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

2. 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

3. Rating agencies
Solvency margins and regulatory requirements

4. Rating agencies
Solvency margins and regulatory requirements

5. 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

6. 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)

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

8. 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.

9. Standard and Poor’s Website

10. 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?

11. 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

12. Rating agencies
Solvency margins and regulatory requirements

13. 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

14. 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.

15. 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

16. 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

17. 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

18. 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

19. 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:

20. 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

21. Source: https://www. bankofengland. co

22. 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

23. Supervisory ladder intervention
Source:

24. 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

25. 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

26. 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

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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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 © Elnur | Dreamstime.com

34. 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)

35. 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?

36. 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

37. Rating agencies
Solvency margins and regulatory requirements

38. Economic and industry risk

39. Competitive position

40. Management and corporate strategy

41. Enterprise risk management (ERM)

42. Operating performance

43. Investments

44. Capital adequacy

45. Liquidity

46. Financial flexibility