1. Intensive Actuarial Training for Bulgaria January 2007
Lecture 9
Insurance Solvency - EU
by Michael Sze, PhD, FSA, CFA

2. Importance of Solvency Margin
It is imperative that insurance companies be solvent under most circumstances
There is much uncertainty in life insurance
Insurance assets must be greater than insurance liabilities
An additional layer of assets to cover the contingent uncertainties: solvency margin

3. Solvency Margin Systems
Importance of solvency of insurance companies is well recognized
Different countries come up with different systems to enhance solvency
Each system has its strength and weakness
We should study these systems and apply their respective strong points to India

4. Major Solvency Margin Systems
EU Solvency Margin
U.S. Risk Based Capital
Australian Prudential Standards (No. 3) for Life Insurance
Canadian Minimum Continuing Capital and Surplus Requirement (MCCSR)

6. Impact of Solvency Margin
Asset of insurance company > or =
insurance reserve + required solvency margin
No amount of the required solvency margin may be used to pay dividend to shareholders
Only excess surplus may be used to pay dividend
In many countries, investment return on technical provision is tax exempt
Investment return on solvency margin may not be

7. Ways to Guarantee Solvency
Assets not allowed to be depleted below liability reserve
In fact, assets are required to be substantially in excess of the minimum solvency margin
Most countries require assets to be in excess of 150% of liability reserve + solvency margin
Regulatory intervention when assets decrease to close to the solvency margin

8. Investment Returns on Different Segments of Assets
Assets covering insurance reserve: tax deductible in most countries
Excess assets: not tax deductible in most countries
Assets covering solvency margin: mixed,
Deductible in some countries,
Not deductible in others

9. Major Risks Covered C-1: Risk of loss of asset values
C-2: Pricing or insurance risk
C-3: Disintermediation or asset/liability mismatch risk
C-4: Business or operation risk
Other related issues:
Subsidiary or affiliates
Reinsurance

10. Solvency Margin Systems
Different jurisdictions have different emphases
Two different categories of solvency margins
Implicit margin
Conservative method and assumptions in reserve calculations
Margin provided by higher reserve values
U.S. and European Union
Explicit margin
Realistic method and assumptions in reserve calculations
Explicit margins in solvency reserves
Canada and Australia

11. Solvency Margin System in European Union Countries
European Council solvency margin directives
Protecting the solvency of an insurance company is of paramount importance
Solvency I (Council Directive 73/239/EEC) provides regulations on solvency margins
3 strategic objectives
A single EU wholesale market
Open and secure retail market
State-of-the-art prudential rules and supervision

12. External Motivation for Refined Solvency Rules
Increased competition
Pressures to promote “shareholder value”
Convergence between financial and insurance sectors
Basel I and II of Banking Industry
Development of risk analysis and control methods
International developments
IAIS, IAS, IAA

13. Basic Principles of Solvency Rules
Aim: Overall solvency
Qualitative aspects
Management structure
Internal risk control system
Risk-based approach
Better measure and control of risk for an insurance company

14. Solvency I: Council Directive 2002/13/EC
Amends Council Directive 73/239/EEC
Provides uniform solvency margin system for all EU countries
Simple, robust
Easy to understand and use
Inexpensive to administer
Works well in practice

15. Two Major Aspects of EU Solvency Rules
Asset rules
Solvency margins
Guaranty fund

16. Assets Covering Insurance Reserve (Technical Provisions)
Max 10% in one piece of land or building
Max 5% in single bond, share, debt, etc.
Max 5% in unsecured loan
1% in single unsecured loan
Max 3% in cash
Max 10% in unregulated market securities

17. Assets Covering Insurance Reserve (Continued)
No obligation to invest in particular assets
But Member States may impose own limits
EU localisation
EU risks should be matched by EU assets
Currency matching
Max 20% non-currency congruence
Euro always considered congruent

18. Eligible Solvency Assets
Paid-up capital (contributions)
50% of unpaid capital (after 25% paid)
Free reserves
Profit carried forward
Cum. preferred shared / subordinated debt (max 50%)
Less: Intangibles
Unrealised gains
Max 50% future profits ( max 10 years)

19. Different Lines of Business
Accident
Sickness
Land vehicles
Railway rolling stock
Aircraft
Ships
Goods in transit
Fire & natural forces
Other damage to property
10. Motor vehicle liability
11. Aircraft liability
12. Liability for ships
General liability
Credit
Suretyshop
Miscellaneous financial losses
Legal expenses

20. Insurance Premium (IP)
Solvency margin depends on insurance premium (IP) and claim payment (CP)
IP for business other than classes 11, 12, 13
Higher of gross written premium for insurance and reinsurance or contributions
IP for classes 11, 12, 13
Above IP increased 50%
IP adjusted by premium or contribution cancelled and by premium taxes paid

21. Claim Payment (CP) CP for business other than classes 11, 12, 13
Average of total insurance and reinsurance claims during the last three years
Averaging period is increased to seven years for credit, storm, hail or frost risks
CP for classes 11, 12, 13
Above CP increased 50%
CP is adjusted by increase in provision for outstanding claims

22. Solvency Margin (SM) SM equals higher of SM1 and SM2
SM1 = (18% IP up to EUR 50 million % IP in excess of EUR 50 mill) x % claims not covered by reinsurance
% claims not covered by reinsurance
= 3-year average of remaining claims after deduction for reinsurance / gross amount of claims
Each ratio is not less than 50%

23. SM2 SM2 = (26% of CP up to EUR 35 million
+ 23% of CP in excess of EUR 35 million) x % claims not covered by reinsurance
% claims not covered by reinsurance is defined as for SM1

24. Solvency Margin for Life Insurance
Sum of two components
Based on technical provisions
4% for policy with investment risk
1% for policy without investment risk
Based on capital at risk
0.3% of capital at risk
Capital at risk = amount insured – technical provisions
Reduction due to reinsurance
15% on 1.
50% on 2.

25. Example on Solvency Margin
Data
Insured amount ,000
Technical provision with investment risk 2,000
Technical provision without investment risk ,000
SM based on technical provisions
4% x % x 2000 = 100
Reinsurance reduction = 15% x 100 = 15
Net SM = 100 – 15 = 85
SM based on capital at risk
Capital at risk = 10,000 – 2,000 – 2,000 = 6,000
SM = 0.3% x 6,000 = 18
Reinsurance reduction = 50% x 18 = 9
Net SM = 18 – 9 = 9
Total SM = = 94

26. Required Solvency Margin
Required solvency margin for any year >
Solvency margin for previous year
Adjusted proportionally for change in technical provision
Technical provision equals the regular reserve liability for the insurance
Required solvency margin is reviewed annually
Adjusted for CPI increases
If cumulative increase from last adjustment < 5%, then do not reflect
If policyholders’ rights are threatened, the insurance authority may require higher SM

27. Guarantee Fund Additional amount over the required solvency margin
Equal to 1/3 required solvency margin
Guarantee fund > or = EUR 2 million
In case classes 10 to 15 are covered & life insurance
Guarantee fund > or = EUR 3 million

28. Advantages of Solvency I Factors Approach
Simple and easy to apply
No significant compliance cost
Results are easy to understand
Formula uses factual, historical data
Avoids subjectivity

29. Disadvantage of Solvency I Factors Approach
Difficult to draw up useful capital definition
Only related to objective of prudential supervisor
Arbitrary
Focus on certain types of risks only
Mostly on underwriting risks
Difficult to extend methodology to other risks
Reinsurance risks not adequate reflected in calculations

30. Disadvantage of Solvency I Factors Approach (Continued)
Use of premiums and provisions as exposure bases
Provides incentives for under-provisioning
Does not give credit to companies with prudent provisions
Not sensitive to company-specific risk profile
No credit given for company’s internal risk management process
Inadequate consideration given to diversification and size effects
Not dynamic (forward-looking)

31. Push towards Solvency II
Solvency margins are only one of the three pillars
Strong insurance supervision is essential
Transparency and full disclosure are required
Must also compare the EU factor approach to other solvency methodologies

32. Objectives of Solvency II
Enhance policyholder protection
Early warning to supervisors on adverse experience
Uniform accounting policies
Comparability, transparency and coherency
Level playing field for all insurers
Solvency margin to match true risks
Avoid undue complexity and not prescriptive
Avoid unnecessary capital costs
Increase global competitiveness of EU companies

33. Solvency II: 3-Pillar Approach
Comparable to Basel II of banking industry
Parallel international development: IAS, IAA, IAIS
Risk based approach to solvency
3-pillars
Pillar I: Minimum standards
Asset and liability valuation rules
Pillar II: Supervisory review process
Internal controls, sound risk management
Supervisory intervention
Pillar III: Market discipline
Transparency and disclosure
Frequent, forward-looking, relevant

34. Expected Timetable Solvency I (2004): Current solvency
Yearly solvency rating
Bulk evaluation for risk management
Solvency II (2005): Improved solvency
Guidelines on scenario testing,
Dynamic financial analysis
More solvency guidelines, 3-pillar concept
Risk assessments, leading to EU regulations
Qualitative risk supervision, and reporting

35. Capital Requirement under Pillars I
Rules relating to capital requirements and quantitative rules to regulate risks
Underwriting, market, credit, operational, A/L mismatch
Two fold regulations
Minimum capital requirement (MCR)
Close to Solvency I
Automatic supervisory intervention upon breach
Solvency capital requirement (SCR)
Using “standard” or internal model for going-concern basis
May be factor-based, scenarios, dynamic

36. Pillar II
Presented by European Insurance Supervisory Authorities (EISA) in 2003
Principles of internal control and administration by clearly define
“Values” and strategic goals of company
Responsibility of staff at each level
Principles of risk management in
Company organization, leadership strategy, decision-making, monitoring, information, corrective measures
Ongoing review of reinsurance solvency
Appropriate methods of evaluating provisions

37. Pillar III – Market Discipline
Main contributing factors
Financial markets
Rating agencies
Greater transparency
Harmonization in accounting rules
Coordinate with international bodies
IASB, IAIS, IAA
Public disclosure must strike balance between
Usefulness of information for public
Competitive interests of insurers

38. Five Risk Categories for Solvency
Underwriting risk
Premium calculation, reserves, reinsurance
Market risk
Volatility of capital instruments
Credit risk
Default debtors in capital market
Default reinsurers
Operational risk
Technology, personnel, structure, external
Asset-liability mismatch
Coordination of assets and liabilities

39. Analysis of Risk Categories
Static or dynamic methods
Current solvency model
Static RBC models
Easy to implement
Inconvenient for wholesale evaluation
Used in Pillar I to determine MCR
New supervisory requirement
Scenario analyses and stress tests
Dynamic model, which complements static models
Enhance risk management of companies
Risk management system must also include
Planning, control, monitoring of associates, internal systems and control

40. Reinsurance Companies
Currently not supervised in some EU countries
Proposed to require registration like primary insurer
Fulfilling Solvency I would be precondition for license
Increase in required capital for some reinsurers