ENSURING SOLVENCY Flashcards
What does a life insurer need capital for?
- protection against adverse experience
- funding new business
- supporting a riskier investment strategy
- funding overheads and developmental costs (upgrades/new computer software/product development)
- acquiring other companies and or blocks of business
- satisfying solvency valuation requirements
- supporting with-profits bonuses and their smoothing
- providing day to day working capital.
Reasons for projecting solvency
- allow assessment of key business strategy decisions
- show amount of new business strain that can be supported by available capital
- determine maximum volume of new business that can be written
- help create funding plans when available capital is insufficient
- essential for preparing run-off plans for closed or declining with-profits funds
- estimate pattern of capital releases to shareholders
- used to assess cost of capital in embedded value calculations
- play important role in risk measurement and risk management
- required as part of the Own Risk and Solvency Assessment (ORSA) process under SAM regulations
What regulatory adjustments need to be made to calculate basic own funds?
Basic own funds, will be used to calculate solvency capital:
- cannot have ineligible assets (assets not recognized for regulatory purposes)
- can’t count your own shares as capital
- can’t count capital/reserves that is restricted
- cannot count participations in financial/credit institutions
What are the key requirements of using an internal model to calculate SCR?
- insurers must have an effective system of governance for the internal model (must develop and maintain a model change policy that sets out the processes and controls that they will adhere to when implementing changes (both
major and minor) to 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 a
What is the use test?
- need to demonstrate internal model is wide-used in risk management and decision making
- show used in business planning,
risk management, capital assessment and allocation processes, and the Own Risk and Solvency
Assessment (ORSA).
Why are prudential supervision liabiltiies lower than IFRS liabilities?
Different Valuation Objectives:
IFRS aims to represent the economic reality of contracts over their lifetime
Prudential supervision focuses on the current transferable market value of liabilities
Market Consistency Requirements:
Prudential supervision requires market-consistent valuations
This means using market-observed discount rates that are typically higher than those used under IFRS
Higher discount rates = lower present value of liabilities
Risk Margin Differences:
While prudential frameworks do include risk margins, they’re often calculated differently than IFRS risk adjustments
IFRS may include additional margins for certain contract features
Profit Recognition:
IFRS (especially IFRS 17) defers profit recognition through mechanisms like the Contractual Service Margin
Prudential frameworks generally recognize profits earlier, resulting in lower liabilities
How is prudence applied if not through higher liabilities in the prudential supervision basis?
Capital Requirements: Requiring additional capital (SCR) on top of the market-consistent liability valuation
Stress Testing: Requiring capital to withstand severe scenarios
Asset Quality Rules: Restrictions on what assets can back liabilities
What are the shortcomings of the calculation method of SCR?
l The use of multiple correlation matrices is theoretically invalid and can result in
inaccuracies in the correlations between risks.
l It may not be appropriate for fast growing or closed books.
l Operational risk is modelled at a very high level with no link to the insurer’s actual risk
management framework.
l 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. A common area where this can occur is in
an annuity book, where longevity risk impacts the duration of the liability, which then
changes the interest rate risk.
l Complex risk management techniques such as dynamic hedging and certain
reinsurance structures cannot be allowed for in the standardised formula.
l The standardised formula only adjusts for potential double counting of the loss
absorbing capacity of technical provisions in the market risk module. For policies where
the insurer is able to vary future bonus rates or alter premiums and charges in response
to non-market shocks, there is a risk of double-counting that is not captured in the
standardised formula.
l The allowance for the risk sharing inherent in cell captive business between third party
cells and the promoter cell is allowed for on an approximate basis, which may overstate
the SCR for this business.
What criteria are considered in order to be considered capital under eligible own funds?
LSD REM (uneration)
1. Loss absorbency: These funds must be able to absorb losses - meaning they can be used to cover unexpected costs or claims without the company becoming insolvent.
2. Subordination: In case of financial trouble, these funds are “last in line” for repayment - they only get paid after policyholder claims and other creditors.
3. Sufficient duration: The funds must be available for a long enough period to properly support the insurance business, not just short-term financing.
4. Free from requirements and incentives to redeem: There shouldn’t be conditions forcing or encouraging the company to pay these funds back at inconvenient times.
5. Free from mandatory costs: The funds shouldn’t come with unavoidable, fixed payment obligations (like guaranteed interest payments) that the company must pay regardless of its financial situation.
6. Free from encumbrances: The funds can’t be tied up or pledged for other purposes - they must be fully available to absorb losses when needed.
What is the difference between MCR and SCR?
- The prescribed Minimum Capital Requirement (MCR) is the absolute minimum level of eligible own funds that the Prudential Authority considers necessary to protect policyholders
- The prescribed Solvency Capital Requirement (SCR) is the level of eligible own funds required to ensure the value of assets will exceed technical provisions and other liabilities at a 99.5% level of certainty over a one-year time horizon.
What kind of operational expenses are used to calculate the absolute floor of MCR?
Gross annualised expenses incurred in carrying on an
insurer’s day-to-day activities including claims handling
expenses, management expenses, asset management and
fund management fees.
What is excluded from operational expenses which are used to calculate the absolute floor of MCR?
New business costs: Any expenses for acquiring new customers
Inventory write-downs: When you reduce inventory value to what you could sell it for
Property/equipment depreciation: When you reduce asset values to recoverable amounts (and any reversals)
Restructuring costs: Expenses for reorganizing the company (and any provision reversals)
Property disposal: Costs related to selling buildings or equipment
Long-term investment sales: Expenses from selling long-term investments
Disaster/expropriation impacts: Gains or losses from natural disasters or government takings
Linked policy fees: Asset and fund management fees specifically for linked policies
Market risk
Category 1: Market risk
- Equity risk: global equities, SA equities, other equities
- Interest rate risk: up scenario, down scenario
- Property risk: commercial, residential, geographic regions
- Spread risk: by credit rating, by duration
- Currency risk: by individual foreign currencies
- Concentration risk: by individual counterparty exposureds (counterparty diverisification, exposure limits)
What kind of risk categories are there?
- Market risk
- Underwriting risk (life and non-life)
- Operational risk
- Counterparty default risk.
Underwriting risk
Non life
- Lapse risk: mass lapse, permanent increase, permanent decrease (customer retention strategies, product redesign)
- CAT risk: pandemic, natural disaster, terrorism (reinsurance, geographic diversification, risk selection)
- Mortality risk: permanent increase (repricing, reinsurance, underwriting changes)
- Longevity risk: permanent decrease in mortality (product design, reinsurance, longevity swaps)
- Disability/Morbidity risk: permanent increase, permanent decrease (claims management, repricing, underwriting changes)
- Expense risk: absolute addition to expense inflation and increase in expense inflation (cost-cutting, operational efficiencies, outsourcing)
Counterparty default risk
Default risk
- Type 1 exposures (reinsurance, derivatives, deposits)
- Type 2 exposures (receivables, mortgage loans)
(counterparty selection, collateral requirements)
Operational risk
Divided by operational risk categories (process improvements, controls, outsourcing)
What effect with smoothed bonus funds have on capital requirements?
- investment guarantees incur insurers lots of risk
- these guarantees relate to vested benefits, death or maturity benefits
- investment risk usually reflected in: how much capital required if equity market values fall by 30%?
- insurer usually holds 1.5 to 3x SCR as capital.
- consider management actions e.g. under-declaring bonuses or removing non-vested benefits, that can lower capital required in extreme situations.
What increases capital requirements?
- increases in investment guarantees (smoothed bonus business)
What can decrease capital requirements?
- management actions e.g. under-declaring bonuses or removing non-vested benefits, that can lower capital required in extreme situations.
