Solvency Requirements Research Articles

The growing importance of the compliance function on the example of Austrian insurance industry

Compliance describes the goal that organizations aim to achieve with their efforts to ensure that the personnel is aware of and takes steps to comply with the relevant laws and regulations as well as with standards, guidelines and contracts. Due the increasing number of regulations and the need for operational transparency, organizations have to establish a compliance management system and compliance controls. In the Austrian insurance industry a special compliance management used to mainly concentrate on the regulations against improper use of insider information. Solvency II, the new framework for the European insurance industry, becoming effective with delay on January 1 2016, includes not only effective quantitative solvency requirements, but also an effective system of governance. The system of governance includes the risk management function, the compliance function as a part of the internal control system, the internal audit function and the actuarial function. These tasks are key functions of insurance companies and the persons in charge of these functions have to fulfill the proper requirements. In autumn 2013 the European Insurance and Occupational Pensions Authority (EIOPA) presented 'Guidelines on System of Governance.' Following EIOPA, early preparation is essential in order to ensure that, if Solvency II is fully applicable, organizations will be well prepared and able to apply the new system. Therefore, the national insurance supervisory authorities and regulators are expected to put the guidelines on System of Governance in place, starting January 1 2014. In Austria the implementation in the insurance supervisory law is scheduled for July 1 2014. Three special parts of regulations by law are discussed in this paper: unauthorized use of insider information, money laundering and corruption. Insider information is intimate knowledge or non-public (privileged) information about the affairs, operations or financial position of a corporation that will affect the market price of its publicly traded stock. Insurance Companies are requested by the Austrian stock exchange law to inform the employees and install procedures to avoid improper use of insider information. The Austrian insurance supervisory law requests all life insurance companies certain regulations and procedures to avoid money laundering and terrorism financing. They must have a special officer responsible for regulations and controls, reporting directly to the top management. Corruption is the abuse of power, office or resources for personal gain by politicians, public officers, judges and also responsible managers in private companies. Bribery is the improper use of gift s and favours in exchange for personal gain or a gain for an organization. The Austrian criminal law knows a lot of offences concerning corruption and white collar crime. The Austrian insurance companies have to introduce effective Compliance Management Systems (CMS) immediately. Based on COSO Internal Control - Integrated Framework, the German Institute of statutory auditors developed an audit standard for auditing CMS. In this standard the integrating parts of an effective CMS are Compliance Culture and Environment, Compliance Objectives, Assessment of Compliance Risks, Compliance Program and Processes, Compliance Organization, Compliance Communication and Information and Compliance Monitoring and Improvement. Prerequisite for an effective and helpful Compliance Management System is the readiness of all members of the organization on all levels in the chain of command to act according to the common rules in the organization. .

Solvency II Assumptions for Increasing the International Competitiveness of EU Insurance Industry

This paper aims to analyze Solvency II quantitative impact study made under conditions of undergoing legislative changes in the insurance market of European Union, called Solvency II regime. The main contribution of this paper is to present the analysis of quantitative and qualitative requirements, which insurers will have to meet under new Solvency II regime, how to escape mistakes during implementation period. Implementation into practice Solvency II Directive will help to increase the international competitiveness of EU insurance industry as they could reallocate own funds according the results of potential decrease or increase in solvency requirement relative to the standard formula.

Fixed-Income Portfolio Selection

This paper formulates and solves the selection problem for a portfolio of credit swaps. The problem is cast as a goal program that entails a constrained optimization of preference-weighted moments of the portfolio value at the investment horizon. The portfolio value takes account of the exact timing of protection premium and default loss payments, as well as any mark-to-market profits and losses realized at the horizon. The constraints address collateral and solvency requirements, initial capital, position limits, and other trading constraints that credit swap investors often face in practice. The multi-moment formulation accommodates the complex distribution of the portfolio value, which is a nested expectation under risk-neutral and actual probabilities. It also generates computational tractability. Numerical results illustrate the features of optimal portfolios. In particular, we find that credit swap investment constraints can have a significant impact on optimal portfolios, even for simple investment objectives. Our problem formulation and solution approach extend to corporate bond portfolios and mixed portfolios of corporate bonds and credit derivatives.

Portfolio Optimization under Solvency Constraints: A Dynamical Approach

We develop portfolio optimization problems to a non-life insurance company for finding the minimum capital required, which simultaneously satisfy solvency and portfolio performance constraints. Motivated by standard insurance regulations, we consider solvency capital requirements based on three criteria: Ruin Probability, Conditional Value-at-Risk and Expected Policyholder Deficit ratio. We propose a novel semi-parametric formulation for each problem and explore the advantages of implementing this methodology over other potential approaches. When liabilities follow a Log-Normal distribution, we provide sufficient conditions for convexity for all our problems. Using different expected Return on Capital target levels, we construct efficient frontiers when portfolio assets are modelled with a special class of multivariate GARCH models. We found that the correlation between assets plays an important role in the behaviour of the optimal capital required and the portfolio structure. The stability and out-of-sample performance of our optimal solutions are empirically tested with respect to both, the solvency requirement and the portfolio performance, through a double rolling window estimation exercise. Our results indicate that a time-varying correlation model outperforms the constant and no-correlation counterparts.

Are Croatian Banks Ready for Pass on AIRB Approach?

This paper presents banks' fulfillment of preconditions for application of advanced internal rating based approach (AIRB). We investigated the level of qualitative and quantitative preconditions matched by Croatian banks in order to reveal readiness of Croatian banks for AIRB application. Results of the test on assumed value of proportion show that the majority of Croatian banks don't fulfill qualitative and quantitative preconditions for AIRB. Furthermore, according to the document of Public disclosure on solvency requirements that banks are obliged to disclose on their web sites, all Croatian banks are applying standardized approach for credit risk estimation. The main goal of credit risk management is to maximize a bank's risk-adjusted rate of return by maintatining credit risk exposure within acceptable paremeters. That is why banks need to managethe credit risk inherent in the entire portfolio as well as the risk in individual credits. Since exposure to credit risk continues to be the leading source of problems in all banks, the effective credit risk management is a crucial component of a comprehensive approach to risk management and essential for long-term success of all credit institutions. Nevertheless, more sophisticated methods of credit risk estimation are needed in order to adjust the level of regulatory capital with the risk profile of banks which leads to strenghtening of financial system on local as well as on global level. Our paper thus provides analysis of preconditions fulfilled by Croatian banks.

Macroeconomic Policies for Slovenia after the “Great Recession”

The paper analyses the effects of different global developments and the resulting reactions of fiscal policies after the “Great Recession” on the Slovenian economy. We use the macro model SLOPOL8.1, an econometric model of the Slovenian economy, to simulate the effects of different scenarios for the global economy under the assumption of “no-policy” reactions, i.e. assuming that macroeconomic policies are conducted without attempting to deal with the effects of the world economy. Moreover, we investigate how fiscal policy should react under each scenario if it aims at minimizing some intertemporal objective function containing important macroeconomic policy targets as arguments. It turns out that the development of the Slovenian economy depends strongly on world business cycles. If another crisis follows the “Great Recession”, a highly expansionary design of fiscal policies is required in order to achieve reasonable rates of growth or levels of output, which is neither realistic nor sustainable. There are strong trade-offs between countercyclical fiscal policies and the requirements of fiscal solvency. Although acceptable fiscal policies have to be mildly countercyclical, they are not able to protect the Slovenian economy from the negative effects of another slump such as the one occurring during the “Great Recession”.

Macroeconomic Policies for Slovenia in the “Great Recession”

The paper analyzes the effects of different reactions of fiscal (and to some extent monetary) policies to the Great Recession in Slovenia. We use the model SLOPOL8.1, an econometric model of the Slovenian economy, to simulate the effects of the global crisis under the assumption of no-policy reactions, i.e. assuming that macroeconomic policies are conducted without attempting to deal with the effects of the recession. Moreover, we investigate whether (and if so, how) fiscal policy can reduce or even annihilate the macroeconomic effects of the recession. It turns out that in order to achieve reasonable rates of growth and of unemployment, a highly expansionary design of fiscal policies is required, which is neither realistic nor sustainable. There are strong trade-offs between countercyclical fiscal policies and the requirements of fiscal solvency. Acceptable fiscal policies are mildly countercyclical and are not able to shelter the Slovenian economy from the negative effects of a slump like that occurring during the Great Recession.

The Impact of Introducing Insurance Guaranty Schemes on Pricing and Capital Structure

AbstractThe introduction of an insurance guaranty scheme can have significant influence on the pricing and capital structures in a competitive market. The aim of this article is to study this effect on competitive equity–premium combinations while considering a framework with policyholders and equity holders where guaranty fund charges are volume‐based, as levied in existing schemes. Several settings with regard to the origin of the fund contributions are assessed and the immediate effects on the incentives of the policyholders and equity holders are analyzed through a one‐period contingent claim approach. One result is that introducing a guaranty scheme in a market with competitive conditions entails a shift of equity capital towards minimum solvency requirements. Hence, adverse incentives may arise with regard to the overall security level of the industry.

Pension Benefit Security: A Comparison of Solvency Requirements, a Pension Guarantee Fund, and Sponsor Support

AbstractDeveloped countries apply different security mechanisms in regulation to protect pension benefits: solvency requirements, a pension guarantee fund (PGF), and sponsor support. We compare these mechanisms for a generalized form of hybrid pension schemes. We calculate the expected log return for the beneficiaries, the shortfall probability, that is, the likelihood of the pension payment falling below the promised level and the expected loss given shortfall. Comparing solvency requirements to a pension guarantee system or sponsor support involves trading off risk and return. Additional spending on default insurance reduces the shortfall probability and the expected loss given shortfall but also lowers the probability of high positive returns as are feasible under solvency requirements.

Risk processes with dependence and premium adjusted to solvency targets

This paper considers risk processes with various forms of dependence between waiting times and claim amounts. The standing assumption is that the increments of the claims process possess exponential moments so that variations of the Lundberg upper bound for the probability of ruin are in reach. The traditional point of view in ruin theory is reversed: rather than studying the probability of ruin as a function of the initial reserve under fixed premium, the problem is to adjust the premium dynamically so as to obtain a given ruin probability (solvency requirement) for a fixed initial reserve (the financial capacity of the insurer). This programme is carried through in various models for the claims process, ranging from Cox processes with i.i.d. claim amounts, to conditional renewal (Sparre Andersen) processes.

A Utility-Based Comparison of Pension Security Mechanisms

Adequate funding of occupational pension plans is key to benefit security. Across countries different methods of securing funding exist: solvency requirements, a pension guarantee fund, and sponsor support. The key goal of this paper is to investigate the welfare implications to the beneficiary in a hybrid pension scheme. We show that the three security mechanisms can be made utility-equivalent by adjusting the pension contract specifications. The utility-equivalence approach could serve to strengthen the holistic balance sheet approach as advised by EIOPA. It enables regulators to compare various pension systems across Europe in a single framework from a utility perspective in stead of a valuation perspective.

Revised version of: Solvency requirement for a long-term guarantee: risk measures versus probability of ruin

Solvency requirements are based on the idea that risk can be accepted if enough capital is present. The determination of this minimum level of capital depends on how we consider and measure the underlying risk. Apart from the kind of risk measure used, an important factor is how time is integrated in the process. This topic is particularly important for long-term liabilities such as life insurance or pension benefits. In this paper we study the market risk of a life insurer offering a fixed guaranteed rate on a certain time horizon and investing the premium in a risky fund. We develop and compare various risk measurements based either on a single point analysis or on a continuous-time test. Dynamic risk measures are also considered.

Insurance Guaranty Schemes in a Contingent Claims Setting

The introduction of an insurance guaranty scheme can have significant influence on the pricing and capital structures in a competitive market. This contribution summarizes the major findings of a working paper written by Schmeiser and Wagner (Working Papers on Risk Management and Insurance (IVW-HSG), No. 80, 2010). The effect on competitive equity-premium combinations is studied while considering a framework with policyholders and equity holders where guaranty fund charges are volume-based, as levied in existing schemes. Several settings with regard to the origin of the fund contributions are assessed and the immediate effects on the incentives of the policyholders and equity holders are analyzed through a one-period contingent claim approach. One result is that introducing a guaranty scheme in a market with competitive conditions entails a shift of equity capital towards minimum solvency requirements. Hence adverse incentives may arise with regard to the overall security level of the industry.

Solvency requirement for long term guarantee: risk measure versus probability of ruin

Solvency requirements are based on the idea that risk can be accepted if enough capital is present. The determination of this minimum level of capital depends on the way to consider and measure the underlying risk. Apart from the kind of risk measure used, an important factor is the way to integrate time in the process. This topic is particularly important for long term liabilities such as life insurance or pension benefits. In this paper we study the market risk of a life insurer offering a fixed guaranteed rate on a certain time horizon and investing the premium in a risky fund. We develop and compare various risk measurements based either on a single point analysis or on a continuous time test. Dynamic risk measures are also considered.

Deferred life annuities: on the combined effects of stochastic mortality and interest rates

The paper analyzes the systematic risk which is inherent in a portfolio of deferred life annuities. We take into account stochastic mortality as well as stochastic interest rates. For the specification of the mortality rate dynamics, we consider a pure diffusion model as well as a compound Poisson jump model. The interest rate dynamics are given by a one-factor Hull–White model. All models, interest rate and mortality rate, are calibrated to financial market as well as demographic data. We use Monte Carlo simulations to approximate the variance of the discounted cash flow and its decomposition into a pooling and a non-pooling risk part. We also consider pricing effects using the principle of zero expected utility and the quantile principle. The estimated risk premiums are benchmarked to the equivalence premium. Finally, we focus on solvency requirements which are based on the investment decisions and the associated shortfall probability of the annuity provider.

Strategic Complementarity, Fragility, and Regulation

The paper analyzes a very stylized model of crises and demonstrates how the degree of strategic complementarity in the actions of investors is a critical determinant of fragility. It is shown how the balance sheet composition of a financial intermediary, parameters of the information structure (precisions of public and private information), and the level of stress indicators in the market impinge on the degree of strategic complementarity. The model distinguishes between solvency and liquidity risk and characterizes them. Both a solvency (leverage) and a liquidity ratio are required to control the probabilities of insolvency and illiquidity. It is found that in a more competitive environment (with higher return on short-term debt) the solvency requirement has to be strengthened, and in an environment where the fire sales penalty is higher and fund managers are more conservative the liquidity requirement has to be strengthened while the solvency one relaxed. Higher disclosure or introducing a derivatives market may backfire, aggravating fragility (in particular when the asset side of a financial intermediary is opaque) and, correspondingly, liquidity requirements should be tightened. The model is applied to interpret the 2007 run on SIV and ABCP conduits.

Optimisation of limit systems for investment risks in accordance with Solvency II

In order to satisfy the requirements of Solvency II (e.g. Framework directive on the EU Solvency II Project on Safety Measures and its implementation according to § 64a German Insurance Law)—insurance companies should implement an overall risk limit system. The starting point for developing this system is the entity’s risk strategy and risk bearing capital approach based on economic principles. For life insurance companies, the dominant risk category is investment risk. Therefore, the limit system should focus on such risks. In practice there are multiple interactions between the core life insurance business and the asset side. Because of these interactions, a limit system for investment risks cannot be separated from life business risks. There is a particular need to integrate the entity’s asset liability management approach into the risk limit system. The regulatory requirements call for consistent integration of a top-down view with a bottom-up risk management perspective in the investment department. In creating an adequate system, the first step is to categorise the individual types of risk and the corresponding risk management approaches. It is most important to get clear definitions of the bottom-up and the top-down views in the context of life insurance investment risks, and to integrate these into the entity’s overall solvency control regime. The current financial crisis has revealed problems of valuation and an enormous and unprecedented increase in volatility in the capital markets. It is clear that an ongoing and effective analysis of these market developments and their impact on asset allocation and portfolio optimisation is necessary. The crisis also implies the need to think in detail about how to manage model risk implications. In this paper we propose an integrated view of these issues as the basis for optimal design of the company’s risk limit system.

Solvency requirements for Swiss pension funds and how to ensure the guarantee of benefit payments at any time

We develop an approach for practitioners for setting up the target value of investment fluctuation reserves for autonomous Swiss pension funds and determine a desirable level for them to better ensure benefits payments during times of volatile financial markets. The Swiss pension legislation does not stipulate any methodology and requirements for setting up such reserves. We give an overview of methods used and suggest some improvements based on our experience as many pension funds are underfunded after 2008. A suggested approach will help trustees to better comply with funding and solvency requirements for Swiss pension funds.

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.

Creation of Shareholder Value: Focus on the Mauritius Insurance Sector

The insurance sector in Mauritius is seen as being well regulated and policyholders feel that their money is in safe hands. We are not denying any part of this previous statement. However, insurance companies have shareholders who are the ultimate beneficial holders. This study provides an insight of the current situation in terms of creation of shareholder value, corporate governance recommendations and compliance of solvency requirements by insurance companies in Mauritius. During my several years working as an auditor, several anomalies were noted in terms of compliance by insurance companies with the net effect being that the value of the shareholders was impaired. This is one of the reasons that have prompted me to carry out this study and analyse the real causes of the problems that arise within insurance companies.