E is the excess charge for concentration of counterparty exposure.

Valuation of balance sheet items is important IASB project may further enhance valuation for risk Readily adjusted as IASB project comes forward But attention to valuation standards might be needed in the mean time.

CONTROL LEVELS AND ‘OWN SOLVENCY ASSESSMENT’ Trends in solvency regulation

Corporate Governance & Risk Management Everyone who has capital requirements should intend not to breach them –they need more than the minimum to allow for adversity –how much? –how do they determine it? –the minimum of a capital policy So all companies with capital have a capital policy –Determined at the board level –Implemented effectively by management

Proportional to risk Complexity of capital policy can be consistent with the complexity of the business

Risk Based Supervision Company’s own solvency and capital assessment and capital policy can feed into assessment of company risk –We do not have a capital policy –We do not really know what capital we need for our business –We just take what you tell us

Some formal approaches in regulation Ladder of trigger levels based on Risk capital –For example 150% for no action 120% for some intervention to correct Sometimes requires legislative power to intervene progressively

Another option in small markets Supervisory concurrence of target capital levels –Requires transparent supervisory process robust company solvency assessments (perhaps) regulatory support

INTERNAL MODELS Trends in solvency regulation

Useful for some cases Sophisticated companies should have their own model anyway But complex to upgrade for use for regulatory capital minimum purposes Relevant also for well diversified firms where capital on standard method will probably be high compared to risk. Implies capital relief benefit available – economic incentive of better management.

Preconditions Actuaries Sophisticated firms Supervisory capacity All optional for supervisors but once accepted cannot go back

In Caribbean Would only be relevant for large regionally operating firms. Supervisory assessment requires resources but can be supported by consultants Framework for review can be taken from international standard setters (IAIS and BCBS in particular) A second order issue in terms of timing and priority.

STRESS TESTING Trends in solvency regulation

Can be applied Canada – DCAT –Scenario determined at each cycle –Companies perform scenario test and report to board and supervisor of issues raised and actions proposed Can be incorporated in capital –Adverse interest rate movement scenarios are the most common –Australia – Resilience and Chile – Calce rules are examples Can be required as part of company risk management –On company own risk assessment scenarios

Can be applied - continued Supervisors can do some internally –Relatively easy scenarios can be tested using financial return data –But some limitations (performance of reinsurance in response to claim increases) Supervisors can request companies to advise on impact of defined scenarios from time to time –As part of ongoing Risk Based Supervision –Select a scenario and request a study –May use tripartite process with insurers and auditors or actuaries

Full stochastic models Match scenarios with return period or tail probability Hurricane models are an example More complex approaches with wider coverage of range of risks probably not yet to be expected from mid sized firms (including even the largest Caribbean insurers)

In the Caribbean Not widely used by supervisors But feasible Perhaps a useful place to start a cross border project –Impact analysis focused on events and larger systemically important firms –Could be coupled with a fire drill or cross border resolution analysis project

Thank you Craig Thorburn