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Policy Issues in Insurance
Assessing the Solvency of Insurance Companies This volume is the fourth of a series devoted to major policy issues in insurance. It comprises an in-depth analysis on the assessment and the management of the major technical and financial risks insurance companies have to face. It responds to the growing concerns of economic, financial, political and social actors in the insurance market. It addresses the ever increasing risk exposure of insurance companies that could endanger their financial health. This book constitutes a unique reference work for the attention of both OECD countries and emerging economies.
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No. 4
Assessing the Solvency of Insurance Companies
Assessing the Solvency of Insurance Companies
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Policy Issues in Insurance
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ISBN 92-64-10189-6 21 2003 03 1 P
No. 4
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Policy Issues in Insurance No. 4
Assessing the Solvency of Insurance Companies
ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT
ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT
Pursuant to Article 1 of the Convention signed in Paris on 14th December 1960, and which came into force on 30th September 1961, the Organisation for Economic Co-operation and Development (OECD) shall promote policies designed: – to achieve the highest sustainable economic growth and employment and a rising standard of living in member countries, while maintaining financial stability, and thus to contribute to the development of the world economy; – to contribute to sound economic expansion in member as well as non-member countries in the process of economic development; and – to contribute to the expansion of world trade on a multilateral, non-discriminatory basis in accordance with international obligations. The original member countries of the OECD are Austria, Belgium, Canada, Denmark, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The following countries became members subsequently through accession at the dates indicated hereafter: Japan (28th April 1964), Finland (28th January 1969), Australia (7th June 1971), New Zealand (29th May 1973), Mexico (18th May 1994), the Czech Republic (21st December 1995), Hungary (7th May 1996), Poland (22nd November 1996), Korea (12th December 1996) and the Slovak Republic (14th December 2000). The Commission of the European Communities takes part in the work of the OECD (Article 13 of the OECD Convention).
Publié en français sous le titre : Évaluation de la solvabilité des compagnies d’assurance
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FOREWORD
Foreword This fourth volume of the series devoted to major policy issues in insurance presents an in-depth analysis of the management of the major technical and financial risks to which insurance companies are exposed. The report provides an extensive comparative analysis of the major current trends in the assessment of the solvency of insurance companies in OECD countries. It also points out at the risks causing most of insurance undertaking failures – namely underpricing, underprovisioning, unexpected depreciation of key assets, mismanagement, and inadequacy of information support provided to supervisors which could prevent them from issuing early warnings. It also emphasises the growing concern related to risks that may arise from financial convergence or from the recourse to new financial instruments. The report also compares the different regulatory and supervisory frameworks in OECD countries and the various strategies enforced to assess and curtail the scope of insurer risk exposure in order to best protect policyholders. Special emphasis is put on the various methods used to assess the solvency of insurance companies, and on the various tests to appraise the technical provisions and balance sheet assets that are undertaken by the OECD supervisory authorities. The importance of considering the operating conditions and business environment of insurance companies is underscored as well. Finally, the study details the different recovery measures that are conducted in OECD countries in case solvency difficulties of insurance companies can not be overcome. This report was elaborated by Mr. Jean-Louis Bellando, former Head of the French Insurance Supervisory Authority (Commission de Contrôle des Assurances). The views expressed here are the sole responsibility of the author and do not necessarily reflect those of the Insurance Committee, the Secretariat or OECD Member countries. This volume was prepared by the Insurance and Private Pensions Unit, within the Financial Affair Division and is published under the responsibility of the SecretaryGeneral of the OECD.
ASSESSING THE SOLVENCY OF INSURANCE COMPANIES – ISBN 92-64-10189-6 – © OECD 2003
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TABLE OF CONTENTS
Table of Contents Introduction .................................................................................................................. 7 Executive Summary ...................................................................................................... 9 Chapter 1.
Analysis of the Main Risk Exposures of Insurance Companies ................................................................... 11
I. Technical risks ................................................................................................ 12 A. Underpricing ............................................................................................. 12 B. Underprovisioning ................................................................................... 16 II. Investment risks............................................................................................. 19 A. B. C. D. E. F.
Depreciation risk ...................................................................................... 20 Liquidity risk ............................................................................................. 20 Interest rate risk ....................................................................................... 20 Asset-liability matching risk................................................................... 21 Valuation risk............................................................................................ 21 Risk associated with the use of derivative financial instruments .... 21
III. Reinsurance risks ........................................................................................... 23 A. Technical risk............................................................................................ 23 B. Risk of debtor default by a reinsurer ..................................................... 23 IV. Risk of default by a special partner .............................................................25 A. Brokers .......................................................................................................25 B. Shareholders ............................................................................................. 26 C. Subsidiaries and affiliates....................................................................... 26 V. Risk arising from membership of a group or financial conglomerate.... 27 VI. Other risks .......................................................................................................28 VII. Risk of mismanagement ............................................................................... 29 VIII. Systemic risk................................................................................................... 30 Conclusion ................................................................................................................ 31 Chapter 2.
Regulation and Supervision of Overall Solvency .......................... 33
Summary................................................................................................................... 34
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TABLE OF CONTENTS
I. Solvency ratio ................................................................................................. 34 A. Assessing a firm’s wealth (available margin) ....................................... 35 B. Capital adequacy requirements: Required solvency margins ................ 40 C. The limitations of solvency margin systems ....................................... 50 Conclusion................................................................................................. 52 II. Triple test of balance sheet soundness ....................................................... 53 A. Technical provisions ................................................................................ 54 B. Balance sheet assets ................................................................................ 68 III. Operating conditions ..................................................................................... 98 A. Static solvency, dynamic solvency......................................................... 98 B. An insurance undertaking’s operating conditions determine its future................................................................................. 99 C. The mechanics of solvency supervision .............................................100 IV. The business environment .........................................................................108 A. B. C. D. E. F. G. H. I. J. K.
Regulatory constraints...........................................................................108 Competition ............................................................................................109 External auditors ....................................................................................109 Actuaries..................................................................................................110 Rating agencies.......................................................................................111 Delegated underwriting and management ........................................111 Members of mutual insurance associations ......................................111 Shareholders ...........................................................................................112 Reinsurers................................................................................................114 Insurance groups....................................................................................120 Financial conglomerates .......................................................................124 Conclusion...............................................................................................125
Chapter 3.
Treatment of Ailing Companies .....................................................131
I. Diagnosis .......................................................................................................132 II. Procedures and solutions ............................................................................133 A. B. C. D. E. F. G. H. I. J.
Dialogue...................................................................................................134 Recovery programme .............................................................................134 Additional measures..............................................................................134 Warning and follow-ups (portfolio transfers) ....................................135 Sanctions .................................................................................................137 Cessation of activity...............................................................................138 Withdrawal of licence............................................................................139 Appeal ......................................................................................................140 Winding-up .............................................................................................140 Policyholder protection funds ..............................................................141
Chapter 4.
6
General Conclusion ..........................................................................145
ASSESSING THE SOLVENCY OF INSURANCE COMPANIES – ISBN 92-64-10189-6 – © OECD 2003
INTRODUCTION
Introduction A new environment is surrounding the insurance business. The increasing liberalisation of markets has resulted in most prior supervision of products and tariffs being relinquished in favour of ex post supervision; the concentration and internationalisation of insurance companies has necessitated greater mutual understanding and closer co-operation between supervisory authorities in the different countries. Moreover, the supervisory authorities have had to meet the challenge represented by increased convergence between the different financial sectors – banks, insurance, securities and pensions – by drawing up solvency rules for insurance groups and financial conglomerates and co-operating closely or even merging with other financial sectors’ supervisory authorities. Finally, the new emerging risks have had to be taken into account and the protection of the insured has in some instances been increased, by introducing an additional level of cover, i.e. general funds for the protection of policyholders. The insurance solvency supervision is evolving in response. To better understand the changes and goals, it is necessary to know how authorities have been assessing the financial health of insurance undertakings, i.e. on the solvency rules. This study was written by an insurance expert, Mr. Bellando, former chairman of the OECD Insurance Committee and former General Secretary of the French Supervisory Authority. It is meant to complete the OECD recent publication on Insurance Solvency, which presents contributions from the 30 OECD countries on solvency supervision and a comparative analysis of the different systems. This study is published by the Financial Affairs Division of the Directorate for Financial, Fiscal and Enterprise Affairs. Where the report not only includes facts and analyses, opinions expressed in the report do not necessarily reflect the opinions of member states or the secretariat, but only the consultant’s view.
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EXECUTIVE SUMMARY
Executive Summary The need to give insurance policyholders special protection is now universally acknowledged. In judgements handed down on 4 December 1986, the Court of Justice of the European Communities (CJEC) gave four reasons why such protection is necessary: 1.
Insurance is a highly particular service because it is linked to future events, the occurrence of which is uncertain at the time a contract is concluded.
2.
An insured person may find himself in a precarious position if he does not obtain payment after filing a claim for compensation.
3.
It is very difficult for a person seeking insurance to assess the terms of a contract and the outlook for the insurer’s future financial position.
4.
Insofar as insurance has become a mass phenomenon, it is equally essential to protect the interests of third parties. Protection is generally based on regulation and supervision.
Regulation comprises the set of rules applicable to insurance companies as such, these rules being set in light of the role that these companies must perform in society and the objectives they must attain. The extent of regulation varies from one country to the next, covering in greater or lesser detail such aspects as insurance products and their distribution, insurance companies and their officers, how these parties are monitored, market organisation, competition and so forth. Supervision applies to the operation of companies and is exercised in different forms by the State and in some cases partially delegated to the private sector. In most cases the government is empowered to authorise insurance companies to do business and to withdraw such authorisation. It may refer observed cases of infringement to the legal authority, and in most cases it has the power to impose administrative penalties of varying severity. The purpose of supervision is to make certain that insurance undertakings comply with the relevant laws and regulations, and in particular that they: ●
Honour the contractual commitments (i.e. promises) they have made to the insured (legal supervision).
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EXECUTIVE SUMMARY
●
Are financially able to meet their commitments at all times (solvency supervision).
Regulation must ensure that supervisors are in a position to perform their assignment satisfactorily, by giving them: ●
Guarantees of independence from the entities supervised (and their partners) and from policymaking and business circles. Special measures are required in respect of the recruitment and promotion of supervisors and their transfer to the private sector.
●
Effective powers of intervention so as to be able to act preventively.
●
Appropriate material means.
An insurance undertaking is deemed solvent if it possesses the resources needed to honour, at any time and in any circumstances,1 its contractual commitments to insured parties and other policy beneficiaries. But insurance undertakings are exposed to risks that can jeopardise their ability to meet these commitments. Analysis of the causes of a number of business failures around the world shows that the losses of insurance undertakings are attributable primarily to underpricing, underprovisioning, depreciation (or even misappropriation) of certain investments, default by certain partners (e.g. brokers or reinsurers), mismanagement or inadequacy of tools given to supervisors to carry out their missions. The aim of regulation and supervision is to preclude these risks or to limit and repair their effects. The first chapter of this report will analyse the different risks and their remedies. The second will synthesise the prudential arrangements instituted by countries to safeguard the rights of policyholders. The third chapter deals with companies in financial difficulty despite regulation and supervision.
1. This is a prudential point of view. It means that a company should be able to cope even with events such as the 11 September attacks, which were not foreseeable. Otherwise, the entire sector might fail.
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ISBN 92-64-10189-6 Policy Issues in Insurance No. 4 Assessing the Solvency of Insurance Companies © OECD 2003
Chapter 1
Analysis of the Main Risk Exposures of Insurance Companies The following list is not exhaustive: I. Technical risks (due to insurance activities): ● Underpricing ● Underprovisioning ● Inappropriate reinsurance ● Unforeseen management expenses (may be included in the “underpricing” risk) II. Investment risks: ● Investment depreciation ● Interest rate fluctuations ● Insufficient liquidity ● Asset/liability mismatching ● Risks arising from the use of derivative financial instruments III.-IV. Risk of default by a partner (e.g. broker, reinsurer, shareholder, affiliate, etc.) V. Risks arising from membership of a financial conglomerate VI. Other related risks VII. Risk of mismanagement VIII. Systemic risk
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ANALYSIS OF THE MAIN RISK EXPOSURES OF INSURANCE COMPANIES
I. Technical risks A. Underpricing This risk of miscalculation is intrinsic to every insurance transaction. Premiums are set in advance, before the insurer knows what the actual cost of the services it has undertaken to provide will be. Economists call this an inversion of the normal production cycle. Even the most reasonable forecasts of expenditure on claims (number, cost, assessment of damage by the courts at the time of judgement as opposed to the date of an accident) and overhead costs may be exceeded. And because a very long time may elapse between payment of the premium by the policyholder and performance of the service promised by the insurer, the latter may in fact be insolvent without experiencing any cash flow problem, new premiums being used to pay out earlier claims. To avoid this, premiums have to be sufficient to cover the insurer’s expenditures – claims and management-related costs – allowing for the contribution of financial income. In non-life insurance, the equilibrium equation may be written thus: P + FI = C + AMC
[1]
Equation [1] should be read as: ●
inclusive of reinsurance;
●
by period of claims filed;
●
in the aggregate at company level and separately by class of insurance written, or even by product. The terms of the equation are:
P = premiums earned in accounting period n,2 i.e. written premiums less the unearned premium reserve. P represents the premium portions corresponding to the estimated cost of the risk and its management during accounting period n. C = claims incurred during period n, comprising claims paid and provisions for claims filed but not yet paid, together with provisions for claims incurred but not yet reported to the insurer (“late” or IBNR claims). AMC = acquisition and management costs during period n. These costs are apportioned between insurance classes and products on the basis of cost accounting figures or, failing this, pro rata to premium revenue.
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ANALYSIS OF THE MAIN RISK EXPOSURES OF INSURANCE COMPANIES
FI = Financial income. Premiums paid in advance are invested pending future claims. The investment income naturally accrues to the policyholders as a group, rather as though their premiums were discounted. This leaves the income from investments made with the company’s own capital: apportionment is according to the ratio of technical provisions net of reinsurance3 to the company’s equity. The income accruing to policyholders in the aggregate is apportioned between insurance classes and products in ratio to the net technical provisions for each class or product. From equation [1] it follows that the equilibrium loss ratio (C/P), corresponding to an operating out-turn with neither profit nor loss, may be written thus: C/P = 1 + (FI – AMC)/P
[2]
Since income is apportioned among insurance classes in direct ratio to the claims provisions, C/P equilibrium may differ appreciably from one class to another. Example: France 1998, as percentage of premiums earned: ●
Third party motor AMC = 21.1% FI = 15.3% C/P (equilibrium) = 94.2%
●
Homeowner fire AMC = 27.2% FI = 6.0% C/P (equilibrium) = 78.8%
●
Total direct business AMC = 23.3% FI = 9.2% C/P (equilibrium) = 85.9%
In France, third-party motor vehicle insurance is profitable if claims for the year amount to less than 94% of earned premiums. Homeowner fire insurance is profitable if the loss ratio is below 79%. In assessing a product’s profitability it is also necessary to factor in the cost of reinsurance and the establishment of an equalisation provision to smooth out the company’s results over time. The weight of these additional costs is in inverse ratio to the size of the contract portfolio (pursuant to the law of large numbers). Solvency is generally equated with a positive aggregate out-turn, the deficits on some lines of insurance being offset by surpluses on others. Equity demands that the loss-making lines should not always be the same. Some countries apply tighter constraints. Belgium, for example, requires the financial out-turn for each of the products defined by law to be positive every year (the law defines over 80 products). The linkage between profitability and solvency is evidenced here by the fact that the insurer must, in order to safeguard its financial position over the
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ANALYSIS OF THE MAIN RISK EXPOSURES OF INSURANCE COMPANIES
longer term, set premium rates that are adequate. But there are many reasons why the premiums charged may be too low: 1. Lack of reliable statistics, as in the case of new risks (long-term care insurance). 2. Incorrect processing of the statistics on a policyholder population: inappropriate classification of risks, incorrect allocation of claims expenses. 3. Inadequate provision for pending claims, due to overoptimistic earnings forecasts. 4. Changes in insured risks: past statistics will not be exactly repeated in the future (longer lifetimes, natural disasters, interest-rate changes, etc.). 5. Insufficient acquisition and management cost loading4 to cover the insurer’s actual expenses. 6. Aggressive business policy in a given market segment, or simply defence of a contract portfolio under attack from competitors able to bear a higher loss ratio (e.g. mutual associations with no commission-earning intermediaries). 7. Failure of marketing agents to comply with pricing instructions, either because they are inadequately supervised by the head office, or because certain major contributors impose their own conditions. When a broker’s clients account for a significant share of a company’s business and contribute largely to its performance, their switch to a competitor may break the company’s equilibrium. 8. Even if a premium rate is properly set on the basis of reliable statistics, the frequency of claims filed in a given year is always liable to diverge from the theoretical frequency assumed in calculating the premium – the smaller the number of policyholders, the wider the divergence. Operating losses liable to bankrupt an insurance company at some future date may therefore result from the structure of the company’s activities (new risks, diversity of operations, volume of business), from management initiatives taken through ignorance, incompetence or carelessness, or from a deliberate effort to win a market. The risk of premium miscalculation cannot be totally separated from the risk of mismanagement. The regulatory and supervisory framework includes arrangements to support or reinforce sound management decisions on the part of insurance companies: 1. Competition permitting, insurers may build a safety margin into their premiums. This safety margin is sometimes incorporated in the statistical base used (e.g. life table). A general mortality table, i.e. based on health statistics for a whole population, takes into account sick or dying persons who are not insurable: this constitutes a safety margin.
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ANALYSIS OF THE MAIN RISK EXPOSURES OF INSURANCE COMPANIES
A survivorship table based solely on a female population and applied equally to both sexes will also provide a safety margin, given that men have a shorter life expectancy than women. 2. Reinsurers may be required to make good the losses from catastrophic events or out-turn shortfalls, which are particularly serious for small policy portfolios and new companies. 3. Mutual insurance companies may have the right to charge policyholders additional amounts of premium to cover unexpected losses. 4. A minimum capital standard enables the insurer to cover operating losses for some time. 5. In some countries, regulators prescribe pre-control of premium rates, which have to be officially approved before they can be offered to the public. In others (e.g. Japan), rating agencies propose rates under the aegis of insurance associations. These solutions limit miscalculation, but an official endorsement can never be a guarantee of sustainable solvency. S u p e r v i si o n o f p re m i u m - se t ti n g i s o f t e n d i c ta t e d by e c o n o m i c considerations related to price control. Insurance is a service that has to be paid for, but not so as to generate a disproportionate profit for a powerful, well-organised insurer dealing with defenceless, unknowing policyholders. But price controls have been known to jeopardise the financial health of market undertakings when the ceilings imposed are lower than the rates needed to break even. The European Union directives rule out systematic notification or prior approval of premium rates. Directive 92/49/EEC on non-life insurance adds that “Member States may not retain or introduce prior notification or approval of proposed increases in premium rates except as part of general price-control systems”. As for rates sponsored by an insurance association, they may contribute to the formation of a cartel that restricts competition at the expense of consumers. 6. Insurance segmentation can be defined as the custom tailoring of services to the specifics of persons and property on the basis of selective criteria, with premium rates set accordingly. The insurance company uses the criteria that will enable it to set the most appropriate premium rates for the different risks to be covered, and also to find profitable market niches and develop customer loyalty. Segmentation thus permits more appropriate premium rating, but if taken to excess it undermines the principle of solidarity among policyholders in the same risk category. 7. In life insurance (Article 29 of Directive 92/96/EEC), for the purpose of verifying compliance with national provisions concerning actuarial principles, EU Member States may require systematic communication of
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the technical bases (survivorship or mortality table, interest rate, expense loading) used in calculating premium rates and technical provisions. But this requirement does not constitute a prior condition for a company to carry on its business. 8. Article 19 of the same directive establishes an essential principle: “Premiums for new business shall be sufficient, on reasonable actuarial assumptions, to enable insurance undertakings to meet all their commitments and, in particular, to establish adequate technical provisions.” 9. Supervisors look not only at a company’s financial position at a given point in time but also at its operating environment, which will have a decisive effect on its future finances. Even if there is no prior check on pricing, supervision must be preventive and closely monitor premium levels, incurred loss ratios and technical results. In France, insurers send confidential annual statements to the supervisory authority specifying the loss ratios recorded for each class of business for the accounting year. Supervisors obtain further information on the premium rates applied to each product by means of on-site inspections. Similar arrangements exist in many countries. 10. In Sweden, the annual statements sent to the supervisory authority before 1999 specified 14 ratios for each of which there is a designated range of normalcy, any result significantly outside that range necessitating tighter supervision. Some of these ratios may provide evidence of inadequate premium rating: ●
C/P (net of reinsurance): a range of 0-80% is normal
●
AMC/P (net): 0-25% is normal
●
Underwriting result/Net earned premiums: 0-10% is normal.
11. Belgian law has established profitability supervision, stressing that adequate premium rating is the best guarantee of a company’s financial soundness [see document DAFFE/AS/SOL/WD(93)1]. 12. In a number of countries, actuaries officially (appointed actuaries) or unofficially supervise life premiums (in many countries) and non-life premiums (in some countries).
B. Underprovisioning Technical provisions5 represent over 80% of an insurance company’s debt. They are a measure of its contractual obligations to policyholders and other beneficiaries.
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ANALYSIS OF THE MAIN RISK EXPOSURES OF INSURANCE COMPANIES
These obligations cannot be known exactly; they have to be estimated, and the persons estimating them can make mistakes. There are several causes of error: 1. In the case of long-term commitments, the corresponding technical provisions are subject to wide variations over time, in some cases unforeseeable, in others difficult to quantify: ●
interest rate fluctuations on financial markets (mathematical provisions);
●
longer lifetimes;
●
inflation rate changes (with effects on the cost of claims and management costs);
●
new legal developments (as in civil liability insurance).
2. In some classes of insurance there may be a very long interval between the time a claim is filed and the time it is settled in full, the information needed for purposes of assessment being assembled only gradually. This is especially true of civil liability insurance such as pollution liability, medical liability, decennial liability, etc. 3. At the date of the balance sheet, an insurer is unaware of a certain number of property losses incurred but not yet reported, i.e. IBNR or late claims. Inaccurate forecasting, legal or economic developments, inability to gather the necessary information, misinterpretation of data received or, in some cases, a desire to report higher earnings can all explain why a company may fail to make adequate balance sheet provisions for its contractual liabilities. Provisions for claims in non-life insurance, mathematical provisions in life insurance and provisions for management costs in all cases are most liable to evaluation errors. Underprovisioning harms a company’s financial position in two ways: 1. Liabilities that should have been booked in the relevant accounting period are carried forward, thus compromising future performance. On the balance sheet, underprovisioning makes it possible to show a higher level of owners’ equity for the same level of total assets. Example: in situation (2) the technical provisions are scaled back by 5.5% and the insurance company doubles the book value of its equity capital. All regulations concerning owners’ equity are tied in with the required level of technical provisions.
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ANALYSIS OF THE MAIN RISK EXPOSURES OF INSURANCE COMPANIES
(1) 100
(2) 100
Technical provisions Other debt Equity
90 5 5
85 5 10
TOTAL LIABILITIES
100
100
TOTAL ASSETS
2. Underestimation of provisions for outstanding claims distorts a company’s judgement concerning the equilibrium of its underwriting. Consequently it may decide to promote certain products that it thinks will be profitable but that will in fact turn out to be loss-making – something that would have been apparent earlier with correct provisioning. To preclude these factors of destabilisation, a great many countries have introduced regulations, but in most cases these are merely statements of principle and do not go into details concerning the calculation of technical provisions: 1) The amount of technical provisions must at all times be sufficient to enable the insurance company to meet its contractual commitments to the extent of what is reasonably foreseeable. 2) Technical provisions are booked inclusive or net of reinsurance. In the first case, the reinsurance share is entered on the asset side of the balance sheet; in the second, it is deducted from the gross amount. The gross book value shows, on the liability side, the amount of the insurance company’s debt to its policyholders. In any event the basic valuation always includes reinsurance. The reinsurers’ share must not exceed the amounts for which they are actually liable under reinsurance treaties. In particular, it must not exceed the sums that would be paid by reinsurers if a treaty were terminated. 3) Technical provisions must include a management provision to cover expenses incurred in managing contracts and benefits until such time as a contract expires or is cancelled. 4) Technical provisions must be calculated separately for each contract or for each claim. However, statistical methods may be used as long as the resulting provision is sufficient. In some countries, the calculation bases used for these statistical methods (average costs, frequency of settlements, etc.) must be approved beforehand by the supervisory authority. 5) In life insurance, the technical provisions must be calculated according to a sufficiently prudent prospective actuarial method that takes account of all the future obligations of the insurer under the terms of each contract in force: guaranteed benefits, including surrender values; profit distributions; options offered to policyholders, etc.
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ANALYSIS OF THE MAIN RISK EXPOSURES OF INSURANCE COMPANIES
6) In many countries a long-accepted principle has been that the mathematical provision for a life insurance contract should be calculated on the same technical bases as premiums (life table, interest rate, expense loading). The reasoning is that it would not be admissible for a life insurer to calculate the mathematical provision on less prudent bases than those used for premium rating. At the same time, the recent fall in interest rates and the lengthening of life spans have shown the need to use prospective methods of evaluation as well: recent mortality tables, effective rates of return on company assets, etc. 7) In non-life insurance, technical provisions should permit full cover of claims incurred (claims reserve) or to be incurred (risk provisions). The sums recoverable by subrogation (transfer of rights from the insured to the insurer) or salvage are booked separately. 8) A number of jurisdictions prohibit discounting of loss provisions, i.e. by factoring in a series of future financial income streams. Income cannot be treated as a premium component (as it is in determining the equilibrium claims ratio) and at the same time be taken into account in the estimation of technical provisions. 9) In the case of run-off of claims, the technical provisions must be sufficient to cover all outstanding claims and related management expenses. 10) In countries where appointed actuaries are recognised, one of their assignments is often to certify the level of mathematical provisions, and sometimes that of non-life technical provisions. 11) Supervisors must check the aggregate level of technical provisions from the figures given in the confidential annual report that insurance companies must file with the supervisory authority each year. With regard to claims, statistical statements make it possible to compare provisions and payouts from year to year and by year of occurrence. If they deem it necessary, supervisors conduct on-site checks of the methods used in estimating claims provisions, the rules prescribed for booking the latter and the application of those rules. 12) Lastly, owners’ equity can be used to offset insufficient provisions, to the extent that the capital exceeds the shortfalls.
II. Investment risks The sometimes very long lapse of time between premium collection and benefit payment means that an insurance company is the depository of large sums of money, which it endeavours to manage as well as possible in order to be able to meet its commitments. While it is necessary to carry technical provisions on the balance sheet as liabilities, they must be matched by an
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equivalent volume of assets of select quality. This continuous matching of technical provisions with assets of at least equal value enables the company to meet its obligations to policyholders. But the investments of insurance undertakings are exposed to a variety of risks that can jeopardise the rights of policyholders.
A. Depreciation risk Any investment may lose value following a stock market or real estate market downturn (market risk), exchange rate fluctuations (in the case of foreign currency assets), a rise in interest rates on financial markets (with a consequent fall in listed bond prices), or default of a debtor (unlisted bonds).
B. Liquidity risk The liquidity risk is linked with the ability to pay debts when they fall due. Some assets are liquid in regard to any debt that may fall due, while others are liquid only in regard to the debts they match. Other assets, such as shares, may be considered liquid only if they can be sold in such a way that their market value is not affected too much. An insurance company may have difficulty in converting its investments to cash on satisfactory terms when it is time to meet contractual obligations. Liquidity problems can be caused by brokers failing to remit substantial amounts of premium income, by a collapse in real estate prices making sales impossible other than at knock-down prices, by an accumulation of outstanding recoverables, etc. When cash surrender values are contractually guaranteed, a life insurer is exposed, in the event of an interest-rate rise, to a flood of requests from policyholders wanting to switch their savings to more profitable products. At the same time, the prices of bonds representing the mathematical reserves fall and the insurer will be obliged to sell some at a loss in order to generate cash. In many cases, liquidity problems precede solvency problems. Cash difficulties may be resolved by borrowing, if lenders can be found, which will depend on the company’s financial position and loan costs.
C. Interest rate risk In life insurance, as has been seen, a rise in financial market interest rates causes certain assets to lose value at a time when policyholders want to recover their investments, while a fall makes it more difficult to provide guaranteed high returns. In non-life insurance, high-yield bonds that mature when rates are falling can only be replaced by assets that are less lucrative, which will have an impact on the breakeven loss ratio (this being dependent on the amount of FI, see above).
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D. Asset-liability matching risk Technical provisions must be covered at all times by appropriate assets of equivalent value, despite capital market fluctuations that affect asset prices and yields. Those same fluctuations can also affect how technical provisions are calculated. The risk is that changes in liabilities and assets will not match, with resulting losses for the insurer.
E. Valuation risk Auditors may compel a company to write down assets that are overvalued relative to their current market value. This risk exists particularly in the case of strategic equity participations (see below).
F. Risk associated with the use of derivative financial instruments The use of derivatives entails specific risks above and beyond the market, credit and liquidity risks already mentioned: ●
leverage effect creating a large loss potential;
●
insufficiently experienced users;
●
absence of regulation in many jurisdictions.
Most countries have adopted regulations that considerably reduce the risks associated with the investments held by insurance companies as cover for their technical provisions. 1. In some countries, these regulations concern not only the assets that cover technical provisions but all of an insurance company’s investments. 2. The assets allowed as cover are selected: European Directives 92/49EC and 92/96/EC established closed-end lists of allowable assets, all of them chosen for safety, profitability and liquidity. Assets such as unsecured loans,6 gold bullion, raw materials are generally excluded. Investments backed by the government of an OECD country are deemed the safest; securities listed on a major stock exchange are the most liquid, bonds are considered profitable, etc. Securities of subsidiaries and equity shareholdings are excluded in some countries. In others they are quantitatively restricted to a greater or lesser extent. 3. Investments must be diversified and split among the different asset categories. Real estate and equities are generally limited to a specified percentage of the technical provisions, e.g. respectively 40% and 65% in
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France. Restrictions are always tighter for unlisted equities than for listed ones. The European directives limit individual investments to: ●
10% of technical provisions in the case of a building;
●
5% in respect of shares, notes, bonds or loans issued by any one issuer.7
4. Investments are subject to prudent and reasonable valuation rules. In some countries, assets are carried on the balance sheet at historical cost. A depreciation provision is booked either permanently, if the asset is deemed unlikely to recover its purchase value, or temporarily, if the value loss can be regarded as cyclical. The provision is calculated separately for each asset or in aggregate. In some countries, assets must be carried at their lowest-ever book value. Elsewhere, the balance sheet records market value, and wide fluctuations are possible. “Resilience tests” gauge foreseeable swings, and the results are set against the company’s equity capital or a special technical provision is established. Supervisors may always seek the assistance of independent experts if they have doubts about the value of a building or an unlisted security. In the United States, the book values of shares and bonds held by insurance companies operating in the different states are standardised by the National Association of Insurance Commissioners (NAIC). 5. The exchange rate risk is neutralised by a rule requiring that liabilities denominated in a given currency be matched by assets denominated in that same currency. Exceptions to this rule are generally limited by a quota system. In Switzerland, for example, there are quotas for technical provision cover by shares and other securities denominated in foreign currency or by claims on foreign debtors. 6. In Australia, the law requires assets to be held in the insurer’s name or to be subject to supervision by the insurer if placed in the custody of a third party. It is therefore possible for an insurance company to use internal or external fund managers to handle its assets, but it must retain legal ownership of them. 7. In some countries, the risks associated with the use of financial derivatives are reduced by quantitative or qualitative limitations set by law, the supervisory authority or the company’s own rules. Special training of the persons empowered to buy and sell derivatives and separation of the decision and control functions also reduce the risk of loss here. 8. It is incumbent upon auditors to verify that the investments entered as assets on an insurance company’s balance sheet really belong to that company and are not pledged to third parties.
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9. The freezing of securities backing technical provisions in banks designated by the supervisory authority is still practised in some countries. In many cases this applies only to branches of foreign companies.
III. Reinsurance risks The reinsurance risk has two components: a technical risk and a risk of debtor default.
A. Technical risk Reinsurance relieves a direct insurer of liability for some of the risks it has underwritten. Technically, reinsurance answers the insurer’s need to constitute a pool of risks that are similar in nature and value. A reinsurer: ●
assumes insured risks in excess of a given threshold, thus making the direct insurer’s policy portfolio more uniform (capping);
●
covers losses, in terms of number of claims and total cost, in excess of the statistical mean used to calculate premiums (smoothing); an insurer’s portfolio is never an entirely accurate reflection of the risks taken into account in premium setting.
Reinsurance treaties have to be tailored to the circumstances of each insurer and protect it against losses due to catastrophic events or to an abnormal accumulation of claims. Furthermore, the cost of suitable reinsurance must be affordable by the insurer or it will have to raise its premiums. The December 1999 storms in France illustrated the technical reinsurance risk of undertakings that exceeded their reinsurance ceilings, even though those ceilings had as a rule been quite appropriate, based on recent weather patterns in the same geographical area. But a good knowledge of the past provides no certainty for the future. Supervisors must therefore check the adequacy of reinsurance treaties. Many insurance company failures can be attributed to a bad choice of reinsurance plan, often as a result of management errors (e.g. inadequate cover of natural disaster risks by local mutual companies, misuse of reciprocity agreements, muddled drafting of treaties so that reinsurers are able to dispute claims).
B. Risk of debtor default by a reinsurer Through a treaty, a reinsurer assumes a portion of the direct insurer’s liabilities vis-à-vis its policyholders. This is reflected on the direct insurer’s balance sheet by the fact that the amount of the reinsurer’s relevant technical provisions is carried as an asset. 8 If the reinsurer defaults on its
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commitments, however, the insurer is still required to pay all claims in full, since it is contractually obligated to do so. There is no legal relationship between the insured and the reinsurer. Default by a reinsurer can therefore seriously harm an undertaking’s financial health if certain precautions are not taken: 1. Booking its technical provisions as a liability inclusive of reinsurance, a direct insurer demonstrates that it bears sole responsibility vis-à-vis its policyholders. 2. Setting this liability is an asset representing claims on the reinsurer (the reinsurer’s share of gross technical provisions on current account). In many cases, reinsurance agreements provide for guarantees to protect these claims: ●
The reinsurer may leave an amount equal to its share of technical provisions with the direct insurer (cash deposit).
●
The reinsurer may remit securities to a depository as security for the direct insurer.
●
The reinsurer may request that a bank provide the direct insurer with a letter of credit that the insurer could utilise if the reinsurer defaulted on its obligations.
3. To negotiate such guarantees is sound management. But regulations and standard practice differ significantly across countries. In some jurisdictions, claims on reinsurers cannot be used to cover gross technical provisions unless they are protected by a pledge of securities or a letter of credit. In France, this constraint compels direct insurers that lack substantial equity to obtain deposits, security or guarantees from their reinsurers. Elsewhere, the quality of the reinsurer is taken into consideration. Some signatures are sufficient unto themselves. While certain specialised agencies rate reinsurers, these ratings should in no way dispense supervisors from all investigation of reinsurer solvency. The OECD Insurance Committee’s Group of Governmental Experts on Insurance Solvency is drawing up a project for exchange of information amongst supervisory authorities, in the form of a voluntary multilateral agreement under which each signatory country would appoint a national co-ordinator to provide information about reinsurers automatically or on request (see Chapter 2). 4. It is the responsibility of insurance undertakings to determine what information they need to assess the soundness of the reinsurers with which they deal.
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On the proposal of the Insurance Committee, the OECD Council on 25 March 1 9 98 a d o p t ed a R e c om m e n da t i on o n A ss e ss m e n t o f R e i n s u ra n c e Companies [C(98)40]. In it, the Council recommends that the OECD member countries: ●
invite insurance companies under their supervision to take all appropriate steps to assess the soundness of reinsurance companies to which they cede or propose to cede business…
●
invite reinsurance companies under their supervision, or established within their territory, to provide, on request, information to insurance companies, which will assist the latter in making assessments.
The Council also invites non-member countries to “take account of the terms” of this Recommendation. The OECD Recommendation should incite supervisors to check that the reinsurance managers of insurance undertakings have in fact assessed the financial health of their partners and have not proceeded merely on the basis of a rating agency’s label or the advice of a specialised broker. Appended to the Recommendation is a list of factors to be taken into account in assessing a reinsurance company. Default by a reinsurer or a retrocessionaire is particularly difficult to foresee or detect, since the problems known to direct insurers are compounded by the variety of geographical areas in which reinsurers operate.
IV. Risk of default by a special partner A. Brokers Brokers who market policies for insurers collect premiums, settle claims and may be delegated general administrative responsibility. In such cases, they continuously hold funds on their partners’ behalf. Default by a broker is especially detrimental to an insurer because the latter incurs liability as soon as the broker receives premium payments from the insured – at least according to case law in a large number of countries. Moreover, if a single broker provides an insurer with a substantial proportion of its total business, that broker is in a position to exert dangerous pressure on the insurer’s pricing and risk acceptance policies. It is in the interest of insurers to minimise the funds they leave at their brokers’ disposal; they should also spread their business outlets and not allow any one distributor to exert too much influence over their marketing policies. For these reasons, most regulations prohibit claims on intermediaries from being included amongst the assets used to cover technical provisions.
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B. Shareholders An insurance undertaking set up as a joint-stock company must be able to call upon its shareholders to cover losses or finance new business; it would be in serious trouble if its shareholders were not in a position to meet its needs. An insurer’s failure is sometimes the consequence of default by its leading shareholder. To preclude this, regulators in a number of countries have instituted supervision of shareholders, implementing some of the following provisions in each instance: 1. Designation of a primary (“reference”) shareholder to be the supervisory authority’s automatic contact in the event the insurance undertaking is in difficulty. 2. Detailed information about shareholders, which will be of paramount importance to the licensing authority. 3. Obligation to report or obtain prior authorisation for any acquisition, increase or divestment of an equity interest in an insurance undertaking. Failure to comply with this requirement is punishable (by order of the court) by suspension of the voting rights attaching to the shares transferred illicitly. 4. Request for information submitted to the relevant local supervisory authorities if the shareholders concerned are credit institutions, investment firms or insurance undertakings having their head office in another country. Here, the organisation of cross-border exchange of information would seem essential. 5. If potential shareholders are not in the financial sector, the competent supervisory authorities should require audits of their financial positions, to be conducted by specialist experts, before licensing or allowing a change of shareholders.
C. Subsidiaries and affiliates An insurance company having shareholdings in other financial firms may be compelled to provide those firms with additional funds. This constitutes contagion risk, or the risk that an affiliate’s difficulties could adversely affect its parent company. The measures taken to protect policyholders against knock-on defaults vary in severity, depending on the country: 1. In some jurisdictions, insurance undertakings are prohibited from acquiring equity interests in credit institutions (and vice versa). In Japan, until 1998 a life insurance company could not control a non-life company (or vice versa).
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2. In a number of countries, shareholdings in other insurance companies cannot be used to cover technical provisions. 3. European Directive 98/78/EC of 27 October 1998 instituted supplementary supervision of insurance undertakings belonging to an insurance group by introducing a “solo plus” rule to eliminate double use of capital between insurers and related undertakings. The European Union is considering similar provisions that would be applicable to financial conglomerates comprising credit institutions, insurance undertakings and investment firms. The IAIS9 is thinking along the same lines.
V. Risk arising from membership of a group or financial conglomerate The increasing numbers of groups and financial conglomerates around the world pose complex problems for supervisory authorities. Within a group or conglomerate, an insurance undertaking is exposed to additional risks, the severity of which depends on the conglomerate’s uniformity, its dimensions and the international spread of its business. These risks include: 1. Double use of capital: capital that appears to be available to guarantee the commitments of an undertaking is in fact tied up in other undertakings belonging to the same group. 2. Risks arising from intra-group transactions: transfers of funds or of risks between companies in the same group may jeopardise the solvency of one of them. 3. Opaqueness: information useful for the supervision of an insurer may be situated in other undertakings located in other countries or not subject to separate prudential supervision. 4. Contagion: the troubles of one firm belonging to a conglomerate can infect healthy businesses within the same conglomerate. The misadventures of one entity can reflect poorly upon companies bearing the same name, the same acronym or logo, or that operate out of the same premises. Financially, losses in one line of business reduce the amount of capital available to other parts of the group. 5. Inter-sectoral conflict of interest: a conglomerate may have to make a tradeoff between the interests of policyholders and the need to reinvest in another group company: for example, participation of a life insurance undertaking in the share capital increase of a banking subsidiary at the expense of future profit-sharing.
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6. Regulatory trade-offs: if an activity can be carried out by either an insurance company or a bank, an entrepreneur will choose the structure requiring the least equity. With regard to guarantees, for example, the preference in the European Union is for large risks to be assumed by an insurance undertaking and other risks by a credit institution. To limit these hazards, Directive 98/78/EC on supplementary supervision of insurance undertakings in an insurance group: ●
maintains “solo” supervision of undertakings;
●
introduces a “solo-plus” requirement for adjusted solvency;
●
requires that the main intra-group transactions (e.g. loans, suretyships, reinsurance, transfers of investments, management agreements, etc.) be reported to the supervisory authorities;
●
requires that the supervised insurer have mechanisms in place to produce any information that would be relevant for the purposes of “solo-plus” supervision;
●
organises co-operation amongst European supervisory authorities, with possible appointment of a co-ordinator or lead authority.
The Joint Forum, which brings together the supervisors of insurance undertakings, credit institutions and investment firms, is making plans for special supervision of financial conglomerates: ●
co-operation amongst the supervisory authorities of the various industries and countries concerned;
●
sharing of prudential information; procedure for appointing a co-ordinator;
●
“fit and proper” criteria for corporate officers;
●
capital adequacy requirements;
●
removal of legal barriers (confidentiality) to information exchange.
VI. Other risks Authors and supervisors cite other risks which could in fact be included with one or more of the risks described above:
A. Growth Portfolio growth is sometimes achieved at the expense of elementary precautions, forgetting about risk selection and adequate pricing. The result of this can be a deteriorating claims ratio. New undertakings are especially vulnerable to the financial consequences of such an approach. The growth risk can be linked with the underpricing risk.
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B. Liquidation If an insurance undertaking goes out of business, it may no longer have the financial resources needed to administer its obligations to policyholders and to settle their claims in full. Appropriate technical provisions will preclude such winding-down problems. Underprovisioning is the issue here. Long-tail claims run-off (pollution, asbestos, product liability, professional liability insurance) is sometimes entrusted to specialist agencies able to keep costs down.
C. Operating expenses The loading of premiums should cover an insurer’s expenses. Loads may prove insufficient if the contract length exceeds that of premium payments (as in life insurance), or if the time needed to settle claims and obtain recoveries is too long. This risk can be included with the risks of underpricing (insufficient loading) and under-provisioning (management provisions must be constituted). In some countries, the tax authorities do not allow management provisions. In Germany, new undertakings are required to constitute an organisational fund to which nonrecurring expenses may be charged.
D. Guarantees on behalf of third parties Guarantees given to third parties (off-balance-sheet commitments) regarding the fulfilment of financial obligations assumed by those parties may lead to heavy losses. This is especially dangerous in the case of performance guarantees for all of the business of an undertaking, and of a subsidiary in particular. Wisdom would dictate that insurance undertakings should be prohibited from granting any such guarantees to firms engaging in lines of business other than insurance. Intra-group guarantees must be taken into consideration when assessing contagion risk.
VII. Risk of mismanagement The quality of an insurance undertaking’s officers and directors is a paramount factor in its financial health. Incompetent or fraudulent management exposes a firm to serious failings. Management risk can be situated upstream from underpricing, underprovisioning, inadequate investment, etc.
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The regulations of some countries set quality criteria for the officers of insurance undertakings; all supervisory authorities are especially attentive to the competence of corporate executives. 1. The laws of some countries set minimum requirements for managing directors: university degrees, experience (number of years in the insurance industry), etc. More generally, “fit and proper” tests are applied to officers when licensing applications are considered and when there are changes in management. In some cases, supervisors can be especially strict concerning the experience of a new officer. They may be tempted to reject a broker, for being likely to favour growth at the expense of sound fundamentals, or reserved vis-à-vis a banker, who may not always be aware of the special features of life insurance contracts or of the precedence of claims over premiums in non-life business. 2. On-site inspection of a company’s operations provides an opportunity to check the effectiveness and competence of its managers. An insurer’s command of distribution networks, pricing policies, tracking of claims and earnings, risk select ion, administrative organisation, financia l management, effectiveness of reinsurance, internal controls, etc. are gauges of the professionalism, experience and reliability of the firm’s divisional and top management. 3. On an international level, the supervisory authorities of the various financial markets make arrangements to exchange information about the competence of the managers of cross-border groups. 4. Nevertheless, regulations to protect privacy, amnesty laws and the aversion of some countries’ courts to subjective assessments can constitute obstacles to the application of “fit and proper” tests. 5. Requirements concerning the quality and reliability of managers should be extended to statutory auditors, appointed actuaries, experts and rating agencies, since all of these parties can affect the image that a company projects. On the other hand, to draw an analogy with airports, the air traffic controller cannot prevent the pilot from making an error of judgement at takeoff or landing.
VIII. Systemic risk Financial markets are now developing and expanding at a very rapid pace. Businesses are overturning the old traditional barriers, designing new products, moving into new markets, setting up complex forms of supranational organisation and operating on a world-wide scale.
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Yet the world’s insurance system has been growing more vulnerable in a business environment that has become less favourable during the past few years: 1. Deterioration of the technical quality of underwriting policy; increased competition over major risks; reinsurance overcapacity, hence underpricing (?). 2. The age of the computer and the Internet and the replacement of administrative, and subsequently marketing, staff by electronic machines are necessitating a new type of business organisation, a revision of internal controls, and a reform of external controls, notably by States. 3. Investments, which used to be sources of strength and security, have become factors of instability. 4. Harmonisation of prudential rules and accounting standards may, by undoing the regulations of the most prudent and experienced States, cause a general lowering of policyholder protection and a destabilisation of financial markets. 5. The concentration of reinsurers means that the biggest companies have to bear all the consequences of a catastrophic loss (e.g. the San Francisco earthquake or the flooding of the port of Rotterdam). 6. But the fact that all markets are affected by these phenomena, to a greater or lesser degree, does not mean that the world insurance system lives under threat of an unbroken string of business failures in accordance with the domino theory. The experience of many countries shows that political or financial crises and natural disasters hit all insurers and reinsurers in the same market, but that only a minority of businesses–those which are mismanaged or unsound–actually go under. Insurers and reinsurers are not lined up like a row of dominoes but in parallel lines behind each major risk or each local cedent. A major crisis may result in business failures, but only among related undertakings. With the possibilities of annual termination of non-life insurance contracts and reinsurance treaties, competent managers–and there are quite obviously plenty of them–are fairly soon able to redress the balance.
Conclusion An insurance undertaking is exposed to a large number of highly diverse risks that can jeopardise its financial health and possibly bring about its downfall. All countries have experienced such occurrences. Most of these risks are peculiar to insurance operations, either directly (inversion of the production cycle, technical provisions constituting the bulk of balance sheet liabilities) or indirectly (assets must be managed to match the nature and structure of commitments). Managers, as well as supervisors,
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should be capable of assessing what distinguishes an insurance undertaking from a credit institution or an investment firm. The subdivisions adopted here between technical, investment and management risks are not perfect. There is some overlapping, and some risks are triggered by others. Prudential rules imposing an accumulation of requirements to cover each risk that could potentially weaken an insurance undertaking would be inherently wrong, since insurance is based on the principle of pooling risks that can offset each another. Clearly, in the case of incompetent management there is a rather abnormal accumulation of errors. On the other hand, space risk and the risk of natural disasters pose more of a bankruptcy threat to a specialised insurer than to a diversified one. In the sections above, the preventive, corrective or reparative measures adopted by regulators and applied by supervisors have in each instance been presented together with the risks that they are supposed to limit, prevent or re ct i fy. B ut t h e s o l ve ncy o f a n i ns u ra nc e u n d er t a k i ng c a n no t b e compartmentalised. Only a comprehensive approach is significant, and Chapter 2 summarises and consolidates the regulatory and supervisory arsenal intended to protect the insured.
Notes 2. The accounting period covers twelve months, i.e. the period separating two balance sheet statements (e.g. between two end-Decembers). 3. Reference to provisions net of reinsurance is justified by the fact that the provisions required of reinsurers are invested by them. 4. Definition: the policyholder pays an “office premium” comprising a pure premium and loading. Office premium (not including tax) = pure premium + loading (corresponding to risks insured against insurer’s expenses. 5. “Technical provisions” is the official term in the United Kingdom, “policy liabilities” in the United States. 6. However article 22, paragraph 1, c of Directive 92/96/EEC and article 22, paragraph 1, c of Directive 92/49/EEC stipulate that unsecure loans are accepted as assets covering technical provisions up to 5%t of gross technical provisions, of which one single unsecured loan is only accepted up to 1% of gross technical provisions. 7. More precisely, according to article 22, paragraph 1, b of Directive 92/96/EEC and article 22, paragraph 1, b of Directive 92/49/EEC the percentage of 5% may be raised to 10% of gross technical provisions, of which one single unsecured loan is only accepted up to 1% of gross technical provisions. 8. Unless the insurer’s own technical provisions are booked to liabilities net of reinsurance. 9. International Association of Insurance Supervisors.
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ISBN 92-64-10189-6 Policy Issues in Insurance No. 4 Assessing the Solvency of Insurance Companies © OECD 2003
Chapter 2
Regulation and Supervision of Overall Solvency
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Summary Solvency supervision is a complex process having many different aspects, which may be grouped under four main headings:
I.
●
solvency ratio;
●
triple test of balance sheet soundness;
●
operating conditions, which (“prospective” solvency);
●
outside forces affecting the firm’s financial health.
are
essential
to
an
insurer’s
future
Solvency ratio A solvency ratio determines whether an undertaking meets a minimum capital adequacy requirement. This is because an insurer’s losses must be covered by charges to its shareholders’ equity – the greater the equity, the more remote the prospect of failure. Capital is scarce and expensive, however, and even substantial equity can be eroded severely and rapidly as a result of mismanagement, as has been witnessed virtually everywhere. Managers “reassured” by the wealth of “their” undertakings sometimes take dangerous risks by entering into underpriced contracts or by making investments that are not as safe as they ought to be. Principle: A firm’s solvency is generally measured by a ratio of its wealth to a stipulated capital adequacy requirement:
SOL
Firm’ s wealth Minimum requirement
In some jurisdictions, the numerator is called the “available solvency margin” (“avail. SM”) and the denominator the “minimum required solvency margin” (“req. SM”). In the United States, the minimum requirement is “total adjusted capital” (TAC), which is compared with “risk-based capital” (RBC) – so-called because of how it is computed. In Canada, the “minimum continuing capital and surplus requirements” (MCCSR) apply to Canadian life insurance companies and the “minimum asset test” (MAT) to non-life
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insurers. In January 2003, the minimum capital test (MCT) will be implemented for Canadian non-life insurers. The MCT approach is similar to the MCCSR. Australians refer, in the life insurance industry, to the “solvency standard” and the “capital adequacy standard”. Japan simply uses the expression “solvency margin”. In the following discussion, the term “req. SM” will cover all of these formulations, although each one will be used when its own particular features are dealt with. The basic formula is thus:
SOL =
avail SM req SM
The numerator and denominator will be studied in turn, even though they are not fully independent quantities: some countries prefer to deduct certain assets from the numerator directly rather than to incorporate them in the risks factored into the denominator.
A. Assessing a firm’s wealth (available margin) The available solvency margin comprises elements that are posted to a firm’s balance sheet, accounting data that for various regulatory reasons are not posted to the balance sheet, and non-accounting data. In some cases, reserves are reclassified as provisions and vice versa.10 Lastly, certain types of “quasi-equity” are in some cases taken into account. Hence the formula: Avail. SM = (L – Q) + Ds – I ± R + CG + H [1] L is the firm’s total balance sheet liabilities (including owners’ equity). Q is committed liabilities, which include technical provisions and equivalents, other provisions for risks, expenses and doubtful debts and debts of all sorts, including dividends to be distributed. (L – Q) measures shareholders’ equity, constituted by all elements of capital free of any foreseeable commitment, i.e. not corresponding to any commitments or debts: share capital, initial capital (for mutual associations), reserves (retained earnings – neither distributed to shareholders nor refunded to members, and net of any applicable profit tax). [2] Subordinated debt (Ds) is considered quasi-equity if the rights attaching thereto are subordinate, in the event of liquidation, to the claims of other creditors, including the insured. Such debt therefore gives policyholders an additional guarantee, provided that the firm is not able to redeem the debt early if it runs into difficulty.
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Some countries do not allow such debt to count towards the available solvency margin unless the redemption thereof is always (and not just in a crisis situation) subject to prior authorisation from the supervisory authority. [3] I represents assets to be deducted, even though their inclusion on the balance sheet is consistent with general accounting standards, even as specifically applicable to insurance. 1. In all countries, balance sheet loss carry-forwards are deducted, along with any assets that are considered fictitious because they cannot be realised. ●
non depreciable incorporation expenses;
●
non depreciable contract acquisition costs;11
●
intangible assets, such as goodwill;12
●
tangible operating assets.
2. The unpaid-in portion of the capital subscribed by shareholders is deducted in full or in part (e.g., 50% is deducted in the European Union). 3. In some countries, the value of shares in financial subsidiaries and shareholdings in domestic or foreign insurance companies must be excluded or reduced. Elsewhere, such investments are deemed to present an additional risk which is factored into the required solvency margin. In the United States, insurance subsidiaries form part of RBC, while certain adjustments must be made to the value of shares in other types of subsidiaries. The European Union takes a different approach: A firm’s solvency margin is measured first without taking insurance subsidiaries or shareholdings into account. A “solo plus” solvency calculation is then added in order to incorporate a group perspective (see below). 4. In the United States, NAIC13 has gone further, insofar as its RBC method deducts a variety of assets that are considered of lesser quality: ●
overdue premiums more than three months late;
●
unsecured loans, loans to company employees;
●
sundry doubtful debts, if not provided for, etc.
This amounts in fact to a qualitative restatement of the balance sheet assets reported by the company. [4] R can be either positive or negative, depending on whether provisions are reclassified as reserves or vice versa. Depending on the applicable accounting standards, certain provisions become reserves, pursuant to local regulations (tax regulations in particular), while various kinds of reserves are reclassified as provisions, to the satisfaction of insurers and supervisors. This results in distortions of the list of elements eligible to constitute the solvency margin in the various countries. Such is the case, inter
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alia, for equalisation or risk fluctuation provisions (or reserves), and for certain provisions (or reserves) arising from the methods companies use to value investments on their balance sheets. Regulations can wipe out these distortions to varying extents: 1. In Japan, the following elements, inter alia, are included when the available solvency margin is calculated: ●
contingency provisions in life insurance, and disaster provisions in nonlife;
●
the fraction of technical provisions corresponding to the surrender penalty incurred by the insured (life insurance);
●
provision for loans in respect of which repayment is in doubt;
●
provision for taxes.
2. In life insurance, hidden reserves are often included in regulatory mathematical provisions. Methods for computing mathematical provisions vary widely from one country to another, and highly prudent valuation methods generate an implicit margin which some jurisdictions incorporate into their solvency ratios. Thus the available margin may be equal to: a) The difference between the mathematical provisions listed on the balance sheet and those calculated using a reference interest rate, which is higher. This reference interest rate may be: ●
a rate from outside the firm, set by the supervisory authority, e.g., 60% of the yield on government bonds denominated in the currency in which policies are written (the reference rate used in the European Union);
●
an internal rate representing the actual yield of the firm’s assets, less a prudential margin for expenses and future fluctuations.
b) In the event of partial non-zillmerisation14 of mathematical provisions, the difference between the provision as calculated and listed on the balance sheet, and a provision zillmerised at a rate equal to the loading for acquisition costs that is included in gross premiums. 3. Provisions for profit-sharing not yet allocated to life insurance policyholders are included by some countries (such as Germany) in the list of elements constituting the available solvency margin. In some countries, the regulations require a certain, and in some cases substantial, percentage of technical and financial profits to be allocated to policyholders, but companies are frequently allowed a period of several years in which to make these allocations individually. Unallocated amounts are put into a suspense account – provision (or reserve) for profit-sharing – for subsequent distribution.
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If some of that provision may be reclaimed to cover the company’s losses, as in Germany, the amount recovered may be restored to the available margin. 4. NAIC’s TAC uses net assets adjusted for any discounting of technical provisions (e.g., provisions for annuities, in damage insurance in particular). [5] Unrealised capital gains (CG) on investments are equal to the aggregate difference between the market value of investments and their book value. Of relevance primarily to firms in countries that require investments to be carried on the balance sheet at historical cost, or that require discounts from their market value, this eliminates all distortion vis-à-vis firms that carry investments at their market value.15 Some jurisdictions include all unrealised capital gains; others reduce them by the amount of expenses and taxes that the insurer would have to pay if it disposed of the investments in question. Others deduct a hypothetical provision corresponding to the amount that would be needed to cover the effects of a significant drop in stock market prices (e.g. 25%) and of a rise in financial market interest rates (e.g. 2 points). In these countries, the supervisory authorities indicate how such “resilience tests” should be calculated.16 In Japan, the available margin includes 90% of unrealised capital gains on listed equities and 85% of unrealised capital gains on land. [6] H is a sum of non-accounting data that are implicit or even only potential. It may comprise the following values from a list that varies from one country to another: 1. Potential supplementary contributions for which a mutual association may assess its members, if the by-laws allow it. Such additional and exceptional contributions by insured members constitute an appropriate way to adjust underwriting results after the fact. But the legal, commercial, and administrative conditions for effective collection all need to be in place. In particular, the society’s by-laws must allow such assessments, which in turn must neither cause policyholders to flee nor demoralise the society’s agents. As a rule, the by-laws of mutual life insurance societies do not allow such assessments. In non-life insurance, a call for supplementary contributions will be successful only if the circumstances surrounding it are exceptional (as in the wake of the late December 1999 storms in France), and if the members concerned ordinarily enjoy significantly lower premiums than the market as a whole (as is the case with large mutual motor insurers in France). 2. Future profits from a portfolio of policies written by a life insurance company.
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In the case of long-term contracts that are priced on prudent technical grounds (mortality tables, guaranteed interest rates, loadings) and may be checked against more recent, reliable data, the emergence of future profits is both foreseeable and quantifiable. Future profits are sometimes estimated on a retrospective basis, and at other times on a prospective basis. For each family of current contracts, a comparison of the applicable pricing with an updated projection of policyholder mortality and the undertaking’s investment income and management costs is used to project future profits on a prospective basis. In the European Union, a retrospective method is used, extrapolating future earnings from the results of previous years: Future Profit = Estimated annual profit x average residual duration of policies. Estimated annual profit equals the average of actual profits, by category of contract, for the five years preceding the policies under study. The average residual duration of policies is capped at ten years, regardless of their actual duration. No more than 50% of this projected future profit stream may be included in the H term of the available solvency margin formula, and only with the supervisory authority’s permission, which is granted on a case-by-case basis. From a qualitative standpoint, a prospective method is always preferable. Future profits are ruled out in a number of countries, and in others where the regulations allow them they are sometimes subject to controversy. This approach is logical, however, insofar as a firm’s accumulated reserves are intended to offset any future losses. Following the same line of reasoning, however, if a prospective calculation projects future losses rather than future profits, the results obtained should be deducted from the available solvency margin. 3. Embedded value (“EV”) of the firm In life insurance, the financing of new business, which can cost more to acquire than the first year’s premium revenue, consumes capital that will be recovered later. An immediate loss will be followed by deferred profits. The result is a diminished margin, which embedded value can correct. Embedded value, or EV, is the present value of future profits (or losses) stemming from current policies and investments. EV is distinct from goodwill, which measures the firm’s capacity to generate profitable new business. Goodwill may be added to EV in certain approaches to a company’s selling price.
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Embedded value calculations incorporate a complex blend of numerous and highly diverse elements involving: ●
contracts: mortality, guaranteed rates, cancellations, surrenders;
●
technical provisions: discount rates;
●
investments: choice, diversification, income, matching with liabilities;
●
reinsurance;
●
business environment: taxation, inflation, etc.
Even the slightest changes in the underlying assumptions can lead to sharp swings in EV. Because it is sensitive to the chosen scenario, which is based largely on subjective considerations and the methodology used, it would appear difficult to incorporate EV into a solvency margin calculation. It can, however, be used to test provisions. 4. Lastly, some jurisdictions reduce the available solvency margin to reflect a firm’s off-balance-sheet commitments, such as guarantees given freely to foreign insurance subsidiaries to help them obtain licences from local authorities. All of these components give the notion of the available solvency margin a far broader perimeter than that of free assets (i.e. free of any foreseeable commitment). But not all of them are treated in the same manner: PV and H in particular are affected by numerous restrictions that reflect the fact that the underlying assumptions are dependent on circumstances, implicit or potential: regulations set overall limits or limits by class, or require deductions, and in many cases they must be authorised by supervisors on a case-by-case basis. Lastly, the adoption of new accounting standards, such as the ones proposed by the IASB (International Accounting Standards Board), will inevitably alter some of the elements making up the available solvency margin and, as a result, trigger a revision of solvency ratio concepts and methods of calculation.
B. Capital adequacy requirements: Required solvency margins (“req. SM”) While regulations are largely convergent, apart from minor details, with respect to elements that may be included in the numerator of the solvency ratio, solutions for determining the minimum requirement diverge. A review of the calculation methods in use in Europe, North America, Japan and Australia highlights two approaches that would appear very different from each other. One is comprehensive, based on a handful of fundamental aggregates characterising the firm as an indissoluble whole, while the other is analytical, identifying the risks to which a firm is exposed in order to allocate an appropriate amount of capital to each one. In both series of methods, the points of reference differ between life and non-life insurance.
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Comprehensive approach (e.g. European Union) The minimum required solvency margin depends on both a firm’s economic need and its probability of failure. A firm’s economic need Independently of any ratio, equity capital is necessary at each stage in the existence of an insurance undertaking. ●
When it is constituted, an insurance undertaking must have equity to finance its start-up and production. Moreover, a new company’s inexperience makes it more prone to pricing errors. Lastly, the gaps between forecasts and actual outcomes tend to get larger as the size of the policy portfolio gets smaller. Hence the need for equity capital (or a start-up fund) that is adequate in view of the undertaking’s planned business. Some countries also require constitution of an organisational fund to which nonrecurring management expenses can be charged.
●
For an undertaking doing business as a going concern, equity capital can be used to finance new operations (purchasing subsidiaries abroad, launching new products, etc.). It also provides a certain safety net for executive “decision-makers” who are always at risk of making errors inherent in their functions: promoting inadequate prices, misjudging certain commitments, making poor investments, and so on. These classic errors of judgement can generate losses that will erode the firm’s equity capital; the extent of that erosion will depend on how quickly managers detect their errors and can formulate – and implement – effective remedial action.
●
When a firm is liquidated, new debts arise that are not incurred in the course of ongoing operations. Among them are staff severance benefits and costs inherent in winding up a business that are incurred to collect receivables, take stock of debts and dispose of investments under conditions that may be rather unfavourable. A liquidation balance sheet therefore shows a rise in liabilities and a decline in assets. A firm must have enough equity capital so that the claims of all creditors can be satisfied, in spite of everything. A minimum solvency requirement could therefore be gauged on the basis of a firm’s salaries and balance sheet receivables. But such an approach, on behalf of the creditors of an undertaking that is being wound up, deviates from the overriding goal of prudential rules, which seek to protect the persons insured by a healthy company.
Probability of failure Even if a firm’s rates are appropriate, its technical provisions calculated correctly, its funds invested prudently and its sales force and administration managed effectively, an insurance undertaking is still exposed to risks,
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because it is an incontrovertible fact that the actual losses of a policy portfolio can be greater or less than expected. Mathematicians would even affirm that a succession of loss-making years cannot be precluded, causing a firm to go bankrupt. Readers are referred to their work. Loading premiums for security can limit such losses. If the losses occur anyway, in spite of everything, they can be covered by a supplementary assessment (in mutual associations) or by the use of equity. Contrary to Proudhon’s assertion in the 19th century that insurance had no need for capital, it is now acknowledged that a firm needs equity as a means of absorbing any losses that may result from its business. In 1957, the OECD Insurance Committee had set up an ad hoc working group to explore a minimum solvency standard on this basis.17 The subject was also taken up by the Conference of Insurance Supervisory Authorities of the members States of the European Community, of which a working group met 11 times between 1967 and 1970. The conclusions of these groups provided the raw material for Directives 73/239/EC, on non-life insurance, and 79/267/EC, on life insurance.18 Under the comprehensive approach, the required minimum solvency margin of an insurance undertaking: ●
is always greater than a specified fixed amount, irrespective of the firm’s volume of business: e.g. European Union, etc. This minimum capital, which cannot be reduced, is justified by economic considerations (fixed portfolio management expenses) and technical ones (under the law of large numbers, the more numerous the risks, the more fully they offset each other, and conversely);
●
is expressed, above that fixed amount, as a percentage of one or more aggregates representative of the firm’s business or commitments. If more than one reference is adopted, they may be used comparatively or cumulatively: – comparatively: The highest result constitutes the “req. SM”.; – cumulatively: The “req. SM” is the sum of a given number of terms.
The aggregates chosen in various jurisdictions include premiums, claims, technical provisions, insured capital, investments, and so on. Uniform coefficients are applied to them, the coefficients being either degressive or variable, depending on the firm’s lines of business. Reinsurance is taken into consideration in one of two ways: either the aggregates in question are taken net of reinsurance, or an adjustment is made to results obtained using gross data.
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European coefficients were obtained from statistics on firms in the markets concerned, which had been gathered at the time of the work cited above. Only selected examples will be given below. For a complete study of regulation in the European Union, see the articles of the Directives cited above (see footnote 19). 1. Premium ratios: used in non-life insurance ●
Australia: net premiums written x 0.2 = req. SM;
●
European Union: gross premiums written and a reinsurance adjustment coefficient – two layers and two rates: 0.18 and 0.16.
A minimum margin requirement indexed on premiums is inconsistent with the fact that a firm is exposed to a risk of underpricing; all else being equal, the lower the premiums, the less effective such a requirement can be. In an extreme case, a firm experiencing difficulties in year n could lower its premiums in order to meet the solvency requirement in n + 1 and then go bankrupt in n + 2! This explains why regulators look at the premium ratio in combination with a loss ratio or a provision ratio. In Europe, there are plans to diversify rates by class of insurance, with liability classes having to set more money aside. 2. Loss ratios: used in non-life insurance in the European Union, in comparison with premium ratios. The reference is the average annual claims burden over the past three years, gross of reinsurance, as taken from the profit and loss account (payments and changes in provisions for claims). An adjustment coefficient – the same as for the premium ratio – is applied to account for reinsurance: the net claims burden divided by the gross burden. Two layers and two rates – 0.26 and 0.23 – are used, so that the European Union’s premium and loss ratios yield the same result if C/P = 0.7. If the higher of the two results, i.e. the one chosen for “req. SM”, is the loss ratio, it may mean that premiums are set too low. By reducing its claims provisions, a firm can also reduce the regulatory minimum solvency margin requirement. 3. Technical provisions ratios (non-life insurance). ●
Australia: Provisions for pending claims (net of reinsurance) x 0.15. This ratio is compared with a premium ratio (see above). The two results are identical when the ratio of net claims provisions to net premiums is equal to 1.33.
●
In Europe, the experts in 1973 had ruled out any criterion based on claims provisions in view of market statistics showing substantial disparities between countries, with the NCP/P ratio ranging from 0.3 to 0.79 and the
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TP/P ratio from 0.76 to 1.34.19 They concluded that to apply a claimsprovision ratio on a Europe-wide level would distort competition by easing up on undertakings that under-provisioned and, for that very reason, most needed equity. Such a paradox seemed unacceptable. However, the claims provision ratio will be higher if an undertaking has proportionately more long-tail risks, such as liability. It so happens that liability classes present the greatest risk of underprovisioning. There is thus a distinct coherency to using this ratio, although in combination with others. Example, France 1999: NCP/P (gross) = 1.63 for all direct insurance; 5.18 for general liability. 4. Mathematical provisions ratio (life insurance) European Union: 0.04 x gross mathematical provisions (MP) (on the balance sheet), which is in turn multiplied by a reinsurance coefficient of not less than 0.85. Mathematical provisions are considered more relevant than provisions for outstanding claims in non-life insurance. There are distortions, however (zillmerisation, capitalisation rate) for which regulations endeavour to compensate at the level of the available margin. In the minds of its inventors, the MP ratio is supposed primarily to cover an investment risk; thus, in the case of unit-linked contracts, in which investment risk lies with the insured, the coefficient of 0.04 is cut to 0.01.20 In addition, the MP ratio does not fully cover the minimum margin requirement, which also factors in risks assumed by the insurer (cumulative method): req. SM = MP ratio + K ratio + ratio for additional risks The K ratio corresponds to capital at risk. The ratio for additional risks is calculated in the same way as the premium ratio, but it is limited to premiums for extended benefit for disability, accident and illness risks included in life insurance contracts. 5. Insured capital ratios (life insurance in the European Union) K Ratio = 0.003 x capital at risk x reinsurance coefficient The capital at risk in a contract is equal to the insured capital less the mathematical provision constituted on the balance sheet in respect of that contract. The coefficient 0.003 is reduced for short-term life insurance. The risk covered here is that of abnormal mortality of the insured as compared with the tables used to set premiums. 6. Investment ratio (life and non-life insurance): One can imagine a ratio obtained by multiplying a weighted mass of the firm’s investments by a given coefficient. For example, using the book value of investments:
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Weighted mass of investments = 0.1 x (listed bonds + bank deposits + secured loans) + 0.5 x (listed equities + real estate) + 1.0 x (subsidiaries and shareholdings + unsecured loans + unlisted equities) Investment ratio = 0.1 x weighted mass of investments Application to two undertakings having different approaches to financial management:
Investment mix
A
Listed bonds
75
50
Listed equities, real estate
19
30
Shareholdings, unlisted equities Total
B
6
20
100
100
Weighted mass of investments
23
40
Investment ratio (% of aggregate investments)
2.3
4.0
Company B, which has apparently a riskier financial policy, would therefore have to produce a much greater margin than Company A. The investments ratio might be used in combination with another indicator, since it covers only asset risks. It would be necessary to add, in life insurance for example: 0.01 MP + 0.003 K + 0.18 P (if the company is not reinsured). In the European Union, the comprehensive approach has provided a satisfactory solution for solvency margin calculations, which has proven its effectiveness over the more than 20 years since the Member States adopted it. Clearly, it has nothing that would appeal to theoreticians of risk, but its main advantage remains its relative simplicity, which the reforms currently under consideration should most definitely not compromise.
Analytical approach (e.g. United States, Canada, Japan) Here, the required minimum solvency margin (req. SM) is the capital needed to cover all technical, investment and miscellaneous risks to which an insurance undertaking is exposed. The risks are identified and quantified, and a certain amount of capital is assigned to each one. The net result of these assessments constitutes “req. SM”, which in the United States is referred to as “risk-based capital” (RBC). In the United States, the insurance industry is supervised by the states, although regulations and controls are co-ordinated by the NAIC,21 which is made up of state supervisory authorities. The NAIC has adopted capital
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adequacy standards that are applicable throughout the US – for life insurance since 1992, and for non-life since 1993. The American model – the RBC system – was subsequently adopted, with minor variations, by Japan. The Canadian model is similar, although it was derived independently from the one used in the United States. 1. In life insurance The NAIC formula incorporates four broad categories of risks: 2
RBC (V) = C 4 + C 2 + ( C 1 + C 3 )
2
Where: C1: investment risk; C2: technical (or insurance) risk; C3: interest rate risk; C4: general business risk. In each category of risks, the necessary capital (C) is valued by multiplying a variable representative of that risk (the “basic value”) by a stipulated coefficient. The risks involved correspond to the definitions supplied in Part I. Investment risks: C1 The basic value is the balance sheet value, and the risk coefficient, which varies according to the category of investment, ranges from 0% for US government bonds to 10% for real estate, 15% for listed equities and 30% for riskier securities (e.g. “junk bonds”). Bonds are weighted from 0.3 to 10%, depending on their ratings. The result is increased if an insurer’s investments are concentrated in certain categories or a small number of lines: e.g. a coefficient of 2 is assigned to bonds belonging to the ten largest lines of securities. Insurance risk: C2 This is the risk of an adverse change in mortality or morbidity. The risk increases as the portfolio gets smaller (law of large numbers). The basic value is capital at risk. Degressive coefficients (0.15%, 0.10%, 0.075% and 0.06%) are applied to successive layers of capital ($0.5, 4.5, 20 and over 25 billion). Interest rate risk: C3 The risk of insurance products is considered to increase with the amount of guarantees in the event of surrender by the insured. The basic value is
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mathematical provisions for the contract, and there are three levels of risk coefficients: ●
0.5% for contracts with no surrender entitlement, for contracts having a residual maturity of less than one year;
●
1% for contracts having a surrender penalty of at least 5% of MP;
●
2% for contracts having a surrender value = MP.
The result is increased by 50% if the insurer cannot prove that assets and liabilities are matched properly. Business risk: C4 C4 represents the other risks to which a life insurance undertaking is exposed: excessive operating expenses, over-expansion, mismanagement, competition, adverse economic conditions, etc. By convention, C4 = 0.02 x premiums. RBC is not merely the sum of the above four components. First, investment and interest rate risks are completely correlated with each other; second, it is acknowledged that the most adverse events will not all occur simultaneously, which was translated into the “square root rule”22 in the RBC ( ) formula. 2. In non-life insurance The NAIC formula has been corrected on several occasions. The latest known version of it is: 2 2 2 2 2 RBC (nv) = R 0 + R 1 + R 2 + R 3 + R 4 + R 5 R0: corresponds to the business risks of subsidiaries R’0 and off-balancesheet risks R”0. R1: corresponds to the risks of fixed-income investments. R2: corresponds to other investment risks. R3: corresponds to credit risk. R4: corresponds to the risk of underprovisioning. R5: corresponds to the risk of underpricing. As in life insurance, the values of R are computed by multiplying a variable representative of the risk in question (the “basic value”) by a coefficient. But the breakdowns and groupings are different.
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Investment risk: R0, R1, R2 The basic value is the balance sheet value (as in life insurance), but the weightings can be different. The portion of RBC corresponding to investment risk is computed separately for each of three groups of investments: 1. Investments in related companies (subsidiaries and shareholdings): ●
US insurance subsidiaries = RBC of the subsidiary x percentage ownership.
●
Foreign shareholdings = 0.5 x balance sheet value.
●
US shareholdings = 0.225 x balance sheet value.
●
The total of the above three RBC values constitutes part of the R0 factor, namely R’0.
2. Fixed-income securities: see life insurance. Yields R1, after adjustment based on the number of issuers. 3. Other assets: see life insurance. Yields R2, after adjustments penalising the ten largest investments (RBC multiplied by 2 up to 30%). Off-balance-sheet risks: R0 (R”0) The basic value is the company’s off-balance-sheet commitments: assets which the company cannot use freely (pledged or loaned securities, assets sold with a commitment to repurchase, etc.), guarantees accorded to a related company (e.g. free security). Coefficient: 0.01 The resultant RBC is included in the R0 term of RBC (R0 = R’0 + R”0). Credit risks: R3 and R4 The basic value consists essentially of claims on reinsurers. The coefficient – 0.1 – is uniform, irrespective of whether the reinsurer is American or foreign, controlled or not. There is no qualitative classification of reinsurers. Claims protected by a pledge of securities or a letter of credit do not receive more favourable treatment. Other receivables are multiplied by 5%, and rental income and accrued, unmatured interest by 1%. The final result is divided by 2. Ultimately, then: R3 = 0.5 x [0.1 x claims on reinsurers + 0.01 (rent, accrued interest) + 0.05 x other receivables] Risk of underprovisioning: R4 The basic value is the provision for claims outstanding, net of reinsurance (PCOn).
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The coefficient, set by NAIC, which has developed a model for each class of insurance,23 comprises elements observed across markets and within insurance undertakings. For each class, an “f (class)” factor incorporates: ●
a PCOn run-off factor derived from the company’s accounts for the previous ten years;
●
a market run-off factor: the most adverse value of the previous ten years;
●
a PCOn discount factor. R4 is the sum of:
●
the RBC for each class: f (class) x PCOn (class);
●
a reinsurance factor corresponding to the run-off of provisions maintained by reinsurers: 0.5% x claims on reinsurers;
●
an increase for over-expansion, if the average growth rate for the previous three years exceeds 10%.
Underpricing risks: R5 The basic value is premiums written, net of reinsurance. Coefficients are computed by class, depending on the company’s and the market’s C/P ratios for the past ten years, as well as the overheads that the firm allocates to the class in question and a financial discount factor. Lastly, RBC (nv) is not merely the sum of its components. As in life insurance, the “square root rule” leads to a lower figure which is deemed to incorporate certain compensation effects between the various risks. The weighted sum of the elementary RBCs representing the risks to which an undertaking is exposed defines its need for capital, which is then compared with the capital actually available (total adjusted capital, or TAC, see above). The NAIC’s prudential rule entails detailed risk assessment and a reduction of available capital through the elimination of the least secure assets and a strengthening of certain provisions. The US model has parallels in Canada and Japan. In Canada, for domestic life insurers, the “minimum continuing capital and surplus requirements” (MCCSR) compare the firm’s available capital with an amount of required capital measured by assessing the following risk factors: depreciation of investments, mortality and morbidity, contractual interest rates, and market interest rate trends. Mortality and interest rate risks are linked to a company’s pricing policies, which may be based on erroneous assumptions. In other countries, if a company’s guarantees to policyholders are too great, regulations require that mathematical provisions be increased.
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In Japan, the same principle has been applied to all insurance undertakings since 1998. The risks incorporated in addition to “normal provisions” are: ●
insurance risk: underprovisioning;
●
interest rate risk;
●
investment risks: depreciation, default by a debtor, reinsurance, offbalance-sheet subsidiaries;
●
business risk.
The Australian system The Australian system set up for life insurance in 1994 is unique in that solvency standards are not established on a company-wide basis but calculated for each of the statutory funds among which a firm’s policyholders are divided: foreign business, pensioners, unit-linked accounts, hybrid contracts (i.e. having some guaranteed capital and the remainder unit-linked), and so on. Some of these funds are required by law, while others are created at the discretion of the firm, which may subsequently decide to merge or to split funds, although, in the interest of policyholders, such decisions must be certified by an actuary, approved by the supervisory authority and notified to all parties concerned. Each of the funds holds assets, collects premiums and financial income, pays out benefits and bears other expenses incurred on behalf of the insured. The investments of each fund are restricted. The funds form the basis of a three-stage prudential system: ●
The solvency standard, which is calculated for each fund, leads to the constitution of additional provisions (or reserves): a fund’s basic mathematical provision (“the best estimate liability”) is established by reference to actual asset yield; it is then topped up so that the fund is capable of meeting all of the firm’s insurance commitments, in view of all of the future income and disbursement streams arising from existing contracts.
●
The capital adequacy standard constitutes a greater requirement: a “new business reserve” must be built up so that the firm will be able to meet not only its commitments as of the date of the balance sheet, but also those commitments that will result from future business.
●
In addition, the firm must possess assets worth at least AUD 10 million on top of the funds required by law.24
C. The limitations of solvency margin systems 1. In the final analysis, none of the methods of calculation used in the world today can be considered entirely satisfactory:
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●
the choice of reference economic variable (e.g. premiums, claims or technical provisions) can penalise prudent companies; or,
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requiring the margin to be differentiated by class of insurance may not correspond to any technical or economic reality, insofar as the trend is moving towards multi-class contracts, and the debate over classes considered the most dangerous is still open, given the wide variety of approaches that are taken around the world; or,
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the extent to which the various risks inherent in any insurance activity offset each other may be misjudged: correlation coefficients are very difficult to determine.
2. Moreover, no solvency ratio currently in use takes account of the fact that a specialised firm is more exposed than a multi-line insurer. 3. A financially troubled insurer will be tempted to reduce its technical provisions in order to convey the impression that its capital is more adequate than it actually is. Regulations must take a coherent approach and link solvency margin requirements to the rules for computing technical provisions and for valuing assets on the balance sheet. In the following example, an insurance undertaking was able to triple the amount of equity on its books by reducing its technical provisions by 10%.
(1)
(2)
Technical provisions Other liabilities Equity
100 10 5
90 10 15
Total liabilities
115
115
Investments Other assets
95 20
95 20
Total assets
115
115
Even so, a solvency ratio performs two functions: ●
First, it meets an economic need: a firm must always have the resources to cover operating losses.
●
Second, it constitutes a threshold that triggers intervention by the supervisory authority, which can compel a firm to take certain action if it fails to maintain the ratio. To be effective, the amount of the threshold must be indisputable, and thus simple, so as to prevent an insurer from going to court to challenge the result found by the supervisory authority.
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Throughout the world, supervisory authorities tend to intervene gradually, in stages: 1. European Union: ●
If avail. SM < req. SM
The firm must submit a recovery plan.
●
If avail. SM < 1/3 req. SM plan.
The firm must submit a short-term financing
The recovery plan must include measures needed to restore balance to the operating account. In more serious situations, short-term financing plans must outline the initiatives that companies plan to take in order to restore their equity capital. 2. United States: ●
TAC > RBC No intervention In life insurance, if TAC exceeds RBC by less than 25%, supervisors examine the TAC trend over the past three years. A subsequent decrease in the ratio triggers the intervention described in Case 2 below.
●
RBC > TAC > (0.75 x RBC) Recovery plan
●
(0.75 x RBC) > TAC > (0.50 x RBC) Supervisor may dictate measures to be taken.
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(0.50 x RBC) > TAC > (0.35 x RBC) Supervisor may undertake a recovery or liquidation procedure.
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TAC < (0.35 x RBC) Supervisor must take control of the undertaking and initiate a recovery or liquidation procedure.
Conclusion For their own peace of mind, supervisors may wish for high solvency requirements. For their part, corporate executives always hope to have the financing they need to expand and diversify. Moreover, they would be more willing to accept higher minimum standards if they already met them: the journal Sigma noted that “insurers in the US, UK, Germany and France currently hold far more capital funds than required by the regulators”.25 Higher constraints might also hamper competitors that have less cash but are nonetheless shielded from impending failure. Some people fear collusion between supervisors and the supervised, to the detriment of insurance consumers, if the cost of additional security is passed on in higher premiums. The most normal way of increasing capital is
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to allocate profits to reserves. The effort that policyholders might be asked to make would rise with the rate of corporate income tax. Where solvency requirements are concerned, competition and the cost of capital are paramount factors in prompting insurers to resist the temptation of engaging in prudence for the sake of prudence: 1) International competition has intensified with the spread of auto insurance amongst multinationals, the rise of captive reinsurers and the aggressiveness of companies based in offshore jurisdictions or businessfriendly countries that cultivate tax benefits and regulatory freedoms. European governments hesitate to saddle their national firms with higher prudential standards than the minima set by Community directives, for fear of penalising their own markets. 2) Investors try to make the most of their capital by demanding high returns: as a result, firms are tempted to minimise their need for equity while endeavouring to maximise earnings. From this perspective, rating agencies look at the remuneration of shareholders and earnings-linked securities when assessing a business. The planned reform of international accounting standards aims to make the accounts of insurance undertakings easier for existing or potential investors to read. Lastly, mutual associations, which have practically no access to capital markets, could be marginalised by the institution of increased capital adequacy requirements, which would be regrettable in view of the quality of service that some of them deliver. Borrowing could, of course, be an alternative to a share capital increase if hybrid funds are allowed to count towards the available solvency margin, but 1) the capacities of mutual association members are generally limited, and 2) subordinated debt is expensive because it forces the lender to bear a greater credit risk than in the case of ordinary debt. In the end, regulators may have to choose between a solvency requirement that is moderate but covered by indisputable elements and a greater requirement that could be covered more flexibly. A good compromise is provided by a two-tier system.
II. Triple test of balance sheet soundness In his comments regarding an OECD report of 11 March 1961 on minimum solvency standards for insurance undertakings that had been prepared by the working group chaired by Professor Campagne, the Danish delegate, Mr. S. Bjerreskov, confessed his reticence on a number of points:
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“For life insurance undertakings, it is my view that we should also hesitate, based on existing theory and statistics, to adopt a standard such as the one being proposed. Along these lines, I should like to note that when assessing the solvency of a life insurance undertaking it is of paramount importance to know how the basic parameters for calculating premiums and mathematical reserves [sic], such as mortality, interest rates, etc. are set in relation to the level of interest rates and mortality, etc. existing in the country in question, insofar as establishing a standard common to all undertakings and all member countries may, from the outset, be highly arbitrary.” Mr. Bjerreskov’s comments also hold true, to a certain extent, for non-life insurance. Any policyholder protection mechanism that was limited to a solvency standard – even the most rational one – would have no effectiveness, because such a standard would necessarily be shaped by other essential economic factors affecting a company’s operations. The solvency margin must be seen from two standpoints: one static – the balance sheet; and the other dynamic – the profit and loss account. It is only one aspect of the triple test of balance sheet soundness, which tests whether: ●
technical provisions are adequate;
●
the provisions are backed by quality assets of at least equivalent value;
●
equity capital exceeds a minimum standard.
The third test was discussed in Part I of this chapter. With regard to technical provisions and investments, rules were discussed in Chapter 1 in respect of the main risks that they limit or eliminate: ●
underprovisioning;
●
underpricing;
●
default by debtors (e.g., reinsurers);
●
investment depreciation.
We shall now expound upon these rules in an overview highlighting the various methods and options.
A. Technical provisions Strictly speaking, technical provisions are a balance sheet reflection on the commitments that an insurer makes when it signs its name to insurance contracts. They are the accounting counterpart of the company’s contractual promises.26 Legally, they represent the insurer’s aggregate debt vis-à-vis its policyholders. Some people would contend that they are the “property” of the insured, although this does not correspond to legal reality.
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In many countries, the notion of technical provisions has taken on a broader meaning – in some cases for tax reasons, and in other cases for technical reasons, when the aim is to prepare for special risks that might disrupt an insurer’s earnings and reduce its capacity to meet commitments. But here the borderline between technical provisions and reserves becomes blurred, with the same liability item being treated differently from one jurisdiction to another.
Technical provisions in the strict sense: life insurance 1. Mathematical provisions Mathematical provisions constitute the largest liability on the balance sheet of an insurance undertaking: any error in calculating them will have grave repercussions on the company’s financial position. Theoretically, mathematical provisions (MPs) are calculated contract by contract. Depending on the jurisdiction, the MP for a contract is determined in relation to its pure premium or its valuation premium. Policyholders pay a gross premium, excluding tax, which breaks down as follows: Gross premium (P) = (Pure premium + loading) (p) Loading (g) = (management + acquisition costs) (a) The pure premium (or technical premium) covers risk, while the loading covers acquisition costs, paid by the insurer immediately at the time the policy is written, and management costs, which are consumed throughout the policy’s lifetime. Hence the notion of “valuation premium”: Valuation premium = pure premium + management loading The pure MP is therefore the difference between: ●
the probable present value27 (PPV) of future insurance benefits; and,
●
the PPV of pure premiums remaining to be paid by the policyholder. The valuation MP is the difference between:
●
the PPV of the insurer’s total commitments, including its management commitments; and,
●
the PPV of valuation premiums remaining to be paid by the policyholder.
PPVs are sometimes computed from premium rates (the accounting method), and sometimes – as is more consistent with the general principle of prudence – from assumptions that are more recent than rates (e.g., survival or mortality tables, discount rates, loading). Applying a more recent survival table to MPs for annuities will factor in the lengthening of human lifetimes, while an updated mortality table will incorporate deaths from AIDS amongst young generations.
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Depending on the country, tables can be general (showing the mortality of an entire country) or limited to statistics compiled from the experience of one or more companies. Their use can be imposed by law or freely chosen by the insurer. They may be comprehensive or limited to a particular category of insured, such as non-smokers, women or dependent employees. In some jurisdictions, segmentation of this type is prohibited. Discount rates are generally correlated with the method used to value investments on the balance sheet. They can be imposed by the authorities, capped by reference to a market index or linked to actual yields on the insurer’s investments. Loading can be fixed, subject only to supervision, or free. Pure premium MPs must be supplemented by a provisio n for management costs. In the valuation premium MP, the PPV of the insurer’s commitment includes a management commitment which usually takes the form of a mark up in a certain percentage of insured capital. Insurers use acquisition loadings to cover their production expenses, which consist primarily of commissions due to intermediaries who sell their policies. In the case of contracts involving periodic premiums, commissions are generally discounted, i.e. paid entirely (at the beginning of the policy: the insurer gives somehow what he will receive latter) out of future premiums if acquisition loadings as a percentage of premiums are constant. MPs computed from valuation premiums do not factor in these prospects for recovery. In the formula, the subscriber’s actual commitment is therefore reduced. A correction is legitimate, and the MP of a contract involving periodic premiums and discounted commissions can be zillmerised,28 i.e. calculated as follows: MP = PPV (insurer’s commitments) – PPV of the (p + g + a) still due from the policyholder. Zillmerisation reduces the amount of the MP, which can even be negative at the outset of a contract, which would be meaningless from a bookkeeping standpoint insofar as it would imply that the insurer holds a claim on the policyholder: such a claim would be highly uncertain, since insurers can generally take no action to compel payment of life insurance premiums. In countries in which policyholders cannot be compelled to pay, it is logical not to post negative MPs: if zillmerisation yields such a result, it is replaced by 0. Loadings for acquisition costs cannot always be computed precisely: in such cases, a flat rate is used, in line with local practice (as in Germany). The Campagne report suggests a prudential rate of 2% – which is less than economic reality.
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An alternative to the zillmerisation of MPs is to book a claim on premium payers, corresponding to the acquisition loadings to be paid with future premiums, as an asset. A contract’s MP measures the amount of savings accumulated by the subscriber at the date of inventory. It is not, however, the property of the policyholder,29 who holds only an entitlement to a claim, equal to the MP, on the undertaking. a) This entitlement is exercised at the term of the contract, but b) The policyholder may request to cash it in. Many contracts give policyholders the option of foregoing the insurer’s guarantees and obtaining a refund of the policy’s surrender value, which is a part of its MP. Many countries impose a contractually guaranteed minimum surrender value, which, expressed as a percentage of the MP, varies substantially from one jurisdiction to another. 30 A very high guaranteed surrender value gives the policyholder’s savings a degree of liquidity that can cause trouble for the insurer by exposing it to massive cash-in requests in the event of such adverse economic circumstances as rapidly rising interest rates in financial markets. In some countries, however, the amount of any surrender value is not set contractually from the outset: the insurer’s actuary determines it on the basis of the company’s financial position at the time the policy is cashed in. This solution shelters the insurer from the consequences of a sudden policyholder reaction to economic events. The MP must be adjusted if necessary so that it exceeds the contractual surrender value at all times. If an undertaking fails, i.e. is no longer able to meet its commitments, policyholders and other contract beneficiaries become creditors whose claims are equal to the MP of their contracts at the date the undertaking is liquidated. 2. Other technical provisions While mathematical provisions constitute the bulk of a life insurance undertaking’s technical provisions, other provisions fulfil the definition given above: Provision for claims The MP that expires at the term of a contract (at maturity or upon the death of the insured), and the capital due to beneficiaries, are transferred to a provision for claims pending completion of settlement formalities.
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Provision for policyholders’ profit-sharing (PS) This is a suspense account in which a portion of the company’s earnings is set aside for the insured if bonuses are neither distributed immediately nor added to contract MPs in application of legal or contractual provisions. Provisions for PS may be undifferentiated or comprise both a portion allocated in advance and a free portion. For example, an actuarial calculation can measure the cost of bonuses to be awarded when contracts mature. The free portion is sometimes treated like a reserve (as in Germany). In the United Kingdom, there is no PS provision in the strict sense, bonuses being taken from the difference between the insurer’s assets and liabilities within policyholder funds (see “Investments” below). Provision for management costs The provision for management costs covers an insurance undertaking’s future management expenses that are not covered elsewhere, i.e. by MPs or management loadings to future periodic premiums. Based on a reasonably limited time frame (e.g. ten years) and calculated for each uniform category of policies, the management provision is equal, in present value terms, to: ●
the difference between a projection of the company’s future management costs and the loadings included in periodic policyholder premiums; plus,
●
a financial margin, represented by the excess of future financial income over the share of such income allocated to the insured (guaranteed technical interest, contractual PS).
The various technical provisions in life insurance are calculated in accordance with the rules set forth in Part I of the report under the heading “Underprovisioning”.
Technical provisions in the strict sense: non-life insurance A terminological distinction is commonly made between provisions for risks or premiums and provisions for claims. The former cover potential liabilities before qualifying events occur, while the latter cover obligations arising after they occur. In the European Union, harmonised accounting regulations distinguish between: ●
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provision for unearned premiums (PUP): a mechanical pro-rated projection of a portion of premiums; and,
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provision for risks outstanding (PRO): a supplement to the PUP which is constituted if premiums are found to be insufficient (in some countries, the regulatory authorities prefer that the PUP be increased).31
a) Provisions for unearned premiums The PUP, arising from the time lag between due dates and the date of the balance sheet, measures, in the aggregate for all contracts in force, the share of premiums corresponding to the period between the date of record and the next date on which premiums are due (or when contracts terminate). Bases for calculation: ●
premiums written (or, in some jurisdictions, premiums received);
●
net of cancellations;
●
gross or net of reinsurance;
●
contract by contract, pro-rated (with a set minimum in some cases); some countries require the use of a statistical substitution method;
●
gross premiums or valuation premiums: the PUP comprises a provision for management costs corresponding to the deferral of a portion of the management loading.
The valuation premium is derived from the gross premium by deducting acquisition costs, either by convention (i.e. a set percentage) or using the actual amount. If the PUP is calculated in respect of gross premiums, acquisition costs are then posted to a countervailing suspense account on the asset side of the balance sheet. Example: Annual premium of 1 600 for a contract running from 1 October to 30 September. P = p + g + a = 1 200 + 160 + 240 = 1 360 + 240 ●
using valuation premiums: PUP = 1 360 x 9/12 = 1 020;
●
using gross premiums: PUP = 1 600 x 9/12 = 1 200, with deferred acquisition costs carried as an asset: 240 x 9/12 = 180. The two outcomes are equivalent on a net basis.
If actual acquisition costs are less than the loading for that purpose, the amount of deferred acquisition costs carried as an asset is reduced accordingly. In the event that premiums have been set too low, the PUP is supplemented by a PRO. b) Provision for risks outstanding The PRO is designed to cover claims and related expenses for all policies in respect of the period between the date of record and the due date of the first
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premium for which a rate adjustment is possible (if applicable) or the expiration of the policy, to the extent that they are not covered by the PUP. The PRO is comprehensive and is calculated class by class or for all of a company’s business. Premiums are deemed insufficient if: C + AMC > P + AMC or: C ------------------- = 1 + z P and PRO = z x PUP e.g.: P = 100 , C = 80 , AMC = 30 –-> z = 10 / 100 = 0.1 or PRO = 0.1 PUP P, C, and AMC are data from the year in question or an average over several years. c) Provisions for claims outstanding According to a definition commonly accepted in both hemispheres, the provision for claims outstanding (PCO) measures the estimated total cost of ultimate settlement of all claims incurred before the date of record, whether reported or not, less any amounts already paid out in respect thereof. The PCO also includes a management provision intended to cover all expenses arising from the processing of claims. The PCO aggregates three different types of claims: ●
claims for an amount known precisely but not yet paid to the beneficiaries;
●
claims reported, and thus known, but for an as yet indeterminate amount;
●
claims incurred but not yet reported as of the date of the balance sheet (late or IBNR).32
The PCO combines elements having varying degrees of certainty, which should, under strict accounting principles, be broken down into a number of different items. But here the overriding concern is ex post supervision of pricing, and this is achieved by classifying claims paid and provided for by year of occurrence. PCOs are generally recorded on the balance sheet as liabilities gross of reinsurance, with reinsurers’ shares of the provisions carried as assets. Some jurisdictions accept net figures, but this conceals the undertaking’s aggregate debt to its policyholders and constitutes a lack of transparency.Some countries assign claims to the year in which they are reported. Seriatim33 valuation is used and required in most countries and for virtually all classes. Exceptions are allowed here and there for claims regarding motor, health insurance and transport insurance, etc.; they are stipulated by the regulations or granted by the supervisory authority. Some countries do not call for any particular method. In the United Kingdom, new methods must be approved by the supervisory authority. In
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c o u n t r i e s t h a t re c o m m e n d o r re q u i r e c a s e - by - c a s e c a l c u l a t i o n , supplementary or substitute methods – flat-rate or statistical – may be recommended or authorised by the regulations or by supervisors. The most common method is based on the average cost of claims. The treatment of recoveries from third parties that bear responsibility for claims varies: in some countries, the PCO is posted to the balance sheet net of recoveries, whether they are certain or forecast. In other countries, recoveries are estimated on a seriatim basis, the total of which is distinct from the PCO. In some countries, only claims that are certain may be booked as assets, while in others recoveries may be deducted from the PCO only if the debtor has acknowledged the claim. In other countries, the supervisory authority must give prior consent. In still others, recoveries are not taken into consideration at all. Seriatim valuation may or may not take future inflation into account: it is compulsory in Spain and France. In some countries, projected inflation is offset by a revaluation of the investments covering the PCO. But, in the United States, regulations prohibit any discounting of the PCO, i.e. a present-value calculation that would be less than the foreseeable final amount of benefits. In the European union, the Insurance Accounting Directive (91/674/EEC, art. 60, paragraph 1, g) prohibits implicit discounting or deductions, whether resulting from the placing of a present value on a provision for an outstanding claim which is expected to be settled later at a higher figure or otherwise effected. However, in paragraph 2 of the same article, Member states are being given the power to permit explicit discounting or deductions to take account of investment income, provided that a number of specific requirements have been taken into account. If information regarding claims outstanding is insufficient at the date of the balance sheet, insurers assign a value to the PCO, e.g.: ●
by assuming a zero surplus: PCO = P – AMC – Cpaid
●
by setting aside a certain percentage of premiums: x% P.
To assume a zero surplus is dangerous for two reasons: it precludes ex post review of pricing; the PCO will be insufficient if premiums have been set too low. This method should be abandoned as soon as enough information has been gathered to calculate the provision more exactly. Moreover, transparency dictates that any use of the method should be explained in the notes to the balance sheet. Throughout the world, many supervisors consider that the regulations or insurers’ own practices contribute to the calculation of loaded PCOs, i.e. provisions that include a safety margin. In some cases this results from comparative use of more than one method, with the highest figure appearing on the balance sheet, while in others an additional provision is constituted for
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equalisation. Elsewhere, overprovisioning is considered inconsistent with the obligation that a firm’s accounts reflect its true financial position. Technical provisions, in the strict sense of the term, include (although the list is not exhaustive) the highly specific provisions that may be found in certain countries. d) Mathematical provisions for annuities They are assessed by the present value of the firm’s liabilities in respect of annuities payable as a result of disabling bodily injuries. Here, the mortality tables and discount rates are generally not the same as those used for conventional life insurance in particular, since the disabled do not have the same survival expectancy as able-bodied people. e) Provision for ageing or increasing risks Provisions for ageing or increasing risks, which are constituted in health and disability insurance, offset the imbalance between the respective trends in risks and premiums as the insured get older. In this class of insurance, some regulations limit price increases and, as is the case in France, prohibit companies from cancelling a policy after a claim is made. One point of reference is the average age of the persons insured. While it is acceptable to overcharge young people for their own risks, insofar as they will be compensated for it when they are elderly, it does not seem right to increase their premiums because the average age of the insured population is rising. The provision for ageing endeavours to smooth out this unfairness. Even so, some countries treat it as a free reserve. The provision is generally calculated on an actuarial basis, although in most cases neither the regulations nor the supervisory authorities stipulate what that basis must be. In the Netherlands, private health insurance has since 1991 been restricted in two ways: premium increases may not exceed the rate of inflation, and aggravated risks are pooled amongst all of the insurers concerned. Accordingly, there are three options for calculating premiums: a single rate (claims spread equally); rates by age bracket; and rates computed on an actuarial basis (with the premium depending on the age of the insured when the contract is written, but remaining constant thereafter, apart from adjustments for inflation). Under this system an insurer cannot refuse to provide standard cover to a potential customer under any circumstances. The provision that incorporates the risk that a group will get older is calculated like a pure premium mathematical provision, making allowance, in addition, for a degressive rate of cancellation ranging from 5% (for insureds under 25 years of age) to 1% (at age 50) and 0 thereafter.
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Other technical provisions Other, contingent technical provisions for unforeseen events are considered reserves in many countries. This corresponds to the current stance of the IASB 34 in its attempt to harmonise accounting standards in the financial sector, and for insurance in particular, on a world-wide basis. Classifying these funds as provisions is especially advantageous for insurers in countries in which tax is based on profits, whereas it makes no difference if firms are taxed on their financial income. In non-life insurance, equalisation provisions and provisions for risk fluctuations serve two purposes: to offset significant year-to-year variations in loss experience, and to supplement basic technical provisions that are considered too thin. [1] European Directive 87/343/EC of 22 June 1987 instituted an equalisation reserve for credit insurance, the purpose of which is to offset losses stemming from an above-average C/P ratio. In profitable years, the provision is constituted in one of the following two ways: ●
75% of the profits for the class of insurance in question are allocated to the provision until it reaches 134% of aggregate annual gross premiums (or 150% of net premiums).
●
The provision is credited with an amount equal to: (C/Paverage – C/Pyear) x EP35
If the C/P ratio for the year is above average, the loss is charged to the equalisation provision. The average C/P ratio is computed over 15 or 30 years. [2] In some countries, insurance supervisors feel it is not necessary to constitute equalisation provisions insofar as companies can effectively protect themselves through adequate reinsurance and equity. Nevertheless, equalisation provisions are recommended or regulated in many countries. The diversity of the solutions adopted stems from: ●
the reasons underlying the regulations;
●
the classes of insurance involved;
●
whether the provisions are mandatory or elective;
●
their tax treatment;
●
how they are calculated.
In some jurisdictions, provisions for equalisation or risk fluctuation are comprehensive, constituting a sort of first level of solvency margin (a “premargin”) to cover losses resulting from adverse loss experience fluctuations or forecasting errors. Calculations are based on a firm’s underwriting volume,
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premiums and provisions for claims. For example, in Sweden, a Swedish nonlife insurer is allowed to use profits to build up a voluntary equalisation reserve, and since this will reduce the profit (if any) subject to company taxation, this is a tax benefit. This benefit is limited, however, by the requirement that the total equalisation reserve must not exceed a limit prescribed by the supervisory authority and defined below: M = aP + bQ P: premiums net of reinsurance; Q: provisions for claims; a: a coefficient ranging from 0.1 (damage) to 6 (credit), depending on the class; b = 0.15 (0.45 for acceptances and operations abroad). Elsewhere, the C/P ratio constitutes an indicator that affects the amounts that are added to or taken back from provisions. In each class, a firm’s most recent C/P ratio is compared to either: ●
the C/P ratio of major undertakings in the market; or,
●
the firm’s average C/P ratio over the past 10 or 15 years.
If the average C/P ratio is greater than that of the firm for the year in question: An amount equal to (C/Paverage – C/Pfirm) x P is added to the provision. If the average C/P ratio is less than that of the firm for the year in question: An amount equal to (C/P firm – C/Paverage ) x P is deducted from the provision. In Germany, equalisation provisions must be constituted for all classes except health insurance. Provisions must be constituted if: 1) EP > DEM 250 000 (average for the past three years); 2) the standard deviation of C/P ≤5% of the average C/P ratio for the past three years; 3) C + AMC > P (during at least one of the past three years). The annual allocation to the provision is 3.5% of its ceiling amount, which is set in relation to the standard deviations of the C/P ratios for each class. As in the previous method, the provision is drawn down if the year’s C/P ratio is above average. In Japan, in each class, every year, a certain percentage of gross premiums is allocated to the provision for catastrophic losses, up to a ceiling which is also set in relation to premiums. Allocations are 2 or 3%, depending on the
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class, and the ceilings are 100% or 160%, the endowments being effective if the C/P ratio exceeds 50% or 80%. Household earthquake insurance and compulsory motor insurance are treated differently, with all profits being paid into the provision, to which losses are charged until they are fully extinguished or the provision is exhausted. In other countries, insurance undertakings are required to constitute equalisation provisions only in respect of risks that are subject to considerable fluctuation. In Belgium, these include: natural risks, nuclear energy, defective product liability, space risks, terrorism and labour conflicts. In France, the list is somewhat different and includes pollution liability. In France, contributions in each category amount to 75% of the profits, up to a ceiling representing between two and six years’ worth of premiums, depending on the risks. Losses are charged to the provision until they are fully extinguished or the provision is exhausted. There is no minimum required amount for the provision. [3] In life insurance, equalisation provisions are constituted in some countries to cope with loss experience fluctuations in respect of the death, disability and sickness claims of groups of policyholders. Group life insurance contracts are priced according to the experience of a population far larger than the group being insured. Thus, the frequency of claims will match the theoretical probability used to compute premiums only over a long period of time – the smaller the group, the longer the period.36 For a small group, the constitution of an equalisation provision can smooth out results over time. The smaller the group, the larger the provision should be as a percentage of premiums. Regulations differ as to the ultimate assignment of the provision: for example, at what point should the provision for any given year be transferred to the provision for policyholders’ bonus?
Provisions involving investments In some countries, technical provisions encompass provisions that in fact cover investment risks. Their purpose is to offset asset depreciation, interest rate fluctuations, insufficient liquidity or mismatched assets and liabilities. Some of these provisions record losses that it is hoped are temporary, while others project potential future losses using pessimistic but feasible scenarios. Some seek to stabilise the income from assets used to cover technical provisions, using a ricochet mechanism to force an increase in the volume of those assets when market rates decrease. Other provisions enable life insurers to cope with a massive wave of policy surrenders. Insofar as such provisions37 are linked to the structure of the firm’s investment portfolio, and to how investments are valued on the balance sheet, it would be preferable to describe them in the section on investments – apart from one exception, however:
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Provision for interest rate differentials An important aspect of a life insurer’s solvency is the match between the interest rates that are guaranteed in its contracts and the actual yield on the assets that cover the firm’s mathematical provisions. A drop in financial market interest rates can ultimately compromise an insurer’s soundness. Regulators and corporate financial managers propose a number of solutions to prevent falling interest rates from disrupting an insurer’s equilibrium: ●
recalculate MPs year after year using lower discount rates;
●
use derivative instruments;
●
gradually build up an additional technical provision, the amount of which is determined by comparing updated forecasts of financial income with contractually guaranteed technical interest payments.
For example, the provision for interest rate differentials is equal to the excess of technical interest payments for the next (e.g.) ten years over the financial income projected over the same number of years (using conservative assumptions incorporating the structure of the investment portfolio and changes therein). The provision is constituted only when such an excess occurs, and it is reincorporated into earnings when it disappears. The advantage of this method is the gradual way in which the provision is constituted when rate decreases persist. The purpose of the French provision for financial contingencies (PFC) is the same: if, at the date of record, the ratio of guaranteed technical interest payments to MPs exceeds 80% of the actual yield from investments, MPs are recalculated at a discount rate equal to 80% of that yield; the PFC is then as follows: PFC = MP (recalculated using 80%) – MP (balance sheet) The calculation is done over again each year. The PFC has the drawback of necessitating sudden action upon crossing a threshold, at a time when the firm may no longer have the resources needed to compensate for the risk of falling interest rates.
Supervision of technical provisions The critical role of technical provisions in assessing the financial health of an insurance undertaking is acknowledged by regulators and supervisory authorities around the globe, even though their reactions to any deficiencies may diverge significantly – with some demanding a reinforcement of technical provisions or the constitution of additional ones, and others preferring to impose substantial equity requirements.
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Other differences – in the level of compulsory minimum standards, methods of calculation, rules, supervisory techniques, etc. – stem from individual market characteristics, approaches to supervision and the resources that supervisors are given to carry out their missions. Just as some markets are more concentrated than others, the number of supervisory personnel varies, as do their training, and the mix of lawyers, economists, mathematicians, accountants, etc. The degree of computerisation varies as well. The methods chosen to analyse technical provisions also depend on the powers invested in supervisors: continuous oversight, on-site inspections, use of private experts, etc. In some cases, supervisory tasks are delegated to joint bodies combining representatives of government and the insurance industry. The “Anglo-Saxon” concept of supervision combines demands for freedom and transparency: insurers are free to calculate technical provisions as they see fit, but their methods must be set forth in detail in published reports. Elsewhere, prior control of prices shapes the valuation of technical provisions, but that does not obviate the need for ex post checks. Lastly, the supervisor’s task is more complex when the regulations do not make a clear distinction between technical provisions and reserves. Supervisors must first enforce the application of prudential rules concerning technical provisions. This oversight is carried out on site and using company records, based on prepared models or random samples: 1. In all cases, companies must file a report on technical provisions to their supervisory authority at least once a year. This report generally includes standardised tables showing C/P trends over time, and year-to-year loss settlement – by class or by type of contract. Some company reports also provide detailed information on the valuation methods used. They also confirm implementation of any calculation methods that may have received prior approval from the supervisory authority. 2. In life insurance, in some jurisdictions, mathematical provisions are certified by appointed actuaries, who may or may not be company employees. The selection of an appointed actuary is sometimes subject to approval by the supervisory authority. In some countries, non-life technical provisions are also certified by an independent actuary. 3. Some supervisory authorities limit their intervention to a documentary analysis of technical provisions, which can be carried out using a particular model and data on claims and expenses collected from the leading firms in the market. Highly detailed data are thus compiled by uniform categories of
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risk. Instead of resorting to empirical models, other supervisors prefer using models based on risk theory. 4. In some cases, supervisors are authorised by law to delegate some of their tasks to private experts. 5. More often, supervisors themselves conduct on-site checks, whenever they deem it necessary, verifying claim files selected at random. They review valuation rules and whether those rules have been applied faithfully by the persons responsible for investigating and assessing claims. Their conclusions may help insurers to mend their ways. 6. Depending on the results of their inspections, supervisors are empowered to impose – or in any event to recommend – the constitution of additional provisions or the reinforcement of existing technical provisions. In their mission, supervisors do not have the same objective as internal auditors: in particular, it is not their role to interfere with a company’s management, other than to offer advice and recommendations that could help the firm to honour its commitments. Nor is their role that of a financial analyst who must assess the value of a company with a view to selling it or listing it on a stock exchange. To avert the consequences of an erroneous estimation of an insurer’s commitments to its policyholders, regulatory and supervisory authorities have adopted a widely varying range of solutions and attitudes. There is a broad panoply of techniques for eliminating or limiting risks that are characteristic of the insurance industry: 1. impose highly prudent calculation rules that add a margin of safety to technical provisions; 2. supplement “reasonable” (?) technical provisions with an overall additional provision, the amount of which can be determined using a theoretical or statistical model; 3. require substantial equity capital. In any event, it is essential that the level of the required solvency margin be consistent with the approach used to determine and check technical provisions. At the same time, regulations and supervisory procedures must incorporate the correlations that exist between a firm’s technical provisions and its investments, and between its pricing and its technical provisions.
B. Balance sheet assets General principle Protecting the insured requires that adequate technical provisions be constituted on the balance sheet as liabilities. It is also necessary that these
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liabilities be matched by an equivalent amount of assets of select quality. It is these real assets – investments, cash and receivables – that give a firm the means to honour its commitments to its customers. An insurer’s receivables primarily involve its economic partners – reinsurers and cedents, customers and intermediaries. Another idea that has historically guided national regulators is that the funds held by insurers, because they represent policyholders’ savings, should be invested in the best interests of the group. But this is not always consistent with general security requirements. The OECD has stressed the need to regulate investments, stipulating:38 Investment regulation should ensure that both security and profitability requirements are respected. It should promote the diversification, spread and liquidity of investment portfolios as well as the maturity and currency matching of assets and liabilities […] Regulations might include a list of admitted assets on which ceilings may be set, and requirements on the way in which investments should be valued. In some jurisdictions, regulations cover all investments. In others, they cover assets (and not just investments) up to an amount no less than aggregate technical provisions. The regulations of some jurisdictions cover an amount equal to the minimum solvency requirement.
Compartmentalisation and preferences Depending on the class and the country, the assets of an insurance undertaking may be commingled or held in distinct compartments. In the United Kingdom, companies that write life insurance are required by law to keep that business entirely distinct from any other. This obligation codified a common practice of composite insurers,39 which had kept life insurance assets separate for reasons of management clarity. Under UK law on the compartmentalisation of their operations, insurance companies must: ●
keep separate books for life insurance business, with respect to both assets and liabilities;
●
book life insurance revenue to distinct accounts, constituting one or more policyholders’ funds, and charge any benefit payments or expenses corresponding to life insurance contracts thereto.
In this manner, the funds of life insurance policyholders are identified clearly, with their own assets and liabilities. Other assets and liabilities, including those arising from the property and casualty business of composite insurers, constitute what may be called shareholders’ funds.
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The status of policyholders’ funds at any given moment may be illustrated as follows:
ASSETS
LIABILITIES
Investments (at market value)
Policyholders’ entitlements: – Mathematical provisions – Bonuses already attributed ___________________
Receivables Investment reserve
If the value of assets in the policyholders’ fund falls below the value of commitments, the company’s shareholders are invited to pay in the amounts needed to make up the shortfall, and even more. If assets exceed commitments, the surplus constitutes the investment reserve, as illustrated above, which provides a sort of buffer against the effects that certain investment risks can have on the fund’s equilibrium. Resilience tests measure the theoretical impact of economic variations on the size of the fund, the book value of securities and the amount of mathematical provisions, the discount rate for which is linked to actual returns on investments. The assumptions underlying these hypothetical projections include a decline in the value of equities and real estate (of 10 or 25%, for example) and a rise or fall in yields on fixed-income securities. The results of these tests determine the fraction of the investment reserve to which future policyholder bonuses may be charged. As a rule, assets in a life insurance policyholders’ fund may be used only for certain designated purposes, and the same applies to investment reserves, except where a statutory “90-10” rule applies.40 In the United Kingdom, companies are completely free to set their own profit-sharing (or bonus) policies. And, according to local practice and the bylaws of many companies, shareholders may be g iven 10 from the policyholders’ fund whenever a bonus of 90 is taken from the investment reserve. Compartmentalised funds constitute an additional guarantee for the insured, investments being subject to the same prudential rules as in countries that do not have compartmentalisation. Earlier, we saw that in Australia a distinct solvency margin was calculated for each of the policyholder funds a company sets up. In some jurisdictions, companies isolate investments corresponding to certain categories of life insurance policies. By managing these investments
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separately, the company can determine the income to be allocated to the policies under profit-sharing provisions. This enhances fairness and transparency, but such compartmentalisation of bookkeeping has no legal force: in the event an undertaking is liquidated, the assets assigned to particular contracts are commingled with all the others and may be used to pay off other creditors and other policyholders. In the absence of compartmentalised funds, laws often stipulate that policyholders be entitled to certain preferential treatment. This preferential treatment is a creditor’s right to take precedence over other creditors in the event the firm is liquidated. The liquidator pays off creditors in the order of precedence of their claims until the company’s resources are exhausted. Preference may be special, i.e. restricted to certain assets and a specific category of creditors, or general, i.e. covering all of the debtor’s assets. Special preference in many cases gives rise to a register of investments comprising securities worth as much as technical provisions. In the event of liquidation, all investments on the register are used to settle policyholders’ claims first, although these same policyholders do not always take precedence when the company’s other assets are liquidated. As a result, policyholder protection may be weakened, or may even become illusory, if the register has not been sufficiently credited, and in particular if technical provisions have been undervalued. In Germany, the Deckungsstock is constituted by aggregate investments covering technical provisions for life and health insurance. Deckungsstock investments are managed separately, with each transaction requiring prior approval by a fiduciary, the Treuhänder. Policyholders’ general preferred claim on the assets of an insurance undertaking is usually immediately subordinate to the claims accorded through special legislation to company employees (labour law), the Treasury (tax law) and social welfare bodies, Social security and pension funds (social law). The list varies from one country to another, which complicates the task of harmonising rules for the liquidation of insurance undertakings on a European or world-wide level. In any event, if the protection afforded policyholders is to be effective, it must be extended to special priority creditors as well, i.e. to all those who, in the event an insurer is liquidated, will be paid off prior to beneficiaries; otherwise, beneficiaries might lose some of their entitlement to employees, the tax authorities or Social Security. In the rest of this report, the term “regulated commitments” will refer to aggregate technical provisions and priority preferred debt, although it should be borne in mind that in practice such debt accounts for only a small proportion of the total.
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Prudential rules governing investments and receivables will be described in relation to these regulated commitments and may readily be transposed to all assets for jurisdictions that take that approach. The presentation will be made gross of reinsurance in order to highlight the problem posed by claims on reinsurers and how countries around the world deal with the risk of reinsurer failure. The realm of investments is a battleground on which partisans of detailed and quantitative prudential rules are pitted against advocates of a flexible approach that relies to a great extent on the wisdom of financial managers (the prudent person rule) and on qualitative criteria. The debate is correlated with the powers of supervisors, with some able to act by virtue of general delegated authority to intervene on behalf of the insured, while others must justify their every action by reference to a specific regulation. The second group deem that such detailed provisions are unnecessary.
Prudential rules Thirteen series of prudential rules have been identified: Rule 1: Matching regulated commitments Technical provisions and other regulated commitments must be represented41 at all times by an equivalent amount of assets selected for their quality. This requirement applies at all times, and not just at the date of the balance sheet. This is important, insofar as it precludes contrivances that would show compliance at 31 December in order to mask, temporarily, shortcomings that would emerge again on, say, 5 January. The coverage rule is read horizontally on the balance sheet:
Assets
Liabilities
Selected assets Investments and liquidities Receivables
A
Other assets Investments Receivables and miscellaneous
B
Regulated commitments Technical provisions Other Other debts and provisions Equity capital
E
D F
Where A + B = E + D + F and the condition for cover: A ≥ E
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Rule 2: Localisation The aim of restrictions on the localisation and physical custody of investments is not only to be able to check ownership, but also to limit the possibility of fraud by company officers. Auditors and supervisors must be able to verify the existence of investments appearing on the balance sheet. Most of the OECD countries require that documents representing financial assets be kept in the custody of financial institutions that are licensed and located in the country in which business is transacted. Within the European Economic Area, localisation has been extended to the entire area: the securities of an Italian company, for example, may be kept in custody by licensed establishments in Liechtenstein, Finland or Portugal. Unfortunately, experience has shown that, because of this, supervisors do not always have the legal resources they need to detect fraud by company officers, and that auditors are sometimes deceived by guarantees in respect of remote investments. Even so, an easing of local restrictions would appear inevitable because of the progress of computer and telecommunications technology, the development of paperless transactions and deregulation. This entails harmonised oversight of the security of financial institutions and suppliers of custodial services. It also entails exchange of information between supervisory authorities and, where needed, delegation of authority to conduct local audits. Rule 3: Currency matching Commitments denominated in one currency must be backed by an equivalent amount of matched assets, i.e. assets denominated in, or convertible to, that same currency. The aim is to prevent insurance from turning into currency speculation. As a rule, matching means that a commitment made in one currency is backed up by a negotiable security traded on a stock market in which listings are carried out in that same currency. Regarding a building in Paris, can it be considered, by extension, that the asset matches the pound sterling or the Swedish krona because the buyer can pay for it in either of those currencies? The European Union allows a number of exceptions of limited scope.42 Some advocate greater flexibility,43 for Europe and beyond, deeming that in fact: ●
rules that are too strict impair asset yields and limit possibilities for diversification;
●
the permanent matching requirement is superfluous, given the inevitable time lags between revenue and benefit pay-outs, and the possibility of using
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derivative instruments to limit the effects of short-term exchange rate fluctuations; ●
the notion of foreign exchange risk for shares in large multinational corporations is no longer meaningful economically.
Moreover, the weakness of currencies in a number of emerging countries militates for a certain flexibility, which can only work in favour of policyholders in those countries. For their part, pension fund managers demand greater freedom than is granted to life insurers, on the grounds that their own commitments have a longer time frame. Lastly, the OECD’s CMIT Committee has agreed on the need for a gradual lifting of quantitative restrictions on investments abroad. A judicious balance between freedom of trade and consumer protection remains to be struck. Rule 4: Free use of investments Undertakings have unrestricted use of their investments and intangible assets, except in a number of special cases. In some countries, branches of foreign undertakings are required to deposit investments equivalent in value to the amount of their technical provisions to a frozen account with a licensed custodian; any withdrawal or disposal of these assets is subject to prior approval by the supervisory authority. Supervisors are thus able to prevent cross-border transfers between branches and other establishments belonging to the same group if those transfers are likely to weaken the protection of domestic policyholders. Nevertheless, the deposit procedure is a ponderous one, and it is obviously not applicable to certain types of assets, such as real estate, premiums receivable, and so on. Rule 5: Catalogue of investments The investments of an insurance undertaking must be safe, profitable and liquid. 1) Safety Investments must offer maximum possible safety, in the interests of the insured. As a result, speculative securities, unsecured loans and particularly volatile stocks are excluded. In many countries, the regulations exclude gold, raw materials, works of art, etc.
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In contrast, investments that are especially favoured include bonds issued or guaranteed by the governments of OECD member countries, loans secured by collateral or guaranteed by a first-rate signature and real estate in a prime location, which facilitates transactions. 2) Profitability Returns on regulated assets need to be taken into consideration, not only in life insurance, where they determine product yields, but in non-life classes as well, where they contribute to underwriting balance. Returns are measured by income and capital gains or losses. In many jurisdictions, preference is given to bonds. The use of junk bonds has shown that some insurers, in certain situations, could value returns over safety, in particular if falling financial market interest rates make it difficult to deliver contractually promised returns to policyholders. 3) Liquidity The investments of insurance undertakings must be sufficiently liquid to cover short-term liabilities. Because the insurance business is characterised by regular inflows and outflows of cash, liabilities that fall due within a relatively short period of time may in fact be covered by medium-term investments. Moreover, the assignment of assets serves different needs, depending on whether an undertaking is financially sound or ailing. However, the surrender options given to life insurance policyholders under the consumer-oriented regulations of some countries oblige insurers to keep a substantial volume of readily realisable assets. Regulators prefer listed shares on high-volume stock exchanges to unlisted shares, which in many cases are difficult to sell. Even so, some listings can be artificial, resulting from transactions conducted exclusively between companies belonging to the same group. In such cases, the liquidity of the shares is dubious. Safety, yield and liquidity requirements are never combined optimally in any one investment; if they were, that investment alone would fill every catalogue. Securities offering the largest yields are not the safest, and the most liquid do not offer the most attractive yields. Financial managers must therefore strike a balance. The laws governing investment catalogues in most countries allow this diversification, proposing highly comprehensive lists of eligible assets, including bonds, equities, real estate, loans and bank deposits, along with claims on customers, reinsurers, cedents, and so on.44 These lists, many of which include financial instruments unique to local markets, will not be discussed in detail here. Only investments in related undertakings will be evoked later on.
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Rule 6: Eligible receivables (on certain conditions) Along with investments and cash, the European Union’s catalogue (Directive 92/49/EEC, Article 21) lists various other assets, including: ●
debts owed by policyholders and intermediaries;
●
debts owed by ceding undertakings;
●
claims arising out of subrogation (claims recoveries);
●
debts owed by reinsurers;
●
deferred acquisition costs;
●
accrued interest, etc.
Insurance undertakings in fact have constant dealings with their policyholders, intermediaries, reinsurers, ceding companies, etc. These transactions are reflected on the balance sheet by receivables and debts, which regulations sort into various categories. In the European Union, for example, member States have the right to be more restrictive than the Directive, excluding certain receivables (e.g., France does not allow debts owed by intermediaries) or imposing various security restrictions. Choices are determined by: ●
the quality of the debtor;
●
the guarantees provided by the debtor;
●
the correlations between receivables and regulated liabilities.
As a rule, a claim on a third party is allowed only after deduction of any amounts owed to that same third party. In life insurance, policy advances may be used to cover mathematical provisions, which is logical insofar as they are charged to the provisions. Premiums receivable are also acceptable, even if demands for payment are not legally enforceable, 45 if they have been taken into account to calculate mathematical provisions as of their due date and not the date they are actually received: in the event of definitive non-payment, the policy’s mathematical provision will be reduced. However, insofar as the amount credited to the provision is less than the premium due because of the amount the insurer takes out of the premium to cover acquisition costs, it is prudent to allow only a portion of premiums receivable to be used to cover mathematical provisions. In non-life insurance, if the provision for unearned premiums (PUP) is calculated on the basis of due dates rather than actual inflows, it is only right, given the incompressible amount of time needed to collect amounts due from policyholders, to allow premiums written recently (e.g., less than three
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months ago) but not yet received, and earned unwritten premiums,46 to count as eligible assets. Prudence would dictate that: ●
the amount allowable be capped at a moderate percentage of the PUP (e.g. 20 or 30%);
●
arrears47 of more than one, two or three months be excluded;
●
amounts due from intermediaries and corresponding to premium payments forwarded by them should be excluded.48
If the PUP is calculated on the basis of gross premiums, it may possibly be covered by deferred acquisition costs carried on the balance sheet as assets, up to an amount corresponding to the acquisition loading included in premiums and to the firm’s actual production expenses. In life insurance, deferred acquisition costs are not eligible as cover unless this is consistent with the way in which mathematical provisions are calculated.49 The American RBC approach is completely different, since arrears and deferred expenses are deducted from equity capital – a procedure that may be considered stricter than merely barring such assets from the list of investments eligible to cover technical provisions. Undertakings may, logically, cover technical provisions corresponding to reinsurance acceptances with amounts owed by the ceding companies, on current account or in the form of deposits with those companies. Calculations are made for each ceding firm, and a claim on one cedent may not be used to cover a debt to another cedent. In non-life insurance, if provisions for claims are calculated without deducting foreseeable recoveries from third parties, these recoveries may constitute allowable assets if they are carried as assets on the balance sheet. The use of projected recoveries to cover technical provisions is generally subject to a number of conditions: ●
individual justification, on a case-by-case basis; or, failing that,
●
a statistical estimate based on experience from past years;
●
reduction of recoveries by an amount not less than the cost of collecting them.
The volume of recoveries varies considerably from one line of insurance to another. In France, compulsory liability insurance in the construction industry generates a great many recoveries, insofar as insurers who pay out claims investigate whether the cause of the damage in question can be attributable to architects, contractors or building materials manufacturers. The time involved can be very long, posing problems of liquidity.
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Amounts due from guarantee funds are allowable if the funds are guaranteed by the government. The treatment of amounts due from reinsurers varies considerably from one country to another. If technical provisions are posted to the balance sheet net of reinsurance, this in effect takes all of the reinsurers’ share in those provisions as cover. If technical provisions are posted gross, regulations can take differing approaches to the admissibility of these claims. In any event, claims on reinsurers comprise the reinsurer’s share in the direct insurer’s gross technical provisions, plus or minus the balance of the current account between the two operators, and less any cash deposited by the reinsurer. Solution 1: All claims on reinsurers are allowed, without discrimination or additional restrictions. The risk of reinsurer default is covered by equity capital, e.g. by an amount of RBC (in the United States, equal to 10% of claims on reinsurers). Solution 2: Claims on select reinsurers only are admissible. The selection criterion may be based on ratings by a well-known rating agency, the degree of supervision to which reinsurers are subject in their home countries or factors involving reputation or nationality. Reinsurance being an international activity, supervisory authorities could significantly enhance the reliability of their judgement by exchanging information amongst themselves. The OECD is preparing a Recommendation along these lines. Solution 3: Only those claims on reinsurers that are protected by a pledge of securities or a letter of credit may be used to cover gross technical provisions. The guarantor signing the letter of credit must obviously be less exposed to the risk of insolvency than the reinsurer it is backing. Some large global reinsurers claim that such a guarantor does not exist, given the magnitude of their own equity capital. And they protest a constraint that hampers their financial management and limits their ability to react immediately to disasters. On the other hand, guarantees could offer effective protection for ceding companies, and thus for their policyholders, if systemic reinsurance risk were ever to materialise, since there are those who feel today that the concentration of reinsurers, and the preponderant market share that some of them have acquired, mean that all of the planet’s operators are running a world-wide risk.
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Solution 4: The reinsurer must deposit with the ceding insurer an amount of cash equal to its debt (or at least the amount needed for the cedent to cover its gross technical provisions in full). This rule is applied by the CIMA,50 and its effectiveness can be seen from a comparison of the following two balance sheets: A) Without cash deposit Assets
Liabilities
Assets acceptable for cover
50
TP
Reinsurers’ share of TP
60
Other debts
Other assets
10
Equity capital
Total
120
Total
100 5 15 120
B) After cash deposit Assets
Liabilities TP
Assets acceptable for cover
100
Debt corresponding to reinsurers’ deposits
Reinsurers’ share of TP
60
Other debts
Other assets
10
Equity capital
Total
170
Total
100 50 5 15 170
In situation A, if claims on reinsurers are not automatically acceptable, the company’s regulatory cover will be 50 short, which should trigger supervisory action that might lead to a cessation of business. In situation B, reinsurers have put 50 at the disposal of the ceding insurer, which has used it as assets to cover technical provisions. The mechanism is based on the concept of policyholder preference, with reinsurers being considered merely as ordinary creditors. C l a i m s a n d s u n d ry a s s e t s a c c ep t abl e f o r c ove r i n g reg u l a t e d commitments represent a highly variable but generally modest fraction of these commitments, depending on the company and the country. In the French market, the proportion averages 6% in life insurance and 15% in nonlife insurance. Rule 7: Allocation of investments Investments listed in the catalogue of assets acceptable for covering regulated commitments do not all offer the same level of required safety, yield and liquidity standards. Various limitations are imposed to deal with these inequalities – some applicable to various categories of investments (distribution rules) and others applicable to individual investments (diversification rules). Insurers portfolios include different types of
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investments, bonds, shares, etc. Diversification rules are aimed at mitigating liabilities carried on a single issuer. Bonds, equities, real estate, loans and bank deposits constitute the various groups of investments enumerated in the regulations, which in many cases distinguish subgroups as well: shares not listed on an OECD-country stock exchange, shares in insurance companies, unsecured loans, bonds issued or guaranteed by the government of an OECD Member country, and so on. Some jurisdictions impose minimum quantities for bonds – a constraint that is now prohibited in the member States of the European Union. As a rule, however, there is no overall ceiling on bonds. For equities and real estate, upper limits – where they exist – vary widely from one country to the next, even within the European Union, which has not set a common rule for these two very important categories of assets. The European Union has imposed overall ceilings only in respect of unsecured loans (5%) and securities that are not traded on a regulated market (10%). Here, the percentages are in relation to technical provisions; elsewhere they are calculated relative to investments. In France, the reference amount is computed by subtracting eligible receivables from regulated commitments. This difference represents the aggregate amount of catalogue investments that the undertaking is required to possess. Whatever reference is chosen, investments that are considered the riskiest must be subject to the greatest limitations. Rule 8: Investment diversification Diversification limits the potential risk from the depreciation or nonliquidity of a given investment, since large sums invested in a single security are generally more difficult to recover. Ceilings set at a number of levels, depending on the safety and liquidity of the various investments, keep an insurer from “putting all of its eggs in one basket”, as the universal saying goes. As a percentage of technical provisions (or assets), 51 the ceilings established in the various OECD member countries are fairly similar; moreover, they are generally the same for life and non-life insurance. For example:
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●
For a building (or a single real estate complex): 5 or 10% Exception: 50% in Turkey, for example.
●
For aggregate securities issued by the same entity (bonds, loans, equities): 5 to 10% Exceptions: 30% in Mexico for credit institutions, 25% in Canada for foreign life insurance undertakings.
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For unsecured loans: 1% in the European Union.
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For unlisted equities: 0.5% in France, for example. There are special cases:
1. Investments backing mathematical provisions for unit-linked contracts must be the same as the ones making up the reference securities, and in the same proportions. The general rules of diversification and allocation therefore do not apply to such investments. 2. There are practically no quantitative restrictions if the issuer is an OECD member country. 3. In some countries, the 5% ceiling is raised for securities issued by a financial institution “subject by law to special official supervision designed to protect the holders of these debt securities” (Directive 92/49/EEC, Article 22, paragraph 4). 4. Cash deposits are not always subject to overall limits, or to limits by depository. It goes without saying that such depositories must be regulated financial institutions. But does the existence of prudential supervision justify the absence of any limitation? Whatever the quality of supervision, the fear that a credit institution will fail is always present. Moreover, special precautions should be taken if the depository and the insurer both belong to the same financial conglomerate. Strict application of diversification rules poses problems that could be resolved if the regulations were applied more flexibly, and on a case-by-case basis: 1. Because ceilings are set by corporate entity, an insurer could invest a significant proportion of its assets in securities issued by several companies belonging to a given conglomerate, as long as it adheres to the 5% ceiling in respect of each firm. But the counterparty risks arising from investments in the same group are not independent; the financial difficulties of any one entity have repercussions for the group as a whole. 2. If an undertaking holds securities issued by a single borrower both directly and through the intermediation of an investment company or UCITS, the diversification rule is effectively circumvented. European Directives 92/49/ EEC and 92/96/EEC propose a general solution: “Where the assets held include an investment in a subsidiary undertaking which manages all or part of the assurance undertaking’s investments on its behalf, the home Member State must, when applying the rules and principles laid down in this Article, 52 take into account the underlying assets held by the subsidiary undertaking; the home Member State may treat the assets of other subsidiaries in the same way” [Art. 22, § 2 (iv) and Art. 21, § 1 (viii), respectively].
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In other words, transparency dictates that diversification rules be extended to go-between entities, as if the insurance undertaking itself possessed the intermediaries’ assets in proportion to its investments therein. While the principle behind this is simple, applying that principle is complex, and common sense dictates that nothing be done mechanically, but rather that supervisors proceed on a case-by-case basis. 3. Listed equities must be treated as if they were unlisted if an insurer holds a significant portion of the shares in question, insofar as the market for such issues may be thin, and the share price may be propped up artificially. 4. Whatever the ceilings, they must be correlated with capital adequacy requirements: this is to preclude situations in which, for example, the entire available solvency margin could be wiped out by a 50% loss in the value of a single line item on the balance sheet. 5. The diversification rule assumes that the risk taken on by the insurance undertaking in respect of each investment is limited: this is the case with shares in joint stock companies, the responsibility of whose shareholders is limited to the amounts of their respective investments. In contrast, if an insurer is a partner in a partnership, it has unlimited liability for the firm’s debts, on a prorated or even joint and several basis. Such an investment could obviously not be allowed to back technical provisions. Rule 9: Asset and liability management One of the aims of asset and liability management is to reduce the interest rate and liquidity risks to which insurers are exposed. This involves two aspects: ●
Matching the time frame of commitments with the maturities of the assets covering them: e.g., bond maturities match the terms of contracts.
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Matching projected inflows of premiums and investment income with projected outflows of benefits and administrative costs.
The fact that these rules of proper management are not generally formalised in regulations does not mean that regulators and supervisors are not interested in such matters. One noteworthy initiative was taken in France, in a 1999 decree: “Insurance undertakings shall continuously assess their financial risks, inter alia by performing simulations of the impact of changes in interest rates and financial market prices on their assets and liabilities, and comparative estimates of when liabilities will fall due and the marketability of their assets.” The results of this assessment are reported to the supervisory authorities on a quarterly basis.
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In some countries, economic circumstances – inflation, default by debtor governments, etc. – preclude effective matching of the timing of assets and liabilities. But is this so important? In a non-life insurance undertaking: ●
Normally, inflows of premiums and financial income cover outflows of claims and overheads. Cash flow problems may therefore arise if premiums have been set too low, or if claims and overheads are greater than expected – events that may foreshadow financial difficulties.
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Even in the case of long-tail risks, the ban on discounting technical provisions imposed by the regulations of many countries precludes virtually any risk from the mismatching of maturities. In a life insurance undertaking:
Policy surrenders, which are unpredictable because they stem from policyholders’ reactions to outside events, cannot be reduced to a formula, which therefore precludes any serious forecasting of matching. Possible solutions include: ●
imposing minimum liquidity requirements;
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defining statistical indicators to be monitored closely by companies and government alike;
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using derivative securities to compensate for short-term divergent variations;
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setting dissuasive surrender penalties;
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developing unit-linked contracts, which could deliver benefits in kind,53
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concluding reinsurance treaties that could provide financing.
Rule 10: Derivative instruments Derivative instruments are financial investments whose value derives from that of other financial instruments. Forward contracts, such as options and futures, enable insurers to protect themselves against a capital loss on a sale, or against rising prices on a planned purchase, of securities. They also offer the potential for earning additional returns: starting with relatively modest capital, investors can achieve leverage effect, to their benefit – or at their expense (as in the Barings affair). For their users, derivative instruments involve special risks: counterparty risks when they are traded over the counter; a risk arising from the inexperience of operators; and particular risks inherent in each type of instrument.
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In the case of an insurance undertaking, any large-scale use of derivative instruments could jeopardise the company’s financial health. The use of derivatives has remained fairly limited, which some would attribute to the fact that there are alternative, regulatory solutions to the problems that derivatives are supposed to resolve in a more “modern” fashion. Accordingly, most jurisdictions have merely issued recommendations, which in many cases are prepared in co-operation with insurers’ associations. Regulators’ initiatives have often been hampered by incompatible accounting systems. The subject is thus a source of concern for supervisors, who have pooled their experience in European institutions, the IAIS and the OECD, whose work has inspired laws, principles and recommendations. Directives 92/49/EEC and 92/96/EEC [Art. 21, § 1 (iv)] set a limit: “derivative instruments […] in connection with assets covering technical provisions may be used in so far as they contribute to a reduction of investment risks or facilitate efficient portfolio management. They must be valued on a prudent basis and may be taken into account in the valuation of the underlying assets”. In a note for the OECD, the Swiss Delegation had identified the risks inherent in the use of derivative instruments by insurance undertakings, and which warrant special vigilance: ●
a lack of appropriate accounting procedures, which can make it difficult for the supervisory authorities to assess the situation;
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mismatch between the short terms of derivative instruments and the time frame of insurance contracts;
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the inexperience of insurance company operatives and officers;
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the temptation to speculate using the leverage effect of derivatives;
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use of over-the-counter transactions.
Even so, derivative instruments also have advantages, which complicates the task for supervisors who must exercise discernment when faced with new products. In its Core Principle 9, the IAIS54 dealt with derivatives together with the “off-balance-sheet items” of insurance undertakings. Supervisors must issue rules covering the following: ●
restrictions on the use of derivatives;
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posting of the rules governing the use of derivatives;
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adequate internal controls.55
The Müller Report56 sums it up in these words: “The risks in connection with derivative financial instruments could best be prevented by limiting the nature and scope of the business operated by legal and/or regulatory rules and
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also rules established inside the undertakings. Internal control mechanisms, training of the personnel entrusted with such transactions and, on the whole, using these instruments responsibly will reduce the inherent potential risk.” It is therefore incumbent upon corporate officers and directors to take practical precautions: ●
set clear, written rules for the use of derivatives;
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separate the execution and audit functions;
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establish a strategy for the use of derivative instruments;
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establish a list of instruments that managers may use.
Barings’ serious mishap in Singapore was attributed to the negligence of the bank’s officers, and to a failure of the internal auditing system, but not, it would seem, to fraudulent support by the London-based management of their local agent, who was able to exploit the loopholes of that system. In the final analysis, the inherent risk of transactions involving derivative instruments stems more from how they are used, and how their use is managed and controlled, than from the instruments themselves. With financial instruments, risk does not disappear – it is transferred, as in a card game in which unwanted cards are passed on from one economic agent to another. Rule 11: Asset ownership A number of situations can arise in which it cannot be considered that an insurer holds full title to its assets, due to incomplete or temporary transactions, or because securities have been pledged as collateral. 1) Guarantees given when securities are sold When an insurer sells an asset, it sometimes gives the buyer a guarantee – in order to obtain a better price, or even because the transaction would not be possible otherwise. Such guarantees may or may not be capped, and the likelihood of their being exercised can vary. In any event, they constitute liabilities. This happens frequently in connection with the sale of an insurance subsidiary, when the seller gives the buyer a guarantee of the firm’s technical provisions. If it does not take this guarantee into account, the insurer artificially enhances the coverage of its technical provisions. 2) Securities purchased on credit Here, the insurer holds securities for which it has not yet paid. Its coverage ratio will deteriorate when it disburses the corresponding funds.
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The transaction can be carried out via a bank overdraft, booked discreetly amongst sundry liabilities. The third European Directives [92/49/EEC and 92/96/EEC, Article 21, § 1 (i)] resolved the problems of guarantees granted in connection with divestments and credit purchases: “assets covering technical provisions shall be valued net of any debts arising out of their acquisition.” 3) Temporary transfers of securities The financial transactions in which insurers engage include: ●
repurchase agreements, whereby securities change hands temporarily in exchange for cash (legally, these are sales with an agreement to buy the asset back at a set price at a later date);
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loans of securities, with or without guarantees. In either case, ownership of the securities is transferred temporarily.
Economically, repurchase agreements are similar to cash loans, with securities handed over as collateral. The same holds true for loans of securities with cash handed over as collateral. Technically, the investment risk remains with the initial seller, since the buyer subsequently returns the securities regardless of their value at the date of repurchase. The insurer who transfers the securities therefore runs a double investment risk if it invests the cash received in exchange. The transaction therefore has a leverage effect increasing the hope of gain and the risk of losses. From an accounting standpoint, the risks transferred temporarily remain on the balance sheet as assets, as do the securities obtained with the cash received. This apparent swelling should not result in any double-counting of the coverage of regulated commitments. The most logical prudential solution would be to: ●
record the debts corresponding to the temporary transfers of securities as liabilities, ranking them as regulated commitments: this cancels out the doubling of the corresponding assets;
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set an overall limit on temporary transfers of securities, when they consist of loans, of, say, 5%. 4) Securities and cash deposited as collateral
The insurer uses a portion of its assets to guarantee debts, either certain or potential: ●
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Cash deposited with a reinsured company or securities handed over to that company as collateral;.
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Guarantees provided in conjunction with certain financial transactions (essentially for derivative products).
Pledged assets are unavailable as long as the insurer has not carried out its obligations vis-à-vis the beneficiary of the guarantee. The insurer therefore cannot use the assets to settle regulated commitments (apart from those to which the guarantee applies). From a prudential standpoint: ●
Assets pledged as collateral for non-preferred debt or for debt that has not been booked must be excluded from the list of assets that may be used to cover technical provisions.
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Assets pledged as collateral for a regulated commitment are allowable up to the amount of the commitment, provided they are on the list of allowable assets and that they meet distribution and diversification requirements. Excluding the surplus will prompt the insurer to achieve optimal management of the assets it pledges as collateral.
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Deposits guaranteeing transactions involving derivatives constitute assurance of the insurer’s solvency vis-à-vis its counterparty, and it does not seem proper to use policyholders’ funds for that purpose. “Defenders” of derivatives do not share this approach, which can penalise the safest derivatives: the fact that guarantees are attached to a derivative may work in the insurer’s favour if the underlying results are positive. A possible compromise would be to allow inclusion of a portion – the portion exceeding the debt or the counterpart – of deposits that could be made available on demand (by executing the transaction in question).
Rule 12: Subsidiaries Insurance undertakings sometimes hold equity interests of over 50% (“subsidiaries”) and in many cases over 20% (“participations”, as defined in European Directive 98/78/EEC on insurance groups) in other insurance companies, credit institutions, investment companies and all other sorts of businesses. While some of these participations are just investments, amongst other investments, financial subsidiaries constitute instruments for the development and diversification of the parent company’s activities. May shares in subsidiaries57 be used to back technical provisions? Should they be financed by equity capital? Should they be excluded from the wealth of an insurance undertaking? The answer may depend on the business purpose of the subsidiaries.
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1) Non-financial businesses As a rule, shares in such companies may be used to back technical provisions, subject to diversification rules, e.g. 5% for listed shares, 1 or 0.5% if they are unlisted (as most of them are). Some jurisdictions follow another line of reasoning and totally exclude such shares from the assets of an insurance undertaking, independently of the problem of covering technical provisions. They invoke the principle of specialisation, by virtue of which an insurance undertaking should limit its aim to insurance business and transactions arising directly therefrom, to the exclusion of any other commercial activity. In their view, this principle applies not only to activities engaged in by the corporate insurance entity itself, but also to those engaged in by the insurer’s subsidiaries, which are only legal extensions subordinate to the parent company. Consequently, an insurance undertaking could not be the parent company to an industrial establishment, nor to a hotel, a clinic or a chain of service stations. The only exception that is tolerated is asset management companies, insofar as the activities of such firms stem directly from the insurance business. In the world today, those still taking this approach have become a small minority. The most common stance towards the specialisation rule is that insurance companies may acquire equity interests in any company, commercial or not, regardless of its line of business. If they acquire a majority interest, they should perform their directorial role to the full, taking decisions, supervising, and so on; but they may not administer or take part in the management of these businesses. 2) Credit institutions The most common solution is to allow shares in credit institution subsidiaries to back technical provisions, subject to the same conditions as other shares, and with the same limits. Some countries, such as Mexico, raise the ceiling significantly (to 30%), on the grounds that credit institutions are subject to special prudential supervision. Elsewhere, including a number of states of the United States, for example, insurance undertakings are not allowed to purchase stakes in banks. Such a prohibition would seem justified if the law compels shareholders of credit institutions, or at least the largest one, known as the “reference shareholder”, to subscribe to any and all share capital increases that are needed to keep the institution solvent. The risk that a shareholder might be forced indefinitely to absorb the losses of its subsidiary is then considerably greater than the risk of any other equity investment, for which the maximum loss is the price of the shares acquired.
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3) Investment companies Shares in investment companies should theoretically be treated like any other equities as concerns the rules of acceptability and diversification. But here the firms in question have for the most part been set up as instruments of decentralised financial management. Moreover, as recommended in European Directives 92/49/EEC and 92/96/EEC, the principle of transparency should be applied to the underlying assets: in other words, the securities held by an investment company should be in compliance with the rules of acceptability and diversification that are globally applied to assets of the parent company and its subsidiary. The principle of transparency has the following consequences: ●
If the subsidiary’s assets are themselves allowed to back technical provisions and are sufficiently dispersed, the 5% ceiling may be substantially exceeded in the aggregate.
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However, an insurance undertaking may use a subsidiary to house securities that would not be allowed if they were carried on the insurer’s own balance sheet. The principle of transparency enables such investments to be “swept away”.
Moreover, if the principle of transparency is not applied, an investment company may be listed on a stock exchange solely to raise the ceiling of acceptability from 0.5 to 5%, whereas the extremely low transaction volume does not justify such a favour. The principle of transparency can dispel the temptation of doing so. 4) Insurance companies An insurance undertaking can finance its expansion by creating or acquiring other insurers. This leads to the growth of insurance groups with their own particular risks and special ways of reducing the potential consequences (see below). Do the regulations allow acquisitions of insurance subsidiaries? Can such subsidiaries be used to back technical provisions? In Japan, until very recently a life insurance company could not own an interest in a property and casualty company, and vice versa. More often, subsidiaries and shareholdings are authorised, on the condition that they be financed by shareholders, using owners’ equity. In the United Kingdom, shares in subsidiaries may not be included in life policyholders’ funds. Elsewhere, such shares may not be used to cover technical provisions. In some other jurisdictions, however, equity investments in life insurance companies are encouraged. In France, unlisted shares in insurance and reinsurance undertakings having their headquarters in an OECD member
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country may be used to cover up to 5% of technical provisions, whereas unlisted shares in other types of firms may not exceed 0.5%. Shares in other insurance undertakings, i.e. those not headquartered in an OECD member country, may be used to cover 0.5%, whereas they would not be eligible at all if the companies involved were not insurers. Moreover, if the regulations deal only with the backing of technical provisions, the surplus may be invested freely in strategic shareholdings, in insurance and banking for example. And the richer a firm is, the more it can expand via acquisitions in its domestic market and beyond. But such a policy gives rise to a new series of risks stemming from double counting of equity capital which today’s “regulators” are striving to quantify and to limit via a comprehensive approach to insurance groups and financial conglomerates that goes far beyond corporate entities, which are all that this chapter has looked at thus far. Rule 13: Investment valuation For the sake of clarity and balance sheet stability, the methods used to value investments that may used to back technical provisions and other regulated commitments must be automatic and indisputable. How investments are valued is in fact crucial to assessing whether, from a quantitative standpoint, technical provisions have been covered properly. While there are many regulatory variations, some countries, such as Germany, use the historical cost method, while others use present value or market value, as in the United Kingdom. Within the European Union, both choices are available to the member States (and not to the undertakings themselves), but, in order to make accounts comparable, the result not used on the balance sheet must be reported in an annex. For investments whose redemption value is known in advance (such as bonds and loans), this element is taken into account as well. 1) Investments having a redemption value The redemption value R is generally greater than the acquisition price A; it can be lower, however, if the security was acquired on the open market at a time when interest rates had declined. The solutions adopted vary widely from one country to another. The balance sheet value B is: a) Market value M (market price or similar price at the date of record). If B = M, a resilience test must measure the undertaking’s capacity to absorb the impact on its equity capital of a rise in interest rates. b) Acquisition value A. In jurisdictions that have adopted this option, the balance sheet value is the redemption value R if R is less than A. Any losses
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that are certain are recognised immediately in the accounts. Thus B = A (or R if R < A). c) Redemption value R, since the insurer will obtain this price if it holds the security to maturity. But if, in the interim, the market value M falls below R, the insurance company is exposed to losses if it is forced to sell its securities before they mature, such as when life insurance customers decide to cash in their policies en masse. Prudence would therefore dictate the constitution of a provision for surrender risk equal to the sum of all (R – M) differentials, line by line. d) The lowest of the three values A, M or R at the date of the balance sheet, with any change in value reflected as a charge or a credit to the profit and loss account. e) Acquisition value A, if A is less than R, and the median of the three values R, M and A, if A is greater than R. ●
If A < R:
B=A
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If A > R:
(1) B = A if M > A > R (2) B = M if A > M > R (3) B = R if A > R > M
In situation (2), the company can sell the security at price M, whereas in situation (3) it would be better off holding the security to maturity. f) A value intermediate between A and R reflecting the gradual shift from A to R, using a straight-line or actuarial progression. ●
If A > R, the excess is amortised over the residual term of the security.
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If A < R, the differential is taken as financial income, spread out over the residual term of the security.
Amortisation of the excess value is a less restrictive option than strict application of the acquisition value method. It must be offset by a provision. g) Lastly, if there is cause to doubt a borrower’s capacity to meet contractual payments of interest and capital, the insurer must constitute a provision for permanent decline in value. The overall risk to which bond portfolios are exposed is interest rate risk. When interest rates rise, the market values of bonds decline; when rates drop, market values go up. Both situations have a favourable and an unfavourable aspect. Accordingly, it can be sound management practice to sell bonds at a loss in order to reinvest the funds in securities offering a higher nominal rate of return. Conversely, the gain reaped on selling bonds when rates are declining
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is illusory, since the firm needs to reinvest the entire proceeds to maintain the overall level of its income. In France, the reserve for depreciation of securities is a technical provision established to offset the depreciation of a firm’s bond assets and reductions in the income therefrom. It is “a means of fictitiously increasing the amount of a company’s commitments. It serves as a regulating reservoir in which companies will place capital gains on amortisable58 securities, and from which they will draw the amounts needed to offset any capital losses they may incur.” [Translated from a course given by Gabriel Chéneaux de Leyritz at the Institut d’Études Politiques, 1946]. The reserve for depreciation of securities mechanism can be used to avoid recourse to derivatives, which are more expensive, in order to cope with interest rate risk. 2) Other investments: real estate, equities, indexed bonds, etc. The methods used are based on either market value (M) or acquisition cost (A), although the actual mechanics can vary significantly. a) Balance sheet value = Market (or current) value The market value of investments acquired in a regulated market is the most recent listed price prior to the date of the balance sheet. Some companies prefer to use the average price over the 30 business days preceding the date of record, which can complicate the task of auditors. The market value of a building is the price for which it could be sold in a private transaction. Each asset must be valued periodically, using a legally accepted method or a method authorised by the insurance undertaking’s supervisory authority: e.g., expert assessment (which is costly), capitalisation of rent payments, application of a construction industry index, or reference to sales of similar assets. The market value of unlisted securities may be ascertained from an expert examination of the issuer’s balance sheet, factoring in, if applicable, a criterion of utility for the shareholder and the value of goodwill. For the sake of transparency, the valuation method must be set forth in an annex to the balance sheet. If an investment must be sold in the short term, the transaction costs must be deducted from its market value. The choice of market value as the balance sheet value has a number of disadvantages: ●
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suffice at the following date of record, for reasons beyond the undertaking’s control. ●
Fluctuations in the value of securities are reflected in the profit and loss account, either partially or totally, depending on whether or not the company has established a provision for such fluctuation, based on valuations from previous years and taking any tax exemptions into consideration.
Resilience tests measure the potential impact on an undertaking’s equity capital of a significant (e.g., 25%) drop in financial market and real estate prices, and they can be used to determine the threshold beyond which, in view of the firm’s financial resources, a market crisis would inflict unsustainable damage. b) Balance sheet value = Acquisition (or historical) value An investment’s historical value is its purchase price or the cost of acquiring it: it reflects the fact that the acquisition of an asset, at the moment that asset is acquired, does not alter the balance sheet total. Initially indisputable, historical value soon ceases to correspond to economic reality, if only because of monetary erosion. Furthermore, each investment has its own life, appreciating or depreciating over time. If a balance sheet is to provide a faithful image of a company’s financial position, periodic revaluations are needed to convey values more in line with reality. In point of fact, insurers are keen to revalue their balance sheets only insofar as the resultant profits are tax-exempt. The historical value method is applied in at least two different ways – line by line or in the aggregate: ●
Line by line: The historical value (A) of each asset is compared with its market value (M) at the date of record, and in each case the balance sheet value is the smaller of A or M.
If M falls below A, then the difference (A – M) is charged to the profit and loss account as a loss. If, at a future date of record, M appreciates to a value greater than A, the undertaking has a choice of keeping M or restoring A as the asset’s book value. The first option is tantamount to carrying each asset on the balance sheet at the lowest value it has ever attained: this is extremely prudent, and it effectively increases the firm’s concealed reserves. ●
In the aggregate: At each date of record, a comparison is made between TA, or the total of all acquisition values of all investments in real estate, equities, indexed bonds, etc. and TM, or the total market value of the same assets.
If TA < TM, then all recorded investments are carried on the balance sheet at their acquisition values, even if for some line items the market value is
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lower. Capital losses are offset in the aggregate by capital gains on other securities. The difference (TM – TA) constitutes an element of the available solvency margin. If TA > TM, then investments remain on the balance sheet at their acquisition values, but an overall provision for depreciation is constituted, equal to (TA – TM), and is considered a technical provision in a number of jurisdictions. This is tantamount to carrying aggregate investments at their market value, TM, to cover technical provisions. Apart from exchanges, acquisitions and sales of investments, TA is subject to various adjustments – upwards or downwards – from one year to the next. If a security seems to have become irreversibly devalued, its balance sheet value must be reduced by the amount of the provision for permanent decline in value charged to the profit and loss account. Conversely, real estate assets may be revalued by appraisers, but no such reappraisal must be undertaken for the sole purpose of constituting a provision by raising TM, if TM falls below TA. In jurisdictions that have opted for carrying assets at historical cost, one exception to this general rule is inevitable: in life insurance, assets underlying unit-based contracts are carried at market value if they are used to back technical provisions stemming from those contracts. In sum: 1. If balance sheet assets are not separated into a number of distinct funds, the same general method of valuation must be applied to all investments, whether or not those assets could be, or are, used to back technical provisions. If there are a number of managed funds, a choice of different methods is acceptable if it is clearly set forth in the notes to the balance sheet. If an aggregate method is used, all investments belonging to the same category, including real estate assets and unlisted equities, must be valued according to the same (published) rules. 2. The European rule making it obligatory to publish market values in a note if assets are carried on the balance sheet at cost, and vice versa, should be adopted everywhere in the interest of transparency. 3. The most prudent method is to carry assets at the lower of cost or market, either line by line or at least in the aggregate. Any other method entails the constitution of special provisions and the use of resilience tests to assess the potential impact of outside events on balance sheet stability.
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4. The incorporation into the available solvency margin of unrealised capital gains, measured by the aggregate difference between market and balance sheet values, restores a certain balance between undertakings that carry investments at cost and those that “mark them to market” (and therefore do not have any concealed capital gains). On the other hand, the method used to value investments determines the result of the coverage ratio, and to reduce the resultant distortions of competition, the equivalent of a “resilience provision” should be carried amongst regulated liabilities. 5. Derivative instruments should be factored into the valuation of the underlying assets. Specifically, they are correlated with market values and can affect either balance sheet values or the level of unrecognised capital gains. 6. The assets of insurance undertakings are the subject of IASC standard E62, which calls for the use of “fair value”, which its inventors define as “the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction”. Without dwelling on the passive side of the definition, which is incompatible with the notion of an insurance commitment, it emerges that the “fair value” of an asset is none other than its market value. However, there is not necessarily anything fair about a market value. First, a number of investments are not negotiable on efficient and liquid markets. As for listed equities, their prices at any point in time are so heavily influenced by general economic and political factors, as well as by fashions of the day (see the example of Internet start-ups, for example), that they could hardly be considered fair. Clearly, a fair value can only be a market value, but it must be adjusted using factors yet to be determined, which under some circumstances could bring it back to the level of historical cost.
Suggestions for an easing of prudential rules The above thirteen rules reduce considerably, if not totally eliminate, investment risks. They are applied with varying degrees of severity from one country to another. Some people, however, see them as far too ponderous and rigid a framework to enable businesses to exploit their financial potential to the full. In their view, regulators should stick to broad guidelines and let “prudent persons” at insurance undertakings implement them with flexibility and discernment. This thesis, which has been developed at length by Professors E. Philip Davis and Gerry Dickinson,59 assumes both that internal controls will be strengthened and that supervisory authorities will be able at all times to
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take steps they deem necessary to protect the insured without having to rely on a particular statute. The arguments in support of the “prudent person rule” are based on the need for continuous adjustments to changing economic and financial conditions, which people can make more easily than laws. ●
A country’s needs change with its level of economic development: the priorities given to institutional investors, and thus to insurers, must be altered accordingly.
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The perceived safety of a given type of investment changes over time: not so long ago, for example, real estate had been considered an immutable refuge.
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New financial instruments spring up which can offer positive alternatives.
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Shareholder demands and the constraints of competition require flexible, dynamic, yield-oriented management, and a prudent person alone would seem qualified to make case-by-case decisions in conflicts between safety and profitability.
Another idea which could theoretically aid financial managers is to alter the rules on asset diversification on the basis of qualitative criteria: insurance undertakings documenting the “quality” of their investments might be able to justify exceeding the 5% diversification ceiling. But even highly rated investments are not without risk, as was shown by the mishaps of Long Term Capital Management (LTCM), a very large US hedge fund. To move from an investment quality criterion to a mathematical model that can comprehensively assess asset and liability management entails a dangerous step if the modelling is geared towards ever-increasing returns and inevitably greater investment risks. Be that as it may, regulators and supervisors have never challenged the effectiveness of any prudential mechanism based primarily on the strengths, capabilities and common sense of the managers entrusted to apply it. The aim of regulations is to assist these managers, and to protect them from the excessive appetites of policymakers and investors. Investment rules do in fact allow numerous degrees of freedom, and a certain easing of those rules would seem inevitable in the light of expanding international co-operation and world-wide liberalisation. Matching and localisation rules are no exception. The catalogue of investments is very vast, and the ceilings for each category allow for contrasting options which insurers generally do not exploit.60 While it is the manager’s job to assess and monitor the quality of assets, it is the supervisor’s responsibility to check that the work is done on sound bases.
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Asset and liability management may see major departures from the rules, which the manager may regret in times of trouble when new business is down and there is a wave of surrenders and cancellations. In such cases, the use of derivatives may narrow the gaps. However, the speculative connotation attached to derivatives still prompts reticence on the part of supervisors, who cannot accept inappropriate bookkeeping and inexperienced operators. Moreover, the fact that restrictions are limited solely to assets used to back technical provisions gives managers freedom to invest available surpluses, which rise as a company becomes wealthier and its working capital (fixed operating assets, arrears, unsecured claims on reinsurers and sundry receivables) more modest. Some European countries have tried to restrict that freedom, and they have been condemned by the Court of Justice of the European Communities (CJEC), which has held that the European Directives provided that “a rule of national law may not prohibit insurance undertakings from holding, as their free assets, shares representing more than 5% of all the voting rights in a domestic or foreign public limited company without administrative authorisation”. Independently of the rules adopted, the ratio by which technical provisions are backed by selected investments and claims constitutes a significant early warning system, the effectiveness of which is further enhanced if rules for the calculation of technical provisions (e.g., gross of reinsurance) and on the choice, diversification and valuation of assets eligible to back the provisions are strict and verified carefully, in particular through on-site inspections. It is possible for a company to satisfy its minimum solvency requirement but at the same time fail to comply with the regulations governing coverage of technical provisions, because premium income does not come in quickly enough to be invested, because reinsurers do not provide adequate guarantees, because investments are dispersed poorly or because the amount of ineligible assets is too high. All of these elements can heighten an undertaking’s exposure to investment risks, and to the risk of debtor default. The prudential “triple test” is an essential aspect of solvency supervision, but it is not enough to assess the financial health of an insurance undertaking over time. Finally to perform the triple test properly, in particular as concerns the coverage of technical provisions, requires appropriate accounting terminology. Today, this is the case of the accounting system instituted by the European Directives. It is no longer the case if the balance sheet becomes an instrument of speculation aimed at stock market analysts, whereas it is
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theoretically intended to convey reality in a way that, if possible, is both faithful and prudent. The IASB’s attempted harmonisation of accounting standards hinges on prior agreement regarding the users that each party would like to favour: investors, existing shareholders, officers, policyholders, creditors, tax authorities, supervisors, and so on. And not even an agreement as to the persons targeted would resolve the considerable divergences between the information needs of multinationals and medium-sized enterprises. The IASB’s main focus seems to be the former. Whatever the future developments of a supranational accounting system, it is certain that prudential balance sheet analysis will have to adapt to them. The dynamic approach outlined below would appear less dependent on changes to accounting standards.
III. Operating conditions A. Static solvency, dynamic solvency An examination of the balance sheet can show whether an undertaking is prepared, at the date of record, to meet its insurance obligations and other debts payable, valued in a prudent manner. If these obligations have been calculated correctly, a balanced balance sheet means that an undertaking, even without reserves, might just be able to cease operations on the date of record and still meet all of its obligations, provided that the circumstances of its liquidation are not too abnormal. Outstanding risks and the subsequent losses they might generate could be covered by goodwill in the event of a transfer of portfolios. But the supervisory authority cannot look only at a static or instantaneous vision of a company. At the date of record, decisions have been taken by corporate management that are already shaping future balance sheets. Hence the need for a reserve of equity capital to absorb losses that are perhaps already in the pipeline; hence also the need to look at the circumstances in which a firm operates in order to project how its financial position will evolve. This is the dynamic approach to solvency. The need for such an approach is acknowledged by the regulations of many countries. Some countries (such as Canada, as seen below) have tried to standardise it. More often, supervisors assess a company’s dynamic solvency (sometimes without saying so explicitly) by scrutinising its operating conditions and its environment on a case by case basis61 (see following paragraphs).
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B. An insurance undertaking’s operating conditions determine its future Even if supervision does not involve prior review of premium rates, it must have preventive effects. The exercise of preventive supervision over the solvency of an insurance undertaking entails continuous monitoring of all of the most diverse aspects of its business – moral and legal, technical and financial. Only through on-the-spot immersion, on an undertaking’s premises, can a supervisor assess the conditions under which a firm operates. “Operating conditions” refer to all of the factors that can affect the results of an insurance undertaking, and thus its financial health: ●
nature and diversity of the risks insured;
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control over distribution channels;
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pricing and risk-selection policy;
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monitoring of claims and results by product;
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reliability of the accounts;
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administrative organisation; effective computer systems;
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financial management: compliance with instructions from the Board of Directors;
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audit of transactions, especially those involving financial derivatives;
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effectiveness of reinsurance; selection criteria for reinsurers;
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internal auditing procedures;
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monitoring of delegated management;
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review of disputes and litigation;
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analysis of off-balance-sheet commitments (guarantees given…)
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etc.
These observations are paramount in assessing managerial competence and evaluating a company’s “particular” need for equity capital at a given point in time – corresponding to the time needed to detect a management error (e.g., an insufficient premium) and to correct it. Regulatory solvency requirements, determined from average figures within a given market, are therefore adjusted on a case-by-case basis, incorporating company-specific elements that shape a firm’s future. The supervisor’s goal is not to check whether a firm was solvent at the date of its last balance sheet, but rather to assess the company’s ability to fulfil its obligations in the short term and farther into the future.
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C. The mechanics of solvency supervision In order to assess the impact of the various factors that reflect an insurance undertaking’s operating conditions, supervisors can either conduct on-site inspections or incorporate data representative of some of these factors into an early warning system (EWS), the conclusions of which may trigger an on-site inspection.
Early warning systems (EWS) A number of OECD Member countries use EWS to detect undertakings whose accounts reveal technical, financial or management anomalies. In this way, supervisors can optimise the allocation of human resources by setting priorities. [1] One of the oldest early warning systems is the Insurance Regulatory Information System (IRIS), which was created by the National Association of Insurance Commissioners for state insurance supervisors in the United States. IRIS was designed to help the authorities zero in on insurers that require close supervision. A series of financial ratios calculated from information published in company annual reports are scrutinised by analysts, who then rate the companies. IRIS has been supplemented by the Financial Analysis Solvency Tracking (FAST) system, which is applied to undertakings of nation-wide dimensions and designed for use by the industry itself. US undertakings are ranked as “immediate”, “priority” or “routine”, depending on the score obtained by adding the weighted results of 22 ratios. These ratios are divided into five centres of interest: profitability, operations, investments, liquidity and cash flow. Operating ratios divide gross premiums, net premiums, reinsurance recoverable on paid and unpaid losses, yearly change in surplus, etc. by the surplus 62 at the date of record. In addition, there are two indicators showing the yearly change in premiums, gross and net of reinsurance. NAIC releases IRIS and FAST ratios to the supervisory authorities of every state over its on-line network. [2] Elsewhere, indicators are classified by destination. In Italy, 18 ratios have been formulated in non-life insurance – overall ratios and ratios covering direct business and motor vehicle liability (accounting for 11 of the 18 ratios, highlighting the especially close supervision of this activity). Thresholds of acceptability were defined for each indicator, and undertakings are ranked according to the number of indicators lying outside the acceptable range of scores. Examples of thresholds of acceptability (in %):
100
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Result/Premiums (by class): –5
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Claims/Premiums: 100 or 80 (depending on the class).
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Management costs/Premiums: 32.
[3] In Spain, recovery measures must be initiated if accumulated losses exceed 25% of equity capital, when the claims provision deficit exceeds 20%, if the coverage of provisions falls more than 10% short, etc.63 [4] In the United Kingdom, the supervisory authority examines the results of a number of quick ratio tests to ascertain the advisability of conducting further analysis and investigation. Some of these ratios are veritable management indicators: ●
claims on policyholders/premiums written;
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paid claims/unpaid claims;
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reinsurance expenses/reinsurance income. [5] The 15 ratios used in Canada for non-life insurers include:
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changes in premiums, gross and net of reinsurance;
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net premiums/surplus (the warning threshold in Canada has been set experimentally at around 3);
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gross premiums/surplus;
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changes in surplus;
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claims on agents and affiliated undertakings (an increase can signal the emergence of financial difficulties, or at least cash flow problems within the group or the undertaking);
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return on investments;
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ratio of surplus to technical provisions or commitments;
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return on equity, etc.
All non-life insurers are required to file an annual Dynamic Capital Adequacy Testing (DCAT) report, projecting their future financial position, with OSFI.64 [6] In life insurance, Canadian law requires an annual actuary’s report to company officers on the firm’s current and, if appropriate, future financial position. The Dynamic Capital Adequacy Testing (DCAT) report on the future financial position of insurance undertakings, prepared in compliance with the professional actuarial standards of the CIA,65 must be filed each year with the federal supervisory authority, OSFI. Dynamic capital adequacy testing examines the effects of various plausible adverse scenarios on the insurer’s projected capital adequacy. It is the actuary’s primary tool for investigating an insurer’s financial position. The purpose of dynamic capital adequacy testing is to identify plausible threats to
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a currently satisfactory financial position, along with actions that would lessen the impact if those threats were to materialise. An insurer’s financial position is satisfactory if throughout the forecast period the company is able to meet all its future obligations under the base scenario and all plausible adverse scenarios, and if it meets the minimum regulatory capital requirement under the base scenario. The forecast period begins at the date of the most recent balance sheet and must be long enough to reveal any adverse effects and the ability of management to react. For a typical life insurer, this period would be five years. The model comprises a base scenario and several plausible adverse scenarios. Each one factors in not only existing policies but also any new business expected to be written during the forecast period, and it encompasses both insurance and non-insurance operations. The base scenario is a realistic set of assumptions used to project the insurer’s financial position over the forecast period. Theoretically, the base scenario is consistent with the insurer’s business plan. A realistic adverse scenario is one that involves adverse but plausible assumptions affecting the insurer’s financial position. Plausible adverse scenarios differ from one firm to another and may vary over time for any given insurer. Actuaries must consider threats to capital adequacy under plausible adverse scenarios that include, but are not limited to, the following categories: 1. mortality risks; 2. morbidity risks; 3. persistency risks; 4. cash flow mismatches and interest rate risk (C-3 risks); 5. deterioration of asset values (C-1 risks); 6. new business risks; 7. expense risks; 8. reinsurance risks; 9. government action and political risks; 10. off-balance-sheet risks. The main goal of this process is to help prevent insolvency by arming a company with the best possible information on events that might lead to capital depletion, and on the relative effectiveness of alternative corrective actions. Furthermore, knowing the source of a risk, an actuary can strengthen monitoring systems in the areas in which a company is most vulnerable, and thus provide timely advice on a continuous basis. Reported to the Board of Directors, the results help shape an undertaking’s strategic choices. Forwarded to the supervisory authority, they
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spotlight companies that are experiencing financial difficulties; they can also demonstrate the need to adjust prudential rules.
On-site supervision On-site checks may be carried out systematically as part of the ongoing supervision of undertakings, or they may be initiated on the strength of offsite inspections or EWS tests, or following a change of management. [1] Off-site checks are carried out on the financial documentation that insurers must submit regularly to their supervisory authority. In most cases, there are regulations as to the list of required information, its content and its presentation in the form of accounts, statistical statements and annexes. Ideally, this documentation will arouse the supervisor’s curiosity and prompt him to visit the insurer’s premises to obtain further information for his satisfaction. [2] Extent and purpose of on-site supervision. The supervisor is not just an auditor. On the insurer’s premises he collects a set of qualitative and quantitative information in order to be able to judge the company’s position. He naturally has to make sure that the company is complying with regulations and proper commercial practice and that the financial information published or sent to the authorities is accurate. But in addition, he has to update and even extrapolate the data he assembles on premium rates, contract clauses, the method of calculating technical provisions, the reinsurance plan, marketing policy, disputes, off-balance-sheet commitments, etc. The supervisor sets his priorities case by case, in the light of each company’s specialities, size, risks covered, distribution networks, and so on. When his work is done, he should be able to form an opinion of the efficiency of a company’s officers, and notably of their ability to recognise and correct the management errors that are inevitably made in a thriving business. For example, how long will it take management to assess the relevance of a new premium rate, the legitimacy of a commercial target or the profitability of an investment? And when an error is detected, how long will it take to take and enforce a corrective decision? The slower and less efficient the reactions of corporate officers and the relevant departments, the more heavily the losses accumulated in the meantime will weigh on the company’s equity capital. The time interval will also depend, inter alia, on the company’s marketing and administrative structures, its schedule of premium inflows and the company’s policy on cancellations. A minimum capital adequacy requirement must consequently be determined for each situation. [3] Premium rates. The first concern of the supervisor is that premium rates are adequate. Whether these have been authorised beforehand or not, post-checking is always essential. But the supervisor has to be even more
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watchful when systematic or prior controls are prohibited, as in the European Union. Insurance company managers must show that they possess sufficiently detailed information to be able to take advised strategic decisions both on policy writing conditions (premium adjustment, risk selection) and on marketing (distributors’ quotas). The analysis is carried out by class of insurance or, better still, by contract category, type of distribution, geographic area, etc. The supervisor must pay special attention to premium rates that are significantly lower than the market average. When business results seem to be in balance, however, this situation 66 can be explained only by specific management initiatives: risk selection upon entry, policy cancellation after a loss, tracking of benefit payments, the effect of deductibles, marketing discipline, etc. The supervisor’s attention will focus more particularly on contracts deemed difficult because they are new, innovative, of highly variable impact over time or long-tail: long-term care insurance, pollution liability, natural disasters, product liability, and so on. An insurance company concentrating on run-of-the-mill products – characterised by numerous homogeneous risks, with relatively frequent claims and moderate average cost – is less exposed than a company focused on special and esoteric risks. The reputedly easy-to-manage categories include private auto insurance and multi-risk home insurance. Where premium rates are subject to prior control, the authority giving the approval often has to steer a course between two sometimes incompatible objectives: economic control, strongly advocating affordable prices; and prudential control, demanding adequate premiums. The rate bases used by individual companies, which in most cases will not have compiled sufficient statistical information from their own activity alone, may be taken from data collected by insurance associations from their members, or supplied by private premium-rating agencies (as in Japan). On-site inspections permit post-checking of the appropriateness of the data inputs and how the company has exploited them. [4] Reinsurance. Here the supervisor checks whether: ●
the cost of reinsurance is affordable;
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the direct insurer is adequately protected against operational setbacks such as large claims or a proliferation of small claims;
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the reinsurers are well chosen. This last point will be discussed further on (see IV).
For the direct insurer, reinsurance constitutes the ongoing cost of a necessary service. This cost has to be calculated reinsurer by reinsurer: it is equal to the difference between, on the one hand, premiums ceded and, on
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the other, claims settled, commissions and profit shares received. Over time, the sustainability of a reinsurance treaty is enhanced if the parties perceive that risks are shared equitably between them. It is important for the supervisor to know whether the reinsurer will continue to apply the same premium rates. In the event of losses, the reinsurer may toughen its conditions, possibly by terminating its indemnification guarantee. The supervisor must then check whether the new risk retention limits and guarantee ceilings are compatible with the company’s size, assets, range of businesses and policy clauses. [5] Internal and external controls. In the case of small insurance companies, reinsurance is a major concern of supervisors. For big companies and groups, corporate procedures and internal/external controls receive particular attention, to wit: ●
reading of board minutes, auditors’ and actuaries’ reports, etc.;
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examination of procedures for overseeing the risks assumed by the undertaking: check on financial managers, notably those dealing in derivatives; check on application of the OECD Recommendation on reinsurers; check on strategic affiliates;
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analysis of co-ordination among the different company departments (accountants, actuaries, underwriters, claims managers): homogeneity of approaches and assumptions used, comparability of studies of policy classes – which implies compatible processing by the various services;
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processing of existing information, cataloguing of information that would be useful but is badly utilised, unutilised or unavailable;
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monitoring of the audit trail tracing basic data from source to balance sheet;
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utilisation by corporate officers of reports received.
The supervisor’s objective has shifted with corporate concentration and the globalisation of financial services. “Supervision of supervision” is now his main assignment where large groups are concerned. [6] Policyholder protection. The essential aim of this financial supervision is to protect the interests of policyholders. But there are other aspects of protection that have to be checked by means of on-site inspection. a) Policyholders’ complaints These complaints – sent to insurance companies, mediators or the supervisory authority – mainly concern failure to answer questions about policies, and delays in the payment of claims. The increasing number of such complaints, even if not attributable to a deliberate intention of the insurer not to settle claims, is evidence of poor business organisation – a potential source of financial troubles.
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b) Misselling of insurance Example: Pension misselling in the United Kingdom. In this particular case, private pension plans were sold in replacement of government-backed plans without offering equivalent guarantees. The insurers were subsequently required to make compensation out of their capital. [7] Change of management. This invariably occasions an on-site inspection. In principle, the supervisory authority has determined at the time of licensing whether company officers are fit and proper. It has regularly to update its conclusions with the arrival of new management, which may signify either continuity or change. Fitness is assessed usually in terms of professional experience, which must match the duties to be performed and the dimensions of the company. Fitness tests are difficult inasmuch as persons change as they grow older, and someone who has succeeded brilliantly at the head of a medium-sized company may be out of his depth in a multinational. Academic qualifications tend to be a secondary consideration. Propriety tests are more objective. The criteria here are absence of a criminal record and a past in which no sanctions have been applied by insurance regulators. Offences under ordinary law, breaches of insurance laws, business crimes, money laundering, questionable business practices, insider trading, and involvement in insolvency proceedings are all grounds for ruling against the choice of a company officer. Depending on the country concerned, such a decision may be pursuant to a specific law or left to the discretion of the supervisor. The fact of having submitted false information to the supervisory authority at some time in the past automatically rules out a candidate in some countries. A number of jurisdictions do not allow the chief executive of an insurance undertaking to be a broker, lawyer or banker, or more broadly anyone performing an activity that might generate a conflict of interests. In many cases, changes in the top management of a company coincide with shareholding changes, which shifts the question of fitness and propriety to the company’s owners (see IV). [8] Conditions for on-site supervision. For on-site supervision to be effective, supervisors must: a) have sufficiently extensive powers to undertake all the investigations they consider necessary in order to carry out their assignment; b) be competent and experienced, or accompanied by colleagues who are more experienced; c) be able to analyse the follow-up to their recommendations and conclusions.
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1) Bound by professional secrecy, supervisors must be empowered by law to examine on site, in hard copy or on screen, all books, registers, schedules, vouchers, statements or any other document relating to the company’s position, activities and results. Companies must give supervisors access to the documents they request and the personnel qualified to provide them with the information they consider essential, both at the head office and in agencies and branches. The law must provide for sanctions (fines and/or imprisonment) against managers who impede the exercise of on-site supervision. 2) Supervisors must possess a high degree of professional skill and allround competence covering life and non-life insurance from the accounting, legal, financial and technical standpoints. If the supervisor is not equipped to operate alone, teams of lawyers, economists and mathematicians must be set up to assist. The law must guarantee the independence of supervisors and protect them effectively against pressure from policymakers or from supervised companies. The conditions of recruitment, training and advancement have to be strictly regulated so that supervisors will not be exposed to interventions and promotions from outside. Most supervisors are civil servants attached to a ministry or to an independent administrative authority. In a few cases, some of their responsibilities are assigned by law to self-regulating bodies that include representatives of supervised undertakings. Also, in a number of countries, a public supervisor may delegate assignments to a third party in the private sector, in which case he must oversee the behaviour and dependability of that third party. The majority of supervisors are insurance specialists only, though a few have competence that covers the entire financial sector. Consequently, when investigations have to be extended to subsidiaries or parent companies not subject to financial supervision (in which case it is sufficient to obtain the necessary information from colleagues), it is preferable to bring in private experts, notably to adjust the value of a subsidiary as an asset on the balance sheet. 3) On-site supervision includes meetings with company officers. Dialogue between supervisor and management is often more effective than formal supervision procedures. The supervisor’s main strength in his discussions with company managers is his power of persuasion, for he has to convince them of the need to rectify some of their lapses and bad habits.
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Every on-site check is written up in a report, which in many jurisdictions is sent to the head of the company, who will reply in respect of the points on which he disagrees with the supervisor’s observations. The supervisor must follow up his report by checking that corrective measures, where needed, are being taken by the company. When the report notes breaches of the prudential rules on technical provisions and their backing by appropriate assets, or on the solvency margin, injunction and sanction procedures are then initiated by the supervisory authority (see following chapter on the treatment of ailing companies). But the report may also show that the interests of policyholders are in danger even though the prudential ratios are (as yet) complied with, the company’s future appearing to be threatened by underpricing, excessive management costs, inadequate reinsurance, insufficiently diversified investments, and so on. Apart from the procedures automatically initiated for non-compliance with prudential ratios, the supervisory authority must also be legally empowered to intervene more flexibly whenever it considers that policyholder interests are endangered, or likely to be. The regulations should give supervisors special powers to use in exceptional cases, e.g. the power to require an increased solvency margin, to write down the value of the assets backing the margin, and to limit the possibility of reducing the margin requirement through reinsurance. The same legal tools must also be available when an EWS gives a negative signal. The supervisor’s reaction is also conditioned by the environment in which the insurance company operates.
IV. The business environment The external factors affecting the financial health of an insurance undertaking are extremely varied: competition, local regulations, qualification of external auditors, behaviour of underwriters and delegated managers, role of the company’s habitual partners (reinsurers, members of mutual a ss o c i a t io n s, s h a reh o ld e r s ), m e m bership of a group or fina ncial conglomerate.
A. Regulatory constraints In a given market, specific regulatory constraints are always likely to affect a company’s results (economic control of premium rates, i.e. ceilings) or financial position (limitation of foreign investments). In some jurisdictions, the premium ceilings for third-party motor insurance have been lower than the breakeven point for that class of business.
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In such a case all the companies writing this insurance are in difficulty and have to count on their earnings in other classes, and on their own capital. A situation of this sort is a deterrent to foreign insurers. Regulations may also require all or a portion of reinsurance ceded to transit via a specialised national enterprise, which accordingly takes its cut. This increases the cost of reinsurance for ceding companies. Finally, some countries restrict or prohibit outward transfer of profits, thus discouraging investors. In such cases, an investor will put up a minimum stake and balk at any requests for capital increases.
B. Competition Competition varies in intensity across countries and classes of business. A one-class company is particularly exposed if its sector comes under attack from wealthier multi-class companies. In France some years ago, multi-class insurers heavily underpriced construction insurance premiums, obliging the specialist mutual associations to follow suit or be crowded out. Then they withdrew, leaving the market disorganised. Fortunately, the mutuals weathered the storm and were able to accommodate the policyholders abandoned by the multi-class insurers, though at significantly higher premium rates.
C. External auditors In some countries, external auditors have to verify the annual accounts published by a company and certify that they give a true picture of the company’s finances. In the United States, when so required, a company’s books are verified and certified by an independent auditor registered as a Certified Public Accountant (CPA) in accordance with the laws of the state in which the firm’s main place of business is situated. Elsewhere, the task of certifying that accounts are in order and accurate is performed by auditors appearing on a special list and mandated by the company’s shareholders (or by the members of a mutual insurance company). As a custodian of the law, the auditor is also concerned with management practice in the company, since he has a responsibility to third parties as well. Here the modern conception of a business undertaking is a decisive factor. A business is no longer just the affair of its officers and shareholders. It also involves the employees, customers, suppliers, banks, tax authorities, etc. The manner in which the auditor conducts his assignment has therefore become a matter of public interest.
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Auditors are sometimes criticised by shareholders seeking transparency. These shareholders wish to be reassured of the merit and integrity of company officers. They want confirmation of efficient management, especially when real out-turns are masked by frequent changes of accounting methods and assumptions. They want a particularly close watch kept on legal and financial arrangements likely to benefit some more than others. And they rightly demand the exposure of any misappropriation of corporate funds. As highly skilled professionals, auditors are handicapped by the manner of their appointment (by the shareholders of the company to be audited) and remuneration (by the company), which is not always compatible with the essential principle of their independence, especially when counselling assignments are included. Although legal custom and regulations prescribe this independence, an auditor is in a position of financial dependence as long as the company pays his fees. There is an inconsistency in the fact that he is at once an auditor and a service provider required to monitor the company’s ongoing business. European legislation addressed this problem, and Directive 95/26/EC of 29 June 1995 (termed “post-BCCI”) increased the duties of auditors as follows: an auditor must now report promptly to the supervisory authorities any company development or decision of which he has become aware while conducting his audit that is of a nature to: ●
constitute a breach of regulations;
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affect the continuous functioning of the undertaking;
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lead to refusal to certify the accounts or to the expression of reservations.
Auditors appointed to assist shareholders are thus also required to enhance policyholder protection, given that their competence and integrity constitute an additional guarantee of company solvency. In some countries, auditor reluctance to inform the supervisory authority is punishable by suspension, compulsory replacement or a fine.
D. Actuaries In jurisdictions where they have statutory duties to perform (the case of the “appointed actuary”), actuaries likewise have to provide guarantees of competence and independence. Actuaries’ associations set a high standard of competence for membership, and their professional codes specify the virtue of independence. As with the auditor, however, an appointed actuary is a company employee or a fee-earning consultant and therefore cannot be regarded as totally independent.
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Be that as it may, the actuary (or any person with the same qualifications) is a major contributor to solvency control in insurance undertakings. Yet even if performing statutory duties such as certifying the mathematical provisions and verifying the financial capacity of a life (and sometimes non-life) insurance company, this valuable auxiliary does not relieve the supervisor of monitoring the same data.
E. Rating agencies Rating agencies exert an indirect pressure on insurance companies that need a good rating to attract capital. This is because a company will be tempted to present a flattering year-end result at the expense of technical provisions without the agency’s being able to spot the manipulation. In addition, as happens customarily in some countries, a highly-rated insurance company may feel encouraged to invest in riskier assets. This, plus the fact that the agency is remunerated by its rated client, can only prompt supervisors to caution as regards ratings. When, on the other hand, an agency publicly downgrades a rating, which is only the reflection of an opinion, it may aggravate business difficulties by developing a contagion risk where discretion would be an effective means of defence. Rating agencies may also exacerbate a financial crisis by creating a systemic risk. Agency ratings are sometimes used by supervisors to appraise foreign reinsurers or to assess the solvency of a borrower. Agencies may also alert the supervisory authorities to weaknesses they have detected in companies or groups, but they need to become better informed about the quality and criteria of supervision exercised in the different countries.
F. Delegated underwriting and management Delegation of underwriting or contract management gives rise to additional risks. The delegated agent is always liable to exceed its mandate, thereby developing risks of underpricing and excessive growth. Supervisors should have the right to retain control over the relevant data, so that they can check that the insurer has set up adequate monitoring arrangements and that the information it books is consistent with the operations performed by the delegated agent.
G. Members of mutual insurance associations Mutual association members, shareholders and reinsurers are financial partners able to contribute on occasion to increases in the equity capital of the direct insurer.
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Thus, members of mutual associations with variable contributions are legally bound to answer a call for additional funding. This potential element of funding enters into the calculation of the European solvency margin. Life insurance mutuals in general cannot adopt the system of variable contributions, which is incompatible with long-term business because it implies post-adjustment of an annual result. In non-life insurance, the decision to call for supplementary contributions is usually taken by the board of directors, occasionally by a general assembly of members. The purpose is to cover operating losses. The bylaws of the mutual set the maximum amount of the contribution (i.e. contribution plus supplement) which the insured member may be asked to pay for a year of insurance. The member is advised of the possibility of having to pay a supplement by being given a copy of the bylaws at the time of taking out insurance. The overall ceiling is generally not too high as to deter him from contracting, but it must allow the mutual to collect substantial additional resources if necessary. From the legal standpoint, the supplement is of the same nature as the contribution itself and, in countries where contributions are enforceable, the insured may be sued for payment of the supplement if he refuses to comply. In theory, the supplementary contribution is a means of ensuring a mutual association’s solvency in all circumstances. In practice, its effectiveness is not so certain. The fact of calling for a supplement is often regarded as a sign of poor management, which may lead to large-scale policy surrenders and demobilisation of the production network. Also, the process of collecting supplements from bad debtors is expensive. Some mutuals are therefore reluctant to charge supplements. To be able to charge a contribution supplement successfully, a mutual association has initially to be well placed, with contribution rates lower than the market average and a network of offices on its payroll. The big French mutuals, whose main activity is motor insurance, are in this position. Supervisors must therefore assess the feasibility of a contribution supplement before allowing it as a component of the solvency margin.
H. Shareholders A shareholder must always pay up the amount of capital promised but may always stay clear of a subsequent capital increase. The notion of the shareholder’s duty to invest appears to conflict with the capitalist principle that an investment may always be “limited” or confined to the amount that has already been invested in the capital of a business. To require more of the shareholders of an insurance company might scare off investors. The supervisor therefore has to make do with “fit and proper” tests.
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The ability and readiness of a shareholder to go along with a capital increase, if it is made necessary by financial difficulties and the supervisor requires it, have to be analysed at the time of licensing. Some jurisdictions require the appointment of a “reference shareholder” to negotiate with the supervisory authority in the event of problems. In all countries, the information required for licensing purposes must include: ●
certification that no criminal or administrative proceedings are in progress against a corporate shareholder, its directors or its officers;
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particulars of the corporate shareholder’s officers such as to permit assessment of their professional qualifications and dependability;
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structure of the group or conglomerate to which the corporate shareholder belongs;
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reputation of the corporate shareholder;
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financial position of the corporate shareholder. Is the size of its shareholding consistent with its financial resources?
If the chief shareholder does not belong to the financial sector, the licensing authority should have a prior audit of that corporation conducted by an independent expert. If the chief shareholder is a bank or investment company, the insurance supervisor should be able to consult his banking and investment colleagues; the same principle applies in the case of a foreign insurance company. Co-operation among supervisors should be organised accordingly and the legal obstacles relating to professional secrecy removed. The same information should be required when a major shareholding changes hands. Regulations generally oblige the purchaser, seller or the insurance company itself to declare the transfer of shares and voting rights, which enables the supervisory authority to ask the new owner for the information needed to assess the supervised company’s new financial position. If this information is not given, the voting rights attached to the transferred shares are blocked. Sanctions are also imposed. These vary according to country and range from a fine, through cancellation of the sale of shares and outright prohibition of the transaction, to withdrawal of the insurance company’s licence. Warned of the transaction, the supervisor may examine the case in the same manner as at the time of the company’s application for a licence. Regulations normally allow him to reject a new shareholder that does not appear to offer sufficient guarantees. In the case of a troubled company with shareholders in default, it may happen that the only rescuer is a corporation whose financial soundness appears uncertain. Here the supervisor is in an uncomfortable position, since
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he has to decide which is the lesser of two evils: withdrawal of the insurance company’s licence or acceptance of a second-rate shareholder. Should the company be closed down, with all the consequences of immediate liquidation for policyholders, or should it be hoped that the new shareholder’s input will help to get the company back on its feet rather than precipitate a final disaster that will involve new policyholders? If the outcome is bad, the supervisor will be criticised, including in jurisdictions where there is a separate authority for company licensing and approval of shareholder changes.
I. Reinsurers A reinsurer may provide financial support, but reinsurance treaties are designed in such a way as to enable transferees to recover their outlays subsequently. Reinsurance protects the direct insurer against performance shortfalls and thus enables it to economise capital. Reinsurance may also ease its cash requirement. But despite reinsurance, the direct insurer alone remains accountable to its policyholders. The prudential rules for policyholder protection must take account of the fact that in the event of the direct insurer’s failure the insured can take no legal action against the reinsurer (see pages 19 and 81-82). Reinsurance provides additional security for the direct insurer to the extent that the reinsurer is solvent. The impact of reinsurance on the solvency of direct insurers is very considerable – a fact that gives rise to three questions: ●
Should reinsurance specialists be supervised?
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How may an insurer choose its reinsurers?
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Are there not reinsurance arrangements that provide only the illusion of assistance? This issue arises in the case of financial reinsurance.
The answers to these questions are shaped by the profound structural change that has been taking place in the international reinsurance market for a decade: a) Concentration of insurance companies has been reducing the need for reinsurance. Retention limits are being raised accordingly. The essential requirements are shifting to cover for long-tail risks, catastrophic losses and frequency irregularities. Non-proportional reinsurance is increasing relative to proportional reinsurance. New arrangements are developing. Direct sharing of risks between ceding insurer and reinsurer, which for a long time was a fundamental of the relationship between the two parties, is becoming less apparent.
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b) The supply pattern of reinsurance has shifted. The world’s four leading reinsurers now hold over 40% of the market. The number of small independent reinsurers is declining. Between 1987 and 1997, more than 200 of them disappeared, either taken over by competitors, in run-off (62) or wound up (92). The fastest-developing markets are the United States, the United Kingdom, Bermuda and Belgium.67 New market entrants, some of them transient, are appearing. Direct insurers are no longer working with the same partners as they were 15 years ago. They are looking increasingly for reinsurers with large capacity and innovative solutions. c) Reinsurers are shifting more and more to direct dealing with the industrial majors, bypassing direct insurers or leaving them just a fronting. Industrial corporations and especially the multinationals, for their part, are attracted to the idea of reinsurance captives, many of which are developing in tax and regulatory havens. This being so: 1. Should reinsurance companies be supervised? The tendency is to answer yes, although situations in the reinsurance industry are very diverse. In a certain number of countries, reinsurance supervision is confined to the ceding insurers. There, this is considered sufficient for the protection of policyholders. In some cases, supervisors put pressure on direct insurers by restricting their choice of reinsurers. In Mexico, only reinsurers well rated by a specialist agency are allowed. In some other countries, supervisors themselves make the selection. Elsewhere again, only reinsurers supervised in their home countries are automatically accepted. The others have to pay an entrance fee in the form of an initial deposit. In France, the choice of reinsurers is entirely free, provided they comply with the local indirect requirements of cash deposits, pledge securities or letters of credit. In other countries, a less exacting form of reinsurance supervision has been organised. Supervision may be based solely on documentation: from information sent to it, the supervisory authority assesses the wealth of a reinsurance company, its independence, its commercial and financial links and its reputation. On this basis, the supervisor may require the cedent to obtain an initial deposit, reduce its cessions or terminate a treaty. But the supervisor may not prescribe a particular reinsurer or type of treaty. In Germany, the supervision of professional reinsurers can be described as limited: no prior licensing; no enforcement of the prudential rules applied to direct insurers; no supervision of officers and shareholders; no specific intervention in the event of financial difficulties. On the other hand,
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reinsurers must send an annual report to the BAV68 and may have to undergo on-site checks. France adopted a similar system in 1994. In the United States, Canada and Australia, reinsurers are supervised about as strictly as direct insurers, with: licensing of domestic and foreign specialist reinsurers, prudential rules, solvency requirements, penalties for infringement, etc. But if the licensed reinsurers do not have sufficient capacity for the domestic market, notably to cover natural disaster and civil liability risks, unlicensed reinsurers are admitted in consideration of initial deposits. In Europe, the United Kingdom and Denmark require their reinsurers to observe the same minimum solvency standards as those for direct insurers. Other countries, like Switzerland, impose more modest requirements. These disparities are all the more significant in that reinsurance is an international activity. Reinsurers see them as distorting competition, and some are calling for the status of supervised entities, whereas there are many unsupervised yet perfectly safe reinsurers around the world. Technically, the financial soundness of a reinsurer is more difficult to gauge than that of a direct insurer. A significant portion of a reinsurer’s business is done abroad, and a domestic supervisor cannot know the specifics of every market. Also, information gets through more slowly to the reinsurer, claims come in later, especially when they have to be forwarded more than once (as in the case of retrocessions) and settlements take longer: with a reinsurer the risks of underpricing and underprovisioning are greater. For many authorities, a thorough check of reinsurance on the basis of the cedent’s information is sufficient to protect policyholders: the direct insurer is a professional and therefore able to deal as an equal with the professional reinsurer. A system of international supervision of reinsurance would be the ideal solution. More realistically, however, national supervisors could agree on two points of convergence: 1) making cedents and intermediaries more accountable; 2) developing information exchanges among supervisors, which implies a basic minimum of supervision in each jurisdiction. The OECD is successfully applying itself to these two objectives, with its 1998 Recommendation regarding the former and a very advanced proposal on the latter. 2. How may an insurer choose its reinsurers? This subject has already been discussed pages 23 and 79.
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In cases where insurers’ receivables from reinsurers are protected by material guarantees (cash deposits, pledge securities, letters of credit), the matter of concern is not the financial soundness of a reinsurer but its ability to provide promptly the guarantees requested by the cedent and to update them periodically as required. But even when the reinsurer’s financial soundness does not constitute an absolute priority, the OECD Recommendation of 25 March 1998 remains essential, since it invites supervisors to bring the necessary pressure to bear on direct insurers’ reinsurance managers to obtain information about the financial soundness of their partners. On the practical level, big insurance companies can afford to employ expert analysts for the purpose of choosing their reinsurers, but small companies, aware of their limitations, often prefer to go only with the biggest reinsurers on the principle that “bigger is safer” in the longer run (which seems truer of reinsurers than of direct insurers). Some think it may be necessary to impose a rule for dispersion of cessions amongst several reinsurers. But this would run counter to the needs of small companies which have everything to gain from relying on the skills of one major reinsurer, whose assistance is not only financial but also technical in risk management and the handling of large claims. Depending on the country, the choice of reinsurers is either entirely free, restricted to licensed reinsurers, or determined by the ratings of a specialised agency. In the last of these cases, a low rating is an indication for ceding insurers. But the agencies are not always well acquainted with the complex and diversified nature of reinsurance, and their criteria are generally copied from those applied to other activities. Supervisory authorities should do everything possible to see that rating agencies do not become all-powerful in financial markets. Reinsurance brokers also play an advisory role. Their concentration enables brokerage houses that have acquired an international dimension to employ teams of analysts that direct insurers cannot always afford. But the ceding insurer should not take a broker’s opinion as a factual truth, since it is only one indication among others. Experience has shown that second-rate (then defaulting) reinsurers are often proposed to cedents by intermediaries anxious to pull off a deal. Finalisation of the OECD Recommendation on exchanges of reinsurance information between member country supervisors will contribute to the transparency and security of markets. But confidentiality and professional secrecy requirements prevent supervisors from disclosing their assessments
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of reinsurers to direct insurers, just as they prevent them from informing policyholders about the soundness of insurers. 3. How should modern reinsurance arrangements be dealt with? The emergence of new and more complex risks and the increasing cost of catastrophic losses have led direct insurers to ask their reinsurers for modern, imaginative solutions suited to their particular situations. Alternative risk transfer, securitisation and financial reinsurance are attempts to meet this demand. Securitisation of catastrophic risks (or the issuance of catastrophe bonds) would warrant a special study. The analytical approach to this question differs fundamentally according to whether insurers are the issuers or the subscribers. In most OECD countries, the issue of such securities is still marginal, and the number of cases identified is too small for it to be possible to take positions of principle at this time. Financial reinsurance takes so many different forms that the Müller working party 69 did not see fit to propose a definition of it. Financial reinsurance contracts may apply to prospective or incurred liabilities and may or may not involve the transfer of risk. The risks transferred in this type of contract are mainly economic, such as credit risk or the risk of interest rate fluctuation (timing risk). Although the economic mechanisms of financial reinsurance agreements generally elicit no comments from supervisors, their translation in the accounts becomes inappropriate if the ceding insurer books a gain that is still very uncertain or does not book a liability that has already been incurred. Financial reinsurance treaties of this type have been nicknamed “cosmetic” when they are constructed so as to allow receipts and assets to be booked immediately and the corresponding expenditures and liabilities to be booked later, in breach of the principle of prudence. The result is a book improvement in the cedent’s solvency, without any real support from the reinsurer. The increase in net assets due to a cosmetic contract inconsistent with the accounting principle of prudence should not be included among the items constituting the direct insurer’s solvency margin. It is sometimes difficult to tell whether a reinsurance treaty is cosmetic or not:
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In the United States, significant risk transfer has been defined as a more than 10% probability that the reinsurer will suffer a loss on a treaty of more than 10% of the premiums ceded. Reinsurance contracts are categorised as “traditional” or “financial” on the basis of this criterion.
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In the European Union, a reinsurance treaty is deemed to be cosmetic if it meets two or three of the following criteria: multi-year duration,
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retroactivity, posting of a significant increase in the net assets of the cedent, a substantial profit-sharing clause, implicit discounting of technical provisions, remuneration of reinsurer unrelated to risk. When, by application of one of these methods, a treaty is presumed to be cosmetic, the supervisor must ascertain whether the corresponding accounting entries are based on realistic technical assumptions and correct application of its clauses. For this purpose, he may ask the company for projections of business figures under the treaty. Once it has been established, according to criteria that may differ from country to country, that a treaty is in the form of financial reinsurance, the supervisor will take one or more of the following courses (here, too, reactions may differ across jurisdictions): 1. Request cancellation of the treaty, which may be unfortunate, as some financial reinsurance contracts are sound and advantageous for the ceding insurer. 2. Prescribe an accounting procedure that the insurer cannot use to “improve” its balance sheet. Losses incurred during the year have to be booked for that year, while only the profits earned or certain to be earned can be booked in accordance with the principle of prudence, which in many countries forms the basis of accounting law. Application of this rule will entirely eliminate the advantage of a losssmoothing treaty, whereby the reinsurer agrees to take over immediately a certain amount of technical provisions in exchange for reinsurance premiums of an equivalent amount, but to be collected later. Here the payment of future premiums is a debt incurred during the current accounting year. Failure to book this debt for the same year constitutes a breach of accounting regulations with prudential consequences that are unacceptable, since the insurer’s net assets are now overvalued. 3. For calculation of the available solvency margin, reduce net assets by the amount of profit earned under the treaty. The following is an example of how technical provisions can be discounted indirectly (non-life insurance): Balance sheet Assets Allowable investments TP taken over by reinsurer Misc. receivables Total
Without reinsurance
With reinsurance
910
860
–
100
90
90
1 000
1 050
Liabilities Technical provisions (TP) Equity capital Total
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Without reinsurance
With reinsurance
1 000
1 000
0
50
1 000
1 050
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Here the reinsurer takes over 100 worth of technical provisions in return for an immediate and outright reinsurance premium of 50 (sum taken by the ceding insurer from its investments backing the technical provisions). In other words, for the reinsurer, 50 is the discounted value of 100 worth of future premium payments. The accounting is correct. On the prudential level, discounting of technical provisions is prohibited in many countries, and reinsurance makes it possible to get around this ban. The prudential solution is to deduct treaty profit from net assets in calculating the available solvency margin. Conclusion: In calculating the European solvency margin, as in the American RBC system, reinsurance is taken into account quantitatively without any qualitative distinctions. However, in order to assess the financial soundness of a direct insurer, it is necessary to evaluate the dependability of its reinsurers and the nature of the treaties entered into.
J. Insurance groups The fact that an insurance company is part of a group (essentially comprising insurance companies) or a financial conglomerate (comprising finance houses, insurance undertakings and investment companies) may strengthen its financial position or, on the contrary, weaken it. An insurance company can find the finance it needs within the group or conglomerate to which it belongs. The alliances made in order to form a group protect shareholders, officers and managers from the appetites of raiders, who would thus be obliged to tackle a bigger prey. The links between entities that may be far distant from one another help to make the administrative services and marketing networks cost-effective. As for customers, they can conduct all the transactions they need within the same financial conglomerate: obtain loans, take out insurance, make deposits, contract a long-term saving plan, etc. Finally, a conglomerate can offer the supervisor internal solutions when one of its supervised entities gets into financial difficulties. On the other hand, a financially sound undertaking can be endangered by its membership of a group or conglomerate, which exposes it to specific risks: double use of equity capital, fund transfers from one entity to another, contagion, opaqueness, regulatory trade-off, etc.70 In some countries, the formation of insurance groups and financial conglomerates had long been curbed by regulations prohibiting cross-sector linkages (Canada, Australia, Japan) or strictly limiting them (United States).
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This explains why the development of these mixed entities is more advanced in Europe. Alliances and linkages necessitate considerable financial resources, which insurers have more of than bankers,71 especially when they can use the funds contributed by policyholders. Despite these obstacles, the number of alliances and restructuring operations around the world has increased, demonstrating the need to take membership of a group into account when assessing the financial soundness of an insurance undertaking. The acceleration of cross-border movements has made this particular exercise even more urgent, and also more complex, since solvency rules differ across jurisdictions. The emergence of insurance and finance Titanics is necessarily of concern to supervisory authorities with competence confined to one sector and one geographic area. Some still consider that existing prudential rules, notably regarding investments, are sufficient protection against the risks arising from membership of a group or conglomerate. The rules on spreading assets limit the size of an equity stake, whilst value losses necessitate the establishment of a standing provision for depreciation. Corporate officers and shareholders are subject to “fit and proper” tests, and the rule of transparency applied to intermediary holdings precludes cloaking. To simplify, the insurer collects the money (savings) and the banker spends it (credit), provided the bank can obtain this money in the form of cash deposits and loans, compulsory or otherwise. But when the rules of asset spread extend to current accounts, the banker can use only a limited portion of the funds managed by the insurer. But even when they are effective, the investment rules cannot neutralise all the risks associated with groups and conglomerates, and especially the risk of double use of capital. Insurance supervisors therefore need additional tools: for them, it is necessary to prevent a company belonging to a group from being able, as a result, to circumvent the solvency requirements it is supposed to meet. Accordingly, supplementary supervision of insurance undertakings belonging to a group has been organised in the European single market by Directive 98/78/EC. “Solo-plus” supervision is added to (but does not replace) “solo” supervision of each entity. a) An adjusted solvency ratio is now applied as the ratio of the group’s equity capital to an aggregate solvency margin requirement computed from the requirements applicable to each legal entity in the group. The three, prudentially equivalent methods of calculation specified by the directive (consolidation; deduction; deduction-aggregation) eliminate double use of capital.
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When the capital of an insurance subsidiary is financed from the parent company’s equity capital, the latter is used twice to cover solvency requirements, but the adjusted solvency ratio eliminates this double use. In many cases, an insurance subsidiary’s shares serve to back the technical provisions of the parent company. The real problem then is the allocation of assets within the group: it is necessary to verify (something which the directive does not require) that each liability incurred by an entity of the group is matched by a separate asset. Robert Maxwell used the same securities to cover the pensions of his employees and to back his personal borrowing. b) Wealth transfers from one of the group’s entities to another by means of internal transactions have to be reported to the supervisory authorities, which will determine whether such operations are prejudicial to policyholders: investment sales, loans, suretyships, reinsurance, expensesharing agreements, and so on. In principle, these transactions have to be conducted on normal commercial terms. But rigid application of that principle would preclude bailout operations. Special arrangements therefore have to be allowed: standby reinsurance, provision of personnel and computer facilities, free suretyship given to a foreign subsidiary to meet a local supervision requirement, etc. c) The competent authorities have to see that each insurance undertaking subject to solo-plus supervision has organised appropriate internal control procedures for production of the data needed for the exercise of this supervision. Countries have to take all steps to lift the legal barriers to information exchanges between entities in a group for the purposes of supplementary supervision. The supervisor must have access to the information he needs in order to carry out his assignment. He may check this information on the premises of the undertaking supervised, and of its subsidiaries, parent and sister companies. d) When the necessary information on a related undertaking is unavailable or inaccessible, the book value of that undertaking is deducted from the assets backing the solo-plus adjusted margin. e) For the supervision of cross-border groups, supervisors organise cooperation around a co-ordinator or leader, who in principle is the supervisor of the group’s head insurance company or of its main entity. Information exchanges in this instance concern the fitness and propriety of officers, as well as the reliability of the accounts.
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The Conference of Insurance Supervisory Authorities of the Member States of the European Union has drawn up a protocol on collaboration prescribing the practical arrangements for supervision of a group: a coordinating committee comprising the supervisors of the countries concerned, a key co-ordinator and a lead co-ordinator, etc. When the insurance company subject to supplementary supervision is part of a group that includes undertakings established in countries outside the European Union, the supervisory authorities of those countries may be asked to participate in meetings of the co-ordinating committee. This extension is a interesting move towards globalised supervision. Directive 98/78/EC has thus constructed a three-tier edifice (of which the fourth, on financial conglomerates, has still to be built): ●
tier 1: prudential rules applied to legal entities (solo supervision);
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tier 2: adjusted solvency for group membership (solo-plus);
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tier 3: interaction of internal and external supervision: supervision of supervision.
The system set up in the European Union should be extended to other jurisdictions in order to give policyholders increased protection, make financial markets more stable and put an end to serious distortions of competition (off-shore countries). The IAIS72 has adopted a concordat that sets out the following principles for supervision of international insurance groups: ●
no foreign insurance establishments should escape supervision;
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all insurance establishments of international insurance groups should be subject to effective supervision;
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the creation of a cross-border insurance establishment should be subject to consultation between the host and home supervisors.
To organise this co-operation, the IAIS has listed the information that should be made available to supervisors and adopted a principle of confidentiality. ●
All insurance supervisors should be subject to professional secrecy constraints in respect of information received in the course of their activities.
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They should maintain the confidentiality of the information received from other supervisors.
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Jurisdictions whose confidentiality requirements continue to constrain or prevent the sharing of information with supervisors in other jurisdictions, and jurisdictions in which information received from a foreign supervisor cannot be kept confidential, should review their regulations.
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K. Financial conglomerates The Joint Forum, comprising representatives of the Basle Committee, IOSCO and IAIS, is preparing a comparable arrangement to apply to financial conglomerates. The many alliances formed in recent years between firms in the different financial sectors have encouraged a number of countries to merge the authorities supervising those firms. The suitability of such a move is now a matter of debate, the arguments against it being that: ●
world-wide, there are few financial conglomerates in the truest sense of the term: in most of the institutions designated as “bancassurers”, one of the activities is largely predominant;
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the common supervisor has to resolve conflicts of interest, as when an insurer is asked to increase the capital of its banking subsidiary at the expense of future profit-sharing by policyholders;
●
insurance business is exposed to very specific risks that have to be dealt with by appropriate regulations. The supervision of insurance undertakings necessitates highly experienced specialists.
At the same time, a single authority can make supervisors more independent of political and business influences. Supervision of the conglomerate as a whole would be the ideal solution. But the difficulty of the exercise increases with the number and variety of component establishments. On the one hand, the objectives of the different supervisors are similar: consumer protection and financial market stability. Yet on the other hand, there are structural variances represented by different accounting and prudential principles. For want of global supervision, regulators have developed two approaches: ●
making the structures of financial conglomerates subject to specific rules;
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organising collaboration of the supervisors in the different sectors.
The finance ministers of the G7 have laid down ten key principles for the supervision of international financial conglomerates. These principles emphasise exchanges of information between sectors: nature, formalisation, revision of laws on confidentiality, etc. The “post BCCI” European Directive 95/26/EC, for its part, defined a few rules to guide supervisors:
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conglomerates must have transparent structures;
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the central management of the undertakings must be located in the country of their registered offices;
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supervisors must exchange prudential information and report observed infringements to the foreign authorities concerned.
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The information to be exchanged covers equity investment between insurers and bankers, officer appointments and coercive measures (recovery programme, sanctions) taken against an undertaking in one sector and liable to influence undertakings of the same conglomerate in other sectors. The Joint Forum has made it a prior objective to define all the criteria by which the full identity of a financial conglomerate can be established: formal and operational structures, administrative organisation, internal and external control systems, marketing strategy, quality of officers, adequacy of principal shareholders, solvency and liquidity. The methodology proposed includes transparency requirements for the conglomerate, “fit and proper” tests for officers, tests for detecting double use of capital and for eliminating the effects thereof, and organisation of information exchanges between supervisors (coordinator, procedures), etc. The essential objective is still to define a regulatory requirement for equity capital specific to the conglomerate so as to prevent double use. There are a number of options for fixing a standard on the scale of the conglomerate: consolidation, aggregation, solo-plus. 73 The fact that there are several definitions of capital and different standards according to sector constitutes an obstacle, as does the treatment of minority holdings and unsupervised entities. A banking-insurance tandem may, depending on the case, present a greater or lesser risk than the sum of its component risks: for example, a fire may render a debtor insolvent. As to consolidation of balance sheets, this implies some compatibility of accounting standards. Finally, although there are as many different situations as there are conglomerates, two basic categories emerge: conglomerates in which one financial activity predominates, and the others. Conglomerates in the first category, which far outnumber those in the second, could be dealt with by consolidation of the leading activity and application of the equity principle to the entities operating in the other financial sectors. The problems of supervision concern small, relatively opaque organisations as well as big international conglomerates like Maxwell, BCCI, Barings, Lloyds, LTCM, etc.
Conclusion There are a great many external influences that may weigh to a greater or lesser degree on the immediate and future financial health of an insurance undertaking. Some of the factors described have to be put up with, and it is solely for the supervisor to gauge their possible impact. Others are the result of management decisions, and here perhaps the supervisor should intervene
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and ask company officers to shift their stance. Also, the dominant influences vary with the size of undertakings, their legal structure, the nature of their activities and their mode of organisation. The supervisor must therefore sift through the information he has obtained and concentrate on those elements liable to have a significant effect on basic financial equilibrium.
Notes 10. Provisions are constituted to cover specific expenses that are likely to be incurred as a result of ongoing events, i.e. expenses that, although they may not actually be paid until later, are incurred by virtue of events taking place during, or even prior to, the current period. Reserves are constituted by increasing the firm’s equity capital. As a rule, they are taken from after-tax profits that are neither distributed to shareholders nor allocated to policyholders nor refunded to members. Some reserves, however, may lawfully be deducted from pre-tax earnings. Some languages have only one word to express “provisions” and “reserves”. In such cases, jurists must use adjectives to differentiate between the two concepts. 11. An amount which in life insurance is linked to the zillmerisation of mathematical provisions. 12. In many jurisdictions, in line with recommendations by the supervisory authorities, goodwill is not included amongst the balance sheet assets of insurance undertakings. 13. National Association of Insurance Commissioners – an institution bringing together the supervisory authorities of each state, since in the United States insurers are regulated and supervised at the state, and not federal, level. 14. The Zillmer method is described later, in Part II of this chapter, under the heading “Mathematical provisions”. 15. See below: Investment valuation. 16. See below: Investments (II, B,13). 17. Group chaired by Professor Campagne, Head of the Netherlands Insurance Supervisory Authority; subsequently, group chaired by M. Buol. 18. Arts. 16 and 17 of Directive 73/239/EC of 24 July 1973; Arts. 18 and 19 of Directive 79/267/EC of 5 March 1979. 19. P: premiums written, net of reinsurance; NCP: net claims provisions; TP: net technical provisions. 20. But this reasoning did not prevail initially. Professor Campagne’s working group, cited above, had shown that the probability of a loss in excess of 4% of MP was only 5% if MP were calculated on proper bases and zillmerised by no more than 2%. 21. National Association of Insurance Commissioners. 2 2 22. 10 + 10 + ( 10 + 10 ) = 32.36 rather than 10 + 10 + 10 + 10 = 40. 23. Classes which in some cases are more specific than those defined by European Directives: e.g. motor liability is divided into personal and business; product liability and medical liability are kept distinct, etc.
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24. AUD 1 = EUR 0.57. 25. Swiss Re, Sigma, No. 1/2000, p. 20. 26. Hence the fact that in the United States the term “policy liabilities” is used in preference to “technical provisions”, since the term “provisions” does not necessarily signify contractual obligations. 27. “Present value” in the financial sense of a discounted stream of future payments. 28. Dr. Zillmer was an actuary who lived in the mid-19th century. The Colonia insurance company has preciously preserved, under glass, a policy signed by Zillmer. 29. This is what distinguishes an insurance contract from a financial investment. 30. In France, the surrender value can be no less than 95% of the MP; elsewhere, ceilings can in some cases be much lower. 31. Cf. distinction between unearned premiums and unexpired risks. 32. Incurred but not reported. 33. Each claim file is subject to an evaluation which is updated as soon as a significant new item of information about the claim (e.g. a survey report or a judgement) becomes available to the insurer. 34. International Accounting Standards Board. 35. EP = earned premiums for the year in question. 36. In accordance with the law of large numbers. 37. Provision for surrender risk, capitalisation “reserve” e.g. in France. 38. OECD, Twenty Insurance Guidelines for Insurance Regulation and Supervision in Economies in Transition, Rule No. 13. 39. Composite companies write both life and non-life insurance. 40. Other options are 92-8 and 89-11, as stipulated by the company’s by-laws. 41. Either “represented” or “covered” can be used in this context with the same meaning. 42. See Directive 88/357/EEC, Annex 1. 43. See Professor Dickinson’s report, 2001. 44. See, for example, Article 21 of European Directive 92/49/EEC. 45. If demands for payment are not legally enforceable, insurers have no means of collecting premiums from recalcitrant policyholders. 46. These premiums have not been written as of their due date because of administrative (e.g., backlog) or technical (e.g., basis for calculation not yet known) reasons. 47. “Arrears” is an accounting and legal term designating premiums not received. 48. By paying the intermediary, the policyholder discharges his or her obligation. The insurer is therefore bound to meet its commitment to the policyholder, even if the intermediary does not pass along the premium payment it has received. 49. See, for example, the discussion of the zillmerisation of mathematical provisions.
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50. Conférence internationale des marchés africains, which brings together 14 Frenchspeaking countries in central and west Africa. 51. Depending on the reference chosen by each country. 52. Rules on acceptability and limitations (or diversification). 53. That is to say, in shares in investment companies or in the UCITS underlying the contracts. 54. International Association of Insurance Supervisors. 55. See Insurance Core Principles Methodology, approved by the IAIS general assembly on 10 October 2000, Cape Town. 56. Report by the Conference of Insurance Supervisory Authorities of the member States of the European Union on the Solvency of Insurance Undertakings (April 1997), p. 11. 57. Which should be taken to mean “subsidiaries and participations” in the rest of the discussion. 58. That is to say, those having a redemption value. 59. Davis, Portfolio Regulation of Life Insurance Companies and Pension Funds; Dickinson, Principles for Investment Regulation of Pension Funds and Life Insurance Companies. 60. In France, equities are capped at 65% and real estate assets at 40%. Nevertheless, insurers hold more than 50% of their assets in bonds, despite all of the analysts’ demonstrations in favour of equities as “the best long-term investment [sic]”. 61. In France, the Commission de contrôle des assurances monitors insurance undertakings to ensure that they are “able at all times to meet the commitments they have made to the insured, and that they present the required solvency margin; to this end, the [Insurance Supervisory Board] shall examine their financial position and their operating conditions.” 62. Assets less commitments and “regulated reserves”. 63. See Chapter 3 on the Treatment of Ailing Companies. 64. OSFI: Office of the Superintendent of Financial Institutions. 65. CIA: Canadian Institute of Actuaries. 66. As per the equilibrium equation described in paragraph [5]. 67. According to a SCOR report on the ten-year period 1987-1997 that was presented at the “Entretiens de l’assurance”, Paris, 15 December 1997: United Kingdom: 16 run-offs and 20 wind-ups; United States: 7 run-offs and 21 wind-ups; Bermuda: 11 run-offs and 13 wind-ups; Belgium: 6 run-offs and 3 wind-ups. 68. Bundesaufsichtsamt für das Versicherungswesen. 69. Report on the Solvency of Insurance Undertakings (April 1997, Conference of the Insurance Supervisory Services of the Member States of the European Union). 70. See I, paragraph V. 71. The reason for this is a technical one: in the insurance business, premiums are collected before claims are paid. This gives insurers a working-capital advantage over bankers.
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72. International Association of Insurance Supervisors. 73. See Competition issues arising in the insurance and financial services industries (document available on the OECD website, www.oecd.org).
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Chapter 3
Treatment of Ailing Companies
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I. Diagnosis The competence of insurance supervisors and the quality of regulation limit the number of company failures but do not eliminate them entirely. All jurisdictions have experienced tragic situations for insurance policyholders.
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The need to give policyholders special protection is now universally acknowledged. This protection is provided essentially through financial supervision of insurance companies – first preventively, then remedially if necessary and possible.
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Essential at all times in the activity of an insurance company, intervention by the supervisory authority is even more necessary when the company encounters financial difficulties liable to jeopardise fulfilment of its commitments to policyholders, and eventually to force it out of business.
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The term “ailing company” designates an insurance undertaking no longer presenting the financial guarantees required by regulations: adequate technical provisions; backing of those provisions by an equivalent amount of safe, liquid, profitable, adequately spread and prudently valued assets; equity capital in excess of a statutory minimum. A company’s difficulties may also be caused by a shareholder default, its inability to conclude appropriate reinsurance treaties or, if part of a conglomerate, the failure of another entity in the same conglomerate, etc.
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The confidential documents that the company is required to send regularly to the supervisory authority must therefore contain such information as will disclose a situation giving cause for concern. In examining these documents, the supervisor will note such developments as rapid sales growth, an operating deficit, high loss experience in certain insurance classes, inadequacy of regulatory assets to back technical provisions, etc.
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But an insurance company may be in difficulty even if apparently it is (still) meeting the required prudential standards. When a company develops problems, it tries first to mask them by utilising the degrees of accounting freedom offered by the mechanisms specific to the insurance business. The supervisor has to be aware of such behaviour, which is frequent in all markets. The purpose of on-site supervision is to detect this type of situation, which can also be revealed by early warning systems.
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All told, an insurance company is ailing when the interests of its policyholders are compromised or likely to become so.
The supervisor must have sufficient latitude to be able to assess each particular situation rather than make do with references to average standards, since a company may be in trouble even when it is still meeting the minimum solvency requirement. The main causes of financial difficulty identified by OECD country supervisors are: ●
incompetent management;
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large losses at start-up;
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excessive acquisition and management costs;
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high loss experience;
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underwriting strategy unsuited to the company’s financial resources;
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losses due to the company’s rapid growth, the latter obtained through high remuneration of intermediaries and below-market premium rates;
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risky investment strategy: too much real estate; suretyships to subsidiaries; disproportionate equity stakes in related companies; investment in high-risk junk bonds to obtain the returns promised to policyholders (life insurance);
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inadequate reinsurance system;
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losses from non-insurance operations;
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felonious activities: fictitious transactions, breaches of insurance contract law. The above list is not exhaustive.
When the supervisor finds that, consequent on these lapses, errors and infringements, the company no longer possesses the required equity capital and assets or is likely soon to find itself short, he must initiate a procedure to redress the company’s financial position. It may be noted here that a very wealthy company can still get by in spite of gross errors. But for how long? The supervisor must then use his powers of persuasion and try to convince the company’s officers of the need to mend their ways.
II. Procedures and solutions When the supervisor has concluded that the situation of an insurance company is likely to compromise the interests of policyholders, the competent authority (minister, council of supervisors, head of a supervisory office) initiates a procedure of recovery or sanction.
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A. Dialogue Often the first step is to engage in dialogue with the company’s officers in order to convince them of the need for corrective measures.
B. Recovery programme74 In most cases (that is, when the company officers have not been convinced through dialogue), the next development is an official request for a recovery programme, which the company must submit to its supervisory authority within a fairly short space of time (one to six months, depending on the jurisdiction). The programme must: ●
set out the financial or administrative measures proposed by the company to improve its situation;
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specify the expected quantitative effects of those measures and the time frame in which results may be obtained.
Depending on the inadequacies observed, the recovery plan will contain measures having an effect on the income statement or the balance sheet. For example: ●
profit and loss account: premium increase, selection of risk, management savings, shift of financial policy, changes in reinsurance;
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balance sheet: capital increase, subordinated loan issue, supplementary contributions (mutuals), asset revaluation, etc.
C. Additional measures The plan proposed by the company is then approved by the supervisory authority, which may decide upon various additional measures. With even more reason, if the plan submitted is not judged satisfactory, or if the company does not submit one, the supervisory authority takes precautionary measures. The list of additional or precautionary measures devised by OECD countries is very long. Those most frequently applied are the following: 1. The insurance company concerned is not allowed to retain an equity holding in an unsupervised company if that holding is, by its nature or size, likely to endanger the insurance company. 2. It may not make certain investments. It must sell certain others. 3. Asset disposal is restricted. It may even be banned, in which case assets are placed in receivership. Another solution is to transfer the assets to a special account in a state bank, any transaction request then having to be approved by a supervisor specially appointed by the authority.
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In some countries, assets are managed by accredited specialists independent of the company. 4. The company’s activities are limited, and in particular it is prohibited from w r i t i n g n ew b u s i n e s s . I n s o m e c a s e s , t h e b an i s re d u c e d t o a recommendation. The ban may be for a limited period. It may concern only reinsurance acceptances and foreign business. 5. In life insurance, the supervisory authorities of some countries have the power to suspend payment of surrenders and to prohibit loans on policies. This decision prevents a cash flow crisis. It also prevents certain insiders from gaining an advantage over policyholders collectively. 6. In some countries, the supervisory authority may require that life policies in force be modified. For example, a compulsory reduction of guaranteed benefits may make a company viable again. But this measure cannot be taken in jurisdictions that disallow policy modification without the agreement of the signatories. 7. A temporary special commissioner or trustee is appointed to take over all the powers vested, by law or by corporate charter, in the company’s decision-making bodies (shareholders, directors, chief executive officer). This decision is usually taken when grave administrative irregularities have been found by the supervisor. In some jurisdictions, the appointment of a special commissioner is preceded by a request from the supervisory authority to the company to replace officers and directors. As a rule, precautionary or additional measures are temporary. They are lifted as soon as the company’s financial position is considered to have been righted. On the other hand, if the recovery plan is not carried out or proves ineffective, the supervisory authority initiates a procedure of sanctions.
D. Warning and follow-ups (portfolio transfers) Before imposing a sanction, the supervisory authority is required, in most countries, to send a warning to the company so that it may organise its defence before an administrative court if necessary. OECD countries in general are attached to this principle, which is part of the due process of law. A company under threat may decide to curtail its activity by not writing any new business. It then has to inform the supervisory authority, which determines whether in those circumstances the company can meet its current commitments. It may also voluntarily cease all activity, in which case the supervisory authority requests a transfer of the policy portfolio to another licensed company. If life insurance policies are involved, some regulators
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allow the portfolio to be handled for a time by the supervisory authority or by a liquidation trust specially set up for that purpose. The threat of sanctions may also make a company seek support from outside, with loss of independence as a result: new shareholders, back-up reinsurance treaty, merger with another company, partial or total transfer of the policy portfolio. The financially troubled company may thus conclude with another insurance undertaking an agreement that effectively transfers to it all or part of the company’s portfolio of contracts, with the rights and obligations attaching to them. Portfolio transfer preserves the former situation of policyholders and protects them adequately, always provided that the rescuer presents sufficient financial guarantees. In jurisdictions where prior approval is required, the supervisory authority will approve the transfer agreement only after making sure that the guarantees are there. The transfer agreement, between the “transferor” (which transfers its policy portfolio) and the “transferee” (which takes it over), specifies the date on which the operation takes effect, the contracts involved, the claims outstanding, the financial statement of transfer and, in particular, the assets transferred to cover the liabilities taken over by the transferee (unearned premiums and possibly claims provisions). When the ceding company retains part of its portfolio, the supervisory authority can authorise or accept the transfer only if the retained assets are sufficient to cover the residual liability. Given that the ceding company is in difficulty, this requirement cannot be met unless the financial statement of transfer is out of balance, with the transferee taking over a smaller amount of assets than of liabilities. The discrepancy may be said to represent the price paid for the contracts transferred. The success or failure of the deal will depend on the value that can be assigned to the contracts (which is why the supervisor must in all circumstances form an opinion as to that value). Portfolio transfer has the immense advantage of fully preserving the rights of policyholders, whose contracts continue to run, but with an insurer that is presumably more solvent. The entirety of the liabilities and assets of an ailing company can also be transferred to another insurance undertaking by way of merger/takeover. Such an operation, decided by shareholders or members of mutuals, in principle requires the prior approval of the supervisory authority. Portfolio transfer may or may not be part of a merger/takeover deal. With all these operations, when the supervisory authority takes a favourable view it publishes a notice asking policyholders to make known any
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objections they may have, within a period of one to three months, depending on the jurisdiction. In most countries, portfolio transfer may not be cited by a policyholder as justification for cancelling a contract. In a few countries, mutuals may have the right to reduce the benefits payable to their members so as to post-adjust expenditure to receipts. This method of balancing the books is prohibited in most countries, whose laws oblige all insurance companies to meet their commitments in full or else be declared insolvent. In France, the only exception concerns epizootic disease in livestock insurance.
E. Sanctions In the event of failure to find an amicable solution to improve the situation of policyholders, the supervisory authority orders a sanction proportionate to the company’s omissions. A ground must be furnished for any penalty, since in principle the company has the right of appeal before a court. The grounds most frequently cited are: ●
the company no longer satisfies the conditions required for licensing;
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it has committed grave breaches of the regulations, notably as regards the prudential rules concerning technical provisions and their asset backing, and the solvency margin;
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it has failed to implement, within the prescribed time, the measures specified in its recovery plan;
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it has supplied the supervisory authority with misleading information concealing the weakness of its financial position;
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its officers and directors are no longer fit and proper;
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reinsurance is inadequate.
When these shortcomings do not rule out the possibility of the company’s continuing its insurance activity, sanctions are applied to persons and to certain business operations: ●
reprimand published in the national press;
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prohibition of writing and managing certain contracts;
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temporary suspension of one or more officers;
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fines.
Prohibition of certain operations and temporary suspension of officers may – depending on the jurisdiction and, in some circumstances, even within the same jurisdiction – be presented as a precautionary measure or as a sanction.
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Either way, the supervisor’s aim here again is to salvage what can be salvaged: policyholders’ rights above all, but also goodwill, production equipment, jobs, etc. But even if efficient supervision cannot prevent the emergence of some difficulties, it has to be organised in such a way as to allow supervised companies and their supervisors enough time to find ways of preventing disaster. Good supervision combines flexibility with formal powers.
F. Cessation of activity When no external assistance has been found and the company’s situation can only go on deteriorating at the expense of policyholders, the supervisory authority must put an end to the company’s activity, either by compulsory transfer of its portfolio or by withdrawal of all its authorisations. Portfolio transfer becomes a sanction when it is imposed on an insurance company by the supervisory authority, i.e. compulsory transfer. This ultimate recourse is not available to all supervisory authorities, although it is legal in countries as diverse as Japan, Iceland, Switzerland and France. When it succeeds, it protects the policyholders entirely, the company’s employees partly, and the company’s shareholders and structures not at all. The penalised company naturally has to go along with the supervisory authority’s decision to impose compulsory transfer, but first a partner ready to take over the contracts has to be found. So the authority publishes its decision in the form of a call for bids. Candidates have from two weeks to one month, depending on the jurisdiction, in which to come forward. The shortness of this interval is justified by urgency: once the company’s difficulties are made public, market and customer reactions are likely to make its situation even worse. Before coming forward, possible transferees compare the commercial value they assign to the portfolio offered with the asset shortfall that could strain the operation. The supervisory authority selects the candidate it considers best qualified. It may also decide to spread the contracts over more than one company. The final announcement of the transfer specifies its terms and date of effect. If there are no candidates for the portfolio, or if those that come forward are not considered dependable, the supervisory authority has no option but to adjudge withdrawal of the company’s licence. Compulsory portfolio transfer constitutes a middle course, favourable to policyholders, between the continuation of insurance activities and their sudden termination.
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G. Withdrawal of licence A company’s licence is withdrawn only when all other possibilities have been exhausted. In nearly all countries, the licence withdrawal decision is taken by the insurance supervisory authority. This decision is difficult as regards timing. If taken too early, it may be prejudicial to those parties directly interested in the soundness of the company, including policyholders and beneficiaries. If taken too late, it is liable to be even more harmful, especially to the most recent policyholders. In any case, the supervisor will be accused of undue haste or tardiness, and sometimes both, these reactions being due to the fact that licence withdrawal is prejudicial to all concerned: policyholders, accident victims, employees, agents, creditors, shareholders. In the process of licence withdrawal, the supervisory authority cancels the authorisations given to the company to do business in the insurance sector. Withdrawal may be partial, i.e. limited to certain activities, when a separate licence is issued for each class of insurance, as in the European Union.75 As to total withdrawal, in some countries this entails by law the windingup and dissolution of the company. A liquidator is then appointed, sometimes by the supervisory authority, sometimes by a court at the request of a supervisor or a creditor. In other jurisdictions, the company survives but must wind up its insurance business under the surveillance of the supervisory authority. In life insurance, it is still possible at this stage of the proceedings to negotiate a portfolio transfer. In non-life insurance, some regulators allow the company to manage its business for as long as is needed to guarantee a satisfactory wind-up: policies in force continue to be monitored, premiums collected and claims paid until the contracts expire. Sometimes, the supervisory authority itself takes over the management of contracts subsequent to licence withdrawal, or it assigns this task to an agency that specialises in the handling of portfolios being wound up. Various outcomes are possible for insurance companies that are not automatically dissolved after licence withdrawal. If the contracts are not successfully wound up or transferred, the supervisory authority may lodge an application with the court to declare the company bankrupt. From that point on, the ordinary bankruptcy law applies and a liquidator is appointed by the judge. By contrast, a joint stock company that has wound up or transferred its insurance business can in some countries, if the supervisory authority agrees, conduct business other than insurance. On the other hand, a mutual that has
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ceased its insurance activity has to be dissolved, since it has lost the only object it can have.
H. Appeal In nearly every country, a penalised insurance company has the right to appeal against the administrative or judicial decision taken in respect of it. The right of appeal is a protection against arbitrary use of an authority’s powers. The authority must furnish grounds for its decision and justify it by reference to the regulations applicable. It is therefore important for the insurance supervisory authority to have a wide range of statutory instruments to refer to. The coming storm that will bankrupt a small company with inadequate reinsurance will not be accepted by the judge as a valid ground if the company is still in compliance with the prudential rules applying to provisions and their backing and the solvency margin. An appeal entered before the storm hits is likely to be successful; after the storm, there will be no point in appealing. An appeal has to be lodged fairly quickly in accordance with the principle of legal certainty. In most cases it is not suspensive, i.e. it does not prevent the decision appealed against from continuing to apply. If the judge, after some months, overrules an administrative decision prescribing licence withdrawal or compulsory portfolio transfer, this may create a difficult legal situation prejudicial to policyholders. The supervisory authority will then have to begin all over in compliance with the overruling, and try to come up with an equivalent solution without policyholders having to suffer from the complication caused by the appeals judge.
I. Winding-up There are almost as many winding-up procedures as there are countries. A European directive with the purpose of establishing, “for the proper functioning of the internal market 76 and the protection of creditors”, co-ordination rules so that the winding-up procedures practised in each member State would be “recognised by all member States and produce their effects throughout the Community in accordance with the principles of unity and universality”, was under negotiation for more than twelve years before culminating in a text that stays short of harmonising EU countries’ legislation on winding-up procedures. What is true of Europe is necessarily true of the rest of the world. Winding-up procedures are so diverse that it would take a separate report to present them.
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But a few points can be made here: ●
Some countries have a specific procedure for insurance companies, some do not. Other countries have both an emergency procedure conducted by the supervisory authority and a general bankruptcy procedure, which may take over from the emergency procedure or be used instead of it.
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The liquidator may be administrative or judicial, appointed by the supervisory authority or by a court. In Spain, a commission that handles the liquidation of insurance undertakings (CLEA) takes over the running of companies with insolvency or management problems.
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The liquidator realises the company’s assets to pay off the creditors in the order of precedence of their claims. This order varies considerably according to the legislation concerned. The most current situations are the following:
1. Policyholder creditors have an absolute preference on the assets representing the technical provisions, to the exclusion of all other assets. This “special” preference outranks all other preferences. A list of the assets backing technical provisions is entered in a register. If it is not up to date, notably because the technical provisions are undervalued, and this is often the case with an ailing company, policyholder protection will be incomplete. 2. Policyholder creditors have a general preference on the total assets of an insurance company, but they rank after other creditors such as company employees, tax authorities, social security, etc. In the case of wind-up as a result of financial difficulties, redundancy payments and liquidation expenses constitute new charges that take precedence over benefits due to policyholders, making the latter’s situation worse. 3. All creditors are treated equally, being paid the same pro rata share of the assets available. Licence withdrawal and winding-up often mean increased losses for policyholders and beneficiaries, who are likely to have their claims settled only in part, and who never recover premium overpayments.
J. Policyholder protection funds Various countries have chosen to institute guaranty schemes in the form of funds to cover policyholders as creditors of insolvent insurance companies. These protection funds constitute a last resource for policyholders in a comprehensive system of prudential regulations. Proponents of the guaranty scheme cite the need to increase public confidence in the insurance industry, while its opponents speak of moral hazard and an increased risk of competition distortion.
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A vexed question is the financing of such funds: by policyholders required to pay an additional charge, by insurers in proportion to their liabilities or insolvency risk, or by the State, i.e. the taxpayer. In the countries in transition, a trade-off has to be made between the cost of such funds, which could weaken the contributing companies, and the security provided for their beneficiaries. Elsewhere, healthy companies consider that they do not have to stand shoulder to shoulder with imprudent or incompetently managed ones that may have destabilised a market by creating distortions of competition. The territorial limits of a fund’s scope may also be a cause of inequality among policyholders, clients of a foreign branch sometimes being treated less well than those of the company in the home country. Some OECD countries have no policyholder protection fund. In others there are general funds, funds for compulsory motor vehicle liability insurance, funds for other specific classes of insurance, or funds for the protection of victims of various types of accidents. The general funds cover all classes of insurance but not necessarily all policyholders. The funds for compulsory motor insurance are essentially intended to protect road accident victims in the event of the insurer’s default, but also when the driver responsible cannot be identified or is uninsured. In a few countries, special funds exist for industrial accidents, hunting accidents, or farm accidents. Others have been created to compensate victims of terrorism (France), contamination through blood transfusion (France), extortion (Italy) and hit-and-run driving (United Kingdom). In some other countries, insurance brokers finance a fund to protect insurers and policyholders. In France, there is now a fund to protect life insurance policyholders in the event of insurer default, but compensation is capped, as in the system of bank deposit guarantee organised by the French association of credit institutions, which pays out a maximum of FF 400 000 if a bank fails. To sum up, accident victims are generally covered by policyholder protection funds. The same protection is much less frequently provided for the holders of life and non-life policies. Acting in their own interests, they are expected to choose their insurer advisedly, which presupposes transparency of insurance company accounts, sound counselling by intermediaries, and clearly-worded sales literature to describe contracts.
Notes 74. This programme is known by various other names, depending on the country concerned and its regulations: financial programme, recovery plan, short term financing plan.
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75. According to the lists of classes set out in the annex to Directive 73/239/EC (nonlife insurance) and the annex to Directive 79/267/EC (life insurance). 76. The European Union market. Directive 2001/17/CE of 19 March 2001.
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Chapter 4
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P
rotection of insurance consumers can be said to have two basic aims: quality and security. The arrangements designed to guarantee contract quality, which include rules concerning information and transparency, have not been examined here. Nor has the licensing procedure, which constitutes a first safety barrier for the consumer: only companies meeting a certain number of requirements are authorised to write insurance. Starting out with financial resources deemed sufficient for a specific programme of activities, the insurance company is subjected throughout its existence to a variety of stresses (risks) having a positive or negative impact on its wealth, all the while under the surveillance of supervisors who, theoretically, have adequate means of assessment and effective powers of intervention. In a rapidly evolving world where frontiers are opening up, financial services are blending and distance marketing networks are emerging, the protection of insurance policyholders is more than ever a prior objective of governments. Globalisation and deregulation of markets, with the abolishment of preventive action on pricing and contracts and with the removal of protectionist barriers that restricted access to a territory or profession, are being counterbalanced by the introduction or reinforcement of solvency tests, developments in supervision and the creation of facilities for co-operation between supervisors serving in different countries and sectors. The changeover from factual supervision of contracts and premium rates to overall financial supervision based on criteria more qualitative than quantitative is evidenced by systematic reference to such adjectives as “reasonable” (equity capital), “adequate” (technical provisions), “suitable” (choice of investments) and “judicious” (spread of investments). In some countries, the only quantitative criterion still in use is the equity capital requirement, whether it be called solvency margin, RCB or otherwise. In addition, the supervisor has to assign an “appropriate” weight to each of these adjectives, an intelligent task but a delicate one. Hence the need for periodic comparison of supervisors’ points of view in order to work towards a homogeneous reading of the principles involved. The OECD is making successful efforts here, notably with respect to the reinsurance sector.
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Of course, solvency is primarily a question of the company’s capital, but what capital? The present report has tried to provide an answer to that question, which has many different aspects. In particular, solvency ratios are based on company accounts, which reflect only the past, with no view of the future. Consequently, in order to fulfil a requirement, a company is sometimes tempted to present unrealistic accounts. Also, supervisors today have to choose between a simple but incomplete ratio and a more complex calculation that is not necessarily representative of a company’s true situation. A key question here is whether the objective should be to give the supervisor an outright means of intervention or to define a method of assessment that is of relevance to investors as well. Today, everyone agrees that prevention of company failures requires more than the monitoring of a solvency index. A set of prudential rules on technical provisions and their backing by appropriate assets is already a broader framework for the assessment of a company’s ability to meet its insurance commitments now and in the future. But the supervisor must go beyond this stage, which is only one of accounting, and take into consideration the company’s conditions of operation. Continuous monitoring may make it possible to prescribe, before it is too late, rehabilitation measures including internal correctives and a call for external resources, the availability of which likewise constitutes an important element of the company’s financial soundness: shareholders, reinsurers, and so on. Analysis of the respective performances of supervision and solvency testing has shown that the former is superior to the latter. With his head start, the supervisor is able early to detect financial difficulties that the quantitative tests will reveal later. But this superiority necessitates experienced and competent supervisors with legal tools that permit early intervention, given that laws and regulations are always needed to guide officials of the State, and notably supervisors, in their initiatives and decisions. Efforts are being made to make screening tests forward-oriented so as to prompt more rapid reflexes. The globalisation of financial markets has encouraged the formation of opaque structures, even between establishments in the same sector. Conglomerates are a product of deregulation: carriers of new risks, they constitute a prudential challenge. The closeness of intra-group links and the vulnerability of a company’s image to the vicissitudes of a related entity are factors of contagion that supervisors have to build into their system of supervision. With conglomerates operating on a multinational scale and the partitions between the different financial activities dissolving, there is clearly a need for world-wide co-operation between supervisors of different institutions, the first task being to redefine the responsibilities of each. But
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collaboration and information exchange between supervisors continue to be restrained by confidentiality requirements, which vary widely in scope across jurisdictions and which, incidentally, are justified by the general need to protect insurance policyholders. In all countries, including those that have the most comprehensive regulations and the most seasoned supervisors, there have been insurance company failures. And policyholder protection does not end with the insurer’s bankruptcy: the insured must remain fully covered (through contract transfer) or be compensated by a guaranty scheme financed by the State, the policyholders and/or the other insurers. These failures, infrequent and largely attributable to parallel noninsurance activities that have been mismanaged, have mostly occurred while the companies were still apparently meeting the statutory solvency requirements. In most of the cases observed, however, there has been nothing to indicate that a more sophisticated system of supervision would have permitted early and effective intervention to put matters right. The solvency of insurance undertakings is a major concern for supervisors, but also for policyholders, brokers and investors – the latter being extremely attached to the return on their investment as well. To make themselves more attractive, insurers will probably have to evolve further, materially and mentally, in a competitive environment in which genuine respect for the customer and mastery of innovations and management tools increasingly constitute the keys to success. Investors are attracted both to guarantees of quality and to promises of return. As regards quality, clear strategies, declared specialisations, ability to meet targets and international management are now the benchmarks. As regards return, companies anxious to find new shareholders and fresh capital are liable to propose such attractive investment returns that their real c a p a c i t i e s w i l l b e e x c e e d e d : t h e d iv i d e n d s p a i d a re l i a bl e t o b e disproportionate to real earnings, with no build-up of equity capital in consequence. The combination of keen competition on insurance rates and mounting pressures to give investors greater returns constitutes a threat to a company’s fundamentals and financial health, contradicting the safety imperatives needed to protect policyholders and maintain a good reputation in financial markets. These strains on insurance companies must not prompt supervisors to reduce their requirements – quite the reverse.
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