CAPITAL ADEQUACY FRAMEWORK FOR LIFE INSURANCE COMPANIES: THE ALTERNATIVE APPROACHES
DR.RAM PRATAP SINHA
ASSISTANT PROFESSOR AND HEAD, DEPARTMENT OF ECONOMICS
A.B.N. SEAL (GOVT) COLLEGE,
COOCHBEHAR-736101
E Mail:
Paper Abstract
The present paper compares the global and Indian scenario with regard to the capital; adequacy frameworks for life insurance companies. In particular, it provides a comparative analysis of the Risk Based Capital framework used in the US with Solvency II being adopted by the European nations in terms of their implications for the life insurers.
CAPITAL ADEQUACY FRAMEWORK FOR LIFE INSURANCE COMPANIES: THE ALTERNATIVE APPROACHES
Introduction:
In the course of their usual business activities life insurance companies are exposed to three major types of risk: insurance risk (originating from an inappropriate underwriting strategy), asset risk( risk of counterparty default, adverse movement in the market value of assets and mismatches in cash inflow and outflows) and operational risk (risks arising form failure of systems, internal procedures and controls leading to financial loss). It is one of the primary duties of insurance supervisory systems to ensure that the Insurance companies have sufficient capital cushion against the risks faced by them in their business operations. Since the nineties, two major approaches have been developed in this regard: the Risk Based Capital system adopted in the US and Japan and the Solvency (I and II) projects for the European nations. The present paper seeks to make a comparison of the two approaches as also to consider the Indian regulatory development relating to capital adequacy in the life insurance sector in the post-deregulation scenario.
Organisation of The Paper:
The paper is organised into four sections. Section I discusses the US Risk Based Capital (RBC) system. Section II discusses the characteristics of Solvency I and II. Section III discusses the Indian capital adequacy framework. Finally, Section IV provides the concluding observations.
Section I: The Risk Based Capital System:
Some countries have moved towards Risk Based Capital (RBC) system for their insurance companies. The fundamental idea behind this approach is to fix risk categories to which an insurance company is exposed, quantify these risk categories and equip them with a specified capital requirement. This stipulation is based on assessment of risk and is considered as the minimum capital amount which is required to cover each specified risk class. These risk based values are further combined into the company level Risk Based Capital, taking cognizance of the correlation between the various risk classes. A definite advantage of such a system is the integrated system of control levels or trigger points. Taking into account the actual risk based capital the levels of intervention by the regulator are laid down.
The risk based capital system for insurance companies originated in the U.S.A. following initiatives from the NAIC (National Association of Insurance Commissioners) in the early 1990s. For the life insurance companies the RBC system came into force from 1993. Prior to this, solvency requirements had substantial inter- state variations and, in some cases, comprised of a relatively low minimum capital requirement.
The Risk Based Capital system operates by allocating capital requirement to each of the major a priori classified risks facing insurance companies. In the life insurance sector the following are the major risks categories identified by the RBC system:
Asset Risk:
Asset risks relate to losses associated with a fall in the market value of assets(market risk) or counterparty failure.
Insurance Risk:
This represents the risk of an adverse development in the mortality or morbidity rate. Insurance risks arise if the premiums are inadequate to cover the risk or there are fluctuations in the claim rate.
Interest Rate Risk:
This represents the risk originating from adverse movement in the rate of interest.
Affiliate Insurers and Other Off-balance-sheet risk:
Risks emerging from affiliate companies and off balance sheet activities of insurers.
Business Risk:
It includes the miscellaneous other risks not included in the previous categories.
Calculation of Risk Based Capital (Individual Components):
Asset Risk:
The capital requirement corresponding to asset risk is computed by multiplying investments by weights ranging from 0% to 30%. In 2001, the N.A.I.C. introduced tax adjustment factors for the weights applicable to investments.
Insurance Risk:
The capital requirement for insurance risk is calculated on the basis of the following:
(i) premiums for permanent health insurance (weights vary from 7% to 35% )
(ii) the capital at risk for insurance against death (vary between 0.5% to 0.15%) .
Interest Rate Risk:
Interest rate risk is calculated by applying to the mathematical provisions for each contract category: the corresponding factor range from 0.7% to 3%.
Affiliate Insurers and Other Off Balance Sheet Risk:
It has two distinct components:
(i) one for insurance subsidiaries owned by the insurer concerned: This consists either of the accounting value of the shares held or of the subsidiaries' RBC margin requirement;
(ii) another for the insurer's off-balance-sheet liabilities.
Business Risk:
The capital cushion to business risk is allocated as a flat-rate of 2% of life insurance premiums. For life insurers who are also engaged in health insurance another component corresponding to health administrative expenses is added.
Calculation of Total Risk Based Capital:
Total Risk Based Capital is calculated as:
Risk Based Capital = C 0 + C4a + √ (C1o + C3a )2 + C1cs 2 +C22 + C3b2 + C4b2
Where:
C0 = capital requirement for affiliate insurers and other off balance sheet risk; C1o = capital requirement for asset risk component (other investments), C1cs= capital requirement for shares ( part of asset risk), C2 = capital requirement for insurance risk, C3a = capital requirement for interest risk, C3b = capital requirement for health insurer credit risk, C4a = capital requirement for business risk and C4a = capital requirement for health administrative expenses.
Initially, the NAIC working group thought of a simple summation of the amounts corresponding to the different risks taken into account by the RBC system. In 1991, an initial formula based on this simple summation principle was submitted to the life insurerindustry for consultation. Following that consultation, the NAIC proposed that the square-root rule be applied to quantities instead of a simple summation. This rule was justified on the ground that in the actuarial model, the capital requirement is roughly proportional to the standard deviation of the total loss risk facing the insurer. If this risk is the sum of independent risks, its standard deviation is indeed the square root of the sum of the squares of the standard deviations of the included risk factors. However, in case of the of the fully correlated risks(asset risk for affiliates and risk related to health administrative expenses), standard deviations are added together
The empirical evidence from the US market suggests that the biggest risk in the life insurance market comes from investments in stocks, bonds, mortgages and real estate(categories C1o and C1cs ) followed by asset risk of affiliates and insurance risk
Supervisory Initiatives on the Basis of Risk Based Capital Requirements:
In the Risk Based Capital system, the risk based capital requirement for each life insurer is compared with the company's actual level of capital. The ratio of company capital to the capital requirement corresponds to the levels of action open to the supervisory authority (refer table 1).
Table 1: Supervisory Trigger Points on the Basis of Capital Adequacy (Under the RBC System)
Actual Capital to RBC Ratio / Action Level / Action to be initiatedAC/RBC>1 / - / -
0.75< AC/RBC<1 / Company Action Level / The company must present a plan for capital enhancement.
0.50< AC/RBC<0.75 / Regulatory Action Level / The company must comply with the corrective measures prescribed by the
supervisory authority.
0.35< AC/RBC<0.50 / Authorised Control Level / The supervisory authority may take control of the insurer.
AC/RBC<0.35 / Mandatory Control Level / The supervisory authority must place the insurer under control.
Source: National Association of Insurance Commissioners, U.S.A.,www.naic.org.
Section II : Solvency Standard For Insurance Companies: The European Commission Approach
In Europe, solvency regulations for life insurance companies were frame by virtue of two directives in 1973 and 1979. In the nineties, the importance of solvency regulations increased because of the opening up of the insurance market and abolition of rate regulations. This led to the adoption of Solvency I and now Solvency II.
Solvency I:
In 2002, the members of the European Economic Community adopted the Solvency I Regime which became obligatory for the insurers from the year 2004.According to Solvency I, insurers are required to hold capital funds equal to the calculated solvency margin or the minimum capital requirement, whichever is higher. The required solvency margin for the life insurance business is calculated as:
4% x gross mathematical reserves x retention rate mathematical reserves +3% x capital at risk x retention rate capital at risk
where,
Retention rate mathematical reserves = net reserves+ gross reserves (but not less than 85%)
Retention rate capital at risk= net capital at risk=gross capital at risk* (but not less than 50%).
(Note: Capital at risk is the maximum amount of risk to the insurer. For term assurance policies capital at risk is equal to the sum insured. For endowment policies capital at risk is calculated to be the difference between death benefit and the reserve already created for providing such benefit).
Major Weaknesses of Solvency I:
Solvency I suffered from a number of limitations:
(a) Under Solvency I, valuation of assets and liabilities (including technical provisions) is not based on a market-consistent approach.
(b) In this system, solvency requirements depend on parameters that are inadequate proxies for the and mathematical reserves and capital at risk .
(c) Risks other than underwriting risk are either not accounted at all or only partially accounted for. For example, investment risk is not included in the required solvency margins, but is addressed by regulations on investment of technical provisions.
(d) Under Solvency I, there is no allowance for diversification, certain forms of risk transfer, and dependencies between assets and liabilities.
Solvency II:
The insurance solvency standards through out the world are undergoing a radical shift because of initiatives from the European Commission, the International Association of Insurance Supervisors (IAIS) and the Insurance Regulation Committee of the International Association of Actuaries. The new regime which is being adopted by the European Community from 2007 is named as Solvency II. The new solvency system will provide supervisors with the appropriate tools and powers to assess the capital position of an institution based on a risk-oriented approach. It includes both quantitative and qualitative elements, which influence the risk-profile of the undertaking (managerial capacity, internal risk control and risk monitoring processes, etc.). The new system is having three-pillar structure:
Pillar I: Quantitative capital requirements,:
Under Pillar 1, the new solvency system includes two capital requirements: the Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (MCR). The Solvency Capital Requirement (SCR) corresponds to a level of capital which enables a life insurer to absorb significant unforeseen losses . The SCR is to be calculated on the basis of economic capital corresponding to a particular loss scenario and time horizon.
In the new solvency regime, the solvency capital requirement can be calculated by applying either the standard approach or the insurer’s own internal risk model (subject to validation and approval by the regulatory authority).In case of in house models the insurers will calculate their solvency capital on the basis of actual risk profiles and this is expected to result in a lower solvency capital requirement compared to the standard approach.
For calculation of solvency capital requirement it is essential to define a risk measure and a confidence level. A risk measure is a function which assigns an amount of capital to a distribution of economic profit and loss.
Value at Risk (VaR) and Expected Shortfall (ES) are two commonly used measures for the assessment of risk. VaR refers to the maximum possible loss (at a given confidence level) over a specified time horizon. Expected Shortfall on the other hand considers the consequences of a potential default.
The Minimum Capital Requirement (MCR) reflects a level of capital which all life insurers will have to maintain irrespective of their SCR. If the actual solvency capital is below the minimum capital requirement then it will lead to the initiation of supervisory action .
The risks addressed in the capital requirements should be based on the International Association of Actuaries risk classification standard and includes the following risk components: underwriting risk, credit risk, market risk, operational risk and liquidity risk .Non-quantifiable risks will have be included in Pillar 2.
Pillar II: A Supervisory Review Process :
The supervisory review process should increase the level of integration of supervisory methods, tools and processes. In particular, it should aim to identify high risk insurance. Such insurance companies require a higher solvency capital than under the SCR.
Pillar III: Disclosure Requirements:
Disclosure requirements are aimed towards enhancing market discipline. The disclosure requirements should be in line with those specified by the IAIS and IASB. They should also be compatible with disclosure requirements in the banking sector. Additions and adjustments could be proposed provided specific reasons for such exceptions are given.
Implications of The New Solvency Regime For The Insurer:
(a) Sophisticated corporate risk management:
Solvency II will require many insurance companies to redesign the way in which they manage their entire business, to enhance their existing risk management policies and procedures, and to identify and quantify various risk categories. This will need to be embedded in the business to provide a better understanding of risks, more risk sensitive measurement and business planning, and more efficient applicable solvency requirements. This will also lead to improved decision making and transparency in reporting., Life insurance companies now need to demonstrate consistent and quality data in order to support model input and results, as well as to facilitate the required transparency
(b) Value Based Management:
The challenge for insurers is to move beyond a mindset of risk management as a control and oversight function, and beyond Solvency II as purely a regulatory requirement, to one that creates