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M92 Insurance, Business and Finance - AF > Learning Objective 8 - Chapter 10 ( 3 marks) > Flashcards

Learning Objective 8 - Chapter 10 ( 3 marks) Flashcards

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1
Q

what are rating agencies used for?

A

Large insurance / reinsurance companies pay rating agencies to provide an opinion of their financial strength which is a measure of their ability to pay claims under their insurance policies and contracts

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2
Q

who are the four main rating agencies?

A

Standard & poors, A M Best, Moodys and fitch

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3
Q

why is it important to know the financial rating of an insurer?

A

a high rating indicates a lower chance of the insurer going into liquidation and thus not being able to pay claims.
- it demonstrates to policy holders that a third party has measured the likelihood of them meeting their financial commitments
- it allows for financial strength comparisons against different insurers
- Insurers with extremely strong (AAA) ratings are able to charge higher premiums
-

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4
Q

what are the 8 factors within a typical analytical framework that would be used in the rating processes?

A
  • Economical and industrial risk
  • competitive position
  • management and corporate strategy
  • enterprise risk management
  • operating performance
  • investments
  • capital adequacy
  • liquidity
  • financial flexibility
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5
Q

what part of the rating process looks at the environmental framework that an insurance company operates?

A
  • the economic and industrial risk part
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6
Q

What part of the rating process looks at the profile of the business mix in terms of competitive strengths and weaknesses?

A
  • Competitive position
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7
Q

what part of the rating process looks at the quality and control of an insurers senior management team and the strategy it has set?

A

the management and corporate strategy part

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8
Q

what part of the rating process looks at the method by which a company manages its risk i.e severity of risk, risk mitigation, etc?

A

The Enterprise risk management (ERM) part

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9
Q

What part of the rating process looks at the performance ratios i.e loss ratio, expense ratio, combined ratio, return on equity etc

A

The operating performance part

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10
Q

What part of the rating process looks at the insurers investment strategy?

A

The investment part

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11
Q

What part of the rating process looks at the quality of level of capital required to run the business based on the risk adopted?

A

capital adequacy

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12
Q

What is the part of the rating process that looks at the ability to manage cash flows efficiently and easily borrow money if required?

A

Liquidity

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13
Q

What is the part of the rating process that looks at the insurers potential need for additional capital or liquidity in the future

A

Financial flexibility

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14
Q

what rating companies also show - & + signs?

A

S&P and fitch

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15
Q

what is one main critic on the credit rating process?

A

That agencies do not downgrade companies promptly enough

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16
Q

what is one main example of the credit rating agencies not downgrading companies quick enough?

A

Enrons - their rating remained at investment grade 4 days before they went bankrupt despite the fact that the agencies has been aware of the issues for months

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17
Q

What is a yield spread?

A

This is the difference between the yield on a bond and a benchmark of a yield)

Yield spreads may be a good early indicator of deteriorating financial strength.

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18
Q

if a company has a rating of AAA what does this indicate?

A

That the company may be overcapitalised and the ROE (return on equity) is depressed.

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19
Q

What is the overriding regulatory requirement put on alll firms in terms of financials?

A

’ 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’.

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20
Q

who would determine an insurance companies risk appetite?

A

The board

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21
Q

What 6 things may usually be included within an insurance companies risk appetite statement?

A
  • The statement of risks that is acceptable for the company to bear.
  • What risks are not acceptable
    -The probability of failure that is deemed to be acceptable
  • The maximum loss that is acceptable from any one accident
    -The target level of financial security
  • The quality and diversity of investments
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22
Q

what should the scale of probability of failure be according to the PRA?

A

The PRA states that the probability of failure should not be higher than one chance in two hundred over a 12 month scale. An insurance company may wish to target a higher confidence level if, for example, they wanted to reach a strong financial strength rating

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23
Q

What is the risk appetite used for by the insurance company?

A

To set:
-The risk acceptance criteria
- an investment policy
-a reinsurance policy
-other financial and risk policy statements

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24
Q

what can be used to minimise exposure to risks that an insurance company does not want to bear, limit exposure to catestrophe events and act as a capital substitute?

A

Reinsurance

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25
Q

who governs the regulatory regime for solvency/financials?

A

Solvency II

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26
Q

When was the solvency II directive introduced?

A

January 2016, replacing the Solvency I directive

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27
Q

What does the solvency II directive set out to establish?

A

A set of EU-wide capital requirements, valuation techniques and risk management standards with the intention to enhance policyholder protection and create a safer, more resilient insurance sector

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28
Q

what has the impact of brexit been on the Solvency II directive which governs on a EU wide basis?

A

The Solvency II directive is still being used today in the UK,. Post brexit - the PRA is consulting on some of the more controversial aspects of the requirements to see if changes should be made.

29
Q

what are the three pillars to the Solvency II requirements?

A
  • Pillar 1 - Financial requirements
  • Pillar 2 - Governance and supervision
  • Pillar 3 - Reporting and disclosure
30
Q

what is the first pillar of the solvency II requirements and what does it set out?

A

Pillary 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 (SCR) and minimum capital requirements (MCR) through either an approved full or partial internal model or the standard formula approach

31
Q

According to Pillar 1 - Financial requirements within the solvency II requirements, what are the rules arround an insurance companies financials?

A

An insurance companies balance sheet is to be based on the principal of market-consistent valuations. Essentially, this means that the value of assets and liabilities refflect the current value at which they could be traded in financial markets rather than their original accounting value.

32
Q

How are reinsurance assets calculated?

A

On a best-estimate basis

33
Q

what is regulatory capital?

A

This is qualifying capital that satisfies regulatory requirements

34
Q

What does Solvency II’s interpretation of the marke value of insurers liabilities require insurers to do?

A

This requires insurers to forecast expected future liability cash flows then discount them using a risk free interest rate of an appropriate maturity, to arrive at a ‘best estimate’. a ‘ risk margin’ is added to this best estimate in order to produce a market consistent value.

35
Q

Why is the way that an insurers liabilities market value is calculated different to the market value calculation of a normal company?

A

Assets are usually traded in sufficiently deep and liquid markets that provide readily available prices, which are generally traded to be market values, however this kind of market doesnt exist for insurance liabilities as these are always specific to the contract between the firm and the policy holder

36
Q

will capital available for solvency II purposes differ from the capital available as shown in the insurance companies published accounts?

A

Yes

37
Q

how many forms does solvency II classify capital into?

A

3 - which is broadly speaking, seperates capital on its ability to absorb losses

38
Q

What is tier 1 capital according to solvency II?

A

Teir 1 capital includes equity and retained earnings. This is the highest quality of capital and must be able to absorb losses on a day -to-day, ongoing basis.

39
Q

What is tier 2 capital according to solvency II?

A

Tier 2 capital includes subordinated debt. This is of a lower quality and only needs to absorb losses on insolvency

40
Q

What is tier 3 capital according to solvency II?

A

Tier 3 capital is the lowest quality of capital permitted and has only limited loss absorbing capacity. It is unlikley that firms will have significant quantities of tier 3 capital under Solvency II

41
Q

what is business capital?

A

The money a firm has available

42
Q

what are the 4 main measures that solvency II has introduced to improve the quality of capital held by insurance firms?

A
  • Effective loss absorbency: High quality tier 1 capital must be able to absorb losses effectively - either automatically or through a mechanism to absorb losses when defined ‘trigger points’ are breached

-Duration of capital: Capital must have a sufficient duration to be reliably able to absorb losses when needed. S II imposes strict requirements for those forms of capital that are not perminent

  • Full flexibility over payments to debtors: for tier 1 capital there must not be any mandator payments to investors.
  • capital composition limits: solvency II requires insurers to have sifficient quantities of high-quality capital and limits the amount that can be covered by low quality capital
43
Q

what are the two levels of capital requirements specified in solvency II?

A
  • The solvency capital requirement (SCR)
  • The minimum capital requiremnt (MCR)
44
Q

what is the solvency capital requirement?

A

This is the quantity of capital that is intended to provide against unexpected losses, over the following year, up to the statistic level of 1 in 200 - year event’
This is designed so that insurers should be able to withstand all but the most severe of shocks.

This level acts as an intervention point for supervisors to step in i.e if the firm reaches a capital level below SCR they should consider an action plan to restore its capital position.

45
Q

What is the Minimum capital requirement?

A

This denotes a level below SCR which policy holders 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.

If a firm is at this level, regulatory action is taken and the firm must submit a plan for approval, explaining how it will restore capital above the MCR within three months. If the firm is unable to do so, is authorisation may be withdrawn.

46
Q

what are the two basic options available in case of inadequate regulatory capital?

A
  • Raise more capital - this could be by means of:
47
Q

what are the two basic options available in case of inadequate regulatory capital?

A
  • Raise more capital - this could be by (1) issuing new shares in a ltd company, (2) issuing long term debt that meets the PRA requirements for teir 1 or tier 2 regulatory capital

or

  • Reduce the capital regulatory requirement - i.e (1) the volume of business written, particularly in lines which geberate hgh capital requirements, (2) increasing reinsurance, (3) switching out of higher risk asset such as equities, into lower risk ones such as government bonds
48
Q

how do most firms calculate their SCR (solvency capital requirements)?

A

By using a ‘standard formula’ - standardised calculation intended to capture the risk profile of most insurance firms. first they need to identify risks which are relevent to their business, such as market and insurance underwriting risks. A prescribed calculation is then used to determine the quantity of capital required to cover these risks.

or they may use an internal model. several tests and standards are set out in solvency II, which an internal model needs to satisy in order to gain regulatory approval. including the use test .

49
Q

What is the ‘use test’?

A

This is used to verify that internal models are employed not just to satisfy the regulatory requirement of calculating the SCR but also as a tool that is part of a firms wider risk management and decision-making process.

50
Q

what else can an internal model be used for?

A
  • Pricing
  • Portfolio target returns
  • reinsurance purchasing
  • investment selection
  • dividend decisions
51
Q

why is continuous monitoring of internal models needed?

A

To verify that, following approval of an internal model, it continues to reflect the true risk profile of a firm and is used and understood appropriately within the business.
When considering ongoing appropriateness of internal models, the pra will consider the lessons learnt from the use of models in the banking industry.

52
Q

what does the second pillar of solvency II set out?

A

Governance and supervision.

53
Q

why is good governance and supervision important within firms and what study is used to back this up?

A

Good governance practices is fundamental in solvency II and prudential regulation framework. Sharma et al 2002., identified a casual relationship between firms that fail and those that are inherently vulnerable due to underlying management or operational weakness.

54
Q

what is the purpose of the Senior Managers and Certification Regime (SM&CR) that was produced by the PRA?

A

This is intended to ensureaccountability of senior managers within the insurance sector, making sure they have clealry defined responsibilities and are behaving honestly, with integrity and competence.

55
Q

what is the purpose of the Senior Managers and Certification Regime (SM&CR) that was produced by the PRA?

A

This is intended to ensureaccountability of senior managers within the insurance sector, making sure they have clealry defined responsibilities and are behaving honestly, with integrity and competence.

56
Q

what is the Own Risk and Solvency Assessment (ORSA)

A

This is a assesment taken by insurers to ensure a comprehensive approach to considering their risks, imposed by Solvency II requirements. The ORSA should help firms to understand and manage all the risks they are exposed to

57
Q

where else is ORSA used?

A

Many countries adopt the requirement to prepare an ORSA, including tthe USA - especially for large and medium sized US insurers.

58
Q

What is the ‘prudent person principal’?

A

This is an approach to regulation that places responsibility for investment decisions on a firms management, The PRA will then form judgements on the ability of a firms management to idenify, manage and mitigate investment risks.

59
Q

how is a complex insurance groups structure, whereby it consists of a mixture of regulated and non-regulated entities that may operate accorss different regulatory jurisdictions, managed by Solvency II?

A

Solvency II contains additional governance and reporting requirements to facilitate group supervision.

60
Q

What does pillar 3 of solvency II requirements set out?

A

Reporting and disclosure.

61
Q

Why did solvency II introduce new reporting and disclosure requirements?

A

With the aim of improving the availability of information to the market.

62
Q

How does solvency II ensure bettwe reporting and disclosure proceedures are taken up by companies?

A

They have imposed a requirement that firms have to publish a Solvency and Financial Condition Report (SFCR) annually. and will also need to disclose additional information privately to regulators within a Regulator Supercisory Report.

63
Q

what is a firm required to do if they are non-compliant with SCR?

A

They have to disclose the non -compliance with the SCR in the Solvency and Financial Condition Report, they have to explain the causes and consequences of the non-compliance and also disclose measures taken to resolve the breach.

64
Q

What is Stress and Scenario testing and why is it important?

A

This is when firms consider the potential impact of adverse circumstances to their business. This is very important within the firms planning and risk management processes, helping them to identify, analyse and manage risks.

65
Q

what are the requirements on S&S testing on insurers?

A

Insurers are required to develop and implement effective S&S testing programmes that assess their ability to meet capital and liquidity requirements in stressed conditions.

Insurers are also required to undertake ‘reverse stress tests’

reverse stress tests are stress tests that require a firm to assess scenarios and circumstances that would render its business model unviable, thereby identifying potential vulnerabilities.

66
Q

What is the PRA’s impact on S&S testing?

A

The PRA also runs its own stress tests on a periodic basis for a number of firms. It does this regularly for specific high-impact firms and for other firms as the need arises, to assess their ability to meet minimum specified capital levels throughout a stress period.

System-wide stress testing is also undertaken by firms using a common scenario for
financial stability purposes.

To support its framework, the PRA sets policy for firms’ stress testing requirements, sets
stress scenarios and monitors test results.

67
Q

What is ‘reverse stress testing’?

A

These are tests that require a firm to assess scenarios and circumstances that would render its business model unviable, therby identifying potential business vulnerabilities.

Undertaken by insurers

This is primarily designed to be a risk management tool, encouraging firms to explore more fully the vulnerabilities and fault lies in its busniess model, including tail risks. and to explore potential mitigating actions.

68
Q

how does reverse stress testing differ from usual S&S testing

A

This differes from general stress and scenario testing as S&S testing tsts for outcomes arising from changes in circumstances but RST are for senarios and circumstances already there causes the market to lose confidence in the firm.

69
Q

what are solvency II requirements on actuarual functions?

A

Solvency II specifies the requirement for an actuarial function.

Access to actuarial knowledge is deemed indispensable to an adequate system of governance, according to regulators.

M92 Insurance, Business and Finance - AF (6 decks)

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