Solvency Regulations in the Insurance Industry
In the previous article, we have explained why regulation is important for the insurance industry. We have also understood how the focus of regulation has changed from merely restricting prices to protecting the rights of the consumer. In this article, we will have a closer look at the solvency regulations i.e. the rules regulators create to ensure that insurance companies do not go bankrupt.
It needs to be understood that the financial services industry is a closed loop. Hence, bankruptcy of one company also ends up severely affecting the other companies. Hence, solvency is not the companys private matter. This is the reason why companies which manufacture goods and service do not have to follow regulations while utilizing their capital, while financial services like insurance companies have to!
The way insurance companies deploy the funds that they receive via premium is highly regulated. Some of the principles that form the basis of solvency regulation are as follows:
- Capitalization: Insurance companies in different countries are governed by different regulators. However, in each of these countries, there are rules and laws which restrict how much money an insurance company can invest. Insurance companies receive cash upfront but need to pay back the money when a claim is made. It is for this reason, they need to have adequate cash on hand to pay claims.
The question is what constitutes an adequate amount of cash. All over the world, regulators are the ones who determine the minimum capital that needs to be kept on hand in order to pay claims. Insurance companies are obligated to maintain at least the amount of cash specified by the regulator. Failure to do so can lead to fines, penalties and even disbarment in the long term.
It is the responsibility of the regulator to ensure that the rules are set in a fair and unbiased manner.
It is for this reason that the formula to calculate the minimum capital requirements needs to be same for all companies.
However, the formula does have factors such as size of the company, its current financial position and the riskiness of their investments. This is the reason why different companies may have different amounts that they need to maintain as minimum capital. In some countries like the United States, there might be different minimum capital requirements at state and the federal level. In such cases, federal laws supersede the state laws.
- Asset Quality: Insurance companies are also one of the biggest investors in the market. They collect premium from people and invest them in market traded securities. Prior to 2008, there was very little oversight regarding what assets insurance companies are holding.
As long as the asset was AAA+ rated by credit agencies, insurance companies were allowed to invest money in them. As a result, many insurance companies were left holding mortgage backed securities during the 2008 financial meltdown. This incident almost bankrupted AIG which sent alarm bells ringing as far as insurance regulators were concerned.
Ever since the AIG incident, insurance companies have now started taking more interest in where insurance companies invest their money. There are various limits and sub-limits regarding the asset classes where the money can be parked. The regulators want to ensure that some of the money is available in liquid form.
Hence, the mandate holding of some cash equivalents. Also, they want to ensure that all the money is not concentrated in few asset classes. This would expose the insurance company to unnecessary risk.
The very basis of insurance is risk diversification. As such, it is only understandable that insurance companies themselves would want to hold a diversified portfolio. The insurance regulators also keep an eye on risks such as interest rate risk and counterparty risks and ask the insurance company to change their asset portfolios accordingly.
- Reinsurance: Regulators across the world insist on the use of reinsurance in order to mitigate risk. These regulators provide incentives to the insurance company using reinsurance. For instance, when a company uses reinsurance, its capital requirement is reduced. As such, the company is left with more money which it can use to invest and earn a higher profit. This profit offsets the premium that needs to be paid for reinsurance. Hence, insurance companies can offload a big chunk of their liabilities at a very low cost.
The regulators ensure that there is genuine pooling of risks via reinsurance. This means that they have rules to check that the reinsurance is not being done by an overseas branch of the same company. Also, the regulators want to ensure that the risk is not contained within the same country. This is the reason why regulators insist that some of the risk be transferred to overseas companies. However, it is also the job of the regulators to ensure that these overseas companies are financially stable to take on the risk.
- Liquidity: Regulators across the world want to ensure that insurance companies are always in a position to pay a claim if the situation arises. This is the reason why they ask insurance companies to keep aside some of their money in investments which can be easily liquidated if the need be. If investments are parked in illiquid assets, it can trigger the insolvency of an insurance company even though they do have the assets.
|❮❮ Previous||Next ❯❯|
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Risk Management - Introduction
- Benefits of Risk Management
- Principles of Risk Management
- Risk Management Process
- Risk Identification and Assessment
- Aspects of Risk Management
- Steps in Risk Management Process
- Approaches to Risk Management
- Risk Management Policy
- Commonly Used Measures of Risk
- Risk Management Plan
- Evaluation of Risk Management Plan
- Risk Treatment
- Role of HRD in Risk Management
- Enterprise Risk Management
- Implementing ERM
- Risk Management and Stock Market
- Outsourcing Risk Management Program
- Risk Management as a Profession
- Anticipating and Mitigating Organizational Risks in the Digital Age
- Challenges Facing the Australian Economy
- The Economic Costs of MeToo
- Automated Claims Processing
- Challenges in Global Insurance And International Claims
- Conflicts of Interest in the Insurance Business
- The Cost Structure in the Insurance Industry
- How Drones Will Impact the Insurance Industry?
- How Is Health Insurance Funded?
- How Self Driving Cars Impact Insurance?
- How Stock Market Volatility Affects Insurance Companies?
- Insurance Agents vs. Insurance Brokers
- The ABCs of Insurance Fraud in India
- Technological Advances in the Insurance Industry
- The Basics of Unemployment Insurance
- The Pros and Cons of Unemployment Assistance and Why it Matters in the Present Times
- The Role of Insurance In #MeToo Movement
- Why the Flood Insurance Market should be Privatized?
- Basics of Pet Insurance
- Cannabis Insurance
- Challenges Facing Cryptocurrency Insurance
- Evolution of Insurance Regulation
- Food Delivery Apps and Insurance
- How Does Captive Insurance Work?
- On-Demand Insurance
- Reinsurance vs. Double Insurance
- Solvency Regulations in the Insurance Industry
- Terrorism and Insurance
- The Basics of Microinsurance
- The Basics of Reinsurance
- Types of Captive Insurance Companies
- What is P2P Insurance?
- How Risks Affect Companies Providing Financial Services
- Risk Management Information System
- Disadvantages of Risk Management Information Systems
- The Known-Unknown Classification of Risk
- Operational Risk: Definition and Drivers
- How Regulations Have Affected Operational Risk?
- Identification of Operational Risks
- How to Identify Operational Risks
- Using Internal Loss Data to Mitigate Operational Risks
- External Loss Data in Operational Risk Management
- Risk Control Self Assessment (RCSA)
- Scenario Analysis in Risk Management
- Key Risk Indicators
- Basel Approaches in Operational Risk Management
- The Basel Risk Categories
- Cause Categories in Operational Risk Management
- Loss Distribution Approach
- The COSO Framework for Internal Control
- Mistakes to be Avoided While Building a Risk Management System
- Credit Rating Terminology
- Types of Exposures to Determine Credit Limit
- Types of Credit Events
- Active Credit Portfolio Risk Management
- Metrics to Measure Credit Risk
- Credit Derivatives: An Introduction
- Credit Linked Note
- How do Credit Default Swaps Work?
- Why are Credit Default Swaps Dangerous?
- Total Returns Swap
- What are Collateralized Debt Obligations and How do they Work?
- Collateralized Debt Obligations: Advantages and Disadvantages
- Mark To Market Accounting
- What are Recovery Rates? - Different Types of Recovery Rates
- Netting, Close Out, and Acceleration
- Expected Default Frequency (EDF)
- Expected Default Frequency: Advantages and Disadvantages
- Altmans Z Score Model
- Unexpected Loss and Economic Capital Buffer
- Stress Testing in Credit Risk Management
- Provisioning in Credit Risk Management
- How Corporate Governance Impacts Credit Risk
- Exit Strategies In Credit Risk Management
- What is Market Risk? - How its Measured and Sources of Market Risk
- Why is Market Risk Management Important?
- Introduction to Value At Risk (VaR)
- The Three Types of Value at Risk (VaR)
- Marginal, Incremental and Component Value at Risk (VAR)
- How Value at Risk (VaR) is Implemented?
- Backtesting Value at Risk (VaR)
- Advantages of Using Value at Risk (VaR) Model
- Disadvantages of Using the Value at Risk (VaR) Model
- How Margins Are Calculated Using Value at Risk (VaR)
- Market Risk Limits
- Tail Risk
- The Upside of Market Volatility
- Relationship between Volatility and Risk
- Importance of Data Quality in Risk Management
- Impact of Using Poor Quality Data and Metrics to Measure Data Quality
- Enterprise Risk Management (ERM) vs Traditional Risk Management
- Benefits of Enterprise Risk Management
- Corporate Risk Governance
- International Risk Governance Committee (IRGC) Framework
- Failure of Market Risk Management
- Mistakes to Avoid in Risk Management