28 July 2008
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Solvency capital margins – the amount of regulatory capital an insurer is obliged to hold to cover the risks they are exposed to – exist to ensure the financial soundness of insurers and reinsurers, to protect policyholders and to protect the stability of the financial system as a whole.
In the EU, work on Solvency II, the fundamental review of the capital adequacy regime for the European insurance and reinsurance industries, is progressing well. Similarly, in early July the Bermudian government passed the Insurance Amendment Act 2008. This introduces a number of changes to the Bermuda Insurance Act 1978, such as allowing the Bermuda Monetary Authority (BMA) to prescribe standards for an enhanced capital requirement and a capital and solvency return that insurers and reinsurers must comply with.
Solvency II – the EU perspective
The third generation of EU insurance directives adopted in the 1990s established the EU passport for (re)insurers based on the concept of minimum harmonisation and mutual recognition throughout the EU. These directives also recognised that existing EU capital adequacy rules should be reviewed and updated, with particular emphasis on examining the overall financial position of insurers, current developments in insurance and reinsurance, risk management and prudential standards. As a result the European Commission was mandated to conduct a review of the EU solvency requirements. Following this review, a limited reform, Solvency I, was agreed by the European Parliament and the Council of the European Union in 2002.
Solvency II should also harmonise EU requirements to create a single market and enable ‘passporting’ for insurance and reinsurance services. In the past, many EU member states felt that minimum solvency capital requirements were not sufficient, prompting them to instigate their own reforms. In the UK, the Financial Services Authority (FSA) put rules in place in 2004, leading to the current situation where there is a patchwork of regulatory solvency capital requirements across the EU.
The Solvency II development framework is based on a three-pillar approach, similar to that of the banking sector framework. Pillar one sets out a valuation standard for liabilities to policyholders and the capital requirements (re)insurers will be required to meet for insurance, credit, market and operational risk. Pillar two will be the supervisory review process that focuses on evaluating the adequacy of capital and risk-management systems and processes, while pillar three deals with supervisory reporting and disclosure.
There is a number of issues on which the Solvency II working party is yet to reach agreement, but the Commission aims to have the new Solvency II system in operation by 2012.
The Bermuda perspective
The changes in the Bermuda environment were instigated following consultation with Bermuda market stakeholders and flowing from recommendations made during an International Monetary Fund offshore assessment carried out in 2003 and published in January 2005. Generally, the Insurance Act 1978 and its regulations require (re)insurers to meet a margin of solvency, as well as minimum amounts of paid-up capital for registration – the Regulatory Capital Requirement (RCR). This is calibrated based upon the scale of a (re)insurer’s business, with higher premiums and/or reserving levels requiring more statutory capital and surplus. No account is taken by the RCR of the fact that certain lines or classes of business are inherently riskier than others.
The Insurance Amendment Act 2008 now provides for a risk-based capital model as a tool to assist the BMA both in measuring risk and in determining appropriate levels of capitalisation. The Bermuda Solvency Capital Requirement (BSCR) employs a standard mathematical model that can relate more accurately the risks taken on by (re)insurers to the capital that is dedicated to their business. (Re)insurers may adopt the BSCR model or, where an insurer or reinsurer believes that its own internal model better reflects the inherent risk of its business, an in-house model approved by the BMA.
The BMA also enjoys a limited degree of discretion, enabling it to impose additional capital requirements on insurers in particular cases. In those cases, the new risk-based capital model should be supplemented by a requirement for the affected (re)insurers to conduct certain stress and scenario testing in order to assess their potential vulnerability to defined extreme events. Where the results of scenario and stress-testing indicated potential capital vulnerability, the BMA would be able to require a higher solvency ‘cushion’.
What makes these latest developments interesting, whether within the EU and
its member states or Bermuda, is the independent movement to establish a new yet similar risk-based capital model as a tool to assist supervisory bodies, both in measuring risk and in determining appropriate levels of capitalisation.
Tim Faries is head of the Insurance group at Appleby and Jeffrey Kirk is an associate in the Bermuda Insurance group