1. ICP 23A: Solvency Principles and Structures

2. 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

3. Units in the module … Introduction Elements of a solvency regime Capital adequacy

4. 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

5. 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

6. Overview of the Session A.Solvency Concepts B.Elements of a Solvency Regime C.Capital Adequacy Requirements D.Solvency Challenges

7. A. Solvency Concepts What is solvency? Why is adequate capital important? Where does capital come from? What roles can supervisors play?

8. 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.

9. 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 (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 company’s business, which time horizon is to be adopted, and what is an acceptable degree of probability of becoming insolvent should be considered.

10. 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

11. 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. Three key distinctions

12. Another critical concept Time horizon Minimum Requirement Actual Solvency Level time

13. Short Time Horizons Not noted Noted 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

14. 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

15. 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 company’s financial position and prospects

16. Supervising solvency is essential Protecting policyholders is a fundamental objective of supervision If insurers are insolvent, they cannot make good on their promises

17. 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.

18. What roles can supervisors play? Establish a solvency regime Monitor compliance Take action to resolve problems

19. Group Work Time available is 45 minutes Discuss the assigned question Develop a response Prepare to report back ≤10 min.

20. Questions for Discussion 1.How might the interests of an insurer’s board and senior management in solvency coincide with those of the supervisor? How might they differ?

21. Questions for Discussion 2.Consider the most recent instances of insurers in your jurisdiction raising additional capital. Why did they do so? What were its sources?

22. Questions for Discussion 3.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 jurisdiction’s solvency regime.

23. First Break

24. Elements of a Solvency Regime

25. 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.

26. Balance Sheet Basics Solvency is an assessment of an insurer’s 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

27. A Model to Illustrate the Approach to the Solvency Margin Formula and it’s oversight

28. Liabilities Starting with liabilities

29. Liabilities 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. Policy Liabilities Other Liabilities

30. 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

31. 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) Policy Liabilities Other Liabilities Best Estimate or Central Estimate Margin Other Liabilities

32. 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

33. Assets Now looking at the assets –Assume they are at the currently assessable market value.

34. Assets 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 Asset Margin

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

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

37. 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

38. Asset and liability Values can behave differently as the economic (valuation) environment changes. Asset Class 1 Asset Class 2 Asset Class 3 Fixtures and Equipment Inadmissible Assets Asset Margin Best Estimate or Central Estimate Margin Other Liabilities CAPITAL? ALM Risks

39. 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 insurer’s exposure to adverse fluctuations

40. 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

41. 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

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

43. 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

44. 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

45. Many other factors influence whether resources are “adequate” or can be expected to be “adequate” over time horizon. Asset Class 1 Asset Class 2 Asset Class 3 Fixtures and Equipment Inadmissible Assets Asset Margin Best Estimate or Central Estimate Margin Other Liabilities CAPITAL? ALM Risks Economic EnvironmentMarket Environment Business StrategyRisk Control Systems Risk Management Policies Corporate Governance Fitness and Propriety Multiple Control LevelsGroup Participation ControlsCapital and Risk Policies

46. Second Break

47. C. Capital Adequacy Requirements Sensitivity to risk Risks mitigated by capital Minimum requirements Providing greater resilience Branch and group issues

48. Types of capital requirements Fixed minimums Standards proportional to size Risk based standards

49. 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

50. 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

51. 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

52. Risk-based Capital Approach Requirements vary by nature of assets and liabilities –Usually factor-based –May include correlation adjustments √ –Sometimes involves the use of models More sensitive to an insurer’s risks, but also more complex than index- based

53. Sensitivity to Risk Capital adequacy requirements are sensitive to the size, complexity and risks of an insurer’s operations, as well as the accounting requirements that apply to the insurer – ICP 23 d, PCAS 6

54. 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

55. Risks Mitigated by Capital Underwriting risk Credit risk Market risk Operational risk –See IAA draft “A Global Framework for Insurer Solvency Assessment”

56. 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

57. 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

58. 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 insurer’s risk management and business planning Some solvency regimes require it

59. 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

60. 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

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

62. 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. 1.What aspects of each valuation approach must be considered when setting capital adequacy requirements?

63. 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 2.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?

64. 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. 3.In this situation, what steps might the supervisor take to address the solvency risks related to group membership?

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

66. 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.

67. 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.

68. 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.

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

70. Wrap-up Any final questions or observations? Ideas for using this module in your jurisdiction?

71. For further information, questions, discussion, clarification, or to exchange ideas… Email: cthorburn@worldbank.orgcthorburn@worldbank.org Phone: +1 202 473 4932