Chapter 15 Solvency

Solvency management and capital; solvency is often assessed by looking at how

much capital is available to absorb risks, it will be useless however if an institution
does not manage its risk appropriately.
To assess solvency, we need to understand the amounts and nature assets and
liabilities, the relationship between them, and the risk management procedures in
place.
Most financial institutions are also subject to additional requirements that are
suitable for their own particular industry, which are known as statutory solvency
requirements or regulatory solvency requirements.
We can impose strict solvency requirement but comes at a price; less innovation,
higher prices, and shifting of risks to customers
3 pillars approach to solvency regulation: holding adequate capital, effective risk
management and market discipline
An insurance company is solvent if it is able to fulfill its obligation under all
contracts under all reasonable foreseeable circumstances (with an acceptable
probability), three sets of different circumstances:
1. Cash flow solvency; will the company be able to pay its debt as and when
they fall due
2. Discontinuance solvency; if the company ceased doing business today, would
the company be able to cover its obligations
3. Going-concern solvency; if the company remains in business, following a
specified business plan, will it continue to be able to meet its liabilities in the
future

Cash flow solvency (or liquidity)

Liquidity risk in normal conditions
Holding less liquidity means you incur additional cost from borrowing, but
with excessive liquidity it will also affect profits. Liquidity ratio (market value
of liquid assets / total liabilities falling due within a specified time frame) is a
good measure for financial institution liquidity. Company to determine this
based on the nature of assets and liabilities.
Liquidity risk in a crisis
Liquidity risk is more likely to be a problem for a company already in a
weakened financial state.
- They sell illiquid asset well below market value; exacerbating their
financial state
- Difficult to borrow or Borrowing at high interest rates,
Fears of solvency leading to withdrawals, policyholders not renewing,
investors withdrawing their capital also drive for liquidity risk. The situation is
even more real in times of economic downturn. Liquidity problems are
contagious.
 P&C exposed to liquidity risk when catastrophe occurs, but this is can be
alleviated by reinsurer providing the liquidity. But if reinsurer fails, then there
is a ripple effect throughout the industry.
Government may help by lending money.
Managing liquidity risks
o Product design; design can increase liquidity risk. Guarantees
surrender values, policy loan at fixed rate, derivative trader required
for margin call. Can be alleviated by penalties for surrender, or
deferring payment.
o Marketing; if liquidity option is emphasized as desirable feature during
point of sales
o Pricing; price should reflect cost of providing any liquidity option
o Risk Management; to diversify in order to not to have customers all
moving in the same direction at the same time. E.g. if one brokerage or
agency is your significant contributor. It is prudent to diversify source
of business
o Investments; to evaluate existing portfolio, how much would be lost at
a given time by selling on short notice, how much could be borrowed
by pledging the asset as collateral, is the holding of any particular
asset so large that a forced sale would depress the market (2007-2008
crisis)?
o Asset Liability mismatch; borrowing short term and lending long term
creates liquidity risk. Should limit the size of mismatch, but spreading
the maturity of issued bonds over several years to avoid large
refinancing.
o Contingency plans; plans for accessing additional liquidity in an
emergency. In some countries, there are industry arrangements so that
banks and other financial institutions will provide each other with
support under specified circumstances
o Solvency; solvency problems has a higher liquidity risk, so best to
address the credit ratings concerns because they are the informer of
your financial security to public.

Discontinuance solvency and going-concern solvency

Alternative forms of discontinuance solvency; three possible courses of action
when an entity ceases operations:
a) Winding up; Assets are sold and proceeds are distributed among the
creditors. Cause financial hardship for the customers
b) Run off ; stops writing new business or renewing existing contracts, but
continues to run off its existing liabilities in an orderly manner
c) Transfer of business; another stronger financial institution takes over
the liabilities, along with sufficient assets to cover them, preferable
option for the policyholders.
Measuring discontinuance solvency; to assess the discontinuance solvency of
a financial institution:
 a) Determine the value of assets likely to be available to pay off liabilities
in a discontinuance situation
b) Determine the value of liabilities in a discontinuance situation
c) As (a) and (b) involves uncertainty, determine the minimum additional
capital that should be set aside to absorb losses in adverse outcome
d) Considering (a) and (b), assess the amount and quality of capital that
would be available to meet obligations; eligible capital
(d)/(c) is often referred as solvency ratio -> measure of ability to meet its
obligations. Regulators and rating agencies will also use other metrics such
as liquidity ratio and solvency ratio and their trends in measuring financial
strength.
Measuring going-concern solvency; on going concern basis, over a period of
some years into the future on the assumption that the institution will
continue to accept new business. The amount of capital required will be more
than that of run-off for two reasons:
a) It is writing new business-> accepting more risk and incurring more
expense
b) Looking at solvency over a longer time frame, the longer the time
frame, the greater the uncertainty about the future experience
It is assessed by using projections of future experience, allowing for impact of
new business and a range of adverse scenarios.

Valuing of assets for solvency purposes

Assets in companys account has to be adjusted for solvency purposes
1. It may be reported on cost or using DCF, rather than market value. But at
discontinuance situation, assets have to be sold immediately so market value of
assets should be a starting point.
2. Market value of assets in a discontinuance situation may well be less than the
market value of assets. Regulators require the value of certain assets to be
excluded -> inadmissible or non-admitted assets. The following assets may be of
little or no value in the event of winding up:
a. Intangibles; goodwill
b. Assets whose value depends on the continued existence of company;
future income tax benefits, DAC, specialized computer software
c. Assets that may be difficult to collect if the company becomes solvent;
unsecured loans to directors, premiums outstanding from brokers
3. Assets will usually not be admitted if there any encumbrances (drawback), like
mortgaged assets
4. Prevent double counting. When subsidiary company set aside assets for its own
capital requirement
5. Exclude risky assets, such admitting only x% of total assets in a single entity,
encouraging company to diversify.
To avoid manipulation/over optimistic asset valuation, it can be verified by an
external auditor who is a person of integrity, experienced, expertise of the relevant
field, independent, willing to question the company, and can also be a whistle
blower.

Valuing of liabilities for solvency purposes

Another insurer will only be willing to take on the liabilities if it also receives a
transfer of assets equal to the fair value of liabilities. Or that interest of fund
members is safe when there is enough to fund to buy an equivalent annuity from
other insurer, this amount is called the buy out value. This suggest that valuation of
liability should be the fair value.
But fair value of liabilities is hard to obtain; insurance portfolios are not
standardized; each has its own risk; not commonly bought and sold, no liquid
market for insurance liabilities, so there is little information to estimate the market
value of liabilities
o Methods for the valuation of liabilities
I. Statutory valuation basis
PV of expected future cash flow using methods and assumptions specified
by the regulatory authorities. Assumptions are set out to be conservative
to include risk margin. This valuation is objective because everyone is
using the same mortality rates and methods asked by the regulators so it
does not reflect relative risk
II. The margin for adverse deviation method
Allows for the differences in the risks underlying each companys
liabilities. Actuary works out a BEA for each element of valuation basis,
then add margin to each assumption.
Factors that might affect the reliability of that estimate: size of
portfolio/number of claim per annum, number of years past experience,
mix of clients, type of product, underwriting policy, level of lapses and
surrenders.
In determining the appropriate margin, to consider: credibility of past
data, amount of stochastic variation, sensitivity of outcomes due to
changes in assumption, changes in environment that makes the past
irrelevant.
III. The probability of sufficiency approach
Modelling the distribution of all possible outcomes for claim costs, and
determine reserve so so as to provide an x% probability of covering the
claims, where the x% is determined by regulators or BOD. This is similar to
the VaR, and also to use TVaR to measure the loss given that claims fall in
the worst x% of the loss distribution.
Alternatives including: stochastic reserve
o Adjustments to reflect the impact of discontinuance on the liabilities
I. Flood of policy surrenders, sensible to compare assets to the total of
surrender values on all policies
II. Cumulative anti selection trend
III. Increase in expense ratios during run off to pay for terminations of staff
and fixed cost that is spread over reducing portfolio
o Dealing with discretionary benefits; difficult issue
o How can we be sure that the value of liabilities is correct?
Professional standards provide guidance for the determination of appropriate
assumptions., and actuaries should resist any pressure to deviate from these
standards, and also the accuracy of liability valuation depends on data

Capital Requirements: the risk-based capital approach

Minimum capital requirement calculation taking account of the risks faced by that
institution
o Creating risk based capital standard
o Set objectives; the measurable solvency objectives: e.g. 95% probability
of solvency over a one-year time frame
o Identify all significant risks
o Decide which risks should be included in calculating the capital
requirement; if relatively less significant or difficult to quantify can be
excluded for simplicity, or required to hold well above the minimum
requirement to allow for these difficult to quantify risks
o Workout a measure of exposure to risk; e.g. x% of home loans secured by
mortgage or 100% for commercial loans. Or can use projection to
determine the level of capital to provide satisfactory level of solvency
throughout the projection. Must be simple but sophisticated enough to
produce an adequate RBC level.
o Ensure that the measures of exposure are objective and reliable
o Quantify the size of potential losses for each unit of exposure, the number
of x%, from historical data
o Allow for diversification benefits; correlation between risks

Risk based capital: internal models

Can use own internal models, advantages are,
- More accurate and more comprehensive, it has its own sources of more relevant
information
- Improvements in internal risk management procedures, as it helps the
management to make wiser decisions about which risks to accept, and how
different risk should be priced
- Cost savings; cheaper to have one system instead of two. The use of a more
accurate internal system may enable company to justify lower capital
requirement so the cost of setting up may be worthwhile
Have to mind conflict of interest, regulators need examine its internal risk
assessment system to make sure that it is consistent, not too subjective, based on
accurate data, takes accounts of all factors and empirically tested and verified.

Integrating the capital management model into the control cycle

Regulatory RBC rules should allow companies to reduce their capital when proper
risk mitigation is in place (e.g. reinsurance or hedging) as incentive for them to
implement. Capital model should be used as an input for decision making process:
- Product design process to include capital requirements for features like capital
guarantees or premium guarantees
- Pricing should include amount of capital required to support that product
- Capital constraints should be considered before setting sales target.

Asses the amount and quality of capital

Ideally capital should be a permanent and unrestricted investment of funds which is
freely available to meet losses, which does not impose unavoidable charges on the
earnings of the institution and which rank below the claims of those we wish to
protect (policyholder, depositors, etc) in the event of winding up.

Shareholders capital and retained earnings fit this.

Mandatory convertible notes: charges interest but becomes permanent source of
capital during maturity when they become shares
Subordinated debts: ranks below those we wish to protect, but not permanent

The role of risk management and market discipline in solvency regulation

In the past, regulators can just impose restrictions on the concerning risks, these
days, in the face of international competition, there is greater emphasis on taking
these risks but making sure that adequate mechanism are in place to handle these
risks. These mechanism includes:
o Appropriate skills and expertise of management
o Internal risk management; develop formal risk management strategy (RMS)
approved by BOD
o Reporting requirements and early warning systems;
To provide detailed reports to the regulator so problems can be detected early,
allowing action to be taken promptly, before losses multiply. Trends in reserve,
profitability, reliance on reinsurance, changes in mix of business, investment
returns and liquidity. Investigate the unusually large or small ratios.
o Disclosure and ratings
To properly disclose financial condition so investors, customers, brokers, rating
analyst, and creditors are well aware. This will lead to market discipline which
creates strong incentive to conduct business properly.
o The role of professionals
Regulators have limited resources and hence may rely on professionals such as
auditors and actuaries to provide early warnings. Role of appointed actuary or
responsible actuary:
- Advice on valuation of liabilities
- Advice on items such as: the premiums to be charged, the terms and
conditions of insurance contracts, the risk assessment policies, the adequacy
of reinsurance arrangements, the investment policy
- Advice on the determination of allocation of profits (for participating prods)
- An important fiduciary role to represent the interests of policy holder when
decisions are taken within insurer
 - Dynamic solvency testing and reports on current and future financial
conditions of the insurer to assist the BOD in developing risk management
strategies
- Whistle blower
o Financial condition reports;
Include a comprehensive control cycle review, the companys objective, product
design, pricing, customer mix, an analysis of past experience relative to
expected experience, comments on trends in experience, a review of assets and
investments performance, suitability of investment strategies, valuation of
liabilities, analysis of profit by source.
The aim is to identify the strengths and weaknesses, risk and opportunities for
the company
o Dynamic Solvency testing or Dynamic Financial Analyst or Dynamic Capital
Adequacy Testing
Process of analyzing and projecting the trends of an insurers capital position
given its current circumstances, its recent past, and its intended business plan
under many sensitivity testing, allowing the actuary to inform the management
on the implication of business plan on capital and the significant risks to which
the insurer is exposed to.
Goal is to identify possible threats to the financial condition of the insurer and
appropriate risk management or corrective actions to address those threats.

Responding to solvency problems

Three approaches to alleviate the problem in the short term:
1. Raise additional capital; issuing shares, hybrid debt, retaining profits, borrowing
by subordinated debts
2. Improve the quality of capital; sell non-core business with goodwill value,
converting inadmissible assets to admissible assets
3. Reduce risks; increasing reinsurance or switching to a more conservative asset
allocation
If the three measures are not feasible, the financial institution may be forced to
seek a merger with another that can provide financial support. Regulators also have
a role to play. They are given the authority and responsibility to intervene at a fairly
early stage as soon as it appears that this is necessary to protect the public interest

Deciding when to intervene, must not be too fast which exacerbated the whole
situation or too slow and face the wrath of customers. They are rather flexible in
times of economic downturn. But delay often will make the situation even harder
and more expensive. Intervention level when the regulatory capital standards are
breached:
o No action: Capital > 200% required RBC
o Company action level: Capital < 200% required RBC; must submit plan to
regulator
o Regulatory action level: Capital < 150% required RBC; regulator may take
corrective action
o Authorized control level: Capital < 100% required RBC; regulator may take
control of company
o Mandatory control level: Capital < 70% required RBC; regulator must rehabilitate
or liquidate company

Deciding how to intervene, must be flexible in choosing the most appropriate

corrective action. Obtaining additional capital does not address the underlying
causes; If regulators believe the company can be salvaged then they can put it
under judicial management (if its because of poor management); seeks assistance
from other companies in the same industries; if its beyond salvation then can
minimize impact on customers by arranging for another stronger financial institution
to take over the liabilities, but must be careful in not dragging down the stronger
one.

Guarantee Funds
To alleviate the effects of any insolvency, one can set up guarantee fund that will
provide financial assistance to customers and third party claimants. Can be set up
by government or by industry groups, either by taxes or by levies on the industry.
Arguments for and against guarantee funds
o Advantages
Financial burden of failure is spread across the wider community
Reassurance to public, improve the stability of financial system
o Disadvantages
Moral hazard; companies inclined to take more risks, customers
take the cheapest rates without considering the company
solvency
It might have unintended and unexpected side effects, after 2007-2008 crisis, banks
of several countries extended and strengthened their deposit guarantees, this have
to be followed by other countries otherwise there might be outflow to safer havens.
Governments provide some sort of implicit guarantee, because they cannot afford
to allow a loss of confidence in the financial system.
Design of guarantee funds
o Under what circumstances should compensation be provided? Fraud or
dishonest conduct?
o Who should be eligible for the compensation?
o Should there be limits on the compensation?
o Who should pay or fund for this guarantee?
o If it is funded by levy, should be funded in advance or should the levy
be collected only when needed?
o If it is funded by levy, how should the amount of the levy be
determined across the companies?