Sonjai Kumar is a Risk Professional with 24 years of experience in Life Insurance Sector focusing on Insurance, Risk and Actuarial. He is currently working at Aviva India Life Insurance Company.
Introduction
Strong Solvency of insurance companies is important for both the regulator and the policyholders. Financially strong insurance industry not only helps in increasing insurance penetration and economic growth but also help in building the trust of the people on the social security fiber of the country. Regulators over the time have made changes in the regulation to make insurance industry financially strong. The recent regulatory changes across the globe have led to determining solvency capital as a function of risks that insurance companies face rather than a simple formula. The article discusses how risk diversification and risk management helps in optimizing the solvency capital.
How the solvency position of the insurance companies is assessed?
Every insurance Company keeps reserves to meet the future liabilities that will arise in a form of death, maturity or surrenders and this is because annual level premium charged is not commensurate with incidences of expenses and claim arising. The reserves are kept based on prudential regulatory norms. However, regulators also prescribe additional money that the insurance companies must keep aside in a form of solvency capital to meet the contingency.
The history of keeping solvency capital goes back to 1973 when non-life insurance companies were asked to keep the solvency capital and later the same was applied to life insurance companies in 1979 in European Union (EU). The methodology of keeping the solvency capital was modified for life and non-life companies in the mid-1990s. Over the years, similar methodology is used in many jurisdictions including India.
However, during the economically turbulent times, the methodology used to identify such solvency capital has found to be inadequate exposing the limitations of this method leading to insolvency of insurance companies. This is because; the methodology used for such solvency capital calculation is based on a simple formula as a factor of reserve and a factor of the sum at risk. This method does not directly consider how much risk an insurance company is taking.
For example, two life insurance companies of similar size and shape will keep similar solvency capital even if one of them is managing their risks better. However, in reality, those companies that manage their risks better have lesser chances of failing compared to the one where risks are not properly managed. Therefore, the companies that manage their risks better, should ideally hold lesser solvency capital compared to the one where risks are not well managed. But the formula does not allow such benefits to the insurer.
This solvency capital directly comes from the shareholders, so shareholders bear the cost of locking this money which otherwise could have earn higher return. Therefore, shareholders would like to lock lesser solvency capital; while regulator would like to have strong solvency position, that is, higher solvency capital. This is a dichotomy between the shareholders and regulators.
To address this twin problem, many jurisdictions such US, Canada, EU, many of the Asian economies such as Singapore, China, Philippines, Sri Lanka have moved to the solvency capital regime, where the capital will be allocated based on how much risk an insurance undertake. In EU, this is called, Solvency-II regime while in other jurisdictions this is called Risk Based Capital or in short RBC. Some jurisdictions in Asia are moving to the second phase of RBC, which they call, RBC2 such as in Singapore and Philippines.
India, on the other hand, is currently following the traditional approach of allocating the solvency capital which is based on the formula approach. However, the regulator has taken some steps in this direction such as bringing risk management, the disclosure of financials on their website, Corporate Governance etc which is part of RBC regime.
What is Risk Based Capital?
Risk based capital is calculated based on how much risk is taken by the insurance companies as opposed to using a standard formula. The Higher risk would require higher capital requirement and vice versa. One of the benefits of using risk based capital is as risks are correlated; the benefit of risk correlation is passed to the insurance companies. Further, as the risk capital is based on how much risk an insurance company takes, so better risk management also optimizes the capital.
The risks used on a broad term in a life insurance company to quantify the risk capital broadly fall into insurance risk, financial risks, operational risk, credit risk etc. The components of insurance and financial risks are:
- Insurance Risk
- Mortality risk
- Lapse Risk
- Expense Risk
- Financial Risk
- Interest rate risk
- Equity Risk
- Foreign exchange risk
- Spread risks
Risk Capital Calculation methodology is based on Statistical distribution uses the measure of Value at Risk (VaR) defined as the maximum loss that an insurance company can suffer in a given time frame and within a certain confidence level. There are two methods of calculating the risk based capital, one is an internal model approach where Value at risk (VaR) is 99.5th percentile value of loss due to each risk and second is Stress testing or which is based on value of Assets and Liabilities once calculated on base assumption and again calculated on Stressed assumption. The difference between the two is the risk based capital for a particular risk. The stressed assumption is equivalent to 99.5% confidence level for each risk “r” or at any other desired level of confidence.
For example, if 7% interest rate is a base assumption and as an example, 5% down stressed assumption at 99.5% confidence level, then the risk based capital will be calculated as the difference between the value of assets and liabilities calculated at 7% and 5%.
Risk Diversification
The total risk capital is not just the sum of all the individual risk capitals because many of the risks are correlated, for example, Interest rate risk and lapse risks are correlated, lapse risk and mortality risks are correlated, longevity risks are mortality risks are correlated. The benefit of these correlations reduces the risks from the sum of all the risks capital. What does this means, if lapse rate increases, this leaves the portfolio with sub standard lives, as good lives have lapsed their policies because they know their health is better and do not require insurance, the remainder of the portfolio likely to exhibit the worse mortality experience compared to what was originally anticipated.
The advantage of correlation allows companies choosing risks where the correlations are either negative or close to zero. This allows reducing the overall risk capital because the increase in one risk reduces the other risk or do not increase the other risk at a linear rate. For example, mortality and longevity have negative correlation of -0.25, this means that if the portfolio has term products and annuity products, the overall risk of the portfolio will reduce because any increase in mortality rate will reduce the annuity payouts.
This is now understood that the risk capital allows benefits of risk choice to the insurance companies which was not available when the solvency capital was calculated using the formula approach. Another advantage of risk based capital is better to risk management which helps in reduction of capital.
What is Risk Management?
The risk is an uncertainty that can derail meeting the objectives of the company and Risk Management enable meet Company’s objectives by finding the mitigating action to address the risks. In the risk management process, the first step is risk should be identified which can impede meeting the objectives, for example, if a life Company is planning to enter into the annuity business and they do not have any prior experience in manufacturing and selling annuity business, the key risk is, they may not able to achieve the objective of selling required number of annuity business leading to resulting loss.
Therefore, the shareholders will not able to get the return on the solvency capital that they have locked this new line of annuity business. This may happen due to lack of resources, lack of selling skills, system requirement, lack of understanding of the products, management of the longevity risk etc. If the key risks and its sources are not identified properly, its action plan can never be prepared. For every risk identified, the life company must prepare an action plan to address the risks. The action plan could be hiring right professionals who have already dealt in the past with the annuity business. They can also take a help from the reinsurance companies who have experience in annuity business, training to the sales staff could be given to addressing the annuity selling skills. Such mitigation plan may help in achieving the business objectives of selling profitable annuity business and thereby providing desired return to the shareholders.
Risk management not only helps in managing the risks better, but it also helps in taking a good Risk Based Decisions by identifying good risks, knowing whether the new risks are strategic fit or not within the business and whether it adds value to the Company or not. For any new initiative, if the risk-adjusted return on Capital (RAROC) exceeds the cost of equity capital, the initiative will add value to the business. This is one guide can be taken while taking the risk based decisions. Other measures that are often used are whether the new initiatives are within the defined risk appetite or not and if the Company is accepting any risk that is outside the risk appetite should be properly justified by the management to the Board.
How India stands on this front?
As mentioned above, solvency capital in the insurance sector in India is currently calculated using the formula approached or also called solvency-1 approach. Risk management under this method allows second order benefits to the shareholders because, the capital is not directly risk based, however, risk management does help in developing the risk culture, reducing the early and fraudulent claims, improving the persistency of the Company, keeping expense within budget etc. All these efforts help in improving the profitability of the Company and thereby adding the surplus in the insurance Company’s kitty to improve the solvency. In order to bring more rigors into the risk management sphere, the Indian insurance regulator, have enhanced the risk management domain by making the Chief Risk Officer’s position in all insurance companies as key positions; have revised the corporate governance guidelines to bring strengthen the risk management committees, responsibilities of Board members have been enhanced, mandatory disclosure of all financials on the Company’s website etc. These efforts will help the insurance companies in India to develop risk management culture and prepare for the risk based capital regime.
Final word
There is a global effort in providing more social security, peace of mind and strong financial system to help the people, in general, to take benefits of insurance products to meet uncertainties of life. The change in the solvency regime expected to make the insurance sector stronger. This, however, likely to bring some challenges to the insurance industry which they need to gear up to handle the challenges. Risk management in this new frontier will play a key role in the success of capital and profit optimization; it would be good for the insurance players in India to enhance the risk management skills as currently, there is a lot of gap in demand and supply. However, beware of a black swan.
Author
Sonjai Kumar
Vice President (Business Risk) | Aviva India
D: +91-(0)124-2709133 | M: +91-9810389622, +91-9971529922
E: Sonjai.Kumar@avivaindia.com
