Changes to the Japanese solvency regime
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- Alicia Phillips
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1 Changes to the ese solvency regime The ese Financial Services Agency (FSA) has been reviewing the current risk-based capital (RBC) solvency framework, with the stated aim of improving insurance companies risk management practices and overall financial condition. In the recently published RBC rule revisions the FSA explained that it took into account lessons learned from recent insurance company insolvencies and the global financial crisis. The revised requirements will officially take effect from the statutory closing as of March 31, 2012; however, all insurance companies in were also required to calculate and disclose their solvency margin ratios as of March 31, 2011, based on both the current and the new rules. The revised requirements apply to life and casualty insurance companies, but not to niche small amount and short-term insurers 1. As part of its effort to enhance the reliability of the Solvency Margin Ratio, the FSA has further restricted the assets that can be used for solvency margin purposes (i.e., the numerator of the ratio), while at the same time has broadened the measurement of solvency risks (i.e., the denominator of the ratio). (1) Stricter rules for solvency margin component inclusion Introduction of core margin to limit the use of statutory reserve components (such as premium reserve in excess of cash value) and subordinated debt in the solvency margin Limited inclusion of deferred tax assets in the solvency margin 2 Elimination of the future profits 3 from the solvency margin Limited inclusion of the tax effect equivalent 4 (2) Stricter and more sensitive solvency risk measurement The confidence level on which the risk factors are based on is raised from 90% to 95%. The risk factors are updated based on the latest financial market source data. In calculating the diversification effect for the price fluctuation risk, the specific asset portfolio of each insurance company is considered under the revised requirements. Under the current rules, a constant diversification effect of 30% risk reduction was applied for all insurance companies. Recognition of risk reduction due to hedging requires proof of hedge effectiveness. Credit risk factors for securitisation products, re-securitisation products are to become stricter. Credit spread risk for credit default swaps is introduced. Definition of the minimum guarantee risk for variable annuities and variable life products is revised. Under the new requirements, it is calculated as the amount of increase in minimum guarantee reserve under the assumption of prescribed immediate asset depreciation scenarios. (3) Related changes Appointed Actuary s responsibility has changed to include review of the calculation of the Solvency Margin Ratio. The upper limit of the Price Fluctuation Reserve is revised.
2 Milliman Asia e-alert 2 Tables 1 to 3 summarise the Solvency Margin Ratio, Total Solvency Risk, and Adjusted Solvency Capital results as at March 31, Total results include all the 47 life insurance companies currently operating in, including Kampo Life. The tables also show the subtotal results of the following four groups: Group 1: 11 domestic traditional ese life insurance companies Group 2: 6 life insurance companies as subsidiaries of non-life insurance companies Group 3: 17 foreign affiliated life insurance companies Group 4: 13 other life insurance companies such as variable annuity (VA) manufacturers and other recently established companies As the valuation date used was March 31, 2011, the results reflect some of the impact of the Great East Earthquake that struck 20 days earlier. In particular, the decline of equity values due to the earthquake was reflected in the Adjusted Solvency Capital shown in Table 3. Table 1: Change in Solvency Margin Ratio as of March 31, 2011 Table 2: Change in Total Solvency Risk as of March 31, 2011 Table 3: Change in Adjusted Solvency Capital as of March 31, 2011 The tables highlight the following: Total Solvency Margin Ratio (Table 1) decreased significantly from 1147% to 673% (the minimum required solvency margin ratio remains the same as the current 200% under the new rules). Adjusted Solvency Capital (Table 3) was reduced due to newly introduced core margin requirements. Interest Crediting Risk (Table 4) increased by 155% in aggregate. Asset Risk (Table 4) increased by 63% across the industry. We also identified the following differences among the groups: Table 2 shows Total Solvency Risk increases most in Group 1 (68%) followed by Group 3 (60%). Table 4 shows this is driven by the larger proportion of Asset Risk, probably caused by the risk factor for domestic stocks having doubled from 10% to 20%. Table 2 shows Total Solvency Risk increase is smallest in Group 4 (27%). This comes from the fact that Minimum Guarantee Related Risk, which decreased by 21%, contributes a larger proportion of Solvency Risk for this group. This result seems reasonable, as Group 4 includes variable annuity manufacturers. October 3, Milliman, Inc. All Rights Reserved
3 Milliman Asia e-alert 3 Table 4 shows Interest Crediting Risk increasing most in Group 2 (199%). We believe that Group 2 companies have a relatively larger proportion of in-force business lines where the risk factors were raised significantly. Table 4 shows the components of Total Solvency Risk included in Table 2. Table4: Breakdown of Solvency Risk as of March 31, 2011 The above adjustments to the RBC framework were a short-term response from the FSA to the current financial position of the ese insurance industry. However, in the long run, the regulator is planning fundamental structural changes to the solvency framework in. In fact, taking into account global trends in solvency regulation and discussions within the International Association of Insurance Supervisors (IAIS), the FSA is considering the introduction of a solvency framework based on economic value. As a first step, the FSA conducted field tests to identify potential practical hurdles that ese insurance companies may encounter in calculating liabilities on an economic value basis. 5 All the life and casualty insurance companies operating in participated in these field tests, which lasted for seven months starting in June Several key points of the field test are as follows: Insurance companies were asked to calculate the value of insurance liabilities based on economic value and to measure interest rate risks. Calculation methods and interest and other assumptions were prescribed by the FSA. Details of the assumptions were not publicly available. The value of insurance liability based on economic value was defined as the present value of cash flows plus claim reserves plus risk margin. The calculation method of risk margin to be used was the cost of capital method. Risk factors were based on a 95% confidence level. October 3, Milliman, Inc. All Rights Reserved
4 Milliman Asia e-alert 4 There was also a survey regarding the use of internal models. The high level results of the field tests were released on the FSA s website in May and are summarised below. It is important to note that the results of individual companies were not made public. The total economic value of life insurance liabilities in was about JPY260 trillion, which was slightly smaller than the current statutory value of insurance liabilities. In interpreting the results, it is important to consider the fact that ese statutory reserves are fairly conservative, in that typical interest, mortality and morbidity bases include prudent margins, while a net level premium reserving method is used with acquisition costs not deferred. In addition, under the current requirements, additional reserves must be recognised where the Appointed Actuary determines that the premium reserves are insufficient through cash flow tests performed as part of their review. The total economic value of casualty insurance liabilities in was about JPY18 trillion, which was slightly smaller than the current statutory value of insurance liabilities. The economic value of IBNR, as part of claim reserves is tentatively assumed to be the same as the current statutory amount. Care must be taken in interpreting the above results, as they are likely to change materially depending on the calculation methods and underlying assumptions eventually adopted such as reference rates, risk margins, cost of financial options and guarantees, and other key valuation components. Most insurance companies understand the importance of the economic value-based calculation of insurance liabilities because it integrates into ALM and overall risk management. There is general support for the introduction of a solvency framework based on economic value because of the importance of maintaining consistency with IFRS and overseas regulatory trends. A number of companies suggested that use of the internal models for solvency risk measurement should be allowed, as they can reflect company-specific risk profiles more accurately in the risk measurement and give insurers an incentive to implement more advanced risk management practices. Some companies suggested that there should be simplified calculation approaches to allow for financial options and guarantees and risk margins in order to avoid excessive computation. As mentioned above, the field tests were focused on identifying potential practical issues in calculating liabilities on an economic value basis, even though the entire structure of the economic-value-based future solvency regime is not yet known. Although the basic components of the economic-value-based liabilities defined in the field tests were somewhat similar to those under EU Solvency II QIS5 7, definitions of Solvency Capital Requirements and underlying assumptions for calculating risk margins, such as the cost-ofcapital rate, were not disclosed. The FSA has publicly stated that it will make steady efforts to establish a new framework through continuous dialogue with relevant industry stakeholders. October 3, Milliman, Inc. All Rights Reserved
5 Milliman Asia e-alert 5 Contact details If you have any questions about this e-alert, please contact: Fumito Hamamura Consultant, FIAJ Office fumito.hamamura@milliman.com Motoharu Dei Consultant, FIAJ Office motoharu.dei@milliman.com Or Toshiyuki Ikuma Managing Director and Senior Consultant, FIAJ Office toshiyuki.ikuma@milliman.com Disclaimer This e-alert is intended solely for educational purposes and presents information of a general nature. It is not intended to guide or determine any specific individual situation and persons should consult qualified professionals before taking specific actions. Neither the authors, nor the authors' employer, shall have any responsibility or liability to any person or entity with respect to damages alleged to have been caused directly or indirectly by the content of this e-alert. October 3, Milliman, Inc. All Rights Reserved
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