10. Financial Strength of insurance companies Flashcards
Why is a financial strength rating important for an insurance company?
- It reassures policyholders
- It allows comparison of financial strength between insurers.
- A stronger rating may justify charging higher premiums.
- Brokers and customers can align their risk appetite with the insurer’s rating.
What does a financial strength rating measure for an insurance company?
The company’s ability to pay claims under its insurance policies, not its ability to meet debt obligations.
What are the key components of a typical analytical framework used by rating agencies?
- Economic and industry risk
- Competitive position
- Management and corporate strategy
- Enterprise risk management (ERM)
- Operating performance
- Investments
- Capital adequacy
- Liquidity
- Financial flexibility
What is a yield spread, and why is it significant in credit rating analysis?
A yield spread is the difference between a bond’s yield and a benchmark yield. Expanding spreads can signal deteriorating financial strength before a rating downgrade.
Why might an AAA rating indicate that a company is over-capitalised?
Because it suggests that the return on equity (ROE) is likely to be depressed due to an excessive capital base.
Who is responsible for determining an insurance company’s risk appetite?
The board
What elements are typically included in a risk appetite statement?
- Acceptable risks
- Unacceptable risks
- Probability of failure deemed acceptable
- Maximum acceptable loss from one incident
- Target level of financial security
- Quality and diversity of investments
What is the PRA’s requirement for the probability of failure over a 12-month period?
It should not exceed one chance in 200
What policies are influenced by the risk appetite statement?
- Risk acceptance criteria
- Investment policy
- Reinsurance policy
- Other financial and risk policy statements
What are the main objectives of Solvency II?
A:
- Enhance policyholder protection
- Create a safer, more resilient insurance sector
What are the three pillars of Solvency II?
Pillar 1 – Financial requirements
Pillar 2 – Governance and supervision
Pillar 3 – Reporting and disclosure
What is the principle of market-consistent valuations under Solvency II?
The value of assets and liabilities should reflect the current market value at which they could be traded, not their original accounting value.
How are insurance liabilities valued under Solvency II?
Insurers forecast expected future liability cash flows, discount them using risk-free interest rates, and add a risk margin to produce a market-consistent value.
What are the three tiers of capital under Solvency II?
Tier 1 – Highest quality capital – absorbs losses on a day-to-day basis.
Tier 2 – Lower quality capital – absorbs losses on insolvency.
Tier 3 – Lowest quality capital – limited loss-absorbing capacity.
What are the two capital requirements under Solvency II?
- Solvency Capital Requirement (SCR)
- Minimum Capital Requirement (MCR)
What is Solvency Capital Requirement (SCR)?
Capital needed to protect against unexpected losses up to a 1 in 200-year event.
What is Minimum Capital Requirement (MCR)
Capital level below which policyholders face unacceptable risk, with an 85% probability of adequacy over the next year.
What are the two main responses if an insurer breaches capital requirements under Solvency II?
- Raise more capital
- Reduce capital requirements
How do most insurers calculate their SCR under Solvency II?
Using the standard formula or using an internal model.
What are some key uses of internal models beyond calculating capital requirements?
- Pricing
- Portfolio target returns
- Reinsurance purchasing
- Investment selection
- Dividend decisions
What regime was introduced by the PRA to ensure the accountability of senior management?
The Senior Managers and Certification Regime (SM&CR) ensures senior management behaves with honesty, integrity and competence.
What is the purpose of the own risk and solvency assessment (ORSA)?
ORSA requires insurers to identify, measure, and manage all risks, including those not fully covered by capital rules (like cyber risk and climate change).
What is the ‘prudent person principle’ under Solvency II?
An approach to regulation that places responsibility for investment decisions on a firm’s management
What is the aim of the reporting and disclosure requirements under Solvency II?
To improve the availability of information to the market and strengthen market discipline.
What report must firms publish annually under Pillar 3 of Solvency II?
The Solvency and Financial Condition Report (SFCR).
What 2 key aspects must be explained in the SFCR?
- Use of an internal model (if applicable)
- Any non-compliance with regulatory solvency requirements
What is the goal of reverse stress testing?
To help firms understand vulnerabilities, tail risks, and potential mitigating actions.
Why must insurers implement stress testing programmes?
o ensure they can meet capital and liquidity requirements under stressed conditions as part of effective risk management.
What are reverse stress tests?
Tests that identify scenarios that would make a firm’s business model unviable, highlighting vulnerabilities.
How does reverse stress testing differ from general stress testing?
Reverse stress testing identifies points where a firm becomes unviable, whereas general stress testing examines the impact of adverse conditions.
What does Solvency II specify regarding actuarial functions?
Solvency II requires firms to have an actuarial function.
Is a formal actuarial qualification required for the actuarial function?
No
