Chapter 10 - Financial Strength Of Insurance Companies Flashcards
Rating agencies measure insurance companies ability to ?
Pay claims
What are the four main rating agencies?
Standard and Poors, Moody’s, AM Best and Fitch.
Who generally relies on rating agencies financial strength ratings when placing business?
Commercial customers and brokers
What are four 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
- brokers will likely only deal with companies of a certain rating, e.g A- but none less than this.
Which areas are part of Standard and Poor’s common analytical framework?
- economic and industry risk
- competitive position
- management and corporate strategy
- enterprise risk management
- operating performance
- investments
- capital adequacy
- liquidity
- financial flexibility
What have academics claims may be a good indicator of deteriorating financial strength and why?
Yield spreads.
Do insurance companies and reinsurance companies pay rating agencies to assess 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.
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
What four items would 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
Risk appetite statements are used by an insurance company to set what four item?
- the risk acceptance criteria
- an investment policy
- a reinsurance policy and
- other financial and risk policy statements
What type of insurance can be used as a capital substitute
Reinsurance
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
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.
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 what can an insurer do?
- 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, what can insurer do?
- 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 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
Insurers using an internal model have to pass the use test. The use test requires what?
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.
Solvency II directive specifies the requirement for which function?
Actuarial
Under Solvency II assets and liabilities in an insurer’s balance sheet must reflect…
Their current market 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
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
The Level of capital blow which a firm must submit a plan to the PRA to restore its capital to above this level in 3 months or have its authorisation withdrawn
MCR
Test to see that an insurance company is using its internal capital model to make risk decisions and allocate capital is known as?
Use test
Difference between asses and liabilities is known as
Solvency margin
Process undertaken by insurer to ensure they have sufficient capital is known as?
Maintaining capital adequacy
What capital counts most for regulatory purposes
Tier 1
A statement from a company about the risks it is acceptable to bear, what risks are not acceptable is known as?
Risk appetite statement
Regulators require the value of assets and liabilities in an insurance company’s balance sheet must reflect the value that they could be traded in the financial markets. This is known as what?
Market consistent valuation
What do the PRA require insurers to produce under Pillar II of solvency II which outlines the risks to their business plan, how they intend managing those risks and to demonstrate they have sufficient capital to withstand those risks.
ORSA (Own Risk and Solvency Assessment)
What is the Level of capital below which PRA will intervene and firm will be required to consider and action plan and or reduce its risk profile.
SCR - Solvency Capital Requirement
