Risk Management in the Insurance Industry: A Comparison of Solvency II to U.S. Insurance Regulations

Transcription

1 Risk Management in the Insurance Industry: A Comparison of Solvency II to U.S. Insurance Regulations Deborah L. Lindberg 1 and Deborah L. Seifert 2 Abstract: Solvency II is being enacted in the European Union (EU) to increase riskbased capital requirements and to reduce insurer failure rates to near zero (KPMG, 2011). Many speculate that U.S. firms will be affected by the Solvency II regulations not only because some insurers have an EU parent or subsidiary, but also because of a belief that increased risk based capital requirements will likely become the new expectation around the world (Hay, 2011). Consequently, the cost of Solvency II implementation is a concern for both EU and U.S. insurers (Tuohy, 2011). However, others argue that the U.S. insurance industry already has a strong risk based financial solvency system in place, so additional regulations may not be needed to achieve recognition as being Solvency II equivalent (NAIC, 2010; Veysey, 2011). The debate over Solvency II will continue for some time to come as the implementation date in the EU has been pushed back to January 1, 2016 (Europa.eu, 2014). S INTRODUCTION olvency II is a relatively new regulatory framework for the European insurance industry. It is the term used for a European Union (EU) directive that became effective in 2009 and codifies and harmonizes insurance regulations in the EU. It should be noted that the rules and tenets of Solvency II are still evolving, and that Solvency II has its roots in Solvency I, the term used to describe changes to the insurer solvency regime made in the EU in Professor, Department of Accounting, Illinois State University. 2 Associate Professor, Department of Accounting, Illinois State University. Corresponding author: e mail address dseifer@ilstu.edu; phone: ; fax ;, mailing address Deborah L. Seifert, Illinois State University, Campus Box 5520, Normal, IL Journal of Insurance Issues, 2015, 38 (2): Copyright 2015 by the Western Risk and Insurance Association. All rights reserved.

2 234 LINDBERG AND SEIFERT The goal of Solvency II is to have a near zero failure rate among insurers due to risk adjusted capital requirements. Additionally, the implementation of Solvency II in the European Union (EU) will allow insurers to operate across all EU countries with a single license due to a unified legal framework. Solvency II was originally scheduled to become required by January 1, 2014 but the implementation date will be January 1, 2016 (Benari, 2012; Ernst & Young, 2012; Europa.eu, 2014; KPMG, 2011; PwC, 2012). It has been speculated among insurers and their advisors that Solvency II will affect the United States as well as the EU. Some insurers who will certainly be impacted by Solvency II are those with subsidiaries or parent companies in the EU. Many also believe that Solvency II will raise standards globally with regard to risk management and capital adequacy (Hay, 2011; MarketsMedia, 2013). COMPARISONS BETWEEN THE EU AND U.S. INSURANCE INDUSTRIES In the European Union, insurance regulations are promulgated by the International Association of Insurance Supervisors (IAIS), which was formed in The IAIS represents insurance regulators and supervisors of more than 200 jurisdictions in nearly 140 countries, accounting for 97% of the world s insurance premiums. Its stated objectives are to promote effective and globally consistent supervision of the insurance industry in order to develop and maintain fair, safe, and stable insurance markets for the benefit and protection of policyholders, and to contribute to global financial stability (IAIS, 2013). In the U.S. the comparable body is the National Association of Insurance Commissioners (NAIC). The NAIC was formed in 1871 and is a voluntary organization of the chief insurance regulatory officials in the 50 states, the District of Columbia, and five U.S. territories (Vaughan, 2009). As previously noted, in the EU the current insurance regulatory framework is known as Solvency II; in the U.S. the regulatory framework for the insurance industry is known as the Insurance Financial Solvency Framework. Similar to accounting standards, in the U.S. the regulatory framework for insurance companies is primarily rules based, whereas in the EU the framework is primarily principles based (Vaughan, 2009). What this means is that an EU insurer must use relatively more judgment to establish the correct risk based capital for their circumstances. The inputs for the calculation will vary from insurer to insurer (KPMG, 2011). U.S. insurance regulations stress risk based capital (RBC). The RBC calculation uses a standardized formula to indicate capital levels. If capital

3 RISK MANAGEMENT IN THE INSURANCE INDUSTRY 235 Exhibit 1. Key Comparisons between the EU and U.S. Insurance Industries European Union (EU) United States (U.S.) Supervisory body International Association of Insurance Supervisors (IAIS) National Association of Insurance Commissioners (NAIC) Regulatory framework Solvency II Insurance Financial Solvency Framework Framework concepts Principles based Rules based Capital requirements Source: KPMG, Minimum Capital Requirement (MCR) and Solvency Capital Requirement (SCR) Risk Based Capital (RBC) levels fall below RBC capital, regulatory action would be taken for any such weakly capitalized insurers (NAIC, 2010). RBC limits the amount of risk a company can take, considering its size and risk profile; it requires a company with a relatively higher amount of risk to hold a higher amount of capital (NAIC, 2012b). EU insurance regulations discuss minimum capital requirements (MCR) and Solvency Capital Requirements (SCR). MCR is the level of capital required by Solvency II below which there would be an unacceptable risk to policyholders. Accordingly, supervisory intervention would require the firm to rapidly restore the level of solvency to MCR (Central Bank of Ireland, 2013). The SCR is the amount of economic capital required to be held to limit the probability of ruin to 0.5%; it is calculated using either a standard formula, internal models, or a combination of partial internal models coupled with parts of the standard model (Central Bank of Ireland, 2013; Vaughan, 2009). An insurer that has capital in an amount between the MCR and SCR may be subject to supervisory action (Vaughan, 2009). Exhibit 1 summarizes some fundamental information about the EU and U.S. insurance industries. Pillar 1 THE THREE PILLARS OF THE EUROPEAN UNION S SOLVENCY II Solvency II is often described as being composed of three pillars. Pillar 1 discusses all of the quantitative aspects of risk based capital. To make sure that they are adequately capitalized with regard to their risk strategy

4 236 LINDBERG AND SEIFERT and their appetite for risk, insurers may use either a standard formula or an internal model to calculate regulatory capital. If a company uses an internal model, they will be subject to stringent regulatory oversight to make sure that the model provides for adequate capitalization (Deloitte, 2013; KPMG, 2011). Pillar 2 Pillar 2 introduces a relatively higher standard for risk management and oversight. Each insurer is required to perform a forward looking selfassessment. To accomplish this task, organizations will use an assessment tool titled Own Risk and Solvency Assessment (ORSA) to determine company specific risk and capital resource adequacy (Deloitte, 2013; KPMG, 2011). In other words, when using ORSA, insurers make their own forward looking assessments of risks, capital requirements, and adequacy of capital resources, as opposed to having such requirements imposed upon them. Pillar 3 Pillar 3 requires additional disclosures. The goal of Pillar 3 is greater levels of transparency for use by the insurance supervisors and the public. Accordingly, insurers must issue an annual private report to regulators and a Solvency and Financial Condition report to the public. The reports will have more information than prior reports have had to improve transparency. Insurers will also have to provide regulators with quarterly reports, as well as annual reports, so that more current data is available for review (KPMG, 2011; Deloitte, 2013). While it is still too early in the Solvency II implementation process to view a completed disclosure, some insurers are moving in that direction. For example, Prudential, in the U.K., has started to communicate more about their solvency and risk based capital. They have publicly disclosed their economic surplus capital of 11.3 billion and their economic solvency ratio of 257%. These calculations use a methodology similar to that of Solvency II (Davidson, 2014). DIFFERENCES IN CAPITAL REQUIREMENTS BETWEEN THE EU AND U.S. INSURANCE INDUSTRIES Capital requirements should be determined based on the amount of capital needed to meet liabilities and to sustain operating losses; regulatory capital is the amount of capital required by regulators (Ho, 2012). Capital requirements are intended to enable insurers to meet the needs of their policyholders and to maintain solvency (Ho, 2012; NAIC, 2010). There are

5 RISK MANAGEMENT IN THE INSURANCE INDUSTRY 237 several different capital components and associated terminology; these capital components are similar, but not identical, when comparing Solvency II to U.S. insurance regulations. Under Solvency II, the main capital requirement is termed the Solvency Capital Requirement (SCR). In addition, a lower Minimum Capital Requirement (MCR) is required. Further, Solvency II refers to capital as own funds. Own funds comprise basic own funds (BOF), which consist of balance sheet amounts, and ancillary own funds, which may include capital instruments such as letters of credit and guarantees (Norton Rose Fulbright, 2013). In addition to the MCR and SCR capital requirements, additional supplementary capital may be required if a Pillar 2 supervisory review determines it is needed (Lloyd s, 2014). Surplus capital is any capital amounts in excess of regulatory requirements. The NAIC regulations require an insurer to maintain a minimum amount of capital necessary to maintain and ensure solvency, based on the inherent risks in the insurer s operations; this capital is termed risk based capital (RBC) (NAIC, 2010). In the U.S. insurance industry, the excess of assets over liabilities is called policyholders surplus. For capital stock insurers it is calculated as capital plus surplus, and for mutual insurers it is simply surplus. Exhibit 2 summarizes the key differences in capital requirements and terminology of Solvency II compared to U.S. capital requirements for insurance companies. THE POSSIBLE IMPACT OF SOLVENCY II ON THE UNITED STATES Ratings agencies such as Standard & Poor s have shown an interest in utilizing Solvency II as a role model for best practices in the U.S. insurance industry. This could mean that U.S. insurers may need to voluntarily adopt many aspects of Solvency II in order to maintain a favorable status with the ratings agencies (Hay, 2011). Further, Solvency II promotes assessing risk management and regulatory compliance at the group level (NAIC, 2012a). Accordingly, it is possible that U.S. regulators may be pressured by international regulators into moving away from an entity level risk assessment and compliance system and toward a more group level approach (Hay, 2011). The Dodd Frank Act may also encourage U.S. insurers to adopt many aspects of Solvency II. The Dodd Frank Act established the Federal Insurance Office (FIO) and that agency must evaluate the effectiveness of state and federal insurance regulations. It is possible that the FIO could push

6 238 LINDBERG AND SEIFERT Exhibit 2. Key Differences in Capital Requirements of Solvency II Compared to U.S. Insurance Regulations Conceptualization of capital Solvency II U.S. insurance regulations Surplus Capital Capital Solvency capital requirements Capital held in excess of regulatory capital requirements. Termed Own Funds or Basic Own Funds (BOF) under Solvency II. Composed of 3 components: (1) Minimum Capital Requirement (MCR); (2) Solvency Capital Requirement (SCR), is a riskbased capital solvency level; insurers may use internal models to estimate the SCR or use the standardized approach; (3) possible supplementary capital requirements determined through a Pillar 2 supervisory review. Policyholders Surplus is the excess of assets over liabilities; for capital stock insurers it is capital plus surplus, and for mutual insurers it is surplus. Termed Risk-Based Capital (RBC) by the NAIC; the amount of required capital that the insurance company must maintain to ensure solvency, based on the inherent risks in the insurer s operations. Risk-Based Capital (RBC) has components of economic capital, but several of the fundamental constructs are different. RBC is a method of measuring the minimum amount of capital appropriate for a reporting entity to support its overall business operations in consideration of its size and risk profile. RBC limits the amount of risk a company can take. It requires a company with a higher amount of risk to hold a higher amount of capital. through regulations equivalent to Solvency II in the U.S. if it believes that they better mitigate systemic risk and other regulatory concerns (Hay, 2011). SOLVENCY II NOT WELCOMED BY ALL Many U.S. domestic insurers do not see a need for Solvency II equivalence. One reason for resistance is the cost of the regulations. Even some European insurers such as Lloyd s of London have pressed for a reduction in the capital requirements they must meet under Solvency II. It is

7 RISK MANAGEMENT IN THE INSURANCE INDUSTRY 239 estimated that Lloyd s has spent over $100 million annually since 2009 to be Solvency II compliant. The CEO of Lloyd s has criticized Solvency II for being too onerous for global insurers such as Lloyd s (Tuohy, 2011). Munich Re is also asking for a lengthened timeline to adopt Solvency II. They claim they need a five year transition period due to the cost of the initiative. Many EU insurers have stated that they will likely pass the cost of Solvency II on to consumers in the form of higher premiums (Tuohy, 2011). An additional cost for firms adopting Solvency II will be updating their information technology. Most insurers in the U.S. and abroad currently have a patchwork of different information systems. It has been asserted that all information needs to be available in one place so that the additional risk analysis required under Solvency II can be performed. The cost of upgrading and integrating information systems will be substantial for most firms (Tuohy, 2011). Additionally, insurers and regulators in the U.S. may not see a need for Solvency II equivalence because the U.S. already has a strong regulatory solvency framework. The National Association of Insurance Commissioners (NAIC) has integrated seven core principles into the U.S. Insurance Financial Solvency Framework, thus closely aligning the framework with Solvency II. Those seven core principles are: Regulatory reporting, disclosure, and transparency; Off site monitoring and analysis; On site risk focused examinations; Reserves, capital adequacy, and solvency; Regulatory control of significant, broad based risk related transactions/activities; Preventative and corrective measures, including enforcement; and, Exiting the market and receivership (NAIC, 2010). Exhibit 3 provides additional information about the core principles of the U.S. Insurance Solvency Framework. In general, the NAIC sets model laws and regulations that are adopted by the states. An accreditation program is in place that allows states to demonstrate that they have an adequate infrastructure in place to enforce insurance regulations and to provide consumers with an adequately capitalized and secure insurance market. The states must also have procedures in place to allow for the orderly exit of an insurer from the market, if

8 240 LINDBERG AND SEIFERT Exhibit 3. Seven Principles of the U. S. Insurance Financial Solvency Framework Principle # principle Description Principle 1 Principle 2 Principle 3 Principle 4 Principle 5 Regulatory reporting, disclosure and transparency Off site monitoring and analysis On site risk focused examinations Reserves, capital adequacy, and solvency Regulatory control of significant, broadbased risk related transactions/activities Insurers are required to file standardized annual and quarterly financial reports that are used to assess the insurer s risk and financial condition. The reports contain both qualitative and quantitative information and are updated as necessary to incorporate significant common insurer risks. Off site solvency monitoring is used to assess on an on going basis the financial condition of the insurer as of the valuation date and to identify and assess current and prospective risks through risk focused surveillance. The results of the off site monitoring tools are maintained by the NAIC for regulators (such as FAST). U.S. regulators carry out risk focused, on site examinations in which the insurer s corporate governance, management oversight and financial strength are evaluated, including the system of risk identification and mitigation both on a current and prospective basis. The reported financial results are assessed through the financial examination process and a determination is made of the insurer s compliance with legal requirements. To ensure that legal obligations to policyholders, contract holders, and others are met when due, insurers are required to maintain reserves and capital and surplus at all times and in such forms so as to provide an adequate margin of safety. The most visible measure of capital adequacy requirements is associated with the risk based capital (RBC) system. The RBC calculation uses a standardized formula to benchmark specified levels of regulatory actions for weakly capitalized insurers. The regulatory framework recognizes that certain significant, broad based transactions/activities affecting policyholders interests must receive regulatory approval. These transactions/activities encompass licensing requirements; change of control; the amount of dividends paid; transactions with affiliates; and reinsurance. Table continues

9 RISK MANAGEMENT IN THE INSURANCE INDUSTRY 241 Exhibit 3. continued Principle 6 Principle 7 Preventive and corrective measures, including enforcement Exiting the market and receivership The regulatory authority takes preventative and corrective measures that are timely, suitable, and necessary to reduce the impact of risks identified during on site and off site regulatory monitoring. These regulatory actions are enforced as necessary. The legal and regulatory framework defines a range of options for the orderly exit of insurers from the marketplace. It defines solvency and establishes a receivership scheme to ensure the payment of policyholder obligations of insolvent insurers subject to appropriate restrictions and limitations. Source: The United States Insurance Financial Solvency Framework (NAIC, 2010). necessary. All fifty states are currently accredited, as are Washington, D.C. and five U.S. territories (NAIC, 2010). The NAIC provides solvency monitoring tools that are termed FAST (Financial Analysis Solvency Tools). These tools can pinpoint an insurer who is at risk of financial distress so that the state regulator can address the issue proactively. The tools utilize risk based capital analysis. The NAIC reviews nationally significant insurers every quarter and alerts state regulators if a problem is found (NAIC, 2010). The NAIC also requires disclosure and transparency through reports that must be filed with state regulators. Additionally, the NAIC has developed statutory accounting principles that are to be used in all financial reports. The reports include both quantitative and qualitative information for better transparency (NAIC, 2010). On site reviews by regulators are required for all insurers at least once every five years. However, if an off site monitoring tool flags a problem, regulators may perform reviews more frequently. The NAIC can assist with the coordination of multi state reviews for large insurers (NAIC, 2010). The risk based capital requirements used by U.S. insurers are thought to work very well; therefore, adding more Solvency II equivalent regulation may be seen by some as redundant and unnecessary. The risk based capital system requires additional capital to be reserved if an insurer has comparatively riskier assets or lines of business. A ladder of interventions is in place if an insurer s risk based capital is deemed inadequate by regulators. If necessary, state regulators may place an insurer in receivership to prevent bankruptcy. State regulators can then coordinate an orderly

10 242 LINDBERG AND SEIFERT exit from the market for the insolvent insurer while still protecting consumers (NAIC, 2010). THE DEBATE CONTINUES However, the debate is far from settled. It remains to be seen if Solvency II implementation in 2016 will have an additional ripple effect on U.S. regulation. Indirectly, Solvency II has already influenced the U.S. insurance industry. For example, the NAIC undertook a Solvency Modernization Initiative to promote risk based capital analysis on par with Solvency II. Further, insurers that have an EU parent or subsidiary will be directly subject to Solvency II requirements beginning in 2016 (Europa.eu, 2014; Hay, 2011). Future impacts of Solvency II on the U.S. insurance industry could include the possibility that Solvency II may give international insurance companies a competitive advantage over U.S. insurers in terms of their assessment of risk and potential enhanced performance management strategies. Thus, U.S. insurance companies may need to adopt the best practices of Solvency II to remain competitive. Moreover, some U.S. rating agencies are already moving towards Solvency II as a guide, since it imposes comparatively higher standards of corporate governance, risk management, and integrated capital modeling. REFERENCES Benari G. (2012) Implications of a Solvency II Delay, available at of a solvency ii delay/ Central Bank of Ireland (2013) Glossary of Solvency II Terms, available at sectors/insurance companies/ solvency2/pages/solvencyiiglossary.aspx. Davidson, Clive (2014) Solvency II: Firms Prepare for Pillar III Scrutiny, available at risk/feature/ /solvency ii firms prepare forpillar iii scrutiny. Deloitte (2013) Solvency II Requirements, available at www2.deloitte.com/uk/en/ pages/financial services/solutions/solvency ii.html. Ernst & Young (2012) European Solvency II Survey, available at GL/en/Industries/Financial Services/Insurance/European Solvency II survey. Europa.eu (2014) Omnibus II Vote: A Big Step Towards a Safer and More Competitive Insurance Industry, available at release _STATEMENT 14 61_en.htm?locale=en.

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