Solvency Requirements for insurance firms – a regulators perspective

KPMG-European Commission Conference June 24.-25. 2002

Download the slides for the presentation here

1. Introduction

Thank you for giving me the opportunity to contribute to this Conference. In my view the subject is indeed timely and very important and the KPMG report is an excellent point of departure. I share most of its conclusions.
The Danish Financial Supervisory Authority is an integrated authority with a staff of banking, insurance and securities supervisors, which are used to be inspired by best practices of other supervisors. My main message today is that insurance supervisors would profit from adopting the 3 pillar solvency approach. This approach was originally conceived in the Basel discussions on new capital adequacy rules for banks. It is however very much inspired by the actuarial notion of probability of ruin (default) and would thus seem to be a logical step when the EU countries are going to implement the new and revised solvency regulation of insurance that will be the outcome of the solvency II-discussions at the EU level.

In my speech today I will deal with each pillar in turn and end up with some concluding remarks concerning their interaction. En route I will refer to some Danish experiences in this area and I will also do a detour in order to touch upon the subject of risk covers - including reinsurance - as an element of financial strength.

However, first of all I would like to briefly outline the elements of the risk profile of a financial firm.

2. The risk profile of a financial firm

The risk profile a financial firm depends on the risks assumed by the firm in relation its financial strength. The risks assumed depend on the sensitivity - or net exposure - to external event as well as the internal risk management. The risks assumed may be measured by a loss distribution, which pictures the probability of any given loss.

The financial firms are remunerated for the assumption of risk. Naturally the firms requires an expected profit – i.e. that the expected remuneration is higher than the expected losses. However outcomes may be different from expectations. The firms may incur unexpected large losses. Internal funds in such situations are much less costly than external funds. In some cases external funds are not even available and the financial firm may have to default on its obligations. This is even costlier as defaulting financial firms tends to be winded up and their value as going concerns to disappear. Hence prudent firms want financial strength to avoid the costs of financial distress – or even worse of default.

The customers of financial firms are concerned with the expected losses on their contracts with the firms. The estimated losses depend on the probability of default of the firm, the loss rate given default and by the exposure at default. Hence naturally the policy-holders are interested in purchasing insurance cover from insurers with a low probability of default and a low loss rate given default – i.e. with a prudent risk profile. However the capital required for financial strength and the operations of internal risk management systems are costly and due to asymmetric information the customers are not able to actually observe the risk profile of the firms. Such considerations may give the firms an incentive to be less prudent – not least if they have a very short-termed perspective.

Supervisors should be in a better position to observe the risk profiles of financial firms – and be better able to take corrective action - than a dispersed group of small depositors, policy-holders etc. Hence the core of supervision is to impose solvency requirements on those firms, where the incentive to be prudent is inadequate, while at the same time maintain the incentive to prudence for other firms. The point of departure for solvency requirements may be the so called 'economic capital', which is used by rating agencies. From the loss distribution they derive the financial strength required to obtain a probability of default less than a certain figure – e.g. a probability of default less than 0.2 pct. within a year, which corresponds to an 'investment grade'.

3. The 3 pillars of a solvency regime

The solvency regime, which was originally conceived in the Basel discussions on capital requirements for international banks, but is now used in the EU discussions on solvency reform both regarding banking, securities and insurance firms, consists of 3 pillars: financial strength, the supervisory review process and market discipline.

The first pillar, financial strength, is the quantitative capital requirements. In the current solvency regime these requirements to a large extent do not reflect the risks assumed by the specific firm. In particular the risk on the investments has no impact on the required solvency margin. The treatment of purchased reinsurance cover may also be inadequate.

Consequently the required solvency margin does not take into account the specific risk profile of a firm. The solvency II discussions are aiming at setting the solvency requirement according to all the types of risks that a firm has assumed. It is anticipated that insurers may use their internal models for setting solvency requirements in order to support the development and operation of costly risk management systems. However the models must fulfil certain criteria in order to be accepted by the supervisor. Smaller firms that do not want to build their own models may use more simple models, which have generally been approved by the supervisor.

The second pillar, supervisory review process, consists of the supplementary instruments in order for the supervisor to assess and potentially reduce a firm's risk profile. The assessments could for example consist of various types of stress testing with the purpose of identifying extreme, but plausible events, which may cause losses so large, that the firm may have to default. In order to avoid such losses the supervisor may require the firm to reduce its risk profile – either by additional financial strength or by reducing the net exposure to external events by the purchase of risk covers.

According to the Danish Financial Business Act the DFSA is able to require a financial firm to reduce its risk profile if the interests of its depositors, policy-holders etc. are in danger.

A level playing field for European financial firms in relation to the supervisory review process requires a convergence of supervisory best practices. Here I see an important role for a reformed Conference for European Insurance Supervisors.

The third pillar is market discipline. The aim of this pillar is to strengthen market discipline by creating transparency. Requirements to disclose inter alia the financial statements of the insurance firms are a part of this, but it is equally important that the financial reports of the insurance firms are readily comparable i.e. that the reports do not contain hidden reserves. From a prudential point of view there is nothing wrong with reserves – on the contrary. In order for market discipline to operate efficiently they just have to be disclosed as part of the financial strength.

4. Risk covers as an element of financial strength

As noted previously the first pillar, financial strength, is the quantitative capital requirements. The solvency II discussions will be aiming at setting the solvency requirement according to the types of risks that a firm has assumed.

The purchase of risk covers may contribute to reduce the net exposure to external events and consequently reduce the risk profile of the firm.

Net exposure to external events may be reduced by reinsurance contracts, alternative means of risk transfers and by financial derivatives. Reinsurance is especially important in general insurance in order to reduce the risk of large exposures due to storms and other natural disasters. However, a reinsurance contract implies another risk namely that of the creditworthiness of the reinsurer. Thus estimation of the reinsurers security is important when evaluating the financial strength of an insurance firm. This also puts emphasis on the importance of harmonisation of rules regulating the reinsurers on an international level. In this respect the idea of a fast-track approach to a European directive on reinsurance looks very encouraging.

Purchase of other kinds of risk covers such as derivatives to reduce the risk on investments also implies that the firm takes on a credit risk on the counterparty.

If these risk elements are properly taken into account, when evaluating the risk profile of a firm and in the calculation of the required solvency margin, the firms are encouraged to use risk covers thus leading to a better match of assets and liabilities.

5. Supervisory review process of Danish life insurers

Due to the long term obligations with a guaranteed interest rate, the interest rate risk (or duration of the liabilities) is very high in the Danish life insurance industry. Since 1998 the level of interest rate has been rather low – also due to a strengthening of the taxation of the return on the assets held by the life insurers. As previously mentioned the required solvency margin does not take into account investment risks – including the interest rate risk. Thus in 2001 the DFSA introduced two stress tests in order to assess the financial strength of the life insurers following a change of the Insurance Business Act that liberated the rules regarding insurance firms' investment. In normal circumstances the firms are required to calculate the effect of the stress tests at the end of each semester.
The two stress tests are named the red scenario and the yellow scenario. The red scenario requires the life insurers to have an equivalent financial strength as a bank that has assumed the same investment risks – but never less than the required solvency margin. In case the red scenario implies that a firm's capital drop below the required financial strength the policy holders' interests may be in danger and the firm is required to immediately report the situation to the DFSA. We will then assess the specific situation and if the policy holders' interests are deemed in danger we may order the firm to decrease its risk profile.

The yellow scenario requires the life insurers to calculate the effect on their financial strength under more extreme, but still plausible circumstances. If the financial strength of a firm is not sufficient in the yellow scenario the policy holders' interest are deemed potentially in danger and the firm is required to report the calculations to us every quarter. Supervision has been intensified.

Turning on the yellow light may hence be seen as a warning to the firm concerned of a high risk profile. The DFSA is using the provision of such risk information to the firms concerned in other areas too – including the security of the reinsurance cover of major non-life insurers.

6. Market discipline – the market value accounting of Danish life insurers

The third pillar is market discipline. In order to strengthen market discipline transparency is the key issue. It is important that the financial reports of the insurance firms are readily comparable so that investors, policy holders and other stakeholders may take decisions based on timely, relevant and reliable information. The EU-decision of requiring the annual, consolidated accounts of all listed companies in Europe to comply with IFRS no later than 2005 is a good point of departure in this respect.

As a securities supervisor the DFSA has been supporting this development. As an insurance and banking supervisor the DFSA consider to de facto implement IFRS for the unlisted financial firms too. It is difficult to imagine marked discipline working efficiently without such an implementation. It may lead to a higher volatility of profit and loss accounts. However we consider that as a reflection of the volatility of the underlying business.

For some years we have been working on developing accounting principles for life insurers based on market values. As of this year all financial assets of Danish life insurers are reported at market value. As of next year all life insurers will have to report the liabilities at market value and they are free to report the liabilities at market value this year.
Reporting the liabilities at market value implies that the technical provisions are being divided into the guaranteed benefits and the commitment to pay bonus for each contract. The value of the surrender option is included in the guaranteed benefits. The commitment to pay bonus is called individual bonus potential. The guaranteed benefit is calculated as the value of the expected benefits discounted by a market interest rate. To this value is added a market value margin. The individual bonuspotential can be interpreted as the value of the expected future bonus given the interest rate guaranteed and the current interest rate on the market. As a consequence of the new accounting regime the bonus equalisation reserves (or bonus equalisation provisions) will be named collective bonuspotential in order to obtain a more uniform terminology.
During some periods in the recent past there has been a negative individual bonuspotential on the Danish life insurance contracts with a relatively high guaranteed rate of interest, which have been covered either by collective bonuspotential or the equity. However prior to that, the individual bonus potential on the contracts has been systematically reduced due to the fall in interest rates and increasing taxation – without being reported in annual accounts. Hence many firms in reality did overestimate their future ability to pay bonus.

The new Danish accounting rules are considered to be a step forward to full fair value accounting as regards life insurance liabilities and I believe that they will not only contribute to a more transparent system - but also improve the asset liability management of life insurance firms thus reinforcing the trend pushed by the introduction of the red and yellow scenarios.

7. Concluding remarks

I have now described the three pillars and I would like to finish by explaining why all three of them in my opinion are needed. The reason is simply because they are mutually reinforcing.

The required solvency margin is needed in order to calculate the minimum capital necessary for the risks assumed by each individual firm. It is important that the required capital margin takes into account all types of risks and that risk mitigation techniques can be used to reduce the capital required properly. Denmark is thus very much in favour of the line taken so far in the solvency II discussions within the EU on insurance.

Stress testing and other elements of the supervisory review process are also important. They serve as means to measure the sensitivity of assumptions and to take into account the elements which are not easily quantified such as the quality of the internal risk management. The supervisory review process may also remind us that models based on past events are not perfect in predicting future events and that hence some judgement - or even imagination - is needed. The WTC-tragedy taught us a lesson in that respect too.

Finally relying on market discipline will contribute to more efficient corporate governance as better informed customers and investors are more likely to move their funds to the financial firms with prudent risk profiles. This in turn is likely to put more competitive pressure on other firms inducing them to increase their financial strength or reduce their risks assumed.

Oprettet d. 24.07.2003 og sidst redigeret d. 14.11.2003

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