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Exam 6 > Solvency II > Flashcards

Solvency II Flashcards

1
Q

3 pillars of Solvency II

A

Pillar 1: Quantitative Requirements (quantification)

Pillar 2: Supervisory Review (governance)

Pillar 3: Supervisory Reporting / Public Disclosure (transparency)

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2
Q

3 Quantitative Requirements for Pillar 1

A
  • calculation of technical provisions (reserves). These are valued at IFRS fair value
  • calculation of solvency requirements
  • investment management
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3
Q

Describe the two separate capital requirements of Pillar 1

A
  1. Solvency Capital Requirement (SCR): the necessary economic capital to limit the probability of ruin of the firm to 0.5% (99.5% VaR). The company may be subject to supervisory action if it drops below this level.
  2. Minimum Capital Requirement (MCR): the insurer will not be allowed to operate if the capital drops below this level
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4
Q

The liabilities & surplus are divided into what components under Solvency II

A
  • technical provisions (including reserves & risk margin): represents fair value of liabilities
  • minimum capital requirement
  • solvency capital requirement (which actually includes the MCR)
  • free surpus (Assets - technical provisions - SCR)
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5
Q

3 methods to calculate the Solvency Capital Requirement

A
  1. Standard formula: a factor based method designed to be a conservative approximation of the 99.5% VaR
  2. Internal models
  3. Partial Internal models combined with parts of the Standard formula
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6
Q

List of components considered by the Standard formula

A
  • market risk (interest rate, equity, property, currency)
  • counterparty default risk (either from risk mitigation devices (reinsurance) or receivables from intermediaries)
  • life risk
  • non-life risk (premium, reserve, catastrophe)
  • health insurance risk
  • operational risk
  • adjustment for deferred taxes
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7
Q

2 Reasons Solvency II encourages firms to use internal models

A
  • better alignment between the firm risk and capital requirements
  • stronger risk management culture
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8
Q

Purpose of Pillar 2

A

This provides supervisors with:

  • means of identifying firms with a higher risk profile
  • ability to intervene
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9
Q

What does the Supervisory Review Process (SRP) review/ evaluate?

A
  • that the insurer’s strategies, processes & reporting procedures comply with Solvency II
  • the firm’s risks & its ability to evaluate those risks
  • focused on the qualitative aspects of supervision
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10
Q

Pillar 2 requires that insurers have implemented a governance structure to address which functional areas

A
  • internal audit: produce annual report about any deficiencies of the internal controls & any shortcomings in compliance with internal policies & procedures
  • actuarial:
    1) ensure the methods and summations used to derive the technical provisions are reasonable
    2) perform a retrospective analysis of best estimates vs experience
    3) opine on the overall underwriting policy and adequacy of reinsurance arrangements
  • risk management:
    1) monitoring the risk management function & maintaining an aggregate view
    2) ensure that the internal model has been integrated with the risk management function
  • compliance
    1) ensure that the internal control system is effective to comply with all applicable laws & regulation
    2) promptly report any compliance issues to the board
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11
Q

Describe the Own Risk & Solvency Assessment (ORSA)

A

An internal assessment of the solvent need based on the risk profile.
- the entirety of the processes and procedures employed to identify, assess, monitor, manage, and report the short and long term risk a (re)insurance undertaking faces or may face and to determine the own funds necessary to ensure that the undertaking’s overall solvency needs are met at all times.

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12
Q

2 objectives of ORSA

A
  • tool for decision making

- too for supervisors to better understand the firm’s risk

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13
Q

What should ORSA assess, at a minimum

A
  • overall solvency need (based on the specific risk profile, approved risk tolerance limits, business strategy)
  • compliance with capital requirements & the requirements of the technical provision
  • extent to which the risk profile deviates significantly from the assumptions underlying the SCR (solvency capital requirement)
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14
Q

What does Pillar 3 focus on?

A
  • increasing the transparency of the insurers risks & capital position
  • provides the means by which the capital & regulatory position derived from Pillars 1 & 2 are reported to the supervisor & financial markets
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15
Q

What is the intention of Pillar 3?

A
  • intention is to provide the market with sufficient information to exercise its disciplinary function
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16
Q

What tools does US regulators have to address solvency concerns?

A
  • RBC
  • On site examinations
  • Off site financial analysis
  • Required independent audits
  • Stress testing of future cash flows (life insurers)
  • Detailed financial reporting
17
Q

4 functions of the NAIC Risk Focused Surveillance Framework

A
  • risk focused exams
  • off site risk focused financial analysis
  • examination of internal and external changes in the organization
  • annual supervisory plan for the insurer
18
Q

Provide examples of the interstate coordination in US regulation

A
  • uniform reporting system between states
  • financial statements are filed with NAIC. These are made available to all states on a centralized database
  • NAIC conducts a centralized financial analysis of multistage insurers
19
Q

Differences between US regulation & Solvency II regarding role of Internal models

A

Use of Models:
US:
- slowly introducing internal models, several limits on these models
- companies will use an internal model if it engages in a specific business that is exposed to risks not well captured in the standard model
S2:
- internal models are encouraged

Model Review:
US: regulators rely on the insurer’s actuaries to ensure that the model & results are appropriate
S2: Supervisors review the models & need to authorize their use

Model Metrics:
US: depend on TVaR
S2: depend on the 99.5% VaR

20
Q

List some other differences between US regulation & Solvency II

A

Capital Requirements:
US: the standard formula is not calibrated to a particular VaR/TVaR target
S2: capital requirements are based on a consistent standard (99.5% VaR)

Risks Captured:
US: different to Solvency II (eg excludes cat & operational risk)
S2: different to US

Calculation of reserves:
US: calculates the greatest PV of the deficit under several possible scenarios. Reserves are derived using a TVaR approach
S2: “Market consistent approach”

Investment Restrictions:
US: Rules based & Prudent Person approach
S2: Prudent Person approach

ORSA:
US: nothing comparable to ORSA
S2: uses ORSA

21
Q

List 3 reasons for the historical shift in focus from rules based to principal based regulation

A
  1. due to increasing complexity, the rules based approaches can not adequately address the differences among companies
  2. insurers will try game the system of rules based regulation
  3. rules based systems tend to stifle evolution
22
Q

What do the supervisors focus on in principle based regulation?

A

Ensuring that the insurers:

  • have effective risk management systems in place
  • are identifying & controlling their risk
  • are holding the right capital based on their risk exposure
23
Q

3 assumptions behind the theory that principle based regulation will work well since insurers should be enhancing their risk management due to the increased complexity of the market

A
  1. companies have an incentive to properly manage risk
  2. regulators can distinguish between firms that did and did not effectively manage risk
  3. regulators would take action once they identify a firm that did not effectively manage a risk
24
Q

3 criticisms of using internal models in solvency regulation

A
  • the inputs to the models are often too optimistic, as they are derived from periods with good experience
  • incorrect underlying assumption that the past can fully predict the future
  • structure of the models
  • failure to account for extreme changes in correlation during troubled times
  • tendency of firms to ignore certain risks
  • internal models don’t necessarily prevent regulatory arbitrage
25
Q

2 types of errors of the RBC system currently used in the US

A
  • Type 1 error: some firms that are destined to fail are incorrectly treated as healthy
  • Type 2 error: some healthy firms are incorrectly treated as troubled
26
Q

Some red flags that the regulators should look for, to complement the various regulatory tools and capital requirements

A
  • excessive growth
  • excessive use of reinsurance
  • unusual investment strategies
  • new line of business
27
Q

2 advantages of having multiple regulators reviewing an insurer

A
  • less likely that there will be regulatory error

- more likely that the regulator will take action if the insurer runs into trouble

28
Q

3 advantages of the US regulation system

A
  • checks and balances: less chance that a mistake will get though
  • combination of Principles Based & Rules Based regulation: Rules based regulation will address the potential for regulatory errors. Principle based rules will account for the increasing diversity and complexity of insurance
  • Importance of Other Supervisory Tools
29
Q

List 2 improvements that can be made to US regulation

A
  • establish model based catastrophe charge for earthquake & hurricane risk
  • refinements to structure of RBC asset charges

Exam 6 (31 decks)

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