Insurance Solvency EU

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Intensive Actuarial Training for Bulgaria
January 2007

• Lecture 9
• Insurance Solvency - EU
• by Michael Sze, PhD, FSA, CFA

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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

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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

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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)

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Impact of Solvency Margin

• Asset of insurance company gt 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

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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

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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

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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

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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

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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

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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

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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

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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

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Two Major Aspects of EU Solvency Rules

• Asset rules
• Solvency margins
• Guaranty fund

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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

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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

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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)

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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

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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

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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

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Solvency Margin (SM)

• SM equals higher of SM1 and SM2
• SM1 (18 IP up to EUR 50 million 16 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

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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

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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.

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Example on Solvency Margin

• Data
• Insured amount 10,000
• Technical provision with investment risk 2,000
• Technical provision without investment risk
  2,000
• SM based on technical provisions
• 4 x 2000 1 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 85 9 94

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Required Solvency Margin

• Required solvency margin for any year gt
• 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 lt 5,
  then do not reflect
• If policyholders rights are threatened, the
  insurance authority may require higher SM

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Guarantee Fund

• Additional amount over the required solvency
  margin
• Equal to 1/3 required solvency margin
• Guarantee fund gt or EUR 2 million
• In case classes 10 to 15 are covered life
  insurance
• Guarantee fund gt or EUR 3 million

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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

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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

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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 companys internal risk
  management process
• Inadequate consideration given to diversification
  and size effects
• Not dynamic (forward-looking)

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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