Cornerstones:Cornerstones:Solvency Monitoring inSolvency Monitoring inDiffering CircumstancesDiffering Circumstances

Michael M. Barth, PhD, CPCUMichael M. Barth, PhD, CPCU

Associate Professor of FinanceAssociate Professor of Finance

Georgia Southern UniversityGeorgia Southern University

Recent IAIS ReleasesRecent IAIS Releases

October 2004 – October 2004 – A New Framework for A New Framework for Insurance Supervision: Towards a Insurance Supervision: Towards a Common Structure and Common Common Structure and Common Standards for the Assessment of Insurer Standards for the Assessment of Insurer SolvencySolvency

February 2005February 2005 – Cornerstones for the – Cornerstones for the Formulation of Regulatory Financial Formulation of Regulatory Financial RequirementsRequirements

IAIS Objectives IncludeIAIS Objectives Include

Assisting regulator and regulated in assessing Assisting regulator and regulated in assessing risk and solvencyrisk and solvency

Enhancing the transparency and comparability Enhancing the transparency and comparability of insurers worldwideof insurers worldwide

Supporting a level playing field while reducing Supporting a level playing field while reducing regulatory arbitrageregulatory arbitrage

Increasing the opportunities for international Increasing the opportunities for international cooperationcooperation

Increasing overall confidence and efficiencyIncreasing overall confidence and efficiency

Let’s Tweak This Thing…Let’s Tweak This Thing…

What Ain’t Broke, Don’t FixWhat Ain’t Broke, Don’t Fix

Common StandardsCommon Standards

Common standards should not mean the same Common standards should not mean the same standards for all insurersstandards for all insurers Loss frequency vs loss severityLoss frequency vs loss severity Market disruptionMarket disruption Market’s ability to absorb both the losses and the Market’s ability to absorb both the losses and the

cost of loss preventioncost of loss prevention Cost associated with monitoringCost associated with monitoring

Translating common standards across Translating common standards across international boundaries international boundaries

Assessing RiskAssessing Risk

Development of appropriate models and Development of appropriate models and techniques that can be used in multiple techniques that can be used in multiple jurisdictionsjurisdictions Technical reserves (?)Technical reserves (?) Investment risk (?)Investment risk (?) Systematic business risk (?)Systematic business risk (?) Political risk (?)Political risk (?)

Processes for determining risk may be more Processes for determining risk may be more exportable than products themselvesexportable than products themselves

TransparencyTransparency

Transparent systems and opaque systems are Transparent systems and opaque systems are complementary and serve different functionscomplementary and serve different functions

Degree of solvency monitoring by outside (e.g., Degree of solvency monitoring by outside (e.g., non-regulatory) bodies affects designnon-regulatory) bodies affects design CompetitorsCompetitors LendersLenders News, trade pressNews, trade press Reinsurers and other business partnersReinsurers and other business partners Other financial services regulatorsOther financial services regulators

Self-fulfilling prophecies and inaccuracy in Self-fulfilling prophecies and inaccuracy in systems affect the ability to be transparentsystems affect the ability to be transparent

Opaque Solvency Opaque Solvency Monitoring SystemsMonitoring Systems

Should be opaque to masses but transparent Should be opaque to masses but transparent to other regulators (e.g., FAST, CAMEL)to other regulators (e.g., FAST, CAMEL)

If insurers are gaming the system, then the If insurers are gaming the system, then the system is not workingsystem is not working

Early Warning System meant to provide early Early Warning System meant to provide early warning of what MIGHT happen, not what is warning of what MIGHT happen, not what is inevitableinevitable

Opaque systems can be used to direct Opaque systems can be used to direct resources more efficiently without causing resources more efficiently without causing disruption that regulator is trying to avoiddisruption that regulator is trying to avoid

Opaque Warning Systems Opaque Warning Systems Should Provide ScoresShould Provide Scores

Regulatory ArbitrageRegulatory Arbitrage

Best defense is cooperation among Best defense is cooperation among regulators IN AN APPROPRIATE regulators IN AN APPROPRIATE FORUMFORUM

Sliding scales of regulatory interest and Sliding scales of regulatory interest and interferenceinterference

Regulatory forbearanceRegulatory forbearance

How Does U.S. Stack Up? How Does U.S. Stack Up? (IMHO)(IMHO)

Regulatory IndicatorsRegulatory Indicators IRIS, FAST, RBCIRIS, FAST, RBC Model laws (e.g., RBC model)Model laws (e.g., RBC model) State law provides teethState law provides teeth AuditsAudits

Non-regulatory regulatorsNon-regulatory regulators Rating agenciesRating agencies Trade pressTrade press Competitors, business partnersCompetitors, business partners

Cornerstone 1Cornerstone 1

The solvency regime addresses the The solvency regime addresses the robustness of the insurer to meet its robustness of the insurer to meet its liabilities both short term and over a liabilities both short term and over a longer time spanlonger time span

Short term and long term: What does that mean?

Ratio systems are relatively short-sighted, but insolvencies often occur over time

AM Best et. al. also provide long-term information

Cornerstone 2Cornerstone 2

The solvency regime is sensitive to risk, The solvency regime is sensitive to risk, and is explicit as to which risks and is explicit as to which risks individually and in combination, lead to a individually and in combination, lead to a regulatory financial requirement and how regulatory financial requirement and how they are reflected in the requirementthey are reflected in the requirement

Pretty much describes the concept of risk-based capital and the accompanying RBC law

Cornerstone 3Cornerstone 3

The solvency regime is explicit on how, The solvency regime is explicit on how, for each of the risks that attract a for each of the risks that attract a financial requirement, individually and in financial requirement, individually and in combination, prudence is reflected in combination, prudence is reflected in these requirements.these requirements.

That is the plan, anyway.

Cornerstone 4Cornerstone 4

The solvency regime requires a valuation The solvency regime requires a valuation methodology which makes optimal use of methodology which makes optimal use of and is consistent with information and is consistent with information provided by the financial markets and provided by the financial markets and generally available data on insurance generally available data on insurance technical risks.technical risks.

For a transparent system, yes.

This does not address the needs of an opaque system

Does the generally available data provide accuracy?

Cornerstone 5Cornerstone 5

The solvency regime includes the The solvency regime includes the definition of technical provisions. definition of technical provisions. Technical provisions have to be prudent, Technical provisions have to be prudent, reliable, and objective and allow reliable, and objective and allow comparison across insurers. The regime comparison across insurers. The regime should require as a minimum that should require as a minimum that sufficient assets are available to cover sufficient assets are available to cover the technical provisions and other the technical provisions and other liabilities.liabilities.

Relatively easy to standardize across borders

Cornerstone 6Cornerstone 6

The solvency regime requires the The solvency regime requires the determination of a “best estimate” of the determination of a “best estimate” of the costs of meeting the obligations arising costs of meeting the obligations arising from the insurance portfolio, taking into from the insurance portfolio, taking into account the time value of money. The account the time value of money. The discount rate for this calculation is discount rate for this calculation is determined by reference to the relevant determined by reference to the relevant risk free interest rates on the financial risk free interest rates on the financial markets.markets.

Best estimate or confidence interval?

Cornerstone 7Cornerstone 7

The solvency regime establishes a range The solvency regime establishes a range of solvency control levels and the of solvency control levels and the supervisory instruments associated with supervisory instruments associated with each of the control levelseach of the control levels

What is meant by “control level”?

RBC requires company to submit a report at the Company Action Level – is that “control”?

The bar for “increased regulatory scrutiny” should be relatively easy to trigger

Cornerstone 8Cornerstone 8

The solvency regime allows a set of The solvency regime allows a set of standardised [standardized] and more standardised [standardized] and more advanced approaches to determine the advanced approaches to determine the solvency requirements, and includes the solvency requirements, and includes the use of internal models if appropriate.use of internal models if appropriate.

The level of “standardization” should differ from system to system. Opaque systems may be particularly suited to advanced approaches. This also allows the monitoring system to be more forward thinking and dynamic by encouraging innovation

ConclusionsConclusions

The US system, a combination of both The US system, a combination of both public and private early warnings and public and private early warnings and capital standards, goes a long way capital standards, goes a long way towards meeting these goalstowards meeting these goals

Harmonization across international Harmonization across international borders seems like a long way offborders seems like a long way off

What ain’t broke, don’t fix What ain’t broke, don’t fix If it ain’t perfect, keep tryingIf it ain’t perfect, keep trying