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The Actuary Magazine October 2004 - Insurer Solvency Assessment? Towards A Global Framework

Insurer Solvency Assessment–Towards A Global Framework

by Stuart F. Wason

Actuaries have been participating in a significant report on insurer risk assessment for solvency purposes that was released publicly this spring. The report, prepared by the Insurer Solvency Assessment Working Party (WP) of the International Actuarial Association (IAA), is entitled, "Insurer Solvency Assessment–Towards a Global Framework." The report is available in electronic or hard-copy form from the IAA by visiting its Web site at www.actuaries.org

The report:

  • describes principles and methods to quantify total funds needed for solvency;
  • provides a foundation for a global risk-based solvency capital system for consideration by the International Association of Insurance Supervisors (IAIS);
  • identifies the best ways to measure the exposure to loss from risk and any risk dependencies; and
  • focuses on practical risk measures and internal models.

The WP consisted of 20 actuaries from around the globe, eight from North America, eight from Europe and four from Australia and Asia.

The report is not intended to express a unique or absolute point of view with regard to the issues, and it will need to be enhanced over time in light of any new developments. It is supplemented with several appendices, including life, non-life and health case studies to illustrate practical implementation of the principles developed in the report. While insurance supervisors are an important audience for this report, it is hoped that it is also a useful reference and educational tool for those interested in insurer risk management and economic capital determination.

To assist in the development of a global framework for insurer solvency assessment and the determination of insurer capital requirements, the WP proposes a number of guiding principles to be used in their design. These principles are summarized below.

"Three Pillar" Approach

The WP believes that a multi-pillar supervisory regime is essential for the successful implementation of the global framework proposed in the report. The conclusions of the report are consistent with the "three pillar" approach to the regulation of financial service entities that is reflected in the Basel Accord for the regulation of banks internationally.

Pillar I: Minimum Financial

Requirements

This involves the maintenance of:

  1. appropriate technical provisions (policy liabilities);
  2. appropriate assets supporting those obligations; and
  3. a minimum amount of capital (developed from a set of available and required capital elements) for each insurer.

Pillar II: Supervisory Review

Process

This pillar is intended to ensure not only that insurers have adequate capital to support all the risks in their business, but also to encourage insurers to develop and use better risk management techniques reflective of the insurer's risk profile and in monitoring and managing these risks. The actuarial profession can assist supervisors within the second pillar by providing independent peer review of the determination of policy liabilities, risk management, capital requirements, current financial position, future financial condition etc., where these entail the use of substantial judgement or discretion.

Pillar III: Measures to Foster Market

Discipline

Pillar III serves to strengthen market discipline by introducing disclosure requirements. It is expected that through these requirements, industry "best practices" will be fostered. Assistance can also be provided within the third pillar in the design of appropriate disclosure practices to serve the public interest.

Principles Versus Rules-Based Approach

Solvency assessment should be based on sound principles. Implementation of solvency assessment will require rules developed from these principles. However, the WP considers that the rules used should include provisions to allow their adaptation to current or unforeseen circumstances with the prior agreement of the relevant supervisor.

Total Balance Sheet Approach

The application of a common set of capital requirements will likely produce different views of insurer strength for each accounting system used because of the different ways accounting systems can define liability and asset values. The WP recommends the use of a total balance sheet approach based on economic values to ensure that hidden surpluses or deficits are appropriately recognized for the purpose of solvency assessment.

Degree of Protection

It is impossible for capital requirements, by themselves, to totally prevent failures. The establishment of extremely conservative capital requirements, well beyond economic capital levels, would have the impact of discouraging the deployment of insurer capital in the jurisdiction. The WP considered the role of rating agencies in assessing insurers and the substantial volume of credit rating and default data available from these agencies. The WP also noted the relation between the degree of protection and the time horizon considered. The WP's recommendation for degree of protection is therefore linked with its recommendation for an appropriate time horizon for solvency assessment.

Appropriate Time Horizon

A reasonable period for the solvency assessment time horizon, for purposes of determining an insurer's current financial position, is about one year. A longer time horizon of a few years (e.g., perhaps five years for life insurance and two years for general insurance) may be a reasonable period for assessing an insurer's future financial position.

Types of Risk Included

In principal, the WP recommends that all significant types of risk should be considered (implicitly or explicitly) in solvency assessment. However, there may be valid reasons why certain risks do not lend themselves to quantification and can only be supervised under Pillar II. The WP believes that the types of insurer risk to be addressed within a Pillar I set of capital requirements are underwriting, credit, market and operational risks.

Appropriate Risk Measures

A risk measure is a numeric indicator that can be used to determine the solvency capital requirement for an insurance company. One risk measure that exhibits several desirable properties for various (but not all) risks is Tail Value at Risk (also called TVaR, TailVar, Conditional Tail Expectation, CTE or even Policyholders' Expected Shortfall). In many situations, this risk measure is better suited to insurance than Value at Risk (VaR), a risk measure commonly used in banking, since it is common in insurance for their risk event distributions to be skewed.

Risk Dependencies

The solvency assessment method should recognize the impact of risk dependencies, concentration and diversification. Risk dependencies within an insurer can have a very significant impact on the overall net effect of its risks (compared to the gross effect without taking account of their dependencies).

Risk Management

The solvency assessment method should recognize the impact of various risk transfer or risk sharing mechanisms used by the insurer. While many types of risk management serve to reduce the risk in question, it is important to note that some of them create additional risk related to the technique itself. For example, both hedging and reinsurance create counter-party risk, a form of credit risk.

Standardized Approaches

Many of the discussions comparing different solvency assessment methods (e.g., fixed-ratio versus risk-based capital; MCCSR versus scenario-based, etc.) do not adequately explain the optimum conditions that must be present for each method to be reliable.

Simple risk measures are appropriate when it is recognized that the risk in question is important from a solvency perspective, but there does not currently exist a generally accepted view of how the risk should be assessed. They are also appropriate if the risk is of minor importance.

Sophisticated risk measures are appropriate for material risks where one or more conditions exist (e.g., the risk in question is very important from a solvency perspective and cannot be adequately assessed through the use of simple risk measures; there is sound technical theory for the risk to be assessed and the risk measure to be used, etc.). The WP proposes a standardized factor-based approach in the report.

Advanced (Company-Specific) Approaches

For stronger, more technically able companies with effective risk management programs, it may be appropriate to introduce advanced (or company-specific) models that can incorporate all types of quantifiable risks. An internal model can also incorporate all types of interactions among risks if those interactions are understood and quantifiable. However, in practice, many aspects of risk are not well understood, particularly in the case of extreme events for which little history exists (and which are most important for solvency assessment). Hence, internal models provide a model of risks faced by an insurer that can, at best, be described as representing reality in an approximate way.

Market Efficient Capital Requirements

It is the WP's view that excessive minimum capital requirements, while affording additional solvency protection, will also serve to impede capital investment in insurers because of the perceived additional cost of capital required in the business, beyond that required by economic levels of capital, that may not be recoverable in product pricing.

Discussion of the report is welcomed and can be sent to swason@mow.com

Stuart Wason, FSA, FCIA, MAAA is chair of the IAA Solvency Sub-Committee.