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Chapter 9 Insurance regulation 9/7

C Capital adequacy of insurers

Capital adequacy and solvency regimes are some of the most important elements in the supervision of
insurance companies. An insurance company is solvent if it is able to fulfil its obligations under all
contracts under all reasonably foreseeable circumstances. Insurance regulatory authorities around the
world require insurers to maintain assets or surplus capital in excess of liabilities; in other words, a
solvency margin.

C1 Importance of establishing and maintaining capital adequacy

An insurer’s board of directors and senior management should ensure that the insurer has adequate and
Capital serves to
appropriate capital to support the risks it undertakes. Capital serves to reduce the likelihood of failure reduce the likelihood
due to significantly adverse losses incurred by the insurer over a defined period, including declines in of failure
the value of the assets and/or increases in the obligations of the insurer, and to reduce the magnitude of
losses to policyholders in the event that the insurer fails.
From a regulatory perspective, the purpose of capital is to ensure that, in adversity, an insurer’s
obligations to policyholders will continue to be met as they fall due. Hence, most regulators ensure that
regulatory capital requirements are established at a level to support this objective.
Requiring insurers to maintain adequate and appropriate capital enhances the safety and soundness of
the insurance sector and the financial system generally, while not increasing the cost of insurance to a
level that is beyond its economic value to policyholders or unduly inhibiting an insurer’s ability to
compete in the marketplace.

C2 Approaches to capital adequacy requirements

Capital adequacy requirements may be determined using a range of approaches, such as standard
formulae, partial internal models or full internal models.

C2A Standard formula Reference copy for CII Face to Face Training

Companies can choose to use the standard formula as set out by the regulator. This is designed to
capture the standard risks a firm may face and calculates their capital requirements. The standard
formula categories risks into modules for capital purposes – these are: market risk, credit risk,
underwriting risk and operational risk.
The standard formula has the benefit of being simple to describe and to calculate. However, there are
drawbacks:
• A general approach may not adequately respond to different risk profiles of individual insurers,
notably in non-life insurance.
• To the extent exposure is based on historical data, there is no explicit dynamic, forward-looking basis
for the approach.
In some cases a firm may change the parameters on the standard formula to ones more appropriate to
their business. This can only be applied to certain risks and needs to follow a set calculation process,
with ultimate approval from the regulator.

C2B Internal models
Complex firms can use a full or partial internal model to calculate the capital necessary to meet the Chapter
regulatory capital requirements of the regime. The IAIS supports the use of internal models as an
alternative to a standardised approach, such as a standard formula, for calculating regulatory capital. 9

Internal models refer to risk management systems developed by an insurer to analyse the overall risk
position, to quantify risks and to determine the economic capital required to meet those risks.
Insurers use a variety of terms to describe their risk and capital assessment processes, such as
‘economic capital model’, ‘risk-based capital model’ or ‘business model’.
There are several different techniques to quantify risk which could be used by an insurer to construct its
internal model.
In broad terms, these could range from basic deterministic scenarios to complex stochastic models.