0. Sesión 9 Adecuación de Capital y Solvencia
English
XXI Asamblea Anual de ASSAL
XI Conferencia sobre Regulación y Supervisión de Seguros en
América Latina y Seminario de Capacitación IAIS-ASSAL
Santiago Chile, 21 de Abril de 2010
Takao Miyamoto, Secretaría de la IAIS

1. Agenda Background Elements of Solvency Regime Capital Available
Capital Required
Capital Adequacy
Stress Test 1 1

2. Definition of Solvency
Ability of an insurer to meet its obligations (liabilities) under all contracts at any time
However, due to the very nature of insurance business, it is impossible to guarantee solvency with certainty.
So, for more practical definition, it is necessary to consider additional factors to set thinking framework. 2 2

3. Definition of Solvency
Issues for consideration
Business circumstances
Going concern: meet obligations for both existing and future business
Run-off: stop new business and manage only existing business until they are settled or expired
Break-up: stop new business and settle or transfer existing business as soon as possible
Time horizon
Degree of certainty 3 3

4. Solvency and Capital Adequacy
Maintain safety margin of assets over liabilities
Risk management
Liabilities
Solvency
Ensure adequate provisioning
Liquidity
Ensure assets cash flows are available to meet liabilities when due
Capital adequacy is important factor for solvency.
However, capital adequacy alone is not sufficient.
Insurer with adequate capital can become insolvent due to liquidity shortage.
Weak capital adequacy may exacerbate liquidity situations.
Reputation, covenants etc. 4 4

5. Importance of Adequate Capital
Serve as safety cushion against adverse environments and financial fluctuations
Reduce probability of insolvency
Reduce loss to policyholder in event of insolvency
Meet strategic and operational needs of business
Start-up, growth (into new products, market segments, geographic territories etc.)
Increase public confidence and maintain competitiveness
Existing and potential policyholders => more chance of getting business
Institutional business counterparties (banks, reinsurers etc.) => better terms 5 5

6. Roles of Supervisors Establish a solvency regime Monitor compliance
Not only capital adequacy
Other prudential requirements: risk management, investment, liabilities, reinsurance etc.
Monitor compliance
Market analysis
On- and off-site monitoring
Give incentives for compliance
Take actions to resolve problems
Corrective measures
Enforcement of actions 6 6

7. Enterprise Risk Management (ERM)
Governance and Enterprise Risk Management Framework
Governance and an Enterprise
Risk Management Framework
Feature 1
Risk Management Policy
Risk Tolerance Statement
Feedback Loop
Own Risk and Solvency Assessment (ORSA)
Feedback Loop
Continuity Analysis
Economic and Regulatory Capital
Role of supervision
Role of supervision
Feature 8 7 7

8. Agenda Background Elements of Solvency Regime Capital Available
Capital Required
Capital Adequacy
Stress Test 8 8

9. Total Balance Sheet Approach
Solvency is assessment of insurer’s balance sheet (currently and prospectively).
Assets
Liabilities (technical provisions and other liabilities)
Asset Liability Management (ALM)
Reinsurance
Capital
Reliable and reasonably consistent base for valuation of assets and liabilities is essential for coherent solvency regime.
Comparison from one period to another
Comparison from one insurer to another
Difference among jurisdictions…? 9 9

10. Assets Quality/Safety Liquidity Return
Need to hold sufficiently high quality assets to maintain value for obligation payment
Risk-based solvency regime provide incentive
Diversification is also important
Restrict types and mix of investment assets (e.g. real estate 20%, foreign currency 30%, single entity 10% etc.)
Liquidity
Need to hold liquid, marketable, unencumbered assets to meet obligations payment
Return
Need to create yield to cover expected rate of liabilities (or assumed rate for liabilities may be lowered)
Finally, comes back to capital 10 10

11. Liabilities Technical provisions Other liabilities
Estimate related to obligations arising from insurance contracts with policyholders
Take up large parts of liabilities
Best estimates and margins for uncertainty
Other liabilities
e.g. borrowing from banks, lease, tax payable, accrued interest (similar to other business entities)
Need to consider relative legal priority of liabilities in comparison to policyholders in case of insolvency 11 11

12. Asset Liability Management (ALM)
Manage business under coordinated decisions and actions with respect to assets and liabilities
More narrowly, align/match assets and liabilities
In terms of: duration, currency, timing of cash flows etc.
By: modeling cash flows, hedging by derivatives etc.
Inadequate mismatch of assets and liabilities (and lack of consideration) can cause
Liquidity problems
Financial position vulnerable to adverse fluctuations (could be especially high for long-term insurance, annuity, saving products) 12 12

13. Reinsurance One of commonly used techniques to transfer risks
Insurer still owes obligations to policyholders even if reinsurer goes bankrupt
Reinsurer owes only to insurer
Any allowance for risk transfer should consider
Effectiveness of reinsurance (does it achieve economically meaningful transfer?)
Creditworthiness of reinsurance counterparty (is reinsurer financially strong and/or reputable?)
Solvency regime may include
Acceptable reinsurers (e.g. license, threshold of ratings)
Differentiated risk mitigation treatment (e.g. threshold of ratings, haircut for low rating reinsurance)
Limit on concentration 13 13

14. Short Quiz Why might the situation have occurred?
What corrective actions would you propose?
A bank has set up a composite insurer to provide life, annuity, motor and property policies to its customers. The bank provides centralised human resources, investment and accounting services to all group companies.
Insurance has been growing rapidly in all line of business. However, paid claims ratios on non-life business have been much higher than competitors, while life and annuity lines experienced significant losses recently, when interest rates moved sharply. 14 14

15. Short Quiz Problems Lack of insurance expertise
Understanding of insurance business and how it differs from banking business
Rapid growth combined with high claims ratio indicates underpricing
Large loss on life and annuity may be due to mismatching of assets and liabilities 15 15

16. Short Quiz Remedies Ensure adequate training or recruitment
Review premium rates
Review investment policy
Restrict certain investment
Implement adequate ALM
Require adequate stress test
Reduce or stop writing new business
Obtain additional capital 16 16

17. Agenda Background Elements of Solvency Regime Capital Available
Capital Required
Capital Adequacy
Stress Test 17 17

18. Quality and Suitability of Capital Resource
Whether to serve as safety cushion against adverse environments and financial fluctuations
Reduce probability of insolvency
Reduce loss to policyholder in event of insolvency
General criteria
Subordination: to what extent capital element is subordinated to policyholders
Availability: to what extent capital element is fully paid and available to absorb losses
Permanence: how long capital element is available (any determined term or incentive to redeem?)
Encumbrance: to what extent capital element is free from encumbrance 18 18

19. Highest Quality Capital
Common shares and retained earnings
Initial capital provided by initial shareholders (or founding policyholders in case of mutual)
Subsequent capital raised from existing shareholder and/or new investors in market
Ability to raise capital and its cost depend on insurer’s financial position and prospect
Retained earnings
Profitability strengthens capital adequacy 19 19

20. Adjustment for Solvency Purpose
Some types of liabilities
e.g. subordinated debt
They may be considered as capital resource because they subordinates to policyholders in insolvency
Some types of assets
e.g. intangible assets, deferred tax assets
They may be considered as capital resource because they may not be fully realisable in insolvency or even on going concern basis
Could be directly deducted from available capital (fully or partially) or be indirectly charged to capital required 20 20

21. Agenda Background Elements of Solvency Regime Capital Available
Capital Required
Capital Adequacy
Stress Test 21 21

22. Short Quiz: Different Perspectives
There are many stakeholders which might affect determination of level of capital for insurer.
List up possible stakeholders.
Explain in which direction (higher capital? or lower capital?) their incentives work on level of capital. And why? 22 22

23. Short Quiz: Different Perspectives
Policyholder
They prefer sufficient capital to protect their interests.
Bank (lender)
Shareholder
To avoid “agency problem”, they would reduce excessive capital.
Existing shareholders may not want to raise additional capital (to new shareholders) because their control would be lowered. 23 23

24. Short Quiz: Different Perspectives
Supervisor
They focus more on protecting policyholders.
They would pay attention to financial stability.
Insolvency of insurer may put senior officer’s job or reputation at risk.
Board and senior management
They would care about returns to shareholders because they are under pressure of market.
Their salary may depend on share price or rate of return.
They may care ratings by rating agencies.
Higher capital may attract more customers, resulting in better business result.
If insolvent, they may lose jobs and damage reputations. 24 24

25. Regulatory Capital and Economic Capital
Amount of capital needed to meet regulatory requirement
Economic Capital
Amount of capital insurer voluntarily calculate as needed to protect insurer against economic losses and/or to best serve for its business
Regulatory capital applies to all insurers and does not necessarily capture specific insurer’s risk and business profile 25 25

26. Types of Prudential Requirements
Fixed amount threshold
Provide minimum assurance of financial capacity
Especially important for new insurers or small insurers
Prudential requirement
Provide reasonable assurance that policyholder interests will be protected
Be sensitive to size, complexity and risk of insurer’s operations 26 26

27. Types of Regulatory Requirements
Index-based
Factor coefficient X various index (e.g. liabilities, premiums, claims)
Index is proxy of risk exposures
Simple but not very risk sensitive
Risk-based capital
Usually factor-based
May include correlation adjustment through square root (√)
Sometimes involves use of models
More risk sensitive but more complex than index-based
Internal model-based
Emerging and evolving practice 27 27

28. Process of Calculating Required Capital
Identify all material risk sources
Underwriting, credit, market, operational, liquidity etc,
Assess & characterise distributions
Aggregate all risks
Measure required capital
Correlation
Dependency
Redistribute & use for management 28 28

29. Underwriting (Insurance)
Risk Identification
Typical category
Features
Underwriting (Insurance)
Risks assumed through insurance contracts insurers underwrite
Line of business: fire, marine, automobile, earthquake, death, injury etc.
Types: pricing, product design, claims, economic environment, policyholder behavior etc.
Credit
Inability or unwillingness of counterparty to fully meet on/off-balance sheet contractual financial obligations
Source: default, downgrade, migration, spread, settlement, sovereign etc.
Relatively smaller for insurers compared to banks 29 29

30. Risk Identification Typical category Features Market
Volatility and uncertainty of market value of assets/liabilities
Variables: stock price, interest rate, foreign exchange rate, commodity price etc.
Liquidity
Obliged to procure funds (e.g. by liquidating assets) under unfavorable terms as financial obligations fall due
In worst case, unable to settle financial obligations
Operational
Risk of loss resulting from inadequate or failed internal process, people, system, external events etc. 30 30

31. Risk Assessment and Characterisation
Treat in capital framework?
Underwriting, credit, market: often included
Operational: also being included increasingly
Liquidity risk: usually considered separately
Quantifiable?
Underwriting, credit, market: more experience in modeling
Operational: newly developing area
Regardless of quantification, qualitative measures (e.g. robust internal control) are important
Distribution shape? How fat tail?
Each risk show particular distribution form
Distribution of tail is especially important for risk management 31 31

32. Aggregation Diversification effect exists
Usually correlation is less than one
Total risks would be less than sum of each risk
Whether / to what extent / in what risk types should diversification effect be allowed?
Horizontal (within risks), vertical (between different risks), business lines, geographical, across entities
Dependencies increase in times of stress
Limited availability of data, especially stressed situation
How to capture fat (non-linear) tail
Robustness and reliability for supervisory actions 32 32

33. Aggregation Possible methods Simple summation Fixed percentage
Conservative (assuming correlation is one)
Fixed percentage
Based on experience and judgment
Variance-covariance matrix
Assuming interactions are linear
Copula
More flexible in capturing tail 33 33

34. Risk Measures Quantitative/Statistical measures
Mean (1st order), Variance/Standard Deviation (2nd order), Skewness (3rd order) etc.
Value at Risk (VaR): possible maximum loss over a specific time horizon (e.g. 1 year) at specific confidence level (e.g. 99%)
Tail Value at Risk (TVaR): average VaR beyond a specific confidence level
Probability
Mean
VaR (e.g. 99%)
TVaR (e.g. 99%) 34
Loss 34

35. Desirable Characteristics
Theoretical perspective
Coherent (by Artzner etc.)
Subadditivity, Monotonicity, positive homogeneity, translation invariance
Stable
Not overly sensitive to modest changes in model parameter, assumptions, simulation etc.
Easy to compute
Accuracy (benefit) vs. complexity (cost)
Easy to understand
Understandable for senior management who makes risk management and business decisions
Application perspective 35 35

36. Comparison – VaR and TVaR
VaR usually violates subadditivity (criteria related to diversification effect)
Coherent
Both are subject to distribution but TVaR would be more stable
VaR would be less burdensome but both would be fine given today’s computer capacity
VaR implies loss amount at certain probability
But not possible loss amount over VaR (this may be problematic when distribution is so fat tailed)
TVaR implies average loss amount over VaR
But not specific probability (but possibly map into VaR with different probability)
Nothing is perfect – both methods have pros and cons. 36 36

37. Capital Requirement and Technical Provision
Technical provision (current estimate and risk margin)
Capital requirement
Probability
Solvency level
(e.g. VaR (1 year, 99%) 37
Loss 37

38. Allocation
Economic capital is not only for risk management in reactive/passive sense
It is allocated to each division/business/product and can be used more proactively
monitor economic profitability
Salary and bonus
Pricing
However, potential problem is how to allocate diversification effect
Does not allocate and make it corporate overhead
Make some kind of rules of thumb
Depend on marginal contribution of required capital 38 38

39. Challenges of Modeling
Modeling requires specialised expertise
e.g. economist, statistician, actuary
Modeling depends on nature, scale and complexity of risks and objectives
Simpler models or standardised approaches are also acceptable for certain cases
More complicated model is not necessarily more accurate
Issues to be considered
Statistical quality: justify appropriateness of methodology, inputs, parameters, underlying assumptions
Calibration
Use test: should be embedded into strategy and operation
Documentation
Ongoing validation 39 39

40. Short Quiz: Effect of Aggregation
Loss distribution forms/shapes are different for different risk types
e.g. credit risk is more fat tail than market risk
How does choice of confidence level affect perception of risks and possibly level of business activities?
e.g. If confidence level is changed from 99% to 99.9%, which risk types may look riskier? 40 40

41. Short Quiz: Effect of Aggregation
Risk types with more fat tail distribution may appear to involve larger risk
Level of activities for risk types with more fat tail may be lowered
(Illustrative Example)
More fat tail risk type
Less fat tail risk type
Business = 10,000
Profit = 500
VaR (99%) = 200
Profit per risk = 2.5
VaR (99.9%) = 250
Profit per risk = 2.0
VaR (99.9%) = 300
Profit per risk = 1.7 41 41

42. Agenda Background Elements of Solvency Regime Capital Available
Capital Required
Capital Adequacy
Stress Test 42 42

43. Demand vs. Supply Supervisory assessment of financial position
Could be different from public financial reporting due to prudential filter etc.
Assets
Available capital
Capital requirement
Risk margin
Liabilities
Current estimate
Technical provision
Other liabilities 43 43

44. Solvency Control Solvency regime should establish
Prescribed Capital Requirement (PCR)
Above PCR, supervisor would not require action to increase capital resources held or reduce undertaken
Minimum Capital Requirement (MCR)
At MCR, supervisor would invoke strongest actions if further capital is not made available
Other solvency control levels
Even if above MCR, supervisor would intervene and require corrective actions in early stage
Not only capital level itself but other viewpoints (e.g. speed of capital level falling, sensitivity) could cause trigger
Not only capital but other factors (e.g. liquidity) could cause trigger 44 44

45. Solvency Control (Example of possible measures) 160%
PCR (supervisory intervention not required)
140%
Submission of business plan to improve capital buffers
Increased on-site inspection
Additional stress and scenario testing
120%
Limit shareholder dividends
Restrict new business acquisition
Delay approval of new products
100%
MCR (winding-up of operation)
Capital Adequacy Ratio =
Capital Available
Capital Required 45 45

46. Short Quiz: Double Gearing
Regulatory capital requirement
9% of life fund for life insurer
20% of insurance liability for general insurer
Assess capital adequacy of below group
Holding company (P)
Assets
2,400
Debt to A
1,000
Equity
1,400 (500 owned by B)
Own 75% of shares
Loan 1,000
Own 100% of shares
Own 500 shares
Life insurance subsidiary (A)
Assets
22,700
Life fund
20,000
Debt to B
700
Equity
2,000
General insurance subsidiary (B)
Assets
3,500
Insurance liability
1,800
Debt
800
Equity
900
Loan 700 46 46

47. Short Quiz: Double Gearing
Capital requirement
Subsidiary A: 20,000 X 9% = 1,800
Subsidiary B: 1,800 X 20% = 360
Capital available
Subsidiary A: 2,000 (and may count another debt 700 if subordinated to policyholders)
Subsidiary B: 900 (and may also count debt 800)
At first glance, it may look solvent. However…
Equity capital from outside party
Holding company: 1,400 – 500 = 900
Subsidiary A: 2,000 X 25% = 500
Could be insolvent if consider equity only
Could be barely solvent if consider debt 800 that B owes to outside party 47

48. Short Quiz: Double Gearing
One way to ensure that capital is not double counted is to deduct investments in associates
Subsidiary A: loan 1,000 is deducted and available capital is 2, – 1,000 = 1,700 < 1,800
Subsidiary B: loan 700 and share 500 are deducted and available capital is – 700 – 500 = 500 > 360
To show solvency for subsidiary A, group needs to transfer 100 of capital from B to A
Fungibility of capital and transferability of assets becomes issue
Conflict of interests between entities, especially in times of stress
Legal constraints in jurisdictions 48

49. Agenda Background Elements of Solvency Regime Capital Available
Capital Required
Capital Adequacy
Stress Test 49 49

50. Uncertainty Mismatch between models and real life Model risk
Model may be wrongly specified
e.g. wrong variables, assumptions about distribution
Parameter risk
Parameters may not be correctly estimated
Parameters may change over time
Stochastic variability
There exists random variation 50 50

51. Farther Drawbacks
Capital adequacy is concerned mainly about tail behavior.
Capital adequacy based on statistical model (e.g. VaR) has limited ability to accurately capture exceptional tail events.
Statistical inference is imprecise due to insufficient number of data/observations
Reality is more fat tail than usually assumed statistical distribution
Extrapolation of past experience into unknown future
e.g. Financial crisis is called “once-in-100-year event”. Couldn’t it be captured by 99% (or higher) VaR? 51 51

52. Importance of Stress Test
Stress test: comparison of capital resource against loss arising from specific and extreme example of adverse experience
Stress test supplements capital adequacy based on statistical method
Can cover drawbacks
Can be useful check on reasonableness
Potentially more “dynamic”
Stress test is integral part of risk management
Supervisors usually requires/requests stress test in addition to statistical method
Methods
Sensitivity testing (in wider sense)
Scenario testing 52 52

53. Scenario Scenarios need to be sufficiently severe but also plausible
What kinds of events?
What risk factors to stress?
How much variation to consider?
Examples
Epidemic of avian influenza
A series of big-size hurricanes
Stock markets crash similar to past financial crisis examples
Interest rate lowered close to zero
Correlation among risk types increase close to one 53 53

54. Management Actions
Management actions based on result should be considered
Stress test without future implication has little value
Management actions (positive effect) can be combined together with adverse scenario (negative effect)
Measures
Reduce risk positions/exposures and limit loss
Raise capital and/or set commitment line
Remember…
These measures also becomes difficult in time of stress (e.g. evaporation of liquidity in markets in financial crisis)
It may take time (e.g. realise symptoms, make decision, implement actions), while stress may come quickly 54 54

55. Short Quiz Why might the situation have occurred?
What corrective actions would you propose?
A large foreign non-life insurer is operating locally through a branch. Its business include local personal and small commercial clients, as well as very large risks arising from its multinational clients.
Large risks are underwritten at headquarters, where reinsurance is also arranged. Losses due to recent fire that destroyed factory of multinational client exceed asses invested locally. 55 55

56. Short Quiz
Problems
Local management of branch does not fully control business that is written
Major financial and underwriting decisions are made at head office
Focus on overall results of insurer without much attention to financial position of branch 56 56

57. Short Quiz
Remedies
Require that asses of branch exceed liabilities to policyholders of branch by solvency margin
Require that assets supporting local policyholders be held in local trust
Separate local personnel and small commercial lines business into subsidiary
Communicate with home supervisor 57 57

58. (A Ri Ga To U Go Za I Ma Shi Ta)
Questions and Answers
Thank you very much!
ありがとうございました。
(A Ri Ga To U Go Za I Ma Shi Ta) 58 58