Mini Case Study on Insurance Core Principles

- MINI CASE STUDY ON INSURANCE CORE PRINCIPLES-

“ICP23 Capital Adequacy and Solvency”

Insurance Training Seminar IAIS - ASSAL

Buenos Aires, Argentina, 1-4 November 2005

Makoto Okubo – Member of the Secretariat

International Association of Insurance Supervisors (IAIS)

Imagine that you are member of a mission team of the IMF/World Bank that has to carry out an assessment of the insurance sector against the Insurance Core Principles (ICP) in connection with an FSAP of the country called Xor Y. There is no self-assessment made due to the fact that the ICP are relatively new.

As you have only 90 minutes for the assessment, we will limit the assessment to topics of the ICP23 (Capital adequacy and solvency).

In this mini case, your group is expected to:

1)Identify key issues and compile a list of questions you would like to ask the commissioner of Country X or Yin a role-playing session (30 min.).

2)Interview the commissioner (role-playing 5-10 min. per group). Your questions should aim to solicit answers to confirm your findings.

3)Taking above into account discuss in a group what criteria of the ICP23 are not observedand what actions are recommended (30 min.).

4)Make a presentation of your group findings (5-10 min. per group),

Reference:

• IAIS ICP23: Capital Adequacy and Solvency (October 2003)

These mini casesare developed by Makoto Okubo, IAIS Secretariat, for the use in the Insurance Training Seminar IAIS – ASSAL, and not refer to any existing jurisdictions.

1 Country X

Description:

Country X has an integrated supervisory authority, the Financial Control Agency (FCA), which regulates all financial sectors including insurance. The insurance sector is relatively competitive and is represented predominantly by foreign registered companies. About 50 companies are carrying on insurance: small mutuals and big international companies and financial groups.

Traditionally, insurers have valued assets at cost, but it was decided that international accounting standards should be used both for general-purpose and regulatory reporting. For example, IAS39 shall be used to value financial instruments.

Technical provisions are calculated using assumptions that are intended to be conservative with implicit margins. The valuation techniques as well as assumptions vary from insurer to insurer, subject to certain restrictions set by the FCA. The FCA is currently investigating a few insurers downgraded by a major rating agency due to insufficient technical provisions.

It is becoming a common practice to use reinsurance products, since some foreign registered reinsurers entered into the market in Country X. Insurers are allowed to take credit on their balance sheet for amounts due from reinsurers.

Minimum solvency requirements are defined in the regulations set by the FCA. The required solvency margin is intended to provide a buffer to absorb unforeseen losses and is based on a simple index-based formula, which is expressed in proportion to the reported value of technical provisions. It aims to achieve a sufficient harmonisation among insurers, irrespective of the insurer’s productsand business operations.

Insurers are allowed to account any subordinated debts as capital in calculating solvency margin.

When an insurer fell below the minimum requirements, the FCA would intervene to take over the company and take necessary and permissible actions to protect the interests of policyholders.

Some foreign insurers are operating in Country X through a branch. The FCA imposes exactly the same solvency requirements on an insurer operating through a branchas on a legally separate domestic insurer.

Some insurers are members of larger corporate groups. In order to prevent the inflation of capital, including double gearing and related transactions, the FCA requires insurers to calculate capital adequacy on consolidated basis.

2 Country Y

Description:

Country Y has functional regulatory systems. The Insurance Commission (IC) is responsible for supervision of the insurance sector. There are separate supervisory authorities for banking and securities sectors. More than 100 companies are competing in the market, including mutuals, financial conglomerate, and foreign insurance groups, and offering a wide variety of different products.

Insurers value assets at mark-to-market and liabilities using their best estimate assumptions, plus explicit margins determined by actuaries. There is no deposit floor requirement, but the own credit trustworthiness may not be reflected in the measurement of liabilities. Such general-purpose accounting principles are directly used as basis in calculating capital adequacy.

Reinsurance is now a commonly used technique for insurers to transfer some of the risks. Some reinsurance arrangementsare also designed to assist insurers in meeting prudential requirements with little or no transfer of risk. Credit for reinsurance on an insurer’s balance sheet takes the form of reductions in liabilities by lowering the technical provisions in proportion to the amount of coverage purchased. In order to address counterparty credit risk, the IC requires that only a certain percentage of the credit may be taken for amounts due from reinsurers of lower ratings.

New risk-based capital solvency regimes has been introduced. It specifies the minimum amount of capital based on a company’s size and risk profiles. The following risk categories are used in the formula: market risk, credit risk, underwriting risk, and liquidity risk. In order to avoid duplicated regulatory burdens, the IC has abolished some of the prudential requirements, mostly related to risk management including liquidity, and some of the disclosure requirements. A limited number of qualified insurers are allowed to use their “internal models”. Such insurers are exempted from the prescribed requirements since their models are more sophisticated.

The IC has recently issued the list of criteria to assess the suitability of instruments to be recognised as capital in solvency requirements. When an insurer fell below 150% of the minimum requirements, the IC would intervene and require corrective actions or impose restrictions to protect the interests of policyholders.

In Country Y, insurers are not allowed to operate through a branch and must establish a legally separate entity to do insurance business. A number of insurers are owned by banks. In such cases, the bank supervisor oversees group-wide capital adequacy and imposes restrictions in capital transfer or related transactions, while the IC has the supervisory power over insurance units, whether subsidiaries or affiliates, and imposes the same solvency requirements to those entities as for other insurers.

ICP 23Capital adequacy and solvency

Explanatory note

23.1.A sound solvency regime is essential to the supervision of insurance companies and the protection of policyholders. Capital adequacy requirements are part of a solvency regime. A solvency regime should take into account not only the sufficiency of technical provisions to cover all expected and some unexpected claims and expenses but also the sufficiency of capital to absorb significant unexpected losses - to the extent not covered by the technical provisions - on the risks for which capital is explicitly required. It should also require additional capital to absorb losses from risks not explicitly identified.

23.2.In order to protect policyholders from undue loss, it is necessary that a solvency regime establishes not only minimum capital adequacy requirements, but also a solvency control level, or series of control levels, which act as indicators or triggers for early supervisory action, before problems become serious threats to an insurer’s solvency. The form of the solvency control level may be based on capital levels or other financial measures related to the solvency regime of the jurisdiction.

23.3.Any allowance for reinsurance in a capital adequacy and solvency regime should consider the effectiveness of the risk transfer and make allowance for the likely security of the reinsurance counterparty.

Essential criteria

1. The solvency regime addresses in a consistent manner:

valuation of liabilities, including technical provisionsand the margins contained therein

quality, liquidity and valuation of assets

matching of assets and liabilities

suitable forms of capital

capital adequacy requirements.

1. Any allowance for risk mitigation or transfer considers both its effectiveness and the security of any counterparty.

1. Suitable forms of capital are defined.

1. Capital adequacy requirements are sensitive to the size, complexity and risks of an insurer’s operations, as well as the accounting requirements that apply to the insurer.

1. The minimum capital adequacy requirements should be set at a sufficiently prudent level to give reasonable assurance that policyholder interests will be protected.

1. Capital adequacy requirements are established at a level such that an insurer having assets equal to the total of liabilities and required capital will be able to absorb significant unforeseen losses.

1. Solvency control levels are established. Where the solvency position reaches or falls below one or more control levels, the supervisory authority intervenes and requires corrective action by the insurer or imposes restrictions on the insurer. The control level is set so that corrective action can be taken in a timely manner (refer to ICP 14).

1. Inflation of capital – through double or multiple gearing, intra-group transactions, or other financing techniques available as a result of the insurer’s membership in a corporate group – is addressed in the capital adequacy and solvency calculation (refer to ICP 17).

1. The solvency regime addresses the requirements placed upon an insurer operating through a branch.

Advanced criteria

1. The solvency regime provides for periodic, forward-looking analysis (e.g., dynamic solvency/ stress testing) of an insurer’s ability to meet its obligations under various conditions (refer to ICP 20 AC g and ICP 21 AC k).

1. The supervisory authority assesses the structure of its solvency regime against structures of a peer group of jurisdictions and works towards achieving consistency.

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