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Monitoring Insurer Solvency

This article explains why we need solvency measures for insurers, what those measures are, how the new ISS is changing them and how the new measures should be interpreted.

Adrian Allott

Summary

This paper explains why we need solvency measures for insurers, what those measures are, how the new ISS is changing them and how the new measures should be interpreted.

Insurers are required to have capital in excess of their liabilities so they will be able to pay claims to customers - even in adverse circumstances. Regulators such as the Reserve Bank establish this capital requirement in proportion to the risks the insurer faces.

Stakeholders have an interest in monitoring the financial strength of their insurer to, among other things, assess the likelihood that it will meet its obligations to customers.

The ISS values solvency capital on an economic basis, as opposed to the more conservative hybrid basis used by our current solvency standards. The PCR is determined by modelling a set of stresses on the insurer, and subtracting the economic value of assets and liabilities from their stressed value. The solvency margin is the amount of solvency capital that would remain after the stress, and the solvency ratio is the solvency capital divided by the PCR.

Due to the introduction of the ISS, solvency margins are expected to generally decrease as the operational risk charge is phased in. Solvency ratios are also expected to drop due to the move to economic value basis. There will also be idiosyncratic effects dependent on insurers’ business and risk profiles. Solvency margins and ratios under the ISS are not directly comparable to those under pre-existing solvency standards.

While margins and ratios will change, there is no change in the financial strength of insurers, just in the way the ISS expresses that financial strength.

At a high-level, solvency ratios can be interpreted as follows:

Solvency ratio < 0% 0% < ratio < 100% 100% < ratio < target Ratio > target
Insurer status In wind-up In distress; possibly in wind-up Needing capital Dividend-paying or re-investing

Care needs to be taken in considering solvency ratios, however, as companies with similar ratios can have quite different outlooks due (non-exclusively) to their capital model, balance sheet structure, profitability, business model and stage of maturity.

Readers should also note that the ISS is interim in nature. The Reserve Bank is about to commence stage 2 of its review of the solvency standards. This is a deep-dive into the methods and parameters used in the standard and will result in a ‘final’ standard, to be issued in a few years from now. At this time, further change in solvency measures can be expected.