INTRODUCTION

Solvency:
A solvency ratio measures the extent to which assets cover commitments for
future payments, the liabilities.
The solvency ratio of an insurance company is the size of its capital relative to
all risks it has taken. The solvency ratio is most often defined as:

Solvency Ratio – (Net assets/Net Premium Written)

The solvency ratio is a measure of the risk insurer faces of claims that it cannot
absorb. The amount of premium written is a better measure than the total
amount insured because the level of premium is linked to the likelihood of
claims.
Different countries use different methodologies to calculate the solvency ratio
and have different requirements. For example, in India insurers are required to
maintain a minimum ratio of 1.5.
Solvency margin means the amount by which the assets of the insurance
company, at fair values, are considered to exceed its liabilities and other
comparable commitments. The solvency margin functions as the company’s
buffer particularly against the risk related to investment activities.

Nature of Solvency
- The financial position of a general insurance company is normally
disclosed though annual accounts for shareholders and through returns
to relevant supervisory authorities. Solvency is demonstrated by
showing that the assets exceed the liabilities. To a large degree the bases
are chosen by the company. For supervisory purposes it is not just a
question of the assets exceeding the liabilities. The assets must normally
exceed the liabilities by a specified margin.
- In life assurance there is a report by the actuary on the valuation of the
liabilities. By contrast the basis on which general insurance liabilities
have been assessed is not just a question of the assets and effectively
advise on the total financial strength of the company, there is no one
with this role in a general insurance company. It is frequently the case
that no specific account is taken of the suitability of the assets to match
the expected liabilities nor of the resilience of the balance sheet position
disclosed to the inherent uncertainty in both assets and liabilities.
- There is in fact no single correct value that can be ascribed to either
assets or liabilities. Different values may be appropriate according to
ones prospective. Shareholder’s want a “true and fair” view, authorities
want a cautious assessment of the position and tax authorities want as
little as possible to be offset against taxable profits, to name but three
interested parties. A balance sheet which shows a solvent position
should reflect an expectation that the assets will be adequate, but it
may, either deliberately or inadvertently, present a misleading picture. It
certainly does not give any idea of the probability that the assets may
prove to be inadequate to meet the liabilities.
- In most countries a general insurance company is permitted by the
supervisory authority to carry on writing business only if it has some
specified excess of the value of the assets over the liabilities. This clearly
increases the probability that the assets will prove sufficient to meet the
liabilities. But mostly solvency margin requirements pay little or no
attention to the differing degrees of uncertainty inherent in different
types of business, nor do they distinguish adequately between the risk of
running off the claim’s payments on the existing portfolio of business and
the risks involved in continuing to write further business.
- Reserving standards are frequently ill-defined or non-existent and do not
require special provision to be made to cover the effects of changes in
the value of assets in their adequacy to meet the liabilities. Problem may
arise from some or all the following:

 Adverse run-off of existing business.

 Poor underwriting experience
 Failure to recover from reinsurers
 Falls in asset value
  Excessive expenses
 Mismanagement
 Negligence or fraud
- The object of a statutory margin is two-fold. It reduces the probability
that the assets will prove inadequate to meet the liabilities and it
provides a buffer against further deterioration in a company’s financial
position which can occur in the period before its authorization to write
new business can be withdrawn. The effect of a statutory minimum
requirement is in practice also to set a somewhat higher formal standard
in the market place.
- A solvency margin is not required of other trading companies, but this
can be said to reflect not only the nature of the business but also the
extent of the insured’s interest in the continued viability of the company.
In many cases the insured can be exposed to quite serious liabilities in
the c=event of the insurer failing to meet a claim. He cannot limit his
liability in the way that he can with a trading company.
- A company can carry on writing business only if the supervisory
authority says that it meets the solvency requirements. The way in which
they lay down requirements for this purpose will differ from the criteria
which would be used by a court in determining whether a company
should be wound up. It is more normal for the existing business to be run
off to extinction or be transferred to another company. The later
procedures is more common in some countries than others.
Solvency Exposures That Face Insurers
Solvency exposures are potentially faced by all insurers, to varying degrees,
arising from various categories of risk. These constitute the factors included in
the required minimum solvency capital and include the following:
 Insurance risk: This is a combination of underwriting risk and run-off risk.
Underwriting risk is the risk to the licensed insurer of writing
unprofitable insurance business. In other words, the risk that premiums
charged are inadequate for the risks assumed. To some extent this is also
links to the exposure of the licensed insurer to operational risk. Run-off
risk is the risk to the licensed insurer of inadequate provision being made
for outstanding claim liabilities, i.e., Inadequate reserving for claims.
 Catastrophe risk: This is the insurer’s potential exposure to extreme
events (e.g., earthquake, flooding, pandemic, etc).

 Asset risk: This is the insurer’s potential exposure of the licensed insurer
to losses on investment assets. It includes credit risk in respect of the
relevant assets as well as asset concentration risk.

 Foreign currency risk: This is the risk of losses in asset values or

increases in liabilities due to foreign currency movement affecting the
value of assets or liabilities denominated in foreign currency, and the
mismatching of assets and liabilities denominated in foreign currency.

 Interest rate risk: This risk of losses in asset values or increase in

liabilities arising from the mismatching of assets and liabilities in terms of
interest rates and duration.

 Related party exposure: This is the risk of losses due to financial

exposures to related parties.
  Reinsurance recovery credit risk: This is the exposure of the licensed
insurer to losses from failure to fully recover on reinsurance contrast,
including losses due to reinsurer failure and contract dispute.

Solvency I
The existing solvency margin requirement were established in 1973 under the
First Non-Life Directive (73/239/EEC) and 1979 under First Life Directive
(79/267/EEC) Insurance Directive established the single market for insurance in
the mid-1990s. This gave the EU one of the most competitive insurance
markets in the world. Insurance undertakings, based on authorization in any
one-member state, are entitled to sell throughout the EU without any price
control or prior notification of terms and conditions (expect for compulsory
insurance). This system relies on mutual recognition of the supervision
exercised by different national authorities according to rules harmonized to the
extent necessary at the EU lerevel. The requirement for insurance undertaking
to established an adequate solvency margin is one of the most important
common prudential rules.

What is Solvency II?

A new set of rules governing how insurers are founded and governed.
Under solvency II, insurer will need enough capital to have 99.5 per cent
confident they could cope with the worst expected losses over a year.
The rule takes a risk-based approach to regulation: the riskier an insurer’s
business, the more precautions it is required to take.
“The theory of an economic balance sheet, which better reflects the underlying
risks on the balance sheet, is a good one,”
Says Jaff Davies, insurance partner at EY. The rules have three so called pillars;
the first is quantitative, laying down how much capital the insurer must hold;
The second covers internal governance and formal supervision; and the third
covers public disclosure and transparency, with the aim that the market will be
able to assess (and price) the insurer properly.
The Three Pillars
1- Financial Requirement:
 Two thresholds:
- Solvency Capital Requirement (SCR)
- Minimum Capital Requirement (MCR)
 SCR is calculated using either a standard formula or, with regulatory
approval, and internal model.
 MCR is calculated as a linear function of specified variables: it cannot
fall below 25% or exceed 45% of an insurer’s SCR
 There are also harmonised standards for the valuation of assets and
liabilities.

2- Governance & Supervision

 Effective risk-management system.
 Own Risk & Solvency Assessment (ORSA)
 Supervisory review & interventions

3- Reporting & Disclosure

 Insurers required to publish details of the risk facing them, capital
adequacy and risk management.
 Transparency and open information are intended to assist market
forces in imposing greater discipline on the industry.
Solvency Margin
The term ‘Solvency Margin’ came into vouge in the 1970s, in Europe. Till then,
the only requirement to be satisfied by a life insurance company was that, after
the distribution of surplus, if any, the value of its asses should not be exceed
the value of liabilities. Instead, it was stipulated that by the value of assets
should exceed the value of its liabilities by a certain margin. This margin was
known as the Solvency Margin. No mathematical technique has so far been
developed to determine the quantum of margin required. The European union
developed an empirical formula based on experience and the same has how
now been adopted in India, with some modifications. The solvency of an
insurance company corresponds to its ability to pay claims. The solvency ratio
is a way investor can measure the company’s ability to meet its long-term
obligation. An insurer is insolvent if its assets are not adequate [over
indebtedness] or cannot be disposed of in time to pay the claims arising. In
other words, it is the extra capital that an insurance company is required to
hold. as per the IRDAI (assets, liabilities, and Solvency Margin of insurers) Rules
2000, both life and general insurance companies need to maintain solvency
margin. Life insurance companies are expected to maintain a 150% solvency
margin. The higher the ratio is the better equipped a company is to pay off its
debts and survive in the long term. All insurance companies must pay claims of
policy holders. These could be current or future claims of policy holder.
Insurers are expected to put aside a certain sum to cover these liabilities. These
are also referred to as technical provision. Insurance, however, is risky business
and unforeseen events might occur sometimes, resulting in higher claims not
anticipated earlier. For instance, calamities like the Mumbai flood, J&K
earthquake, fire, accidents of a large magnitude, etc may impose an
unbearable burden on the insurer. In such circumstances, technical provisions
though initially prudent, may prove insufficient for taking care of liabilities. If
the liability is large, there is a possibility of the insurance sector, regulator and
the government, The solvency margin is thus aimed at averting such a crisis,
the purpose of the extra capital all insurers are required to keep as per the
regulatory norms is to protect policy holders against unforeseen events. The
solvency margin is designed to take care of problems that are usually not
anticipated. It also provides elbow room to the managers of insurers to rectify
problems and take precautionary measures. However, whether an insurance
company fails also depends upon the magnitude of the crisis. Ordinarily, an
insurance company with the requisite solvency margin is not likely to fail.
However, insurance business is risky in nature and there can be no absolute
guarantee.
Events such as the terrorist attack on the World Trade Centre in New York can
create unexpected liabilities of intense difficulty to anticipate and cover.
Liabilities can also increase manifold because of fraud by employee. No
insurance regulator or company can completely guard against fraud, solvency
margin norms notwithstanding. However, such occurrences are rare. Insurance
failure in the past two decades has been very rare.

Q. What is the Solvency Margin?

More specifically, it includes how solvent a company is, or how prepared it is to
meet unforeseen exigencies. It is the extra capital that an insurance company is
required to hold. As per the IRDAI (Assets, Liabilities, and solvency margin of
insurers) rules 2000, both life and general insurance companies need to
maintain solvency margins. While all non-life insurers are required to follow the
regulations, life insurance companies are expected to maintain a 150%
solvency margin.

Q. Why is the Solvency Margin needed?

All insurance companies must pay claims to policy holders. These could be
current or future claims of policy holders. Insurers are expected to put aside a
certain sum to cover these liabilities. These are also referred to as technical
provision. Insurance, however, is risky business and unforeseen events might
occur sometimes, resulting in higher claims not anticipated earlier. For
instance, calamities like Mumbai floods, J&K earthquake, fire, accident of a
large magnitude, etc may impose an unbearable burden on the insurer.

In such circumstances, technical provisions though initially prudent, may prove

insufficient for taking care of liabilities. If the liability is large, there is a
possibility of the insurance company becoming insolvent. This would create an
awkward situation for the insurance sector, regulator, and the government. The
solvency margin is thus aimed at averting such a crisis. The purpose of the
extra capital all insurers are required to keep as per the regulatory norms is to
protect policy holders against unforeseen events.

Q. Does it mean that insurance companies can never fail?

The solvency margin is designed to take care of problem that are usually not
anticipated. It also provides elbow room to the managers of insurers to rectify
problems and take precautionary measures. However, whether an insurance
company will fail will also depend upon the magnitude of the crisis. Ordinarily,
an insurance company with requisite solvency margin is not likely to fail.
However, insurance is a risky business and there can be no absolute guarantee,
events such as the terrorist attack on World Trade Centre New York can create
unexpected liabilities of a magnitude difficult to anticipate and cover. Liabilities
can also increase manifold because of fraud by employees. No insurance
regulator or company can completely guard against fraud, solvency margin
norms notwithstanding. Such occurrences, however, are rare. Insurance failure
in the past two decades have been rare.

Q. How is the solvency ratio worked out

All insurers in India must determine the solvency margin as per the guidelines
laid down under IRDAI rules. The process involves valuation of the assets and
determination of the liabilities. The value is assigned to assets as per the
provisions laid down in IRDAI rules.
For instance, advances of unrealisable character, deferred expenses,
preliminary expenses in the formation of the company, etc are to be assigned
zero value. Assets also include the insurance company’s investment in
approved securities, non-man-dated investment, etc.
The determination of liabilities is more complicated. IRDAI rules have
prescribed a detailed method for the determination of liability by both life
insurance as well as general insurance companies. In the former case, a
company also must consider the options available to the insured while
determining the liability.
After working out the assets and liabilities, the insurer works out the available
solvency margin, which is basically the difference between the value of assets
and that insurance liabilities. Thereafter, the company works out a solvency
ratio, which is the ratio of the available solvency margin to the amount of
required solvency margin.

State-owned Life Insurance Corporation (LIC) has been facing problem in

meeting the solvency margin stipulation which came into effect from April 1,
2001. The problems are owing to its financial structure, and not because there
is a likelihood of the corporation becoming insolvent. LIC’s capital base has
remained unchanged at Rs 5 crore since 1965, though the premium earned and
assets owned have grown manifold. Its total assets are reported to be more
than Rs 3 lakh crore.
After the opening of the insurance sector, LIC, like any private insurer, needs to
adhere to Insurance Regulatory Development Authority (IRDAI) norms,
including those regarding solvency margin. So, it wants to raise funds from the
public to fulfil those norms. In a recent presentation to parliament standing
committee on finance, LIC made a case for amending the LIC Act so that it
could raise the required funds to meet the solvency margin norms.
CONCLUSIONS:
Solvency margin means the amount by which the assets of the insurance
company, at fair values, are considered to exceed its liabilities and other
comparable commitments. The solvency margin functions as the company’s
buffer particularly against the risk related to investments activities.

In most of countries a general insurance company is permitted by the

supervisory authority to carry on writing business only if it has some specified
excess of the value of the assets over the liabilities. This clearly increases the
probability that the assets will prove sufficient to meet the liabilities, but most
solvency margin requirements pay little or no attention to the differing degree
of uncertainty inherent in different types of business, nor do they distinguish
adequately between the risk of running off the claim’s payments on the
existing portfolio of business and the risks involved in continuing to write
further business.

Solvency Ratio = Available Solvency Margin/Required Solvency Margin

 INDEX
S.N TOPIC
O
1 ACKNOWLEDGEMENT
2 INTRODUCTION
3 SOLVENCY EXPOSURE THAT FACES INSURANCE
4 SOLVENCY I/ SOLVENCY II
5 THE THREE PILLARS
6 SOLVENCY MARGIN
7 CONSLUSION
 Acknowledgement
The internship opportunity I had with Royal Sundaram General
Insurance Co. Limited was a great chance for learning and
professional development. Therefore, I consider myself as a very
lucky individual as I was provided with an opportunity to be a part of
it. I am also grateful for having a chance to meet so many wonderful
people professionals who led me though this internship period.

Bearing in mind previous I am using this opportunity to express my

deepest gratitude and special thanks to the Zonal Underwriter Mr.
Rakesh Yadav of Royal Sundaram General Insurance Co. Limited who
despite being extraordinarily busy with his duties, took time out to
hear, guide and keep me on the correct path and allowing me to
carry out my project at their esteemed organization and extending
during the travelling.

I perceive as this opportunity as a big milestone in my career

development. I will strive to use gained skills knowledge in the best
possible way, and I will continue to work on their improvement, to
attain desired career objective.