Solvency Regulation Research Articles

Backtesting the solvency capital requirement for longevity risk

Purpose – The determination of the capital requirements represents the first Pillar of Solvency II. The main purpose of the new solvency regulation is to obtain more realistic modelling and assessment of the different risks insurance companies are exposed to in a balance‐sheet perspective. In this context, the Solvency Capital Requirement (SCR) standard calculation is based on a modular approach, where the overall risk is split into several modules and submodules. In Solvency II, standard formula longevity risk is explicitly considered. The purpose of this paper is to look at the backtesting approach for measuring the consistency of SCR calculations for life insurance policies.Design/methodology/approach – A multiperiod approach is suggested for correctly calculating the SCR in a risk management perspective, in the sense that the amount of capital necessary to meet company future obligations year by year until the contract will be in force has to be assessed. The backtesting approach for measuring the con...

Designing a Countercyclical Insurance Program for Systemic Risk

AbstractThis article proposes a framework for measuring and managing systemic risk. Current solvency regulations have been criticized for their focus on individual firms rather than the system as a whole. We show how an insurance program can be designed to deal with systemic risk through a risk charge on participating institutions. The risk charge is based on the generalized co‐conditional tail expectation, a conditional risk measure adapted from conditional value‐at‐risk. Current regulations have been criticized on the grounds that their capital requirements are procyclical. They require extra capital in periods of extreme stress thus exacerbating a crisis. We show how to construct a countercyclical risk charge and illustrate the approach using a numerical example.

Solvency Capital, Pricing and Capitalization Strategies of Life Annuity Providers

This paper provides a detailed quantitative assessment of the impact of solvency capital requirements on product pricing and shareholder value for a life insurer. A multi-period firm value maximization model for a life annuity provider, allowing for stochastic mortality and asset returns, imperfectly elastic product demand, as well as frictional costs, is used to derive optimal capital and pricing strategies for a range of solvency levels reflecting differences in regulatory regimes. The model is calibrated using realistic assumptions and the sensitivity of results assessed. The results show that value-maximizing insurers should target higher solvency levels than the Solvency II regulatory 99.5% under assumptions of reasonable levels of policyholder’s aversion to insolvency risk. Even in the case of less restrictive solvency regulation, policyholder price elasticity and solvency preferences are shown to be important factors for a life insurer’s profit maximizing strategy.

Underwriting in Property-Casualty Insurance Markets: Regulation, Risk and Volatility

We offer a novel explanation of underwriting volatility in property-liability insurance markets in terms of private uncertainty over public regulatory policy. Underwriting involving random losses to policyholders is one source of risk to the equity value of insurance firms. Solvency regulations, however, pose a second source of risk to equity value when the implementation of such regulations randomly affects the return to underwriting but exhibits imperfect correlation with market conditions over time. Using a differential game in a standard no-arbitrage environment to model interaction between these two sources of risk, we derive the valuation equation for property-liability underwriting inclusive of the respective best-reply underwriting strategy of a representative insurance firm and the implementation strategy of a representative regulator. Owing to the conflicting effects of these strategies on firm equity, regulations adopted to reduce the solvency risk of insurers can, paradoxically, increase underwriting volatility in an otherwise efficient insurance market. Under certain parametric conditions, we also show that, even in the presence of complete financial markets, a subgame perfect Nash equilibrium of this game can exhibit a limit cycle in the value of underwriting which mirrors empirical evidence on the presence of cycles in property-liability insurance markets.

Risk Management and the Global Banking Crisis: Lessons for Insurance Solvency Regulation

This paper investigates the causes of the banking crisis and the resulting lessons that need to be learned for insurance regulation. The paper argues that the banking crisis was predominantly caused by weaknesses in the management and regulation of banks, weaknesses that lead to problems such as flawed compensation schemes, poor risk management communication and an over-reliance on mathematical risk models. On the basis of these findings, doubts are expressed about the direction of certain insurance regulatory reforms—such as the focus on capital requirements and quantitative risk assessment (the so-called “Pillar I” of most reforms). It is also recommended that a more balanced approach to insurance regulation should be implemented, which places much greater emphasis on enhancing risk management guidance and supervisory tools (Pillar II) and improving disclosure rules (Pillar III).

Preventing the Risk of Foreign Reinsurer Insolvency in a Global World: Developments Toward Transnational Recognition and Cooperation in the E.U. and the U.S.

This paper researches a developing issue in regulatory cross-border reinsurance law: What is the approach taken by the European Union and the United States toward foreign reinsurers? National regulatory bodies are under pressure, caused by the reality of a state-less global market, to design adapted regulatory solutions. Several solutions are conceivable: national isolation, mere informal cooperation, mutual recognition of foreign equivalent regulation or internationally binding uniform standards on reinsurance solvency rules. In order to address the first, broader question, the paper presents the actual state of solvency regulation of reinsurers in the EU and in the US. The paper shows that over the last two decades, transnational prudential regulation of insurers and reinsurers has developed differently than by international agreement. A transnational governmental network, the International Association of Insurance Supervisors (IAIS), an association that operates as a voluntary membership of insurance supervisors of several jurisdictions, has silently advocated for cross-border equivalence assessments and mutual recognition. For instance, when the paper presents EU law – the Solvency II Directive – the practical impact of the technical guidelines developed by the IAIS becomes clear. The informal, cross-border “regulation” or soft law developed by the IAIS is transforming into formal rules. The EU Solvency II directive, taking effect in October 2012, has opted to perform mutual equivalence assessments, which implies that its solvency concept is to some extent exported, as a condition to allowing foreign reinsurers to the EU market. As a consequence, foreign regulatory bodies or foreign solvency regulation are faced with the need to find a mutually acceptable form of solvency regulation. In the U.S. the effect of cross-border reinsurance services has led to a new development in insurance law: A carefully defined area of insurance law, the area of “international insurance” or the negotiation of bilateral and multilateral agreements concerning recognition of prudential measures has been expressly federalized by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Accordingly, the federal government will newly be represented in the IAIS, in addition to its separate states that are already member of the IAIS.

Discontinued German life insurance portfolios: rules‐in‐use, interest rate risk, and Solvency II

PurposeThis paper seeks to provide an overview on potential impacts German primary life insurers are exposed to in relation to upcoming Solvency II regulation and potential strategic choices, especially in the light of halting low‐interest rates. Given a large degree of complexity, the paper aims at giving some guidance to decision makers considering a discontinuation of underwriting.Design/methodology/approachThe paper builds upon current observations made in the German primary life insurance industry, especially, recent strategic decisions of two market participants to discontinue their life insurance carriers. On the background of low‐interest rates but yet guaranteed interest participations and additional capital requirements arising from Solvency II, the paper illustrates the strategic options life insurers have in the German market, given the specific market environment.FindingsRegulatory capital requirements of Solvency II will sanction guarantee products in a way that for some insurers life products will become unattractive. As there is evidence in the market that some participants have started to consider the run‐off option for selected carriers, the paper finds that this option may represent an appropriate consequence not only for foreign insurers ceasing their business in Germany but also for domestic insurance groups. Given the specific rules‐in‐use in the German primary life insurance market, the paper discusses the controlled run‐off approach as a strategic option for selected life insurers, enabling a harvesting strategy through maximizing cash flows from existing liabilities while avoiding further investments.Originality/valueDiscussions in this paper help to bring into focus the strong challenges by both the upcoming regulatory Solvency II and current market conditions. The brief case study included in this paper may illustrate the implications as well as some crucial success factors of discontinued life business.

Insurance Regulation and the Dodd-Frank Act

This paper discusses a number of key issues regarding implementation by the Financial Stability Oversight Council (FSOC) and the Federal Insurance Office (FIO) of the Dodd-Frank Act's provisions affecting insurance. The paper emphasizes the fundamental differences between insurance and banking, including much lower potential for systemic risk and substantial market discipline in insurance, and how those differences favor solvency regulation and guaranty systems that reflect the distinctive features of each sector. The FSOC and FIO should carefully consider those differences in their analyses of possibly systemically important insurance companies and in the FIO's study and report to Congress on insurance regulation. Particular attention should be paid to the relatively low systemic risk and relatively strong market discipline in insurance compared with banking.

Insurers as Systemically Important Financial Institutions (SIFIs)? Exploration and Methodology

This paper focuses on developing a methodology for identifying potential Systemically Important Financial Institutions (SIFIs) in the insurance sector. While many contend that insurers do not cause systemic risk, regulators asked to include insurers in the SIFI designation. In order to operationalise the identification process for potential SIFIs, the methodology suggested in this paper uses the definitions of the Financial Stability Board (FSB) and the International Association of Insurance Supervisors (IAIS) for systemic risk. The categories are: 1. Size, 2. Interconnectedness, 3. Substitutability, and 4. Timing, in combination. With these categories in mind, we adopt the results of the seminal report of the Geneva Association “Systemic Risk in Insurance” (2010) which regards the activities of insurers as the key for the analysis. The report concludes that core or traditional insurance activities do not fit into the definition of systemic risk. Activities that are quasi banking or non-core thus may fit into potentially systemically risky activities (pSRAs). Thus, the first step of our proposed methodology is a discovery of pSRAs in insurance. PSRAs are not indicators to insolvency. They are used in the second phase for a discovery of those insurers that engage in pSRAs. Briefly, Phase I is the methodology to discover pSRAs, and Phase II is the methodology to find which insurers are engaged in pSRAs and determine whether they meet SIFI status. Only such insurers are to be scrutinized for a potential designation as SIFIs. Such insurers’ engagement in pSRAs will be measured and examined based on benchmarks indicators in Phase II. If their exposure to the pSRA is above the indicators’ benchmarks, those insurers will be a “pSRA insurer.” Further studies are expected since the IAIS is calling for data collection. The engagement in a pSRA over a specified benchmark should not lead automatically to a SIFI designation of an insurer. As long as the insurer can carry the activity, it should not cause a systemic problem to the economy. Therefore, the current regulatory system is engaged to additional measures of such a “pSRA insurer.” Key is the institutional engagement in pSRAs. The pSRAs is the added dimension above the solvency regulation system. Examples of pSRAs we use here are: derivatives for speculations and mismanagement of short term investments. Indicators in Phase II are provided as well.

The stewardship of European workers’ capital in times of crisis

The global financial and economic crisis has reinforced the need for a broader regulatory and policy approach to responsible investment. This article looks at the interplay between pension policy and responsible investment practices which, it is argued, has been made more complicated and uncertain as a result of the crisis. The article looks first at the impact of the crisis on pension funds, the regulatory measures taken by regulators in reaction and the changing political economy of reform across Europe as a result of the crisis. From there the article outlines the broad features of a trade union perspective on pension fund responsible investment — known as workers’ capital strategies — and focuses on the post-crisis regulatory discussion in Europe on corporate governance and shareholder activism. The article concludes on the need for a comprehensive approach to responsible investment including by making the link with benefit security and solvency regulations.

On the risk situation of financial conglomerates: does diversification matter?

In general, conglomeration leads to diversification of risk (the diversification benefit) and a decrease in shareholder value (the conglomerate discount). Diversification benefits in financial conglomerates are typically derived without explicitly accounting for reduced shareholder value. However, a comprehensive analysis requires competitive conditions within the conglomerate, i.e., shareholders and debt holders should receive risk-adequate returns on their investment. In this paper, we contribute to the literature on this topic by comparing the diversification effect in conglomerates with and without accounting for altered shareholder value. We derive results for a holding company, a parent-subsidiary structure, and an integrated model. In addition, we consider different types of capital and risk transfer instruments in the parent-subsidiary model, including intragroup retrocession and guarantees. We conclude that under competitive conditions, diversification does not matter to the extent frequently emphasized in the literature. The analysis contributes to the ongoing discussion on group solvency regulation and enterprise risk management, which is of relevance to insurance groups and other financial conglomerates.

Optimal Investment and Premium Policies Under Risk Shifting and Solvency Regulation

Limited liability creates an incentive for insurers to increase the risk of the assets and liabilities at the expense of policyholders. We show that solvency capital requirements restrict the set of feasible investment and premium policies and can thereby improve efficiency under the risk shifting problem. This finding becomes particularly important in light of Solvency II, the forthcoming European risk-based solvency regime for insurers. We provide evidence for Solvency II related efficiency effects in a calibration study for a non-life insurer average portfolio.

Risk-Taking and Solvency Regulation in Banking – A Note –

Risikoverhalten und Solvenzbestimmungen im Bankensektor – Eine Anmerkung – Kapitaladäquanzregeln, wie sie vom Basler Ausschuss für Bankenaufsicht empfohlen werden, können sich auf das Risikoverhalten der Banken negativ auswirken. Banken können durch risiko-gewichtete Eigenkapitalregeln dazu verleitet werden, höhere Risken als gesamtwirtschaftlich wünschenswert einzugehen, um mögliche zukünftige Eigenkapitalbeschränkungen zu vermeiden. Der Artikel zeigt, dass im Rahmen des dynamischen Modells von Blum (1999) Eigenkapitalbestimmungen gemäß dem sogenannten Precommitment Approach Banken zu einem gesamtwirtschaftlich wünschenswerten Risikoverhalten veranlassen. Banken geben dabei dem Regulator ihren möglichen maximalen Verlust bekannt und verpflichten sich gleichzeitig dazu, Eigenkapital im Ausmaß dieses Verlustes zu halten.

The Road Map to Pension Reform

This paper was completed in early 2006. The inevitability warned against then is happening now. Public pension plans are in great financial distress, the reasons for which are structural and fundamental, not cyclical, and will get much worse. The ‘first-mover advantage’ is gone; the third way (financial-engineering around the problem) is gone; it is now a zero-sum contest between taxpayers and plan beneficiaries, and the stakes have grown from $1.0~1.5 trillion to $3 trillion or more. At double the size of the current subprime fiasco and its ramifications, the public pension fiasco will be far worse and reach further. - 2010 In the thirty-one years since ERISA the S&P 500 has produced a 5,200% total return. So why are pensions under-funded by $1 to $1.5 trillion? The cause is emphatically not the oft-cited “perfect storm” of weak equity markets and low interest rates, so the solution will not be found in rearranging the investment deckchairs. To paraphrase the late Peter Drucker, “What gets mismeasured gets mismanaged” and that is the root of pension-world’s manifest failure. Current accounting and actuarial standards & practices are materially misleading & deceptive, governance is weak, and solvency regulation non-existent. - 2006

Are non-risk based capital requirements for insurance companies binding?

We investigate whether insurers base their solvency margins on risk factors even when operating under a supervisory regime where minimum solvency requirements do not fully take such risk factors into account. To do this, we use a dataset of about 350 Dutch insurers from all major lines of business during the pre-Solvency II period 1995–2005. We find that the levels of insurers’ actual solvency margins are related to their risk characteristics and not to regulatory solvency requirements. Consequently, the vast majority of insurers hold much more capital than required, i.e. non-risk based capital requirements generally are not binding. Requirements are found to affect solvency adjustment behaviour, though. More specifically, below-target capital ratios are raised most rapidly by those insurers whose targets are relatively close to the regulatory minimum. One implication from our results is that, because insurers already follow a risk-based approach, the transition to the new European regulatory framework, Solvency II, is likely to be smooth.

Risk Aggregation, Dependence Structure and Diversification Benefit

Insurance and reinsurance live and die from the benefits or lack of it in their risk portfolio. The new solvency regulations allow companies to include them in their computation of risk-based capital (RBC). The question is how to really evaluate those benefits. To compute the total risk of a portfolio, it is important to establish the rules for aggregating the various risks that compose it. This can only be done through modelling of their dependence. It is a well known fact among traders in financial markets that diversification works the worst when one needs it the most''. In other words, in times of crisis the dependence between risks increases. Experience has shown that very large loss events almost always affect multiple lines of business simultaneously. September 11, 2001, is an example of such an event: when the claims originated simultaneously from lines of business which are usually uncorrelated, such as property and life, at the same time that the assets of the company were depreciated due to the crisis on the stock markets. In this paper, we explore various methods of modelling dependence and their influence on benefits. We show that the latter strongly depend on the chosen method and that rank correlation grossly overestimates diversification. This has consequences on the RBC for the whole portfolio, which is smaller than it should be when correctly accounting for tail correlation. However, the problem remains to calibrate the dependence for extreme events, which are rare by definition. We analyze and propose possible ways to get out of this dilemma and come up with reasonable estimates.

Minimum standards for investment performance: A new perspective on non-life insurer solvency

The aim of this paper is to develop an alternative approach for assessing an insurer’s solvency as a proposal for a standard model for Solvency II. Instead of deriving minimum capital requirements–as is done in solvency regulation–our model provides company-specific minimum standards for risk and return of investment performance, given the distribution structure of liabilities and a predefined safety level. The idea behind this approach is that in a situation of weak solvency, an insurer’s asset allocation can be adjusted much more easily in the short term than can, for example, claims cost distributions, operating expenses, or equity capital. Hence, instead of using separate models for capital regulation and solvency regulation–as is typically done in most insurance markets–our single model will reduce the complexity and costs for insurers as well as for regulators. In this paper, we first develop the model framework and second test its applicability using data from a German non-life insurer.

Risk and capital transfer in insurance groups

The aim of this paper is to analyze the effect of capital and risk transfer instruments (CRTIs) on a financial group's risk situation. In this respect, we extend previous literature by accounting for the conglomerate discount on firm value, which is a reduction in shareholder value due to diversification within the group. In general, CRTIs between parent and subsidiaries have a substantial effect on the diversification of risks, economic capital requirements, and default risk, which we study in detail for different types of CRTIs, including intra-group retrocession and guarantees. One main finding is that diversification effects within the group are much lower when taking into account conglomerate discount effects. We believe this aspect to be an important issue in the ongoing discussion on group solvency regulation and enterprise risk management.

Why are there so many banking crises?: the politics and policy of bank regulation

Almost every country in the world has sophisticated systems to prevent banking crises. Yet such crises--and the massive financial and social damage they can cause--remain common throughout the world. Does deposit insurance encourage depositors and bankers to take excessive risks? Are banking regulations poorly designed? Or are banking regulators incompetent? Jean-Charles Rochet, one of the world's leading authorities on banking regulation, argues that the answer in each case is no. In Why Are There So Many Banking Crises?, he makes the case that, although many banking crises are precipitated by financial deregulation and globalization, political interference often causes--and almost always exacerbates--banking crises. If, for example, political authorities are allowed to pressure banking regulators into bailing out banks that should be allowed to fail, then regulation will lack credibility and market discipline won't work. Only by insuring the independence of banking regulators, Rochet says, can market forces work and banking crises be prevented and minimized. In this important collection of essays, Rochet examines the causes of banking crises around the world in recent decades, focusing on the lender of last resort; prudential regulation and the management of risk; and solvency regulations. His proposals for reforms that could limit the frequency and severity of banking crises should interest a wide range of academic economists and those working for central and private banks and financial services authorities.

Effort Allocation of Insurance Agent under Asymmetric Information: An Analytical Approach

This study examines the relationship between incentive contracts for managers and the allocation of efforts by the managers as well as the stock market’s role in monitoring allocation of the efforts. It also evaluates solvency regulation in Japan and its effects on the compensation of a manager and allocation of the manager’s efforts and on the shareholders’ profits in a market with asymmetric information. Particularly, we employ a principal-agency model to demonstrate how uncertainty in the insurance market affects the way managers allocate their efforts so that their companies can achieve a higher solvency ratio in order to meet not only regulatory requirements but also stock market expectation. We find presence of a solvency margin ratio that, subject to certain conditions, increases the level of “good” effort, decreases the level of “bad” effort by the manager and increases the expected stock price.