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Understanding Insurance Regulation

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Understanding Insurance Regulation UNDERSTANDINGMove Over ILS? INSURANCE REGULATIONThe Rise and Rise of PriDe And Its Many Forms January 2020 @assetcohen @cohen-and-company-asset-management cohenandcompany.com TABLE OF CONTENTS 1 Introduction 2 2 Insurance - Why Does it Need Regulation? 3 3 A Deeper Dive 5 3(i) Solvency II SCR 6 3(ii) NAIC’s Risk Based Capital (RBC) 8 3(iii) Bermuda Solvency Capital Requirment (BSCR) 12 3(iv) AM Best’s Capital Adequacy Ratio 15 4 Insurance Failure 17 5 Insurance Industry Performance: An Investment Perspective 18 6 Cohen & Company 19 1 INTRODUCTION When ancient Egyptian, Indian, Greek, Roman and other civi- lizations existed, so too did a form of regulation of business- es. To an extent, standardized weights and measures existed in the ancient world in the form of business norms and customs. Insurance, in some form, dates back to ancient times, too. Chi- nese and Babylonian traders had methods to distribute risk in the second and third millen- nia B.C., with the first known written insurance policy carved in the Babylonian obelisk mon- ument known as the Code of King Hammurabi. The ancient law states that in the event of some impossible personal circumstance, such as a flood or a disability, a debtor did not have to pay back his loan. In today’s modern world there is an ever-increasing number of complex regulations that vary by jurisdiction. This paper does not explore whether regulation helps or hinders business but instead focuses on some of the insurance industry’s regulato- ry bodies, its dedicated rating agency and the differing ap- proaches to capital adequacy. 3 2 INSURANCE - 2 WHY DOES IT NEED REGULATION? Insurance is an atypical busi- ness in that the product is priced and sold before the cost of the goods (i.e. the size of po- ““Capital requirements prescribe the tential claims) is known. A pol- minimum amount of capital that (re) icy is written and a premium is collected but a claim might not insurance companies must hold. They arise for months or even years, differ by regulatory body and by rating if at all. Given this, how does agency. Capital requirements are based a consumer know if an insur- ance company will have enough on a formula that takes into account the money and remain in business type of business being written and gen- to satisfy a claim? Regulation by governments and minimum erally are recalculated at least annually capital level requirements as by regulators and rating agencies.” well as ratings help consumers and the financial markets de- termine the financial strength and level of performance of (re)insurance companies. ” Capital requirements prescribe the minimum amount of capi- tal that (re)insurance compa- Dan Bauer, nies must hold. They differ by Credit Analyst regulatory body and by rat- Cohen & Company ing agency. Capital require- ments are based on a formu- la that takes into account the type of business being written and generally are recalculated at least annually by regulators and rating agencies. For regu- lators, there are various “hard” and “soft” floors representing a tiered approach to regulato- ry intervention that is designed Greg Reisner, to rehabilitate a distressed in- Head of US Insurance Analytics Cohen & Company surance company or, if neces- sary, wind down a business in an orderly fashion. For rating agencies, breaching capital requirements often results in downward pressure on a rating. 3 Fundamentally, capital require- ments imposed by regulators and credit rating agencies are formula-based models that seek to achieve similar goals. Insurance companies face pri- mary regulation by a local reg- ulator and secondary regulation by way of scrutiny and surveil- lance by rating agencies. The rating agencies’ rating opinion carries a significant amount of influence in the market. In the U.S. market and Bermuda mar- ket (which largely targets U.S. business), the rating agency, AM Best, is often referred to as the “de facto regulator” since an AM Best rating is a near-ne- cessity for an insurance com- Cohen & Company is a fi- pany to operate successfully nancial services company in many lines of business. Fre- quently, insurance market par- founded in 1999 as a pri- ticipants look for a rating of vate investment firm fo- “A-“ or better in a counterpar- cused on small-cap finan- ty. Also worth noting is the fact cial institutions. Over time, ence when it comes to under- that credit rating agencies’ cap- Cohen & Company’s focus ital requirements are generally standing the insurance indus- shifted to debt financing considered to be more conser- try and its U.S. PriDe Fund and securitization, and vative than minimum regulatory seeks to invest in debt capi- requirements, and greatly in- now focuses primarily on tal instruments (senior debt, fluence how management teams asset management and subordinated notes, TruPS, of rated (re)insurance compa- niche segments of fixed nies operate their business. and surplus notes) issued by income trading. Cohen & small and mid-sized insurance Company has deep expe- or reinsurance groups (stock rience when it comes to companies, mutuals, etc.) or understanding the insur- their holding companies lo- ance industry and debt cated primarily in the U.S. capital instruments (se- and Bermuda. nior debt, subordinated notes, TruPS, and surplus notes) issued by small and mid-sized insurance or re- insurance groups (stock companies, mutuals, etc.) or their holding companies located primarily in the U.S., Europe and Bermuda. 55 4 3 A DEEPER DIVE As noted above, the various in- surance regulatory regimes and credit rating agencies impose different capital requirements. This paper will explore the Eu- ropean Union’s Solvency Capital Requirement (SCR), the United States’ National Association of Insurance Commissioner’s Risk- Based Capital (RBC), the Bermu- da Monetary Authority’s Solven- cy Capital Requirement (BSCR) and AM Best’s risk-based capital model, Best’s Capital Adequa- cy Ratio (BCAR). Although AM Best has no regulatory author- ity, it is the only global cred- it rating agency exclusively fo- cused on the insurance industry and the organization is viewed to be an authoritative voice on the financial strength and reg- ulatory compliance of insur- ance companies, particularly in the U.S. and Bermuda markets. 5 SOLVENCY II’S SCR EUROPEAN UNION TERRITORIES The SCR is a formula-based calculation calibrated to ensure that all quantifiable risks are consid- ered, including underwriting, market, credit oper- ation and counterparty risks. The SCR is part of the Solvency II Directive issued by the European Union. The directive aims to coordinate the laws and regulations of EU member states with respect to the insurance industry. However, it is worth noting that if an EU member state’s local regula- tor determines that the SCR does not adequately reflect the risk associated with a particular type of insurance, the local regulator can increase the capital requirement imposed. 6 The SCR is set at a level to ensure that (re)insurers can meet their obligations to policyholders and beneficiaries over a 12-month period with a 99.5% probability. The formula takes a modular approach, meaning that the individual exposure to each risk category is assessed and then aggregated with the other risks. The EU Solvency II Directive designates three pillars, or tiers, of capital requirements. Pillar I covers quantitative require- ments, i.e. the amount of capital an insurer should maintain. Pillar II establishes requirements for the governance, supervi- sion and risk management of insurers. Pillar III imposes dis- closure and transparency requirements. In addition to the SCR, a minimum capital requirement (MCR) must also be calculated. The MCR represents the threshold below which a regulatory agency will intervene. The MCR is intended to achieve an 85% probability of capital adequacy over a one-year period. For regulatory purposes, the SCR and MCR calculations can be considered “soft” and “hard” floors, respectively. That is, a tiered intervention process applies once the capital held by a (re)insurance company falls below the SCR, with intervention becoming progressively more in- tense as the company’s capital holdings approach the MCR. The Solvency II Directive provides regional regulators with a number of options to address breaches of the MCR, includ- ing the complete withdrawal of authorization from selling new policies and forced closure of a company. 6 7 NATIONAL ASSOCIATION OF INSURANCE COMMISSIONER’S RISK BASED CAPITAL (RBC) UNIteD STAteS Insurance company regulation in the United States is at the state level with each state ap- pointing its own Insurance Commissioner to set policy. However, there is increasing centraliza- tion on the federal level with respect to certain core issues via rules established by the National Association of Insurance Commissioners (NAIC). Capital requirements in the United States are calculated pursuant to risk-based capital (RBC) formulas established by the NAIC . These RBC formulas focus on asset risk, underwriting risk, and business specific risks although the empha- sis on each of these risks differs from one for- mula to the next and not every risk exposure of a company will be captured by the applicable formula. Each formula focuses on the material risks that are common for a particular insurance type. For example, interest rate risk is included in the Life RBC formula because the risk of loss- es due to changes in interest rates is a material risk for many life insurance products. 8 Under the RBC system, state regulators have the au- thority and statutory mandate to take varying preven- tive and corrective measures depending on the capital deficiency indicated by the applicable RBC calculation. These preventive and corrective measures are de- signed to provide for early regulatory intervention to correct problems before insolvencies become inevita- ble, thereby minimizing the number of insolvencies in the insurance industry.
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