In this episode of “The Standard Formula” podcast, partners Rob Chaplin and Patrick Lewis are joined by Neil Horner of Bermuda-based ASW Law to discuss and contrast EU/UK Solvency II, U.S. risk-based capital and the Bermuda solvency capital requirement, as well as equivalent rating agency requirements.
In its simplest form, a prudential solvency regime is designed to ensure insurance policyholders are compensated while allowing insurers to remain competitive and not unnecessarily over-capitalized. The three most significant prudential solvency regulatory regimes globally are Solvency II in the EU and U.K., U.S. risk-based capital (RBC) and the Bermuda Solvency Capital Requirement (BSCR).
There are commonalities among the regimes, and they all reflect three main elements: companies need to be conservative in their estimate of liabilities; calculations need to force insurers to invest in assets with an appropriate liquidity and risk profile; and companies must finance an excess of such assets with sufficient capital. Applying each of the requirements alongside real-world complexities often presents a challenge to insurers when looking at each company’s individual business practices.
New York-based Skadden partner Patrick Lewis and Neil Horner of ASW Law in Bermuda join host Robert Chaplin to review and compare the various regimes.
- Understanding Solvency II
- Regulation in the U.S.
- Credit ratings are particularly important for Bermuda insurance industry
From Skadden, the Standard Formula is a Solvency II podcast for UK and European insurance professionals. Join us as Skadden partner Robert Chaplin leads conversations with industry practitioners and explores Solvency II developments that matter to you.
Rob Chaplin (00:18):
Welcome to the third episode of our Standard Formula podcast. Today, we're going to be looking at three of the most important prudential solvency regulatory regimes in the world, EU and UK Solvency II, US Risk-Based Capital, or RBC, and the Bermuda Solvency Capital Requirement, or BSCR. We'll also touch on Credit Rating Agency, or CRA, requirements, as the agencies are rightly viewed as also imposing an additional defacto floor on many insurers.
I'm Rob Chaplin, one of the insurance partners at Skadden based in London. I'm delighted to have with me today my fellow insurance partner, Patrick Lewis from our New York City office, and Neil Horner, from ASW law in Bermuda, who we routinely work with on Bermuda related matters. So Patrick, before we plunge into the detail, just remind us what prudential Solvency regimes are trying to achieve.
Patrick Lewis (01:21):
Well Rob, at its simplest, any prudential Solvency regime is there to help ensure that policyholders get paid. No prudential regime is intended to be a zero risk system, as that would mean the amount of capital that insurers had to hold would be prohibitive and that would in turn make insurance unaffordable. So it's a question of carefully calibrating the regime to ensure that the risk of non-payment is sufficiently low, while insurers remain competitive and not unnecessarily over capitalized. I should add that the conversation with insurers is inevitably more complicated than simply minimum capital requirements or compliance with applicable hard rules. It's always the case that on the one hand, insurers don't want to be so close to the minimum floors that they could slip through it, with all the consequences that flow on from that. And on the other hand, regulators have soft requirements that can be very considerably higher than the bare minimum. So Rob, tell us about EU and UK Solvency II.
Rob Chaplin (02:28):
Thanks, Patrick. Well, I guess the obvious thing to start with is to ask whether there's any difference between EU and UK Solvency II. Right now, the answer is virtually nil. Essentially such differences as there are come from the way in which the EU Solvency II was originally implemented in the UK. We now have implementation pending of the Solvency II reforms, which were announced last autumn and were the subject of our first podcast, which is available on skadden.com. In practice and like many, we do wonder whether the reforms will make much difference in practice. For example, we suspect that much of the potentially a hundred billion pounds of risk margin release may well get trapped through the new powers of the UK prudential Regulatory Authority and its new rules regarding matching adjustment. We did wonder if the UK government might do something truly radical, like create special regulatory and tax regimes for re-insurers above a certain size, which matched those in Bermuda like for like, which would've been a complete game changer, but the government didn't grasp the nettle.
So how does the Solvency II regime work? Well, like any prudential Solvency system, it's a stack of requirements. First, you must have enough reserves to cover the best estimate of liabilities or BEL, which is essentially an assessment of the present value of reserves you need to cover all claims in the future with no margin of prudence or optimism. Second, you must cover a risk margin. Third, you must hold enough capital to cover your solvency capital requirement, or SCR. The risk margin is an assessment of the cost of the capital required to fund the SCR over its lifetime. The only element of these three which is truly capital is the SCR, as new liabilities coming into the BEL should ordinarily be covered by ongoing premium income, and assuming the cost of capital in the risk margin is correct itself a controversial topic, you would expect to spend the existing risk margin and pay out the existing reserves.
So for today's purposes, it's right to focus on the SCR. Fundamentally, the SCR is an assessment of the capital required to ensure that the insurer can meet its policyholder liabilities with a 99.5% certainty over a 12 month period. Insurers can use a prescribed standard formula to calculate the SCR, or with the agreement of the national regulator, an internal model, which is a bespoke formula developed by the insurer. The regulator may require the use of an internal model for complex or unusual insurers and may increase the standard formula SCR if it feels that's inadequate. The SCR itself is broken down into a series of modules. Essentially, what it's trying to do is ensure that all quantifiable risks are covered. At a glance, the modules cover non-life, life and health underwriting, market risk, counterparty default risk, intangible assets and operational risk. Adjustments are made for the loss absorbing capacity of the technical provisions and defer taxes.
A term you hear often is the solvency ratio. The solvency ratio is simply the eligible amount of capital or owned funds the insurer has divided by its SCR. You also hear the term minimum capital requirement, or MCR. The MCR is a lower trigger level for regulatory intervention set at an 85% rather than 99.5% level. If you go down through the MCR, then the regulatory intervention is much harsher than for an SCR breach. Another jargon point is solo versus group SCR. The solo is for the insurer itself, and the group for the group of which the insurer forms part. Thus recognizing that companies enjoy benefits, but also can suffer detriment from being part of a group. That's a very quick canter through Solvency II. Patrick, tell us about RBC.
Patrick Lewis (06:52):
Thank you, Rob. Of course, the first thing to note is that insurance regulations in the US are at the state level. Each state has its own insurance commissioner who's in charge of the rules of that state. The insurance commissioners then come together in the National Association of Insurance Commissioners, or NAIC. The NAIC sets out template rules, which state commissioners can adopt, these rules prescribe the Risk-Based Capital, or RBC regime. This effectively means that there's a more centralization these days at the federal level on what the court rules are, although not all states have adopted the model rules. Just like the solvency ratio for Solvency II, you hear the term RBC ratio. This is essentially the same concept, the eligible total adjusted capital of the insurer divided by the level of its RBC. Again, like Solvency II, the system works by prescribing regulators to take increasingly strict preventative and corrective measures as the company's solvency position decreases. Again, this is about policyholder security.
Falling below each level of these different levels require action by the company, the regulator, or both. There are four levels. First, there's the company action level, which is at an RBC ratio of 200%. At this level, the insurer has to submit a corrective action plan to the regulator. Second, there's a regulatory action level, which is an RBC ratio of 150%. At this level, the insurer must submit an action plan. Third, there's the authorized action level, which is an RBC ratio of 100%. At this point, the regulator has the option of taking over the management of the company. Fourth and finally, there's the mandatory action level, which is an RBC ratio of 70%. The regulator is then required to take over management of the company. Typical management actions that an insurer might take in these situations are the raising of capital, writing less new business, doing a back book deal to raise capital, changing its asset mix, or selling assets or even itself.
So what are the risks that the RBC system looks at? Again, these can be divided into four buckets. There's asset risk, which looks at the default risk and risks that value may fall, credit risk, which captures the risk of default by policyholders, re-insurers and debtors, underwriting risk, which measures the risk from underestimating insurance liabilities, and finally, off balance sheet risk, which looks at the risk from excessive rates of growth, contingent liabilities or other items not on the balance sheet. The formula works on a square root basis, which means some diversification benefit is reflected, analogous to both Solvency II and BSCR, which both take into account diversification.
Lastly, it should be noted that health, life, and property and casualty insurers each have specific RBC requirements to reflect their specific risks. In short summary, the life RBC includes asset risk, insurance underwriting risk, interest rate risk, business risk, and affiliate and other risk. The health RBC includes asset risk, insurance underwriting risk, credit risk, and business risk. The PNC RBC includes asset risk, credit asset risk, insurance underwriting risk, and catastrophe risk. Rob, I think that's probably enough on RBC for now. You can certainly see there are some common themes between RBC and Solvency II.
Rob Chaplin (10:45):
Thanks, Patrick. That's a really good point. The regulators haven't missed that and have reflected it in a concept called equivalence. Going into that is probably too much detail for today, but suffice to say that Europe and the UK have granted equivalence to Bermuda and provisional equivalence to the US. To cut a long story short, this means that they regard those solvency regimes as the same for the purposes of the Solvency II calculation and allows them with some further steps to conduct business in the EU and UK.
Let's move on to Bermuda and go over to Neil. Neil, it's great to have you with us today.
Neil Horner (11:24):
Thanks, Rob. It's great to be here. I will say some words about the Bermuda Solvency Capital Requirement, or BSCR. The regulator in Bermuda is the Bermuda Monetary Authority, the authority, or the BMA. Just like Solvency II, the BSCR requires companies to comply with the authority's standard BSCR model or an approved internal model. Once more, ratio is important, the BSCR ratio. This is obtained by dividing the available statutory economic capital and surplus by the BSCR. Another important ratio is the ECR ratio, which is calculated by dividing the available statutory economic capital and surplus by the Enhanced Capital Requirement, or ECR. Both these ratios assist the authority in evaluating the financial strength of a commercial re-insurer. Once again, there are two key floors, the Minimum Solvency Margin, or MSM, and the ECR, which is the higher of MSM or BSCR. The authority prescribes a target ECR cover of at least 120% of the ECR. The BCR is almost always more than the MSM in practice.
What I will say will not as a surprise, given what has been said on Solvency II and RBC. There are different categories of risk charge. The most important categories are fixed income investment risk, equity investment risk, which includes real estate investment risk, credit risk on reinsurance and accounts receivable, interest and liquidity risk, concentration risk, premium risk, reserve risk on adverse development, catastrophe risk, operational risk, and foreign exchange risk. The calculation is then done by multiplying the prescribed capital factor by a defined exposure blend.
Rob Chaplin (13:33):
Thanks, Neil. I'm conscious also that credit ratings are particularly important for the Bermuda insurance industry. Can you just say a few words on how the Credit Rating Agencies, or CRAs, approach their task?
Neil Horner (13:45):
Yes, Rob, with pleasure. What I will do perhaps is focus on a leading CRA, although the principles are similar for the others. This leading agency has its own calculation of capital adequacy, which is called its Capital Adequacy Ratio, or CAR. Like the other calculations we have described, the CAR reflects the relationship between an insurer's balance sheet strength and the financial risks it faces and guidelines for the net capital required. As we understand the position, however, CAR isn't the end of the assessment. The ECRA also looks at other matters such as liquidity, how good capital is, reliance on reinsurance and its quality asset liability matching adequacy of reserving, stress tests and group relationships. Operating performance, business profile and operating risks are also considered.
Rob Chaplin (14:47):
Neil, that's super. Thank you. Thank you once again to both Neil and Patrick for participating today. Let's try and draw this together. What I would say is you can really sum up prudential requirements as having three elements, and these are reflected in all the regimes we've talked about today. First, companies must be required to estimate their liabilities in a sufficiently conservative way. Second, the calculation should force insurers to invest in assets with appropriate liquidity and risk profile. Third, that companies must finance an excess of such assets with capital of a sufficient quality. Put that way, it does sound quite simple, although inevitably it's a lot more complex in practice. That takes us to the end of this episode of the Standard Formula podcast. We hope you found this episode useful. We look forward to you joining us next time.
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