Sesión 9 Adecuación de Capital y Solvencia

English Sesión 9Adecuación de Capital y Solvencia 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

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

Definition of Solvency • 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

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

Solvency and Capital Adequacy Capital Maintain safety margin of assets over liabilities Risk management Liabilities Ensure adequate provisioning Solvency Ensure assets cash flows are available to meet liabilities when due Liquidity • 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

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

Roles of Supervisors • 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 6

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

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

Assets • 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 10

Liabilities • 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 11

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

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

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

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

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

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

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

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

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

Short Quiz: Different Perspectives • 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. 23

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

Regulatory Capital and Economic Capital • 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 25

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

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

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

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

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

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

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

Aggregation • 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 33

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

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

Comparison – VaR and TVaR Nothing is perfect – both methods have pros and cons. 36

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

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

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

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

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) 41

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

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

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

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 Own 75% of shares Loan 1,000 Own 100% of shares Own 500 shares Loan 700 46

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

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 2,000 + 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

Sesión 9 Adecuación de Capital y Solvencia