Cornerstones: Solvency Monitoring in Differing Circumstances Michael M. Barth, PhD, CPCU Associate Professor of Finance Georgia Southern University

Recent IAIS Releases  October 2004 – A New Framework for Insurance Supervision: Towards a Common Structure and Common Standards for the Assessment of Insurer Solvency  February 2005 – Cornerstones for the Formulation of Regulatory Financial Requirements

IAIS Objectives Include  Assisting regulator and regulated in assessing risk and solvency  Enhancing the transparency and comparability of insurers worldwide  Supporting a level playing field while reducing regulatory arbitrage  Increasing the opportunities for international cooperation  Increasing overall confidence and efficiency

Let’s Tweak This Thing…

What Ain’t Broke, Don’t Fix

Common Standards  Common standards should not mean the same standards for all insurers  Loss frequency vs loss severity  Market disruption  Market’s ability to absorb both the losses and the cost of loss prevention  Cost associated with monitoring  Translating common standards across international boundaries

Assessing Risk  Development of appropriate models and techniques that can be used in multiple jurisdictions  Technical reserves (?)  Investment risk (?)  Systematic business risk (?)  Political risk (?)  Processes for determining risk may be more exportable than products themselves

Transparency  Transparent systems and opaque systems are complementary and serve different functions  Degree of solvency monitoring by outside (e.g., non-regulatory) bodies affects design  Competitors  Lenders  News, trade press  Reinsurers and other business partners  Other financial services regulators  Self-fulfilling prophecies and inaccuracy in systems affect the ability to be transparent

Opaque Solvency Monitoring Systems  Should be opaque to masses but transparent to other regulators (e.g., FAST, CAMEL)  If insurers are gaming the system, then the system is not working  Early Warning System meant to provide early warning of what MIGHT happen, not what is inevitable  Opaque systems can be used to direct resources more efficiently without causing disruption that regulator is trying to avoid

Opaque Warning Systems Should Provide Scores

Regulatory Arbitrage  Best defense is cooperation among regulators IN AN APPROPRIATE FORUM  Sliding scales of regulatory interest and interference  Regulatory forbearance

How Does U.S. Stack Up? (IMHO)  Regulatory Indicators  IRIS, FAST, RBC  Model laws (e.g., RBC model)  State law provides teeth  Audits  Non-regulatory regulators  Rating agencies  Trade press  Competitors, business partners

Cornerstone 1  The solvency regime addresses the robustness of the insurer to meet its liabilities both short term and over a longer time span Short term and long term: What does that mean? Ratio systems are relatively short-sighted, but insolvencies often occur over time AM Best et. al. also provide long-term information

Cornerstone 2  The solvency regime is sensitive to risk, and is explicit as to which risks individually and in combination, lead to a regulatory financial requirement and how they are reflected in the requirement Pretty much describes the concept of risk-based capital and the accompanying RBC law

Cornerstone 3  The solvency regime is explicit on how, for each of the risks that attract a financial requirement, individually and in combination, prudence is reflected in these requirements. That is the plan, anyway.

Cornerstone 4  The solvency regime requires a valuation methodology which makes optimal use of and is consistent with information provided by the financial markets and generally available data on insurance technical risks. For a transparent system, yes. This does not address the needs of an opaque system Does the generally available data provide accuracy?

Cornerstone 5  The solvency regime includes the definition of technical provisions. Technical provisions have to be prudent, reliable, and objective and allow comparison across insurers. The regime should require as a minimum that sufficient assets are available to cover the technical provisions and other liabilities. Relatively easy to standardize across borders

Cornerstone 6  The solvency regime requires the determination of a “best estimate” of the costs of meeting the obligations arising from the insurance portfolio, taking into account the time value of money. The discount rate for this calculation is determined by reference to the relevant risk free interest rates on the financial markets. Best estimate or confidence interval?

Cornerstone 7  The solvency regime establishes a range of solvency control levels and the supervisory instruments associated with each of the control levels What is meant by “control level”? RBC requires company to submit a report at the Company Action Level – is that “control”? The bar for “increased regulatory scrutiny” should be relatively easy to trigger

Cornerstone 8  The solvency regime allows a set of standardised [standardized] and more advanced approaches to determine the solvency requirements, and includes the use of internal models if appropriate. The level of “standardization” should differ from system to system. Opaque systems may be particularly suited to advanced approaches. This also allows the monitoring system to be more forward thinking and dynamic by encouraging innovation

Conclusions  The US system, a combination of both public and private early warnings and capital standards, goes a long way towards meeting these goals  Harmonization across international borders seems like a long way off  What ain’t broke, don’t fix  If it ain’t perfect, keep trying