Chapter 10

Question 1

What are rating agencies?

Answer 1

Rating agencies provide an opinion of insurance companies’ financial strength which is a measure of their ability to pay claims under their insurance policies and contracts.

Note that this does not refer to the insurance company’s ability to meet its non-policy (i.e. debt) obligations, although debt that a company issues on the capital markets is normally separately rated.

Question 2

Who are the 4 main rating agencies?

Answer 2

Standard and Poor’s (S&P),

AM Best,

Moody’s

Fitch

Question 3

Why do insurance companies prefer to have a financial strength rating?

Answer 3

• it demonstrates to policyholders that a third party has measured the likelihood of them meeting their financial commitments.
• it allows for financial strength comparisons between different insurers.
• it should allow an extremely strong (AAA) insurer to charge a higher premium or be offered a wider range of business than a good (BBB) insurer as the customer is buying into a stronger rated (and therefore potentially more secure) company; and
• brokers and customers can decide on their risk appetite by choosing the financial strength rating that they prefer for their insurance carriers. For example, they may decide that their insurance policies must be placed with companies that have an S&P financial strength rating of higher than A-

Question 4

What is a typical analytical framework that would be used by a rating agency?

Answer 4

• Economic and industry risk.
• Competitive position.
• Management and corporate strategy.
• Enterprise risk management (ERM).
• Operating performance.
• Investments
• Capital adequacy.
• Liquidity
• Financial flexibility

Question 5

Under the typical analytical framework, what is economic and industry risk?

Answer 5

The environmental framework in which insurance companies operate. Typical points would be to look at the threat of new entrants, volatility of the sector, country risk and the potential ‘tail’ to liabilities or risk of catastrophic losses.

Question 6

Under the typical analytical framework, what is What is Competitive position

Answer 6

The profile of the business mix in terms of the competitive strengths and weaknesses. This is particularly relevant in terms of the insurance company’s strategy.

Question 7

Under the typical analytical framework, what is Management and corporate strategy.

Answer 7

This looks at the quality and credibility of an insurer’s senior management team and the strategy it has set and is one of the most important elements in determining how successful the company will be going forward.

Question 8

Under the typical analytical framework, what is Enterprise risk management (ERM).

Answer 8

ERM is the method by which a company manages risk (both risks that have an upside as well as a downside).

Most large insurers are expected to have an effective ERM to earn the stronger financial ratings.

Question 9

Under the typical analytical framework, what is Operating performance.

Answer 9

This involves looking at the performance ratios – loss ratio, expense ratio, combined ratio, return on equity etc.

Question 10

Under the typical analytical framework, what is Investments

Answer 10

Of key importance here is how the insurer’s investment strategy fits with its liability profile, and to what extent investment results contribute to total company earnings.

Question 11

Under the typical analytical framework, what is Capital adequacy.

Answer 11

This looks at the quality and level of capital required to run the business based on the risk appetite adopted.

Question 12

Under the typical analytical framework, what is Liquidity.

Answer 12

The ability to manage cash flows efficiently and easily borrow money if required.

Question 13

Under the typical analytical framework, what is financial flexibility.

Answer 13

This looks at the insurer’s potential need for additional capital or liquidity in the future.

Question 14

Under (GENPRU 1.2.26) what is the regulatory requirement?

Answer 14

‘A firm must at all times maintain overall financial resources, including capital resources and liquidity resources, which are adequate, both as to amount and quality, to ensure that there is no significant risk that its liabilities cannot be met as they fall due.’

Question 15

The risk appetite statement would typically include:

Answer 15

• acceptable risks
• unacceptablerisks;
• the probability of failure that is deemed to be acceptable;
• the maximum loss that is acceptable from any one incident;
• the target level of financial security; and
• the quality and diversity of investments.

Question 16

How is a risk appetite statement used?

Answer 16

The risk appetite statement would be used by the insurance company to set:

• the risk acceptance criteria;
• an investment policy;
• a reinsurance policy; and
• other financial and risk policy statements.

Question 17

What is the solvency 2 directive

Answer 17

a set of EU-wide capital requirements, valuation techniques and risk management standards to replace the previous Solvency I requirements.

The objectives of Solvency II are to enhance policyholder protection and create a safer, more resilient insurance sector.

Question 18

How many pillars are there under solvency 2?

Answer 18

Three

Question 19

What is pillar 1 under solvency 2?

Answer 19

Pillar 1 – Financial requirements. This applies to all firms and considers key quantitative requirements, including own funds, technical provisions, and calculation of the Solvency II capital requirements the solvency capital requirement (SCR) and minimum capital requirement (MCR) through either an approved full or partial internal model or the standard formula approach.

Question 20

What is pillar 2 under solvency 2?

Answer 20

• Pillar 2 – Governance and supervision. This includes an effective risk management system and prospective risk identification through the own risk and solvency assessment (ORSA).

Question 21

What is pillar 3 under solvency 2?

Answer 21

• Pillar 3 – Reporting and disclosure. Insurers are required to publish details of the risks facing them, capital adequacy and risk management. Transparency and open information are intended to assist market forces in imposing greater discipline on the industry.

Question 22

Under solvency 2 what are the three tiers of capital?

Answer 22

• Tier 1 capital, such as common equity and retained earnings, is the highest quality of capital
• Tier 2 capital, such as subordinated debt, is of a lower quality ofcapital
• Tier 3 capital is the lowest quality of capital permitted and has only limited loss-absorbing capacity.

Question 23

What are the two capital requirements under solvency 2?

Answer 23

the solvency capital requirement (SCR) and

the minimum capital requirement (MCR).

Question 24

What is the SCR (solvency capital requirement)

Answer 24

The SCR is the quantity of capital that is intended to provide protection against unexpected losses, over the following year, up to the statistical level of a ‘1 in 200-year event’.

Question 25

What is the MCR (minimum capital requirement)

Answer 25

The MCR denotes a level below which policyholders would be exposed to an unacceptable level of risk and is intended to correspond to an 85% probability of adequacy over the following year.

Question 26

What two options are there if there is inadequate regulatory capital?

Answer 26

• Raise more regulatory capital. This could be by means of: – issuing new shares in a limited company; – issuing long-term debt that meets the PRA requirements for Tier 1 or Tier 2 regulatory capital; or
• Reduce the regulatory capital requirement. – the volume of business written, particularly in lines which generate a high capital requirement; – increasing reinsurance; and/or – switching out of higher risk assets such as equities, into lower risk ones such as government bonds.

Question 27

What tests and standards are set out in Solvency II, which an internal model needs to satisfy, in order to gain regulatory approval.

Answer 27

The ‘use test’, as well as further standards such as the statistical quality, calibration, validation, and documentation of the model

Question 28

What is the use test?

Answer 28

The use test will be used to verify that internal models are employed not just to satisfy the regulatory requirement of calculating the SCR, but as a tool that is part of a firm’s wider, risk management and decision-making processes.

Question 29

When are firms required to publish a solvency and financial report?

Answer 29

A (SFCR) should be reported annually.

Question 30

What are rating agencies paid to do?

Answer 30

Rating agencies are paid by large insurance companies (or reinsurance companies) to provide an opinion of their financial strength which is a measure of their ability to pay claims under their insurance policies and contracts. This does not extend to the insurance company’s ability to meet its non-policy (i.e. debt) obligations.

Question 31

What are the main reasons why insurance companies prefer to have a financial strength rating?

Answer 31

2 Insurance companies prefer to have a financial strength rating because:

• it demonstrates to policyholders that a third party has measured the likelihood of them meeting their financial commitments;
• it allows for financial strength comparisons between different insurers;
• it should allow an extremely strong (AAA) insurer to charge a higher premium or be offered a wider range of business than a good (BBB) insurer as the customer is buying into a stronger rated (and therefore potentially more secure) company; and
• brokers and customers can decide on their risk appetite by choosing the financial strength rating that they prefer for their insurance carriers, e.g. the insurance contract must use companies higher than A–.

Question 32

What statements would you expect to find in the risk appetite statement of an insurance company?

Answer 32

The risk appetite statement of an insurance company would typically include:

*risks that it is acceptable

• which risks are not acceptable;
• the probability of failure
• the maximum loss that is acceptable from any one incident;
• the target level of financial security; and * the quality and diversity of investments.

Question 33

What would the risk appetite statement of an insurance company be used for?

Answer 33

The risk appetite statement of an insurance company would be used to set:

• the risk acceptance criteria;
• an investment policy;
• a reinsurance policy; and
• other financial and risk policy statements Together with the risk appetite set by the board the internal model can also be used to judge the appropriate level of capital to hold

Question 34

Explain the terms SCR and MCR.

Answer 34

The SCR is the quantity of capital that is intended to provide protection against unexpected losses, over the following year, up to the statistical level of a ‘1 in 200-year event’.

The MCR denotes a level below which policyholders would be exposed to an unacceptable level of risk and is intended to correspond to an 85% probability of adequacy over the following year.

Together, the SCR and MCR act as trigger points in the ‘supervisory ladder of intervention’ introduced by Solvency II.

Question 35

What is an ORSA?

Answer 35

Solvency II requires insurers to take a comprehensive approach to considering their risks through the own risk and solvency assessment (ORSA). Regulatory capital requirements may not adequately capture some risks which are difficult to quantify accurately, such as cyber risk (which can be both a risk to the insurer and an insured risk). Furthermore, firms face risks that span the entirety of their business plan, such as the long-term effects of climate change, changes which are not necessarily significant over the one-year time horizon used in the calibration of the SCR. By requiring a firm’s management to consider risks such as these, the ORSA should help firms to understand and manage all the risks they are exposed to.

Question 36

Explain what an SFCR is

Answer 36

Pillar 3 of Solvency II introduces the requirement to publish a solvency and financial condition report (SFCR) annually.

In the SFCR, firms need to clearly explain aspects of their approach to Solvency II, such as the use of an internal model and any noncompliance with regulatory solvency requirements. Solvency II sets out the disclosure requirements for the SFCR such that the quality and standardisation of firm disclosures should improve.

Question 37

What does the Solvency II Directive state about the actuarial function and insurance firms

Answer 37

• All insurance firms have an actuarial function
• The PRA view access to actuarial knowledge as ‘indispensable to an adequate system of governance’.
• The firm’s actuarial function must contribute to the effective implementation of the risk management system.
• The actuarial function should use the outputs of the internal model, for example in providing an improved understanding of its reserve volatility and may well use the internal model to assess the firm’s technical provisions.

Question 38

What is a yield spread?

Answer 38

(a yield spread is the difference between the yield on a bond and
a benchmark yield)

Question 39

What can a yield spread indicate?

Answer 39

yield spreads may be a good early indicator of
deteriorating financial strength

Question 40

What is the objective of solvency 2?

Answer 40

to enhance policyholder protection and create a safer, more resilient insurance sector.

Question 41

What does Solvency 2 require an insurance company’s balance sheet to be?

Answer 41

Based on the principle of market consistent valuations (meaning the market value of assets not original value)

Question 42

What are stress test and scenario tests used for?

Answer 42

consider the potential impact of certain adverse circumstances on their business – is an important element in firms’ planning and risk management processes, helping them to identify, analyse and manage risks.

Question 43

What is reverse stress testing?

Answer 43

primarily designed to be a risk management tool, encouraging firms
to explore more fully the vulnerabilities and fault lines in its business model, including ‘tail risks’, and to explore potential mitigating actions.