Chapter 3: Solvency Assessment and Management (SAM) Flashcards
SAM is based on 3 principles
- principles-based regulatory framework
- based on an economic balance sheet view
- structured on 3 pillars:
- — capital adequacy
- — systems of governance
- — reporting requirements
Objectives of the SAM regime
Primarily: POLICYHOLDER PROTECTION
- to align capital requirements with the underlying risks.
- a PROPORTIONATE, RISK-BASED SUPERVISION with appropriate treatment for all insurers.
- incentivize use of more SOPHISTICATED TOOLS for risk monitoring and risk management - e.g. internal capital models, risk mitigation and risk transfer tools.
- to maintain FINANCIAL STABILITY.
SAM Requirements:
Pillar I
QUANTITATIVE REQUIREMENTS to demonstrate that insurers have adequate financial resources.
The ECONOMIC BALANCE SHEET approach allows for a consistent treatment of all assets and liabilities, calculated at MARKET CONSISTENT values.
MCR
the minimum amount of capital below which no insurer will be allowed to operate.
SCR
a much higher amount and indicates the first “trigger” point at which the regulator would start to intervene in the affairs of an insurer.
Long-term insurers are also required to calculate the Liquidity Shortfall Indicator.
This is a high level assessment of the magnitude of liquidity risk that an insurer may be exposed to following an SCR event.
Valuation of Assets under SAM Pillar I
follows International Financial Reporting Standards (IFRS):
- market consistency
- economic (fair value) valuation approach
Minor deviations from IFRS (intention being to be closer to an economic valuation):
- Goodwill valued at zero.
- Other intangible assets should only be included such that a fair value can be placed on them.
- Property valued at fair value.
Participations in subsidiaries, associates and joint ventures are valued using a market value approach, being a quoted market value or, if this is not available, a market consistent valuation.
Reinsurance assets
- shown as an asset on the balance sheet
- should allow for expected losses due to default of the reinsurer.
SAM:
Valuation method of the technical provisions
Technical provisions are calculated using market consistent principles.
They consist of:
= best-estimate liabilities
+ a risk margin.
Best-estimate liability
= probability-weighted average of future cash flows,
(taking account of the time value of money by discounting using a risk free yield curve)
Risk margin
represents the premium over and above the best-estimate liabilities that a third party would be willing to pay to assume obligation to the policyholders.
Best-estimate liabilities should be calculated GROSS OF REINSURANCE, with reinsurance recoverables reflected explicitly as an asset in the balance sheet.
SAM: Best estimate liabilities
Determined as the discounted value of projected cash flows under each policy up to the “contract boundary”, calculated on a policy-by-policy basis.
The assumptions should be best-estimate with no additional margins for prudence.
SAM:
Risk-free discount rate
The risk-free discount rate used in the calculation of the technical provisions shall in general be the government bonds curve.
SAM
Risk margin
The risk margin represents the premium over and above the best-estimate liabilities that one insurer would require to take on the obligations of another insurer.
It represents the theoretical compensation for the risk of future experience being worse than assumed in the calculation of the best-estimate liabilities.
SAM
Basic own funds
Basic own funds are defined in the market consistent value balance sheet as
… the excess of assets over liabilities,
… plus subordinated liabilities,
… less any regulatory adjustments.
Regulatory adjustments are made for:
- certain ineligible assets,
- holdings in own holding company shares,
- cash and deposits at a bank in the same financial conglomerate,
- restricted reserves,
- participations in financial and credit institutions, and
- for any ring-fenced funds.
SAM
Ancillary own funds
Off-balance sheet capital resources that can be called upon to absorb losses.
Such contingent capital items would include instruments such as letters of credit and guarantees.
SAM
Available own funds
basic own funds
+ ancillary own funds
Tiers of available own funds
3 tiers.
Tiering according to a strict range of criteria, e.g. whether the instrument is immediately available to absorb losses at its full value.
Limits apply as to the proportion of Tier 1, Tier 2 and Tier 3 own funds that can be used to cover the SCR and the MCR.
These limits may result in some of the own funds being regarded as ineligible for the purposes of determining solvency.
The SAM non-life underwriting risk module consists of 4 sub-modules
a) the non-life PREMIUM AND RESERVE RISK sub-module
b) the non-life LAPSE RISK sub-module
c) the non-life CATASTROPHE RISK sub-module and
d) an optional adjustment to the basic non-life underwriting risk capital to allow for the loss-absorbing or amplification capacity of features of (re)insurance contracts that involve an element of risk sharing between one or more of the parties to the agreement.
SAM:
Non-life lapse risk
Non-life lapse risk should be quantified where insurance contracts include policyholder options which significantly influence the obligations arising from them.
(e.g. an option to terminate a contract before the end of a previously agreed insurance period or an option to renew a contract according to previously agreed conditions)
SAM:
2 Scenarios considered for the purpose of calculating non-life lapse risk
lapseshock1:
Lapsing of 40% of the insurance policies for which lapsing would result in an increase of technical provisions without the risk margin.
lapseshock2:
Decrease of 40% of the number of future insurance or reinsurance contracts used in the calculation of technical provisions associated to insurance or reinsurance contracts to be written in the future.
SAM:
Non-life catastrophe risk (4 sub-modules)
The non-life catastrophe risk is determined using a complex series of formulae defined in various sub-modules of the calculation, and comprises:
- NATURAL CATASTROPHE risk sub-modules, sub-divided: earthquake/hail
- a sub-module for catastrophe risk of NON- PROPORTIONAL PROPERTY REINSURANCE
- a MAN-MADE CATASTROPHE risk sub-module, sub-divided between —-- motor vehicle, —— liability, —— fire, marine, —— aviation, —— liability, —— terrorism, —— accident and health; —— trade credit and consumer credit.
- a sub-module for OTHER NON-LIFE CATASTROPHE risk not considered previously by zone or peril.
SAM:
Calculation of Final SCR Requirement
Individual capital requirements are combined using pre-specified correlation matrices, in order to allow for diversification between different risks.
Separate correlation matrices are used to aggregate capital requirements,
- first WITHIN SPECIFIC RISK MODULES
(e.g. combining the capital requirements for global, SA and other equities to get the diversified equity price risk capital requirement), and
- then ACROSS RISK MODULES within the broad risk categories
(e.g. combining the capital requirements for all risk modules within market risk to give the diversified market risk capital requirements), and
- then finally across market risk, life underwriting risk and non-life underwriting risk
to give the BASIC SCR (BSCR).
The OVERALL SCR is obtained by adding the capital requirements for insurance participants within the same sector (i.e. any life insurance participants) and operational risk, and adjusting for the loss absorbing capacity of deferred taxes.
The loss absorbing capacity of deferred taxes arises as a result of companies being able to reduce any existing deferred tax liabilities or establishing a deferred tax asset following a loss as a result of the SCR event.
The capital requirements for other participants (insurance participants in a different sector and non-insurance participants) are included under equity risk.
SAM:
5 Requirements of an INTERNAL MODEL
The use of a partial or full internal model is subject to regulatory approval, and would be required to satisfy the following key requirements:
- Insurers must have an EFFECTIVE SYSTEM OF GOVERNANCE for the internal model.
- Insurers must demonstrate via the Use Test that the MODEL IS WIDELY-USED in risk management and decision-making, and plays an important role in their system of governance.
- Insurers must meet requirements relating to:
- — statistical quality,
- — data quality,
- — model calibration
- — and validation.
- Insurers must ADEQUATELY DOCUMENT the design and operational details of their internal model.
- Partial models may be approved provided they are sufficiently justified and integrated into the remaining standardised formula.
SAM:
‘The Use Test’ for internal models
The Use Test includes the use of the model in
- decision-making processes,
- business planning,
- risk management,
- capital assessment
- and allocation processes,
- and the Own Risk and Solvency Assessment (ORSA).
SAM:
The SCR attempts to address 4 important shortcomings of the CAR methodology.
- The CAR does not consider the risks arising from assets held in excess of liabilities and the CAR, and therefore does not provide the regulator with the full scope of risks that could impact the insurer’s solvency position.
- The CAR uses a fairly simplistic approach to correlating risks.
- The CAR excludes certain risks which are now covered in the SCR, such as lapse risk, catastrophe risk and non-proportional reinsurance risk mitigation.
- The capital requirements for short-term insurers and long-term insurers were not calculated on a consistent basis, potentially resulting in regulatory arbitrage.
SAM:
6 Shortcomings of the standardised formula which need to be adressed in an internal model.
- The use of multiple correlation matrices is theoretically invalid and can result in inaccuracies in the correlations between risks.
- It may not be appropriate for fast growing or closed books
- Operational risk is modelled at a very high level with no link to the insurers’ actual risk management framework.
- It does not allow for non-linearity between risks. This refers to situations where the capital required for two risks occurring simultaneously is greater than the sum of the capital required for each risk individually.
- Complex risk management techniques such as dynamic hedging and certain reinsurance structures cannot be allowed for in the standardised formula.
- The allowance for the risk sharing inherent in cell captive business between third party cells and the promotor cell is allowed for on an approximate basis, which may overstate the SCR for this business.
SAM:
MCR
Establishes a lower bound for the required solvency capital, below which policyholders and beneficiaries would be exposed to an unacceptable level of risk if the insurer were allowed to continue its operations.
The MCR is the minimum amount of capital below which no insurer will be allowed to operate.
It is calibrated (at a high level) at the Value-at-Risk of the basic own funds of an insurer or reinsurer, subject to a confidence level of 85% over a one-year period.
2 Main elements contained in Pillar 2 of Solvency II
- the Own Risk and Solvency Assessment (ORSA)
- the Supervisory Review Process (SRP)
Define the ORSA
Processes and procedures to: - identify, - assess, - monitor, - manage, - and report long- and short term risks an insurer faces / may face
To determine the OWN FUNDS NECESSARY to ensure overall solvency needs are met at all times.
Under ORSA, insurers conduct at least annually, and at any instance of a material change in the risk profile of the business, a SELF-ASSESSMENT of their risks and the level of solvency needed to cushion those risks.
