Sesión 9 Adecuación de Capital y Solvencia XXI Asamblea Anual de ASSAL XI Conferencia sobre Regulación y Supervisión de Seguros en América Latina y Seminario

Sesión 9Adecuación de Capital y Solvencia

XXI Asamblea Anual de ASSALXI 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

English

2

Agenda

1. Background

2. Elements of Solvency Regime

3. Capital Available

4. Capital Required

5. Capital Adequacy

6. Stress Test

Definition of Solvency

3

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.

Definition of Solvency

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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

Solvency and Capital Adequacy

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• 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.

Solvency

Capital

Liquidity

Maintain safety margin of assets over liabilities

Ensure assets cash flows are available to meet liabilities when due

Risk manage

mentLiabilities

Ensure adequate provisioning

Importance of Adequate Capital

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• 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

Roles of Supervisors

7

• Establish a solvency regime– 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

Enterprise Risk Management (ERM)

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Feedback Loop

Governance and an Enterprise Risk Management Framework

Feature 1

Role of supervisionFeature 8

Feedback Loop

Risk Management Policy

Own Risk and Solvency Assessment (ORSA)

Risk Tolerance Statement

Economic and Regulatory Capital

Continuity Analysis

Governance and Enterprise Risk Management Framework

Role of supervision

9

Agenda

1. Background



4. Capital Required

5. Capital Adequacy

6. Stress Test

Total Balance Sheet Approach

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• 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…?

Assets

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• Quality/Safety– 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

Liabilities

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• Technical provisions– 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

Asset Liability Management (ALM)

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• 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)

Reinsurance

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• 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

Short Quiz

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• 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.

• Why might the situation have occurred? • What corrective actions would you propose?

Short Quiz

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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

Short Quiz

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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

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Agenda

1. Background



4. Capital Required

5. Capital Adequacy

6. Stress Test

Quality and Suitability of Capital Resource

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• 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

Highest Quality Capital

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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

Adjustment for Solvency Purpose

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• 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

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Agenda

1. Background



4. Capital Required

5. Capital Adequacy

6. Stress Test

Short Quiz: Different Perspectives

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• 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?


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• Policyholder↑ They prefer sufficient capital to protect their interests.

• Bank (lender)↑ They prefer sufficient capital to protect their interests.

• 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.


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• 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.

Regulatory Capital and Economic Capital

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• Regulatory 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

Types of Prudential Requirements

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• 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

Types of Regulatory Requirements

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• 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

Process of Calculating Required Capital

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Identify all material risk sources

Assess & characterise distributions

Aggregate all risks

Measure required capital

Redistribute & use for management

Underwriting, credit, market, operational, liquidity etc,

CorrelationDependency

Risk Identification

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Underwriting (Insurance)

Typical category

– 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.

Features

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

Risk Identification

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Market

Typical category

– Volatility and uncertainty of market value of assets/liabilities

– Variables: stock price, interest rate, foreign exchange rate, commodity price etc.

Features

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.

Risk Assessment and Characterisation

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• 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

Aggregation

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• 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

Aggregation

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Possible methods

• Simple summation– 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

Risk Measures

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• 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

Loss

Mean

VaR (e.g. 99%)

TVaR (e.g. 99%)

Desirable Characteristics

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• 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

Theoretical perspective

Application perspective

Comparison – VaR and TVaR

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VaR 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.

Capital Requirement and Technical Provision

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Probability

Loss

Technical provision (current estimate and

risk margin)

Capital requirement

Solvency level(e.g. VaR (1 year, 99%)

Allocation

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• 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

Challenges of Modeling

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• 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

Short Quiz: Effect of Aggregation

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• 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?

Short Quiz: Effect of Aggregation

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• 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

More fat tail risk type Less fat tail risk type

Business = 10,000

Profit = 500

Business = 10,000

Profit = 500

VaR (99%) = 200

Profit per risk = 2.5

VaR (99%) = 200


VaR (99.9%) = 250


VaR (99.9%) = 300


(Illustrative Example)

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Agenda

1. Background



4. Capital Required

5. Capital Adequacy

6. Stress Test

Demand vs. Supply

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Assets

• Supervisory assessment of financial position– Could be different from public financial reporting due to

prudential filter etc.

Other liabilities

Current estimate

Risk margin

Capital requirement

Liabilities

Available capital

Technical provision

Solvency Control

45

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

Solvency Control

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Capital Adequacy Ratio = Capital Available Capital Required

– PCR (supervisory intervention not required)

– Submission of business plan to improve capital buffers

– Increased on-site inspection

– Additional stress and scenario testing

– Limit shareholder dividends

– Restrict new business acquisition

– Delay approval of new products

– MCR (winding-up of operation)100%

120%

140%

160%

(Example of possible measures)

Short Quiz: Double Gearing

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Life insurance subsidiary (A)

Assets 22,700 Life fund 20,000

Debt to B 700

Equity 2,000

• Regulatory capital requirement– 9% of life fund for life insurer– 20% of insurance liability for general insurer

• Assess capital adequacy of below group

General insurance subsidiary (B)

Assets 3,500 Insurance liability

1,800

Debt 800

Equity 900

Holding company (P)

Assets 2,400 Debt to A 1,000

Equity 1,400 (500 owned by B)

Own 75% of shares

Own 100% of shares

Loan 1,000

Loan 700

Own 500 shares


• 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


• 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 2,000 + 700 – 1,000 = 1,700 < 1,800

– Subsidiary B: loan 700 and share 500 are deducted and available capital is 900 + 800 – 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

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Agenda

1. Background



4. Capital Required

5. Capital Adequacy

6. Stress Test

Uncertainty

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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

Farther Drawbacks

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• 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?

Importance of Stress Test

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• 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

Scenario

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• 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

Management Actions

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• 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

Short Quiz

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• 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.

• Why might the situation have occurred? • What corrective actions would you propose?

Short Quiz

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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

Short Quiz

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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

Questions and Answers

59

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)

www.iaisweb.org

[email protected]

Documents

Sesión 9 Adecuación de Capital y Solvencia XXI Asamblea Anual de ASSAL XI Conferencia sobre Regulación y Supervisión de Seguros en América Latina y Seminario