Trends in Solvency Regulation

1. Trends in Solvency Regulation CAIR Conference December 2008 Montego Bay, Jamaica. Craig Thorburn cthorburn@worldbank.org

2. Agenda • The old world is passing away • The new world of risk based approaches • Control levels and own solvency assessments • Internal models • Stress testing

3. Trends in solvency regulation The old world is passing away

4. Original idea – Mark 1 • Minimum Solvency requirements started as • leverage rules / a percentage of premium • based on famous ‘kenny ratio’ • scientific basis in statistical risk theory • Solvency I widely copied

5. Original idea – Mark 2 • Allowance for reinsurance • Net premium • Gives full credit for reinsurance • Some adjustment • Limit credit taking account of recoverability reflected in some or other of • Local registration of reinsurers • Credit ratings of reinsurers • Official list of acceptable reinsurers • Collateral

6. Original idea – Mark 3 • There should be an absolute minimum • a test of means at entry and ongoing stability • Ultimately a political trade-off or balance • Variation over the world is wide from low figures (under $US1million) to high figures ($US100 million) • Reinsurance companies often face higher minima.

7. Original idea – Mark 4 • Companies in run-off or those dominated by longer tail business might not be adequately capitalized based solely on premium income measures • “Greater of” approach • Fixed value • Percentage of premiums • Percentage of claims provisions • With allowance for reinsurance.

8. Original idea – Life insurance • More complex but can use actuaries • Treat all as long term and apply proportion of liabilities as premiums are even less relevant • Some innovation • minimum basis for valuation is a form of stress test or dynamic capital adequacy test • run the valuation on particular conservative assumptions and reflect the difference between the economic valuation and the conservative valuation in capital (embedded value) • Company management / actuarial practice reflected approach over time as computing power and actuarial skills developed • quantify new business strain. • find the economic embedded value

9. Trends in solvency regulation The new world of Risk based approaches

10. Solvency I is out of date • IAIS produced Solvency Principles in 2002 • EU reviewed Solvency I • found shortcomings against IAIS benchmark. • noted all EU countries implement Solvency I+ • served well but market has moved on • For those jurisdictions outside the EU, do the same conclusions apply?

11. Other countries had worked on approaches • USA – RBC • Canada – MSCR and DCAT • Australia – Margin on Services

12. Move to a more risk sensitive approach • Methods emerge between RBC and Solvency I • “Factor based” approaches that are more sensitive to risk compared to Solvency I • Asset side risks (credit, liquidity, market volatility) • More refined liability side risks • Solvency II standard approach • Promise of internal models mean standard approach does not have to be as risk sensitive as RBC • Especially the square root sign (allowing for diversification & lack of correlation of risks)

13. Our generic model • Apply factors to balance sheet items • Liabilities by broad class of business • Claims provisions • Premiums (usually premium liabilities at 150% of claims based factors) • Assets by class • May add additional items • Catastrophe risk based on PMLs • Mismatch risk based on a defined stress test • Consistent with Solvency II, Canada, Australia, US principles based project, Malaysia, Philippines, Singapore, Chile, PNG, Basel II

14. K is the total capital requirement subject to a fixed nominal minimum; L is the liability risk charge A is the asset risk charge C is the catastrophic event risk charge Other events relating to significant risk could be added here. The formula

15. Liabilities • Where • P values are premium liabilities with their corresponding j capital charges; and • C values are claims liabilities with their corresponding k capital charges.

16. Assets • Where • A values are asset market values with their corresponding j capital charges; and • E is the excess charge for concentration of counterparty exposure.

17. Valuation of balance sheet items is important • IASB project may further enhance valuation for risk • Readily adjusted as IASB project comes forward • But attention to valuation standards might be needed in the mean time.

18. Trends in solvency regulation Control levels and ‘own solvency assessment’

19. Corporate Governance & Risk Management • Everyone who has capital requirements should intend not to breach them • they need more than the minimum to allow for adversity • how much? • how do they determine it? • the minimum of a capital policy • So all companies with capital have a capital policy • Determined at the board level • Implemented effectively by management

20. Proportional to risk • Complexity of capital policy can be consistent with the complexity of the business

21. Risk Based Supervision • Company’s own solvency and capital assessment and capital policy can feed into assessment of company risk • We do not have a capital policy • We do not really know what capital we need for our business • We just take what you tell us

22. Some formal approaches in regulation • Ladder of trigger levels based on Risk capital • For example • 150% for no action • 120% for some intervention to correct • Sometimes requires legislative power to intervene progressively

23. Another option in small markets • Supervisory concurrence of target capital levels • Requires • transparent supervisory process • robust company solvency assessments • (perhaps) regulatory support

24. Trends in solvency regulation Internal models

25. Useful for some cases • Sophisticated companies should have their own model anyway • But complex to upgrade for use for regulatory capital minimum purposes • Relevant also for well diversified firms where capital on standard method will probably be high compared to risk. • Implies capital relief benefit available – economic incentive of better management.

26. Preconditions • Actuaries • Sophisticated firms • Supervisory capacity • All optional for supervisors but once accepted cannot go back

27. In Caribbean • Would only be relevant for large regionally operating firms. • Supervisory assessment requires resources but can be supported by consultants • Framework for review can be taken from international standard setters (IAIS and BCBS in particular) • A second order issue in terms of timing and priority.

28. Trends in solvency regulation Stress testing

29. Can be applied • Canada – DCAT • Scenario determined at each cycle • Companies perform scenario test and report to board and supervisor of issues raised and actions proposed • Can be incorporated in capital • Adverse interest rate movement scenarios are the most common • Australia – Resilience and Chile – Calce rules are examples • Can be required as part of company risk management • On company own risk assessment scenarios

30. Can be applied - continued • Supervisors can do some internally • Relatively easy scenarios can be tested using financial return data • But some limitations (performance of reinsurance in response to claim increases) • Supervisors can request companies to advise on impact of defined scenarios from time to time • As part of ongoing Risk Based Supervision • Select a scenario and request a study • May use tripartite process with insurers and auditors or actuaries

31. Full stochastic models • Match scenarios with return period or tail probability • Hurricane models are an example • More complex approaches with wider coverage of range of risks probably not yet to be expected from mid sized firms (including even the largest Caribbean insurers)

32. In the Caribbean • Not widely used by supervisors • But feasible • Perhaps a useful place to start a cross border project • Impact analysis focused on events and larger systemically important firms • Could be coupled with a fire drill or cross border resolution analysis project

33. Thank you Craig Thorburn cthorburn@worldbank.org +1 202 415 3760