Chapter 10 - Financial Strength Of Insurance Companies Flashcards
Rating agencies are concerned with the insurance companies ability to pay claims rather than its general…
Debt
What are the four main rating agencies?
Standard and poor, Moody’s, AM best and Fitch.
All customers buying insurance are essentially buying…
A promise.
Who generally relies on rating agencies financial strength ratings when placing business?
Commercial customers and brokers
What are some of the reasons insurance companies bother paying a fee to the rating agencies for their services in assessing their financial rating?
- demonstrates to policyholders and other third parties how likely the company is able to pay its claims
- allows for comparisons between insurers
- would allow an extremely strong insurer to charge a higher amount e.g AAA rated can charge more than BBB as they can say to customers they are buying into stronger and more secure company.
- brokers will likely only deal with companies of a certain rating, e.g A- but none less than this.
Standard and poors rating methodology uses a combination of both …
Both quantities and qualitative information
The rating process looks at a wide range of information so is what In nature and forming an opinion?
Objective
Which areas are part of standard and poors common analytical framework?
- economic and industry risk
- competitive position
- management and corporate strategy
- enterprise risk management
- operating performance
- investments
- capital adequacy
- liquidity
- financial flexibility
In regards to standard and poors analytical framework, what is economic and industry risk concerned with?
This looks at the environmental framework in which insurance companies operate. Typical points would be to look at the threat of new entrants, volatility of the sector and the potential tail to liabilities or risk of catastrophic losses.
In regards to standard and poors analytical framework, what is competitive position?
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.
In regards to standard and poors analytical framework, what is management and corporate strategy section?
This looks at the quality and credibility of an insurers senior management team. Standard and poor believe that this is one of the most important elements in determining how successful a company will be going forward.
In regards to standard and poors common analytical framework, what is enterprise risk management?
ERM is the method by which a company manages risk (both risks that have an upside as well as a Downside.) ERM looks at assessing the frequency and severity of risk, risk mitigation, monitoring and reporting. Some insurers ERM looks at encomic capital model.
In regards to enterprise risk management, standard and poor have said that in the future…
Require companies to have an effective ERM to earn the stronger financial strength ratings.
Standard and poor incorporate the results of ERM modelling in their analysis of ….
Capital adequacy.
In regards to standard and poors analytical framework, what is looked at in the section, operating performance.
This involves looking at the performance ratios, loss ratio, expense ratio, combined ratio, return on equity etc.
In regards to standard and poors analytical framework, what is looked at under the section of investments?
They look at how the company’s investment strategy fits in with its liability profile,and to what extent investment results contribute to total company earnings.
In regards to standard and poors analytical framework, what is looked at under capital adequacy?
This looks at the quality of the capital required to run the business.
In regards to standard and poors common analytical framework what is looked at in regards to liquidity?
The company’s ability to manage cash flows efficiently and easily borrow money if required.
In regards to standard poors analytical framework, what is looked at in regards to financial flexibility?
Looks at the insurers potential need for additional capital or liquidity in the future.
All the aspects of standard and poors analytical framework are what in regards to each other and the rating of a company?
All analytically Interconnected. They are weighted each differently in regards to the contribution towards a company’s rating. A lot depends on a company’s specific circumstances.
The confidence standard and poor have that a company’s capital is adequate will influence their perception of…
A company’s earning stability, it’s ability to grow capital and whether it will be able to meet underlying risks.
What does an AAA rating show?
The highest rating. Extremely strong financial security. Perhaps also seen as too cautious.
What does the AA rating show?
Very strong financial security - differing only slightly from those rated higher.
What does an A rating show?
Strong financial security - somewhat more likely to be affected by adverse business conditions.
What does a BBB rating show?
Good financial security - but is more likely to be affected by adverse business conditions.
An insurer related as BB or lower is regarded as…
Having vulnerable characteristics that may outweigh its strengths. BB Is better than CC.
What is the “NR” additional term that standard and poor use?
Not rated, which implies no opinion.
What does a + or - mean with regards to standard and poors ratings?
Shows standing within major rating categories, e,g A-
What is the additional term, credit watch, that standard and poor use?
Highlights the potential direction of a rating following short term events causing standard and poor to place the rating under surveillance. Negative means the rating may be lowered, positive means the rating may be raised and developing means that the rating may be raised, lowered, or affirmed.
What is pi under standard and poors additional terms?
This means ratings are based off public information and means that there has not been an in depth private meeting with the insurer.
Critics of the credit rating process have commented that…
Credit rating agencies do not downgrade companies promptly enough.
Enrons rating remained investment grade four days before…
The company went bankrupt
What have academics claims may be a good indicator of deteriorating financial strength and why?
Yield spreads. The reason for this is that a yield spread is the difference between a yield on a bond and a benchmark yield. Corporate bonds start to expand as credit quality deteriorates but before a rating downgrade, implying that these may be a good early indicator of deteriorating financial strength.
Do insurance companies and reinsurance companies pay rating agencies to asses their financial strength and ability to pay claims?
Yes
What are the steps of the rating process?
- insurance company meets the agency and signs the contract
- at least two analysts spend a day with the senior executives to understand the insurance company’s business
- an exhaustive analysis is u ever taken over the next few weeks and may require answers to further questions
- lead analyst will recommend a rating to a committee of eight analysts who then debate the methods and reasoning.
- committee will vote on the rating
- insurance company is then told the rating and can either accept it or appeal and the committee re sits. Once agreed the rating issues a press release which is negotiated with standard and poor prior to issue.
- the rating agency will then monitor the insurer and carry out an annual review.
An AAA rating may mean that a company is…
Over capitalised, which from an investors perspective could mean return on equity is depressed. Investors would earn a higher return on equity if company could deliver same returns using a lower capital base.
Some insurers make public their target financial strength and select a rating of…
A or AA
If an insurer is not happy with the rating and withdraws from the rating agency process, the agency can still…
Rate the company using publicly available information
There is an overriding regulatory requirement that: “a firm must at all times maintain…
Overall financial resources, including capital resources and liquidity resources, which are adequate, both as to the amount and quality, to ensure that there is no significant risk that its liabilities cannot be met as they fall due. GENPRU 1.2.26
Who has responsibility for deciding a company’s risk appetite?
The board
The risk appetite statement would typically include:
- a statement of the risk that it is acceptable for the company to bear
- what risk are not acceptable
- the probability of failure that is deemed to be acceptable and
- the maximum loss that is acceptable from any one incident
The Prudential Regulation Authority require that the probability of failure should not be…
Higher than one chance in a two hundred over a twelve month timescale.
Why would an insurance company target a better chance chance of failing than the regulator’s target minimum?
If it wanted for example a stronger financial strength rating
The risk appetite statement would be used by an insurance company to set:
- the risk acceptance criteria
- an investment policy
- a reinsurance policy and
- other financial and risk policy statements
Reinsurance can be used to minimise exposure to risks that a …
Company does not want to bear
Insurance companies increasingly use an economic capital model to assist them in a range of decisions such as:
- pricing
- portfolio target returns
- reinsurance purchasing
- investment selection
- demonstrating capital adequacy
The economic capital model can be used to judge the…
Appropriate level of capital to hold
In determining the appropriate level of capital to hold an insurance company will also have regard to maintaining an appropriate buffer in excess of…
The regulatory minimum capital requirement
In regards to capital, a balance must be struck between…
Having enough capital to minimise breaching the the minimum solvency margin, and not too much capital which could unduly depress the returns on equity available to shareholders.
Solvency II categorises capital into three tiers what is the difference between tier 1 and tier 2 capital
Tier 1 capital such as equity and retained earnings is the highest quality in terms of its ability to absorb losses Tier 2 capital such as subordinated debt is of lower quality and only needs to absorb losses on insolvency
What were the objectives of solvency II?
Enhance policy holder protection and create a safer more resilient insurance sector
The equity for regulatory purposes is likely to be lower than…
The equity in the published financial statements
MCR stands for?
Minimum capital requirement
SCR stands for?
Solvency Capital Requirement
What is the purpose of Pillar 1 of Solvency II
Pillar 1 requires insurance companies to demonstrate that they have adequate financial resources to withstand losses.
It considers the key quantitative requirements including own funds and technical provisions and outlines how the SCR and MCR should be calculated using either an approved full or partial internal model of the standard formula
A breach of the SCR will require a firm to?
Consider and action a plan to restore its capital position or reduce its risk profile. Distributions to investors will be cancelled or deferred. A breach will also act as an intervention point for supervisors
Where a regulated firm is a member of a larger group of companies, this creates additional risk and issues for the firm and requires adjustments to the capital requirement to the firm viewed on a…
Standalone basis
As a member of a group, a regulated firm:
- may have access to additional capital (not in its own balance sheet) from other members of the group
- may increase its risk through intra group trading (e.g risk accumulation, the value of investments in and debts due from other group companies.)
Stress and scenario testing has for a long time been an important element in assessing whether…
Insurance companies have an adequate capital amount.
A new requirement is to conduct reverse stress testing which is…
Process by which an insurance company identifies and assesses the scenarios most likely to render its business model unviable.
If an insurance company breaches its MCR, what happens?
Regulatory action is taken and the firm has to submit a plan for approval explaining how it will restore capital above the MCR in three months. If it is unable to so authorisation is withdrawn.
If a company has long term debt, it is reasonably like to have covenant in the debt agreement which would require….
It to report regulatory breaches to the lender.
An alternative to increasing the amount of capital is to..
Increase the amount of reinsurance as a substitute.
In the case of inadequate regulatory capital there are two basic options:
- raise more regulatory capital.
- reduce the regulatory capital requirement
In regards to raising more regulatory capital, the company can…
- issue more shares
- issue long term debt that meets the requirements for tier 1 or tier 2 regulatory capital and
- switching out of assets which are not fully allowable for regulatory capital purposes into those that are fully allowable.
In regards to reducing the regulatory capital requirement, this could be by means of:
- reducing the volume of business written, particularly in lines which generate a high capital requirement
- purchasing reinsurance
- switching out of higher risk areas such as equities, into lower risk ones such as government bonds
What is the second pillar of the solvency II regime?
Demonstrating an adequate system of governance. This includes an effective risk management system and prospective risk identification through the own risk and solvency assessment (ORSA)
Also includes the supervisory review process.
What is the solvency II supervisory review process?
The overall process conducted by the supervisory authority in reviewing the insurance and reinsurance undertakings, ensuring compliance with the directive requirements and identifying those with financial and or organisational weaknesses susceptible to producing higher risks to policyholders.
What is the third solvency II pillar called?
Public disclosure and regulatory reporting requirements>
Insurers have to publish details of:
- the risks facing them
- their risk management
- their capital adequacy
Solvency II is being created in accordance with the what four level process?
Lamfalussy
What is level one of the lamfalussy four level process?
Involves developing a European legislative instrument that sets out essential framework principles, including implementing powers for detailed measures at level 2.
What is level two of the lamfalussy process?
Implementing measures. This involves developing more detailed implementing measures (prepared by the commission following advice from the European insurance and occupational pensions authority (EIOPA) that are needed to implement the level 1 framework legislation.
What is level three of the lamfalussy process?
Guidance. EIOPA works on joint interpretation recommendations, consistent guidelines and common standards. Additionally, EIOPA undertakes peer reviews and compares regulatory practice to ensure consistent implementation and application.
What is the level 4 of the lamfalussy process?
Enforcement. More vigorous enforcement action by the commission is underpinned by enhanced cooperation Between member states, regulators and the private sector.
Insurers using an internal model have to pass the use test. The use test requires…
The insurer to demonstrate that their is sufficient discipline in its internal model development and application such that it is widely used and plays and important role in the management of the firm.
In addition, approval to use an internal model requires a firm to demonstrate compliance with several other mandated tests and requirements, including…
Statistical quality, data, documentation, calibration and profit and loss attribution. Sensitivity, stress and scenario resting also need to be evidenced.
Solvency II directive specifies the requirement for which function?
Actuarial
Actuarial knowledge by the European regulators is seen as …
Indispensable to an adequate system of governance.
Under Solvency II the actuarial function is compulsory, but they do not…
need a formal actuarial qualification, but must be carried out by persons of sufficient knowledge of actuarial and financial mathematics. And be able to demonstrate relevant experience and expertise.
With regards to the EU regulators requirements for an actuarial function. These must contribute to the effective implementation of risk management system in particular with respect to design, calibration and build of …
Internal model, with feedback loop being used to improve the model.
The actuarial function by the requirements of the EU should use the outputs of the …
Internal model.
An example of an actuary using the outputs of an internal model is…
Providing an understanding of its reserve volatility and may well use the internal model to assess the firms technical provisions.
An insurance company’s standard and poors credit rating contains a pi component, this indicates…
The impact of the relevant yield spread
Under Solvency II assets and liabilities in an insurer’s balance sheet must reflect…
Their current value on financial markets
As there is no market for insurance liabilities insurers are required to…
Forecast expected future liability cash flows then discount them using a risk free interest rate to arrive at a “best estimate”. A risk margin is added to the best estimate to produce a market consistent value.
Under Solvency II insurance liabilities are valued on a ?????????? basis
Best estimate basis
What four improvements were made to the quality of capital under Solvency II?
- EFFECTIVE LOSS ABSORBENCY - either automatically or when defined trigger points reached
- DURATION OF CAPITAL - must be of sufficient duration to absorb losses when needed
- FULL FLEXIBILITY OVER PAYMENTS TO INVESTORS tier 1 capital can have no mandatory payments to investors
- CAPITAL COMPOSITION LIMITS
Requires insurers to have sufficient quantities of high quality capital
SCR is the quantity of capital which will provide….
protection over the following year up to the statistical level of a 1 in 200 year event so insurers can withstand all but the most severe of shocks
MCR is the level…
Below which policyholders will be exposed to an unacceptable level of risk and is intended to correspond to an 85% probability of adequacy over the following year
SCR and MCR are trigger points in the ?????
Supervisory ladder of intervention
Insurers need to ensure that their internal models
Reflect the true risk profile of the firm and are used and understood by the business
What is the SFCR
Solvency Financial Condition Report
What should the SFCR contain?
An explanation of the insurers approach to Solvency II including use of an internal model and any non compliances with the regulation
What is the purpose of the PRA’s Senior Insurance Managers Regime
Ensure the accountability of senior management in the insurance sector
What is an ORSA
Own risk and solvency assessment
Are ORSAs required in other jurisdictions such as the USA
Yes
What do firms need to consider in an ORSA
Risks that effect their business plan over a time period of greater than a year eg climate change
Crude quantitive limitations on insurers investment decisions have been replaced by
The prudent person principle which places responsibility for investment decisions on the firm’s management
