Solvency II Flashcards
3 pillars of Solvency II
Pillar 1: Quantitative Requirements (quantification)
Pillar 2: Supervisory Review (governance)
Pillar 3: Supervisory Reporting / Public Disclosure (transparency)
3 Quantitative Requirements for Pillar 1
- calculation of technical provisions (reserves). These are valued at IFRS fair value
- calculation of solvency requirements
- investment management
Describe the two separate capital requirements of Pillar 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.
- Minimum Capital Requirement (MCR): the insurer will not be allowed to operate if the capital drops below this level
The liabilities & surplus are divided into what components under Solvency II
- 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)
3 methods to calculate the Solvency Capital Requirement
- Standard formula: a factor based method designed to be a conservative approximation of the 99.5% VaR
- Internal models
- Partial Internal models combined with parts of the Standard formula
List of components considered by the Standard formula
- 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
2 Reasons Solvency II encourages firms to use internal models
- better alignment between the firm risk and capital requirements
- stronger risk management culture
Purpose of Pillar 2
This provides supervisors with:
- means of identifying firms with a higher risk profile
- ability to intervene
What does the Supervisory Review Process (SRP) review/ evaluate?
- 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
Pillar 2 requires that insurers have implemented a governance structure to address which functional areas
- 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
Describe the Own Risk & Solvency Assessment (ORSA)
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.
2 objectives of ORSA
- tool for decision making
- too for supervisors to better understand the firm’s risk
What should ORSA assess, at a minimum
- 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)
What does Pillar 3 focus on?
- 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
What is the intention of Pillar 3?
- intention is to provide the market with sufficient information to exercise its disciplinary function
What tools does US regulators have to address solvency concerns?
- RBC
- On site examinations
- Off site financial analysis
- Required independent audits
- Stress testing of future cash flows (life insurers)
- Detailed financial reporting
4 functions of the NAIC Risk Focused Surveillance Framework
- risk focused exams
- off site risk focused financial analysis
- examination of internal and external changes in the organization
- annual supervisory plan for the insurer
Provide examples of the interstate coordination in US regulation
- 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
Differences between US regulation & Solvency II regarding role of Internal models
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
List some other differences between US regulation & Solvency II
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
List 3 reasons for the historical shift in focus from rules based to principal based regulation
- due to increasing complexity, the rules based approaches can not adequately address the differences among companies
- insurers will try game the system of rules based regulation
- rules based systems tend to stifle evolution
What do the supervisors focus on in principle based regulation?
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
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
- companies have an incentive to properly manage risk
- regulators can distinguish between firms that did and did not effectively manage risk
- regulators would take action once they identify a firm that did not effectively manage a risk
3 criticisms of using internal models in solvency regulation
- 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
2 types of errors of the RBC system currently used in the US
- 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
Some red flags that the regulators should look for, to complement the various regulatory tools and capital requirements
- excessive growth
- excessive use of reinsurance
- unusual investment strategies
- new line of business
2 advantages of having multiple regulators reviewing an insurer
- less likely that there will be regulatory error
- more likely that the regulator will take action if the insurer runs into trouble
3 advantages of the US regulation system
- 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
List 2 improvements that can be made to US regulation
- establish model based catastrophe charge for earthquake & hurricane risk
- refinements to structure of RBC asset charges
