0279 0336

JIA 111 (1984) 279-336
THE SOLVENCY OF GENERAL INSURANCE COMPANIES
BY C. D. DAYKIN, M.A., F.I.A., F.S.S.,

E. R. DEVITT, M.Sc., A.C.C.A., F.C.I.I.,
M. R. KHAN, B.Sc., F.I.A. AND
J. P. MCCAUGHAN, M.A., F.I.A., A.S.A.
[Submitted to the Institute, 27 February 1984]
1. INTRODUCTION
1.1. Since its formation in 1974 the General Insurance Study Group has been
considering various aspects of the solvency of general insurance companies and a
number of papers have been produced for discussion at GISG Seminars. These
have been deposited in the library at Staple Inn but have not been presented or
made available to a wider audience in the profession.
1.2. At the Dublin Seminar in October 1981, three working parties reported
on different aspects of solvency: technical risks(1), investment risks(2) and
reinsurance(3). These papers covered a wide field but lacked a coherent theme.
During 1982 some work was set in hand to draw the threads together. This was
not completed for the Stratford Seminar in November 1982 but there was by that
time much interest in the Finnish solvency study(4) which had recently been
presented to the ASTIN Colloquium in Liège.
1.3. Following the Stratford Seminar, a new Working Party on Solvency was
established, of which the present authors were the members. The terms of
reference were:
(a) To review the lessons to be learnt from the Finnish report on Solvency of
Insurers and Equalization Reserves. and to suggest specific investigations
which might be carried out in the U.K. in order to develop the Finnish
work.
(b) To consider the extent to which the variability of a company’s results
should be reflected in the methods and bases used for the valuation of the
assets and liabilities.
1.4. A report(5) addressing itself to these terms of reference was presented to the
Bristol Seminar of the GISG in November 1983 and copies have been deposited
in the library. This paper considers the main themes of the Solvency Working
Party report. It seeks to establish a framework for considerations of solvency of a
general insurance company. particularly from the point of view of whether a
company has adequate resources to continue to write business.
1.5. Attention is focussed on the importance of setting adequate standards of
279
280 The Solvency of General Insurance Companies
prudence for technical reserves, bearing in mind the uncertainties inherent in
estimating outstanding claims and other liabilities.
1.6. The paper goes on to investigate variability as it affects the assets side of
the balance sheet and concludes that mismatching reserves should be included in
the technical reserves and that in addition an element of the solvency margin
should be required of companies to provide against this risk, with its magnitude
depending on the nature of the asset portfolio held.
1.7. A conceptual framework is drawn up for setting the line of demarcation
between technical reserves and the solvency margin. Consideration is given to the
implications of reinsurance for solvency and to the question of discounting
outstanding claims reserves.
1.8. The report concludes with some pointers to a possible reserving standard
embracing concepts of variability which could form the basis for a more
satisfactory system of reporting technical reserves from the point of view of
demonstrating solvency in returns to the Department of Trade and Industry, and
suggests a rational approach to the appropriate level for statutory solvency
margins, having regard to the nature of the risks and the possible variability of
the out-turn. Although considerably more work would be required to develop
this into a firm proposal, we put forward some illustrative figures to demonstrate
the impact which this might have on companies.
1.9. Reference has been made to the report of the Finnish Research Group(4).
Their distinctive contribution is in the area of quantifying the risks of remaining
open to new business. There is a need for their risk theory models and simulation
techniques to be adapted to the U.K. situation, and further work is now being set
in hand to do this, in order to fill in some of the gaps which remain in the
framework we set out in this paper.
1.10. A paper(6) presented to the ASTIN Colloquium in Lindau describes the
outline of a system of solvency control being developed by some members of a
Norwegian Working Party. In common with our approach, this sees the need to
consider the variability inherent in the technical reserves, although, in common
with the Finnish solvency control system, solvency margins are envisaged which
would reflect the risk characteristics of each individual company.
1.11. A Working Party in the Netherlands has also been considering the risks
to the solvency of a company (7), although in their case primarily as seen from a
management point of view. A summary in English has been prepared for the
International Congress in Australia(8).
1.12. This paper has been written in the context of general insurance practice in
the U.K. and requirements under the Insurance Companies Acts. However,
many of the considerations would be applicable in other contexts and we hope
that the paper will contribute to the wider discussions of matters of solvency,
including the adequacy of technical reserves, on an international level.
The Solvency of General Insurance Companies 281
2. THE NATURE OF SOLVENCY

2.1. A problem definition
2.1.1. A solvent insurance company is one which possesses sufficient assets to
meet all liabilities. In practice it may be difficult to be sure of the exact value of the
liabilities, or whether the assets would be sufficient to meet them, even if their
amount were known precisely. Uncertainty is inherent in an insurance com-
pany’s liabilities and a considerable degree of estimation is required.
2.1.2. Although many of the assets can readily be assigned their current market
value, it might in fact not be possible to realize this value on a forced sale of the
whole portfolio. Furthermore, it is more important to consider whether the
assets will prove sufficient to meet the liabilities as they fall due.
2.1.3. Both the uncertainty regarding liabilities and the potential fluctuation in
asset values are often greater for insurance companies than for other enterprises.
Concern about the serious consequences for policyholders of any insurance
failure and the difficulty of being sure of whether a company is solvent or not, in
the strict sense, have led supervisory authorities to require insurance companies
to maintain a solvency margin, by which assets must exceed liabilities, as a
condition for continuing to write new business.
2.2. The need for solvency margins

2.2.1. The authorities’ motivation for imposing statutory solvency require-
ments is to protect the consumer. However, the industry itself also has an interest
in avoiding insolvencies. Sound financial management requires an adequate
solvency margin to be maintained.
2.2.2. The supervisory authority will aim to ensure that a company remains
able to meet its liabilities. Management will also be seeking to maintain the
company’s financial health and profitability. However, for various reasons, the
financial state of an insurer may deteriorate rapidly. The statutory solvency
margin is intended to give early warning of the need for corrective action, or for
intervention by the supervisor, before insolvency is reached. This provides a
mechanism for initiating discussions with a company over the need for additional
capital, changes in underwriting practice, etc.
2.2.3. The solvency margin must be sizeable enough to enable action to be
taken in good time if the company is unable or unwilling to take corrective action
itself. One possibility may be for the portfolio of business to be transferred to
another company: In the majority of cases in the U.K. the ailing company will
simply have its authorization to write new business withdrawn. By the time a
company is closed to new business. much of the solvency margin may have
disappeared, and the remaining assets ought to be sufficient to allow the liabilities
to be run off. The uncertainties inherent in the run-off suggest the need for
significant margins in the valuation of liabilities, and possibly assets, regardless
of the existence of an additional solvency margin.
2.3. How prudent should technical reserves be?
2.3.1. In U.K. life insurance, the actuary has traditionally been responsible for
setting up prudent reserves so that there is a high probability that liabilities will
be met. Excess assets can then be regarded as free reserves, constituting a
solvency margin, and providing the early warning mechanism described above.
2.3.2. The life actuary has well-established methods and bases for establishing
a prudent level of reserves, and has to disclose them in the valuation report which
forms part of the returns to the Department of Trade and Industry and is made
available to the public. General insurance companies are simply required to
assess liabilities ‘in accordance with generally accepted accounting concepts,
bases and policies, or other generally accepted methods appropriate for
insurance companies’. No disclosure of methods or bases is required.
2.3.3. As a result, there are, in our view, serious potential shortcomings in
current general business statutory reporting. There are no agreed standards on
such important matters as how to allow in technical reserves for the variability of
claim numbers and amounts, for the relationship between assets and liabilities,
for the variability of the assets or for the expenses of running off the business.
Without such standards it makes little sense to prescribe a precise solvency
margin by which the assets must exceed the liabilities.
2.3.4. In practice it presents considerable problems to the supervisory
authorities, since a weak company can simply weaken its technical reserves in
order to continue to demonstrate that it has the required solvency margin.
Without any clearly defined standards it is extremely difficult to establish that the
technical reserves are deficient, and it is impossible to take action against a
company unless it can be shown conclusively that the reserves are not in
accordance with generally accepted methods and that the solvency margin is thus
uncovered.
2.4. Relationship between technical reserves and solvency margins

2.4.1. From the point of view of supervision, it is clearly preferable for
provision to be made within the technical reserves for all factors associated with
the run-off of the existing portfolio. This would reflect the realities within which
the supervisory authority’s powers to stop new business being written have to be
exercised and maximize the chance of an orderly run-off. The solvency margin
would be available as a buffer to enable a company to continue writing business,
to cover the risks of unprofitable underwriting, inadequately controlled
expenses, catastrophe accumulations. mismanagement, etc.
2.4.2. Others might regard it as more logical for the technical reserves to
provide only for the expected value of claims, perhaps with some allowance for
future investment income, On this approach the solvency margin would be
regarded as available to absorb adverse fluctuations and all other risks.
2.4.3. The supervisor‘s point of view is relatively short-term. His focus of
concern is the year following the balance sheet date of the latest returns, i.e. until
a further set of returns is submitted. He wants to see adequate technical reserves
and solvency margins to justify allowing the company to take on new
policyholders during the coming year.
2.4.4. The E.C. solvency régime allows the supervisor to intervene only if a
company fails to meet specific solvency requirements. Thus, the solvency margin
must be able to withstand adverse tendencies for up to eighteen months, allowing
for reporting time-lags. If the company has not raised further capital or brought
the situation under control in that period, the supervisor may exercise his powers.
2.5. The company view

2.5.1. For companies operating on slender margins, ability to satisfy the
solvency requirements is of critical importance. In the context of many
well-established offices, however, the statutory solvency requirement is so well
covered as to be of no direct operational significance. The term solvency is
sometimes used in this wider context to refer to financial strength, long-term
profitability and growth potential. The level of cover for the statutory solvency
margin may be seen as an indicator of whether further capital is likely to be
required in the foreseeable future.
2.5.2. Considerations of solvency of companies in the longer term fall outside
the scope of this paper. Although the matters considered here would be equally
relevant, attention would also have to be paid in particular to the adequacy of
premium rates and the long-term consequences of market strategy.
2.5.3. Although written in the context of solvency control, the recent Finnish
report(4) is effectively about the wider aspect of continuing solvency. Their study
was concerned not only with minimum standards for continuing viability but
also with the maximum strength of technical reserves, including equalization
reserves, that could be justified to the tax authorities.
2.5.4. In the U.K. the Inland Revenue do not have such a liberal attitude to
technical reserves, and equalization reserves have to be built up out of taxed
profits. Although there is no general requirement for equalization reserves, the
practice of maintaining substantial cover for the statutory solvency requirement
may be regarded as in some ways equivalent. In this paper we have restricted
ourselves to considering the adequacy of technical reserves and solvency margins
in relation to a limited time horizon. Further study is required to investigate, in
the U.K. contest. the wider subject of long-term financial management.
3. ACCOUNTING FOR GENERAL BUSINESS LIABILITIES

3.1. Current legislation
3.1.1. The accounts of a company are required, in compliance with the
Companies Acts, to give a ‘true and fair view’ of the state of affairs of the
company and of its profit and loss for the year. Insurance companies are,
however, exempt from some of the general requirements imposed on other
companies and to this extent the ‘true and fair view’ concept is diluted. One of the
most important exemptions is from showing separately provisions and reserves
and the movements thereon. Assets may also be shown at less than their current
market value.
3.1.2. To an accountant, the meanings of ‘provision’ and ‘reserve’ are quite
distinct. A provision is an amount retained to provide for a known liability, the
amount of which cannot be accurately determined. A reserve, on the other hand,
does not relate to a known liability and is part of shareholders’ funds. The
technical reserves of an insurance company are, strictly speaking, provisions
rather than reserves. Their assessment is, however, to a large extent subjective,
and this may be seen as justifying the exemptions applied to insurance
companies. Because the determination of these provisions is uncertain, it is
permissible to overstate them but not to understate them. This means that
insurance companies are allowed to create margins by overstating provisions.
3.1.3. Under the Insurance Companies Acts returns must be made annually to
the Department of Trade and Industry. These returns are in some respects similar
in nature to accounts, although they are not required to demonstrate a ‘true and
fair view’. Regulations lay down the form of the returns and how some of the
items are to be determined. The Insurance Companies (Accounts and State-
ments) Regulations 1980 make it clear that the amounts set aside for outstanding
claims at the end of the financial year should include provision for all claims not
yet paid, including claims where the amount of the claim has not yet been
determined and claims arising out of incidents which have not yet been reported
to the company.
3.1.4. In addition provision should be made for any expenses likely to be
incurred directly by the company in settling these claims. In the case of both
claims and expenses, the provisions may be reduced by the amount of expected
recoveries.
3.1.5. Provision is also required for the unearned portion of premiums already
received. Additional provision must be made if unearned premiums are likely to
be inadequate for the claims and other expenses which will correspond to them.
3.1.6. In returns to the Department of Trade and Industry, companies are also
expected to set aside an amount likely to be sufficient to meet the management
expenses which would be incurred in settling outstanding claims if the company
were closed to new business.
3.1.7. The Insurance Companies Regulations 1981 set out only in the most
general terms the requirements for the determination of the amounts of these
provisions. Liabilities ‘shall be determined in accordance with generally accepted
accounting concepts. bases and policies or other generally accepted methods
appropriate for insurance companies’.
3.2. Generally, accepted accounting concepts

3.2.1. In Statement of Standard Accounting Practice No 2 (SSAP 2) four
fundamental accounting concepts are mentioned as the ‘broad basic assumptions
which underlie the periodic financial accounts of business enterprises’. These are:
the going concern concept, the accruals concept, the consistency concept, and the
prudence concept. Although use of these concepts may not be self-evident from
examining a set of accounts, they are presumed to be observed unless otherwise
stated.
3.2.2. The going concern concept implies the assumption that the enterprise
will continue in existence for the foreseeable future. Unless otherwise specified,
there is no intention of reducing significantly the scale of the operation. The
estimation of the various provisions set aside by an insurance company should,
therefore, be made on the assumption that the company will survive to discharge
the claims incurred. A provision should be made for the expenses directly
incurred in settling claims, but it can be assumed that new business will continue
to be written to support other costs. The going concern concept conflicts directly
with the requirement, mentioned in §3.1.6, for returns to the Department of
Trade and Industry, that the solvency of a company shall be considered on the
assumption of notional discontinuance. This is one of the reasons why the
auditors’ report in Department of Trade and Industry returns does not refer to a
‘true and fair view’, but certifies that the forms ‘have been prepared in accordance
with the Insurance Companies (Accounts and Statements) Regulations 1980’.
3.2.3. The accruals concept requires that income and expenditure be
recognized as they are incurred and matched with one another so far as their
relationship can be established or justifiably assumed. Revenue and profits are
matched with associated costs and expenses by including in the same account the
costs incurred in earning them. Where outstanding claims are provided for only
to the extent that they relate to incidents which have already happened, this
means that additional provision must be made in respect of premiums already
received which could give rise to claims in respect of future incidents, in other
words unearned premiums. The accruals concept gives no help in deciding how
to estimate the amount of the provisions.
3.2.4. The consistency concept requires there to be consistency of accounting
treatment of similar items within accounting periods and from one period to
another. There are no special implications for general insurance companies.
3.2.5. The concept of prudence requires that revenue and profits should not be
anticipated, but should be recognized only when realized in the form of cash or
other assets. Provision must be made for all known liabilities whether their
amount is known or estimated. It should be noted that this concept is not
symmetric. In cases of uncertainty. revenue and profits should not be recognized
but expenses and losses should. The prudence concept dictates that the provision
for outstanding claims should be not less than the company’s best estimate. In the
absence of any detailed guidance it seems to imply that account should be taken
of expected inflation and any other trends likely in future settlements. It is not
clear, however, that any margin over and above a best estimate need be
incorporated.
3.2.6. These fundamental concepts give only broad guidelines for insurance
companies’ accounts. No other Statement of Standard Accounting Practice has
any particular application to general business insurance companies and SO
further evidence of what is generally accepted must be sought from the
companies’ accounts.
3.3. Generally accepted accounting practice

3.3.1. We examined the accounting policies of the seven largest quoted
composites, and of two quoted life offices with substantial non-life portfolios, as
stated in their Companies Act accounts. In general there is no disclosure of
principles or methods in the returns to the Department of Trade and Industry. At
present, however, most companies use the same figures for the reserves in their
returns as in the accounts.
3.3.2. In respect of outstanding claims, four companies state simply that full
provision has been made. A further company states that provision has been made
for the estimated cost of all claims incurred, which may be the same thing, but
sounds less strong. Two companies state specifically that the provisions take
account of expected inflation and future trends in settlements. Only one company
refers to the method employed in estimating outstanding claims, and that
method is case estimation. One company makes a partial reference to the method
used for overseas workmen’s compensation, where the provisions are stated to
have been discounted. No indication is given of the parameters used, or of
whether the result is stronger or weaker than undiscounted reserves. Silence on
this aspect by the other companies might be taken as implying no discounting.
but this might not be a justifiable assumption.
3.3.3. All companies in the sample refer to provision being made for claims
incurred but not reported (IBNR). Once again only one company refers to the
method used. The company which says it uses case estimates for outstanding
claims says that ‘statistical methods’ are used for claims IBNR.
3.3.4. Two companies make specific reference to providing for the administra-
tive expenses to be incurred in settling outstanding claims. It is not clear whether
or not the others make such provision. Since it is arguable to what extent this
provision is consistent with the going concern concept, it seems likely that at least
some of the others do not make such a provision in their Companies Act
accounts.
3.3.5. Several companies spell out the fact that provisions are approximate.
Three companies expand on this by stating that revisions are often required in
later years. Such adjustments may be material but are not usually shown
separately in the accounts. For the purpose of Department of Trade and Industry
returns the need for such adjustments is recognized in the requirement that claims
paid and outstanding arising from incidents occurring in the financial year must
be distinguished from any change in the estimated cost of claims arising out of
incidents occurring in previous financial years.
3.3.6. The evidence is sparse since companies do not choose to disclose their
reserving policies in any detail, but it appears to us that, even amongst this small
sample of major companies, there may not be much consistency between the
provisions made by different companies for outstanding claims, claims IBNR,
and future expenses. Experience has shown that interpretation of what is
generally accepted varies to a very much greater extent if the whole industry is
considered, and standards of reserving vary widely.
3.3.7. We suggest that a satisfactory system of reporting for general insurance
should provide enough information for the reader to assess the extent to which
the uncertainty in the claims run-off has been provided for. We also consider that
a minimum standard of acceptable provision should be laid down, at least in
general terms.
3.3.8. Although there has been a move towards showing assets at market
values, some companies still use book values in their Companies Act accounts.
Book value is usually taken to mean the cost of the investments less any hidden
reserves.
3.3.9. In returns to the Department of Trade and Industry, however, all
companies have to value their assets on the basis laid down in the regulations.
The regulations specify, in general. market values, but for two reasons there may
still be some inconsistency between different companies:
(a) For certain types of asset (e.g. property and dependent companies) the
regulations prescribe a maximum value and some companies may include
these assets at less than the maximum value.
(b) The regulations provide that where it appears that an asset is of a lower
value than that specified in the regulations the lower value must be used.
Although differences in practice still exist there can be no doubt that the
operation of the Valuation Regulations has enhanced the comparability of
insurance companies’ balance sheets, as shown in the returns.
3.4. The need for standards

3.4.1. The purpose of the Companies Act accounts is to give information about
the state of affairs and profitability of a business from the point of view of its
shareholders and any one with whom it has business dealings. Particularly given
the uncertainty in some of the items, it is perhaps unrealistic to suppose that they
can give a complete and accurate picture, although we believe that some
consideration should be given to methods of reporting which would highlight the
scope of possible uncertainties. It does not necessarily follow that it is
appropriate for the basic provisions to include substantial margins to allow for
the possible variability. although the prudence concept dictates that profit should
not be assumed to have accrued unless its emergence is reasonably certain.
3.4.2. Returns to the Department of Trade and Industry have a rather different
purpose, in being designed to demonstrate a company’s solvency on a notional
discontinuance basis. To some extent, therefore, different considerations should
apply to the provisions made in these returns. This paper focusses on the special
factors involved in reporting to the Department of Trade and Industry, athough
some aspects may also be relevant to companies’ accounts.
3.4.3. It is impossible to discuss appropriate standards for explicit solvency
margins without defining clearly the scope of the technical reserves. For the
reasons given in § 2.4.1, we consider that it is necessary to ensure that the
technical reserves are adequate to give a reasonable likelihood of an orderly
run-off without the protection of an additional solvency margin. This suggests
that, for solvency reporting, technical reserves should contain a margin over and
above the company’s best estimate of the liabilities.
4. VARIABILITY OF LIABILITIES
4. The need for margins
4.1.1. The previous section has stressed the need to establish a standard for
technical reserves before one can begin to discuss the appropriate level for the
solvency margin. In practice many companies adopt a very cautious approach to
setting up the technical reserves, although the present system does not oblige
them to do so. Other companies are under pressure to keep technical reserves to a
minimum acceptable level, in order to show a respectable level of cover for the
required solvency margin.
4.1.2. Maintenance of strong technical reserves is not simply a matter of
prudence, or of recognizing an unwritten standard of good conduct. The
existence of significant margins in the technical reserves will give a company
greater freedom in writing new business and greater resilience against adverse
events. Tax considerations may also provide an incentive for retaining margins
within the technical reserves as far as possible.
4.1.3. At the other end of the spectrum, the reserves established may be no
more than best estimates of the outstanding liabilities and may even take credit
for some future investment income without a correspondingly prudent inflation
assumption. This would imply that, if the solvency margin became impaired,
there may be only an even chance of being able to run off the liabilities from the
resources available. We would regard that as a highly unsatisfactory state of
affairs, since in our view the technical reserves should be sufficient to run off the
business with a relatively low risk of proving inadequate. The solvency margin
can then be regarded as providing protection against the more remote adverse
contingencies of the run-off, as well as against the risks of remaining open to new
business.
4.1.4. The origins of the E.C. Non-Life Establishment Directive, which lays
down the minimum standard of solvency margins for insurance companies in the
European Community, suggest that the initial proposals were based on the
presumption that the technical reserves would be assessed as the expected value
of the liabilities, but that the solvency margin would be set so as to produce a risk
of ruin of no more than 1/1,000 over a three year period.
4.1.5. However, the resulting solvency margins were found to be higher than
those currently maintained by prudent company managements, and it was
recognized that this reflected a more stringent approach to the technical reserves
in many companies. Although the Directive only lays down that ‘Each Member
State ... shall require the undertaking to establish sufficient technical reserves’,
this can be interpreted to imply a standard significantly stronger than mean
estimates. More details of the development of the current E.C. solvency margins
and the implications for technical reserves can be found in a paper by Daykin(9).
4.1.6. The problem may be stated in general terms as follows:
Lp = Le+M1
Where Lp is the published value of the liabilities;
Le is the company’s best estimate of the liabilities; and
M1 is the margin in the liabilities as published.
Similarly, on the assets side of the balance sheet:
Ap = Ae–M2
where A,,, is the published value of the assets:
A, is the company’s best estimate of the value of the assets; and
M2 is the margin in the assets as published.
Furthermore, the published solvency margin is given by:
PS = Ap–Lp
The actual margin over and above mean estimates of the values of the assets and
the liabilities is then given by:
AS = PS+M1+M2
4.1.7. The question of margins in the assets is considered in the next section of
this paper. Suffice it to note here that in the U.K., with the regulations for the
valuation of assets, the scope for positive margins on the assets side, over and
above current market values, is limited. Consideration does, however, need to be
given to the possibility that assets may be overvalued in relation to the amount
which might be realized if they had to be sold in adverse market conditions. The
actual values of the assets to the company can only be determined by the passage
of time.
4.1.8. It will also be the case on the liabilities side that the true value will only be
known at some future date and it is for this reason that a margin should be held
over and above the current best estimate. However, in the absence of any
standard for technical reserves one cannot assume that the margin in published
liabilities (M1) will be positive. The evidence suggests that it is often zero or
negative. This may be because the reserves have been discounted, or because
inadequate allowance has been made for future inflation or expenses. We give
further consideration to discounting in § 7, but for the purposes of this section we
shall consider the full amount of liabilities before any allowance for future
investment income.
4.1.9. It is clearly dangerous for attention to be focussed on the published
solvency margin, unless one is satisfied that the margins M1 and M2 are
non-negative. The appropriate level of solvency margin to be required depends
on the additional security offered by these implicit margins.
4.2. The scope of the problem

4.2.1. It follows from the framework of technical reserves and solvency
margins which was described in § 2 that these reserves ought to contain prudent
provision for all the liabilities which would or might arise in running off the
existing business of the company (i.e. that for which it is already on risk), on the
assumption that no further risks were underwritten. The principal components
are as follows:
(a) current liabilities (tax, creditors, etc.);
(b) unearned premium reserves (including additional amounts in respect of
the unexpired risks where the premiums may be inadequate);
(c) reserves for reported outstanding claims (where the amount is still
unknown);
(d) reserves for claims incurred but not reported (IBNR);
(e) funds for business accounted for other than on a one-year basis; and
(f) reserves for future management expenses if the company was closed to new
business.
4.2.2. Other special reserves, such as claims equalization reserves and
catastrophe reserves, are true reserves in the accounting sense (see § 3.1.2) being
advance provision for future events for which the company is in general not yet
on risk. Both the unearned premium reserve and the IBNR reserve may
incorporate some provision for large claims arising from events which have not
yet occurred or not yet been reported, but for which the company is already on
risk.
4.2.3. Item (a) in § 4.2.1 is made up of a number of relatively straightforward
accounting items and presents no particular difficulties. Items (b) to (e) are in the
nature of what an accountant would term provisions, although there is
considerable uncertainty about the appropriate level. Item (f) would not
normally be included in Companies Act accounts, which present a company as a
going concern, but it is required for the purposes of returns to the Department of
Trade and Industry demonstrating solvency.
4.2.4. Among the numerous factors which may affect the value of the liabilities
under item (b) above are:
(i) Adequacy of existing premium rates.
(ii) Claims frequency in respect of unexpired risks.
(iii) Weather and natural disasters.
4.2.5. Further factors may affect the value of the liabilities not only under item
(b) but also under (c), (d) and (e), among which some of the more important are:
(i) Court case judgments.
(ii) Inflation.
(iii) Reinsurance recoveries.
(iv) Negotiations on individual claims.
4.2.6. The assessment of the reserve for the run-off of management expenses
presents different problems, including consideration of how a company would be
restructured if it was closed to new business, how quickly changes could be
achieved, what redundancy and other one-off costs would be incurred and what
the longer term pattern of expenses would be, having regard to the likely time
taken to run off the business.
4.3. Estimating variability

4.3.1. The largest items in the reserves of a general insurance company will
usually be the reserves for outstanding claims (including IBNR under this
heading). In considering how to handle the variability in the liabilities we
examine first this part of the reserves.
4.3.2. We start from the presumption that the company is able to make a best
estimate of what it believes the cost of outstanding claims will be for any
homogeneous risk group, having regard to its estimate of the effects of inflation.
It may be necessary to consider a variety of methods of estimation in order to
arrive at such a best estimate, and inevitably considerable exercise of judgement
will be required.
4.3.3. We describe the company’s best estimate for the class of business (i) as
the ‘mean’ estimate of the liabilities (µi) and postulate that a ‘standard deviation’
(σi) can be used to describe the variability of possible outcomes on account not
only of random variations but also uncertainty in the estimated effect of inflation
and such factors as inadequacies in reserving methodology. The reserves set up
can then be expressed in the form:
Li = µi+ Ki σi
where Ki is an appropriate margin factor.
Summing for all classes of business, we have:
Le = Σµi
Lp = ΣLi
M1 = ΣKi σi
4.3.4. In principle, a standard for technical reserves could be established by
specifying a value for the margin factors Ki. The methodology for arriving at the
mean estimates and standard deviations would be left to the company, although
disclosure of methods and parameters used would be desirable. It would have
considerable advantages if the reserves had to be certified by a loss-reserving
specialist capable of making the necessary judgements about the variability of the
liabilities, who would have to report on the reserving methods in much the same
way as the appointed actuary does in respect of life business.
4.3.5. Different values of Ki could be specified for each class of business, but
this seems unnecessary, as the characteristics of variability for the class are
represented by the standard deviation. A simple but logical framework might
postulate a single value of K for assessing the minimum amount of the technical
reserves and a second, higher value to indicate the overall level of provision
deemed necessary, which could be regarded as made up of the technical reserves
together with the solvency margin.
4.3.6. One might postulate, for example, that K should be equal to unity for
minimum technical reserves, which would then be of the form (µi+ σ i). Similarly,
total provision of (µi+3 σi) might be regarded as giving adequate protection
overall, so that the solvency margin for each class of business would be defined as
2 σi.
4.3.7. A more intellectually satisfying theoretical basis might be devised in
terms of risk of ruin, where one could argue for outstanding claims reserves
sufficient to run off the business with a risk of proving inadequate of, let us say,
1/200, whilst the additional solvency margin might be envisaged as reducing the
risk of ruin to, say, l/1,000.
4.3.8. The levels are, of necessity, arbitrary, although they express mathemati-
cally a philosophy of technical reserves and solvency margins. Unfortunately,
they cannot readily be related to a basis defined in terms of standard deviations,
which can be estimated from an individual company’s data, without assuming an
underlying distribution.
4.3.9. By way of example, one can consider what the relationship would be if
the outstanding claims amount was considered to be normally distributed. In
that case, three standard deviations above the mean would reduce the probability
of being proved inadequate to approximately l/1,000. Technical reserves based
on one standard deviation above the mean would be likely to be inadequate 16%
of the time. This might be thought rather weak and a standard based on the mean
plus one and a half standard deviations (likely to be inadequate 7% of the time if
the variable is normally distributed) would in our view give a more satisfactory
standard. In practice the normal distribution may not be very appropriate,
particularly as regards gross reserves, but reinsurance will normally reduce the
skewness to the extent that the normal distribution may not be too bad a first
approximation for the variability in the net reserves.
4.3.10. The numerical correspondence between a risk of ruin approach and a
standard deviation approach would be different if the distribution were other
than normal, depending on the higher moments of the distribution. However, for
practical reasons we would envisage setting the criteria in terms of the standard
deviation, although this might give different probabilities of ruin in different
cases. We suggest that the minimum standard for technical reserves could be
expressed as (µ+1.5 σ) and that the required solvency margins for each class of
business could then be on the basis of 1.5 σ. We consider that a margin of more
than one standard deviation is justified for the technical reserves, partly in view of
the relationship with risk of ruin discussed in the previous paragraph (since the
distribution may in practice be a little more skew than the normal distribution,
the risk of ruin will in fact be somewhat higher than indicated there) but also
because the calculated standard deviation only allows for past experience and
does not take into account the fact that the patterns could change suddenly,
either because of underwriting factors or because inflation turns out to be
significantly different than implied by the variability assumed in the model.
4.3.11. A more sophisticated approach which gives proper recognition to the
skewness of the distribution could be developed along the lines of a formula such
as:
where γ is the skewness of the distribution. and y is the confidence factor (see Risk
Theory(10), p. 44). However. since we are in practice only interested in the
variability in the reserves net of reinsurance. the additional sophistication did not
seem justified, and we have not pursued this approach, although it would be of
interest to investigate it further.
4.3.12. If each class of business has a distribution with mean µi and standard
deviation σi, the standard deviation of the total error for all classes needs to be
calculated by convoluting the separate distributions. Only if the distributions are
fully correlated is the overall standard deviation tot σ given by the sum of the
individual σi:
σtot = Σ σi
If the distributions are independent the relevant formula is:
In practice the situation is between these two extremes (assuming no negative

correlations):
In bringing together the proposals for an overall solvency margin in § 9, we

suggest a rough and ready way of giving effect to this inequality.
4.3.13. Such a framework begs the question of whether an adequate method
can be devised for measuring the variability of the outstanding claims estimate.
Many methods for estimating outstanding claims produce a point estimate and
the variability can only be assessed subjectively. A number of methods of
introducing statistical concepts of variance have been suggested, e.g. by
Taylor(11), Benjamin (12,,13)Devitt(14) and Hertig (15),but more research is needed in
this area to develop practical and reliable methods.
4.4. Monitoring the margin factor

4.4.1. The concept of a margin factor has been introduced as something
essentially within the control of the company. This is clearly how it would remain
in practice, even if a minimum margin factor were laid down in a reserving
standard. Companies would also be responsible for making best estimates of the
outstanding claims and for assessing the variance of the estimates, although
disclosure of the methods used would be desirable. It would also be open to
companies to hold reserves implying a larger margin factor than the minimum.
4.4.2. The required solvency margin could be laid down in terms of a multiple
of the standard deviation for the type of business. It would not be impossible for
this also to be a calculation for which the company was responsible, implying
individual solvency margin requirements for each company which would reflect
the variability in their own outstanding claims provisions. However, it is likely
that this could be felt to place too much discretion on companies in the operation
of solvency margins and there would be situations where the solvency margin
could not sensibly be calculated from the data available.
4.4.3. As far as the solvency margin aspect is concerned, therefore, we envisage
that the requirement would be the same for all companies, although expressed as
a percentage of the outstanding claims reserves and with different percentages
laid down for different classes of business. The traditional argument against
defining the solvency margin in terms of the technical reserves is that this
provides an incentive for companies to weaken their technical reserves. The force
of this argument would be considerably weakened if there was a minimum
standard of technical reserves. In any case, this would be only one component of
the solvency margin.
4.4.4. Since the strength of the technical reserves would depend on the methods
adopted by each company for assessing the mean and variance, supervisory
authorities and other observers would want to make their own assessment of the
implied margin factor from the published information in the returns. If such an
assessment suggested that a K factor of less than 1.5 had been employed for any
category of business, this might imply that the company had assumed either a
lower mean or a lower variance (or both). In such cases further demonstration or
explanations could be sought, depending perhaps on the apparent overall
strength of the company’s reserves.
4.4.5. Apart from establishing whether adequate technical reserves had
been established, monitoring the implied margin factors could yield other
information about the financial position of the company, as it would make it
easier to assess whether the valuation basis was being strengthened or weakened
and to analyse the components of profit or loss in the overall results of the
company for the year.
4.4.6. In practice it seems to us that a number of companies probably do, in
effect, adjust their margin factors from year to year, although perhaps not
explicitly. Reserves may be weakened for previous years of origin to offset new
business strain, to improve the underwriting result or to avoid a fall in the
apparent cover for the solvency margin. In other circumstances, reserves may be
strengthened to absorb profits so that they are available when needed to cover
adverse results at some future date. Used in this way, the margins in the technical
reserves are not unlike equalization reserves and they enable a company to
smooth out, to some extent, the emergence of profit from year to year.
4.4.7. Some variations in the underlying margin factors are, therefore, to be
expected, and further spurious variations will inevitably be detected by any
method which seeks to deduce the factors from information in the published
returns. From the monitoring point of view the most that could be hoped for is an
enhanced ability to detect steady weakening of reserves and a framework for a
screening test which would enable further information to be sought from a
company which appeared to fall short. The onus for proper reserving standards
would be on the professional person responsible for assessing the reserves and on
the Directors of the company who sign the returns.
4.5. Funded business

4.5.1. The principles which we have enunciated are equally applicable to
funded business. The reserves (or funds) should incorporate significant margins,
so as to be adequate to run off the liabilities in a high proportion of cases. The
reserves set up for the closed years would normally be on a full prospective basis
as in the case of unfunded business. However. there is a tendency in some circles
to regard the funding system. whereby no profits may be taken from the
premiums until the year of account is closed (usually 3 years), as automatically
ensuring cautious reserves for the open years. This is not so, particularly in view
of the very high loss ratios which can be experienced on some business
traditionally accounted for in this way.
4.5.2. The certificate which the Directors are required to sign in respect of
funded business already makes it clear that transfers into the funds should be
made in the open years in order to ensure that they are sufficient to meet the
outstanding liabilities. A minimum standard for assessing such liabilities would
impinge on funded business at this point. Furthermore, since one of the
justifications for accounting for business on a funded basis is that there is a high
degree of uncertainty about the liabilities during the open years, this would be
reflected directly in the margins required by a standard of the form discussed in
earlier paragraphs.
4.5.3. Another aspect of funded business is that premiums are not all received
at the start of a contract and significant amounts of premium income may be
expected to be received throughout the open years. For the purposes of
establishing the adequacy of the fund in the open years, it is usually reasonable to
take credit for premiums still to be received although this may depend upon the
terms on which policies are written. On similar lines to our approach to the
liabilities. we would envisage a best estimate of future premium receipts (µc) being
made, together with an estimate of the variance (σ2c). The maximum allowance in
respect of future premiums would be (µc–1·5 σc). However, this assumes that the
level of claims and the amount of late premium income are independent, which
may sometimes not be the case, and a lower margin might in general be
appropriate for premiums. To follow through the logic of the earlier sections,
there should also be an additional component of the solvency margin based on
1·5 σc.
4.6. Unexpired risk reserve

4.6.1. The unexpired risk reserve is a reserve in respect of claims on business for
which the company remains on risk at the balance sheet date. Although some
information about the frequency and size of claims in respect of the part of
premiums which was unearned at the balance sheet date may be available by the
time the accounts are drawn up, this element of the technical reserves is in
principle provision for events which have not yet taken place. There is, therefore,
even greater uncertainty surrounding the level of provision than with the
outstanding claims reserve.
4.6.2. Traditional methods of calculating this reserve are based on the concept
of the unearned portion of the premiums received. Part of the premium is
assumed to be absorbed by initial expenses and commission and the whole of the
balance is reserved towards meeting claims. Alternatively, the unearned
premium reserve can be looked at in terms of deferment of revenue. The
‘unearned’ part is usually calculated on a pro rata basis, by considering the
number of quarters, months or sometimes days for which the company has been
and remains on risk. It is implicit in this that the incidence of risk is uniform
throughout the period of the contracts and that the cost of claims, together with
the expenses and commission, will be no more than 100% of the premiums. In
practice neither of these assumptions may be justified and an addition to the
unearned premium reserve on a pro rata basis may be required. If it is shown
separately, this may be referred to as the additional amount for unexpired risks.
The total of this and the pro rata unearned premium reserve makes up the
unexpired risk reserve.
4.6.3. A prudent assessment of the unexpired risk reserve will allow for the
incidence of risk where this differs significantly from an even incidence. It will
also allow for the possibility of the loss and expense ratio being in excess of 100%.
It should do so not just on the basis of the expected value of the ratio, but such
that the probability of it being exceeded is quite small. The assessment of a
prudent reserve for the unexpired risks offers scope for the use of modelling
techniques on the lines of those developed in the Finnish study(4).
4.7. Expense reserve

4.7.1. Up to now no specific mention has been made of future expenses,
although it is usual to consider costs which are directly attributable to an
individual claim as representing part of the cost of the claim. To this extent
provision for future expenses is built into both the outstanding claims reserve and
the unearned premium reserve. However, if the technical reserves are to be
sufficient to run off the existing business with a low probability of proving
inadequate, some further provision must be made for future expenses. This must
cover both the overheads of maintaining a reduced operation to run off the
business and the higher costs which would be incurred in the short-term in
moving into a run-off situation. The overrun reserve should include the
additional costs, such as redundancy payments, which would be incurred if the
company were closed to new business.
4.7.2. As with claims costs, the level of future expenses can only be estimated.
There are particular difficulties when the estimation involves envisaging
completely different management arrangements for the company in future, and
an unknown and untrodden path from the management of the company as a
going concern to its management as a closed fund. The principles which we have
enunciated for technical reserves apply equally here, however, and the provision
made should be prudent, embodying sufficient margins over the expected level to
ensure a high probability that it will be adequate. As mentioned in § 3.2.2, an
expense reserve calculated on the basis of notional discontinuance would not be
appropriate for the purposes of Companies Act accounts.
5. VARIABILITY OF ASSETS
5.1. Asset valuation
5.1.1. The solvency margin of an insurance company is defined in terms of the
excess of the value of the assets over the value of the liabilities. It is, therefore, as
important to be satisfied about the value of the assets as about the value of the
liabilities.
5.1.2. As discussed in § 3.3.9, companies must value their assets on a current
market value basis for returns to the Department of Trade and Industry. Specific
rules for valuation are laid down for many types of asset. Certain assets cannot be
taken into account at all and in other cases limits are placed on the amount (as a
proportion of the total) for which credit may be taken, in order to reduce
overdependence on particular types of investment and on particular companies
or individuals.
5.1.3. Most assets held are susceptible to a fairly precise evaluation in
accordance with these rules. There is in principle no scope for overvaluation and
the scope for undervaluation is limited to certain areas (e.g. property and
dependants).
5.1.4. However, it is not enough simply to consider solvency in relation to a
static balance sheet position. What is at issue is whether the proceeds of income
and capital from the assets will be adequate, with a high degree of probability, to
meet the liabilities as they fall due. In principle this requires attention to be
focussed on cash flows, and a comprehensive examination of the solvency of a
company would have to give proper attention to this aspect.
5.1.5. Looking at the situation from a cash flow point of view, one would
model the development of the liabilities, in terms of not only their amount but
their incidence, and also the emergence of income from the assets. The asset
projection would need to incorporate stochastic models of the equity and
property markets and due allowance for the risks of default. This would enable
probabilistic statements to be made, in terms of the model, as to the adequacy of
the assets to meet the liabilities. Approaches along these lines are outlined in
papers by Coutts et al.(16) and Ryan(17,18).
5.1.6. For the purposes of financial reporting and the solvency control
mechanism the extent of subjectivity in such an approach is a significant
disadvantage, as is the difficulty of concise presentation. In practice, for
supervisory purposes, we do not see any easy alternative to setting standards for
the solvency margin in terms of the excess of assets over liabilities in the balance
sheet.
5.1.7. Market values may be regarded as a consensus valuation of likely future
cash flows at the market interest rate and for consistency should perhaps be
compared with a similarly discounted value of the liabilities. However, on the
liabilities side we have argued for cautious estimates to be made and the attitude
to discounting must reflect this approach. Market values of the assets do not
normally embody any margins of a similar nature, either in the implicit cash flow
or the implicit market rate of discount.
5.1.8. As a result, there is a significant probability that the assets may prove to
be less valuable than indicated by the market value, for example, because
dividend growth fails to meet the market’s expectation, because of unforeseen
risk factors or because market yields move in an unexpected way.
5.1.9. For their shareholders’ accounts a number of companies use some
variation on historic cost instead of market values. However, historic cost for an
investment portfolio is subject to manipulation by selective dealing. The margins
produced are uncertain and it is possible in certain conditions for assets to be
valued at more than current market values.
5.1.10. On balance we see advantages in disclosing assets on a market value
basis. However, this means that explicit margins are needed to cover asset
variability. In our view a significant part of the necessary margin should be
included in the technical reserves as a mismatching reserve, which, as in the case
of long-term business, would be defined as ‘appropriate provision against the
effects of possible future changes in the value of the assets on their adequacy to
meet the liabilities’.
5.1.l1. For general insurance companies inclusion of such an item in the
technical reserves would be a new departure, although it is logical that provision
should be made. It would still be needed to ensure a satisfactory run off of the
liabilities if the company was closed to new business because its solvency margin
was inadequate.
5.2. Changes in asset values

5.2.1. We are concerned with the appropriate level of provision to cope with
fluctuations in asset values. This requires an assessment of how much capital
could be lost if the market values were to fall, as well as an analysis of any
implications for the value of the liabilities.
5.2.2. Among the factors influencing market values are interest rates, inflation,
profitability and dividend policy of companies whose shares are held, property
rentals, taxation and exchange rates. Many of the factors are inter-related but
they do not necessarily affect different investment sectors in the same way.
5.2.3. A modelling approach could be used to examine portfolio behaviour,
either involving pure technical analysis of data series or embodying explicit
assumptions about some of the relevant economic parameters. However, such an
approach is not without problems, because:
(i) one cannot always assume that asset distributions will be kept stable for
long; and
(ii) market structures change with time so a long past series of data may be of
only limited relevance.
In particular, we did not consider that the model recommended by the Working
Party on Maturity Guarantees(19) was appropriate in view of the very short
projection period on which we were focussing.
5.2.4. Given these problems. the accuracy implied by a sophisticated modelling
approach may be to some extent spurious and a useful working standard can be
obtained by examination of data on price movements over the years. From
analysis of this data we consider that, to ensure a high probability of being
adequate (comparable to that suggested for the liabilities), the provision against
falls in asset values should be at least sufficient to cope with changes of this order:
Sector Change in value

Fixed interest (other than
very short-dated)* –25
Equities-U.K. and overseas –60
Property –50
Index-linked –20
*This might be defined as having a term of
maturity of more than 3 years.
5.2.5. These are by no means the largest falls which have been recorded in
recent times. From the beginning of 1973 to the end of 1974 equities (as measured
by the F.T.–Actuaries 500 Share Index) fell by 68% of their value at the beginning
of 1973. In 1974 alone the fall was 54% of their initial value. The corresponding
figures for medium-term gilts (as measured by the F.T.–Actuaries 20 year
government securities index) were 44%, and 29%. The volatility in short-dated
gilts is. of course, much less.
5.2.6. In 1973 and 1974 the values of equities and gilts both fell. Property
values also declined, particularly in 1974. It is, therefore, not unreasonable to
expect prudent provision against the effects of asset variability to be sufficient to
cover the falls in value indicated above in all sectors at once. Consideration
would also need to be given to the variability or uncertainty associated with other
types of asset held, such as agents’ balances and investments in dependants.
5.3. Avoiding the risks of asset variability
5.3.1. We have referred to the need to consider the relationship between asset
and liability values. Matching of assets and liabilities, well-established in life
assurance, is less easy to apply in general insurance. Sudden changes in market
values will often have a direct impact on the solvency margin, because they
cannot be compensated for in the valuation of liabilities, except where technical
reserves are discounted and the change in the asset values permits an adjustment
to the rate of interest used, or where there has been a marked change in the
prospects for inflation.
5.3.2. To reduce the risks of asset variability, investments should match the
approximate timing and amount of the claims run-off. This suggests a relatively
short average time to maturity and some degree of inflation protection, e.g.
an index-linked gilt of term five years or less. If a reasonable inflation as-
sumption can be made, short-dated fixed-interest stocks may be an alternative.
With some longer-tailed business, matching the incidence of outgo may be
difficult, but it is important to try to secure some measure of protection against
inflation.
5.3.3. Where liabilities are not discounted, changes in the adequacy of the
assets to meet the liabilities can only be avoided by investing in cash deposits.
We have the paradox that investments which could be regarded as matching
the liabilites may result in a volatile balance sheet, whilst investing to
produce stable asset values may result in exposure to losses if inflation
accelerates.
5.3.4. An analysis of the effect of fluctuations in asset values on their adequacy
to meet the liabilities against which they are held has been carried out by Treen
and Thomson(20). This pointed to a need for mismatching reserves and additional
solvency margin of similar order to that suggested by the falls in asset values
given in § 5.2.4.
5.3.5. In practice, companies try to maximize their total investment returns
within certain constraints. This usually involves adopting a riskier investment
strategy, which increases the desirable level of mismatching reserve and
additional solvency margin. Assessing the balance between risk and reward is
very complex and it is necessary to look at the position of each individual
company. However, although many of the stronger companies have adequate
margins to compensate for the riskiness of their investment strategy, it must be
regarded as unsatisfactory that there is no general acknowledgement of the need
for mismatching reserves, and the statutory required solvency margin is clearly
quite inadequate to cover the risks of asset variability.
5.4. The effect on solvency

5.4.1. The following illustrative figures are based on a company with annual
premiums of £100m, technical reserves of 125% of premiums, a solvency margin
of 70%, and an asset distribution based on the average for U.K. general insurance
companies:
Assets % £m
Fixed interest 45 88
Equities—U.K. 28 54
—Overseas 5 10
Property 12 23
Cash 10 20
100 195
Liabilities
Technical reserves 125
Solvencymargin 70
5.4.2. The impact of the falls in asset values envisaged in §5.2.4. would be as
follows:
Current Reduced
value Factor value
£m £m
Fixed interest (other
than very short-dated) 44(say) ·75 33
Equities—U.K. 54 ·4 22
—Overseas 10 ·4 4
Property 23 ·5 12
Cash and short-dated
fixed interest 64 1 64
195 135
This would largely eliminate the solvency margin even without adverse
experience in other respects.
5.4.3. The above assumptions are not particularly stringent, since the initial
solvency margin is fairly high, and the asset distribution and the gearing of
provisions to premiums is average rather than risky. The illustration lends
support to the assertion that for a typical company, most of the current solvency
margin (and much more than the statutory required solvency margin) is required
to cover possible asset fluctuations.
5.4.4. For comparison with the average asset distribution used above, the
distributions of assets for the seven quoted composites at the end of 1982 (from
the shareholders’ accounts) are shown in Table 1.
5.4.5. Our calculations indicate that, over the last twenty years, assuming tax
at an average rate of 50% on income, it has been possible to obtain a net of tax
return on equities of about 10% a year compared with about 2½% on gilts, whilst
inflation has averaged 99½%.The rewards of being in equities have been very large.
If companies had been pressed to reduce investment risk by not investing so
heavily in equities, profitability and solvency margins could have been main-
tained only through higher premiums.
Table 1. Asset distributions as at 31 December 1982
Commercial Eagle General Sun
Union Star* Accident* Royal Alliance GRE Phoenix*
% % % % % %
Text
Gilts 46 17 33 25 42 35
24 }
Other fixed interest 50 11 18 19
23 32
Equities—
U.K. & Overseas 15 39 33 23 34 21 21
Property 8 13 12 8 23 13 18
Cash 8 7 5 4 7 6 7
Total 100 100 100 100 100 100 100
* Estimates—precisemarket values not published.
5.5. Further problems with investments

5.5.1. The growth in the options and financial futures markets enables
companies to reduce the riskiness of their portfolios. However, they can also
significantly increase the risk. The admissibility limits are helpful for limiting the
impact of risky investments and of asset concentration, but they do not restrict
concentration of investment in a number of different companies or properties
whose futures are closely linked, nor do they preclude all high-risk assets.
5.6. A practical solution

5.6.1. It is clear that the potential variability in the assets needs to be taken into
account as a major factor in the assessment of a company’s solvency. In order for
the assets covering the technical reserves to be adequate to run off the liabilities
with a high degree of probability, appropriate provision ought to be made within
the technical reserves to cover the effects of changes in the value of the assets on
their adequacy to meet the liabilities. Such provision will depend on the extent to
which the liabilities are matched, and on whether the value of the liabilities can be
adjusted to reflect changes in the value of the assets. It would not necessarily need
to be so stringent as to be able to withstand the more violent fails in asset values
which might be envisaged.
5.6.2. In addition to such provision being mandatory, the required solvency
margin should include an element to cover the risk of the more extreme falls in
asset values, and to provide an additional buffer. If the solvency margin is itself
maintained in assets subject to considerable variability, its amount should be
correspondingly greater.
5.6.3. Falling asset values may be to some extent mitigated by portfolio
changes but it may be difficult for investment managers to know how to react in
an uncertain situation and there will always be a reluctance to lock in losses. If
asset values fall only temporarily, the problem may be largely presentational, and
the supervisor would not need to withdraw the authorization of companies
unable to meet the solvency requirements at a particular date if the position had
subsequently been rectified. Only with a prolonged shift in market values would
the effects be serious.
5.6.4. With the above factors in mind, and having regard also to the possibility
of some adjustment of the value of the liabilities in the event of very high interest
rates becoming established, it may not be unreasonable to accept total provision
which would be adequate to cover rather less than the direct effect of the full fall
in asset values suggested in §5.2.4. We return to this in §9when we consider the
possible overall impact of our proposals.
6. REINSURANCE
6.1. The need for reinsurance
6.1.1. In assessing the solvency of a general insurance company it is important
to consider the extent to which reinsurance has been effected and also the quality
of the security offered by the reinsurers.
6.1.2. We have already identified that a major area of uncertainty in
determining the solvency of a company is in establishing a prudent level of
reserve for outstanding claims. This uncertainty is especially great where large
claims can arise or where there is the possibility of accumulation of claims in
respect of single events. A properly constructed reinsurance programme can
reduce this uncertainty and help to ensure continued solvency.
6.2. Gross or net provisions?

6.2.1. In many countries insurance companies are required to set up technical
reserves in respect of gross liabilities, even where reinsurance recoveries are
expected. It is common in such countries for a reinsurer, especially in cases of
proportional reinsurance, to deposit premiums back with the ceding office, so
that the ceding office can set up the required provisions. Since technical reserves
are intended to be adequate on a gross basis these countries would not need to
supervise the continued solvency of the reinsurers. In principle, given this
approach, margins in the technical reserves and the explicit solvency margin
should be adequate to cover the uncertainty in the technical reserves on a gross
basis, and the mismatching reserve would relate to the gross assets.
6.2.2. The approach adopted in the U.K. is quite different. Insurance
companies are allowed to take credit, in setting up their technical reserves, for
recoveries expected from reinsurers. Reinsurance companies operating in the
U.K. are subject to supervision by the authorities on a similar basis to the
companies which write business directly with the public.
6.2.3. In assessing the net technical reserves, regard must be had to the security
of the reinsurance. particularly where reinsurance has been ceded to overseas
companies which are not supervised by the U.K. authorities. If there are serious
doubts about the solvency of any particular reinsurer, recoveries from that
source should be disregarded in whole or in part. Even where there is no specific
problem, it may be prudent to provide to some extent against the possibility of
default. These provisions are akin to the bad debt provisions made by banks. The
former is a specific provision against a known problem, whereas the latter is a
general provision against potential problems. To scale down expected recoveries
from reinsurance in this way in determining net technical reserves will be
necessary in many circumstances for reasons of prudence.
6.3. Reinsurance and the solvency margin

6.3.1. If reinsurance recoveries could be relied on absolutely, the margins
required in the technical reserves would be based on the variability net of
reinsurance, and the necessary solvency margin could similarly be calculated by
reference to the uncertainty in estimation of the net technical reserves. In the real
world, however, something less than 100% of expected recoveries should be
credited in setting up technical reserves, as discussed in §6.2.3, and the solvency
margin may also be required to cover the impact of more widespread failure of
reinsurers, particularly in the event of major catastrophes. The allocation of a
general provision against reinsurance failure between the technical reserves and
the solvency margin is bound to be somewhat arbitrary.
6.3.2. Early OECD proposals for explicit solvency margins (the Campagne
report(21)) included a specific addition to the required solvency margin of 2½% of
reinsurance premiums paid, to guard against the risk of failure of reinsurers.
Under the E.C. Non-Life Establishment Directive, net incurred claims cannot be
taken as less than 50% of gross incurred claims in calculating the required margin
of solvency, but for many companies this is not a significant restriction.
6.3.3. To cover as yet unidentified bad debts from reinsurers we suggest that
some part of the required explicit solvency margin should be defined in relation
to the dependence of the company on reinsurance recoveries.
6.3.4. It would be logical to relate this additional margin to the difference
between gross and net technical reserves. It may be argued that gross technical
reserves would be difficult to establish in some cases, particularly with some
forms of treaty reinsurance, and that estimation of gross technical reserves would
involve significant extra work. We would be surprised if this were necessarily the
case, however, since in current circumstances we believe it to be desirable that
prudent management should have some regard to their possible exposure in gross
terms, bearing in mind the perceived security of their reinsurers. The returns
under the Insurance Companies Acts already require a large volume of
information on a gross basis for all classes of business other than treaty
reinsurance.
6.3.5. There are some advantages in using the reinsurance premiums paid as a
proxy for the recoveries expected, as in the OECD proposals. We suggest,
however, that this approach has significant disadvantages, for the following
reasons:
(a) The reinsurance premiums may be inadequate to cover the risks.

(b) The recoveries anticipated in any balance sheet cannot be simply related to
the reinsurance premiums paid in any particular period.
6.3.6. There is no rational basis for deciding on a percentage figure to be
applied to the difference between gross and net reserves. In the event of a
supercatastrophe resulting in widespread insolvencies amongst reinsurers, any
provision short of 100% may turn out to be inadequate. However, provision at
this level is equivalent to requiring gross reserves, and would severely affect the
ability of the insurance market to underwrite large risks. Nevertheless we think
that the solvency margin should include cover against the possibility of some
reinsurance recoveries failing, and, with all the uncertainties of the world
reinsurance market, a figure of 5% of anticipated recoveries does not, in general,
seem too high. For higher quality reinsurers, including those subject to stringent
supervisory systems, this figure may be too high, but for many reinsurers it could
be regarded as too low. For various practical reasons it is impossible to
distinguish adequately the quality of reinsurers for the purposes of setting
statutory solvency margins and so a compromise figure is necessary. Differentia-
tion between apparently higher or lower risk reinsurance programmes can more
easily be made by a professional assessment within the company and reflected in
the provisions within the technical reserves.
7. DISCOUNTING OF LIABILITIES
7.1. The case for discounting
7.1.1. The large reserves accumulated by general insurance companies can be
invested to produce investment income and capital appreciation. Traditionally,
attention has focussed on the underwriting result, investment income being
treated almost as a windfall profit. This contrasts strongly with life assurance,
where premiums and reserves are based on explicit assumptions about the
investment income anticipated on the reserves available throughout the duration
of the contract.
7.1.2. In life assurance, the contingencies insured against have generally not yet
arisen and the office will be on risk for many years to come, in return for payment
of predetermined premiums. The contingencies may be adequately represented
by models incorporating probabilities and, sometimes, stochastic variables. The
amount of a claim is often predetermined and it may be possible to purchase
investments to produce a stream of income and redemption proceeds which will
closely match anticipated outgo.
7.1.3. The largest part of general insurance reserves are generally held for
outstanding claims. where the contingency insured against will already have
occurred. In many cases, the amount and date of settlement may be unknown
and reporting delays may mean that the company does not know that a claim has
been incurred.
7.1.4. Settlement patterns are discernible which, subject to trends and other
perturbations, provide a basis for estimating rates of settlement. Uncertainty of
claim amounts is the factor which primarily gives rise to the variability discussed
in §4.
7.1.5. In life assurance, it is accepted that it would be unreasonable to reserve
for the full face value of future payments. If assets are valued at market value,
representing the market’s assessment of the discounted value of future income
and capital proceeds, liabilities may be correspondingly discounted, provided
they are matched with appropriate assets and conservative assumptions are made
about future investment. Specific mismatching reserves may also be necessary.
7.1.6. Matching general business liabilities presents greater problems because
claim amounts are unknown and they are at least partially dependent upon
inflation. An appropriate investment policy might include equity-type assets but
this would expose the office to the risk of capital depreciation. Investment in fixed
interest securities would permit more satisfactory matching by term but provide
no hedge against inflation. Investment in cash or deposits exposes the company
to a reinvestment risk.
7.1.7. Thus, matching is an elusive concept for general business liabilities.
Hence, market practice tends to be to avoid taking credit for future investment
income, welcoming it as additional profit when it arises.
7.1.8. Corresponding prudence might be expected in providing for possible
asset depreciation. Most major companies, through written down balance sheet
values or large solvency margins. or both, could withstand major asset
depreciation without technical insolvency. In §5we have made out a case for
requiring specific provision to be made against the effects of changes in the value
of the assets.
7.1.9. Some, however. would argue that taking credit for future investment
income is acceptable, particularly if settlement periods are extended and
settlement patterns stable, provided that the assumptions made are reasonably
conservative.
7.2. Is it prudent?
7.2.1. It might be thought imprudent to use discounted reserves because of the
inherent uncertainty of the claims settlement process. However, the assumptions
about future inflation and the allowance made for variability must also be taken
into consideration.
7.2.2. At present, it is not unusual for reserves to be significantly weaker than
the standard envisaged in §4.It is perhaps as well, therefore, that discounting is
not thought appropriate.
7.2.3. Effectively, current practice is implicitly to offset margins which should
be provided for variability and future inflation against anticipated investment
income. This is unsatisfactory, even though the classes of business with the
greatest implicit margins from future investment income are often those which
need substantial margins against fluctuations and inflation.
7.2.4. We consider that discounted claims reserves should be permitted only
where sufficiently prudent assumptions have been made about future claims
inflation and variability has been explicitly allowed for. Otherwise, profit may be
released too early and reserves might later prove inadequate.
7.2.5. We also consider that implicit discounting can be imprudent. Inflation
and variability should be fully taken into account. Where discounting is not
applied, the reserves will contain significant margins; if it is applied prudently, the
reserves will still be adequate.
7.2.6. In most cases, the appropriate guide for investment return is the gross
yield on assets, because additions to reserves are tax deductible. The resulting
yield should be reduced for any high risk content within the existing investment
return and to ensure that a prudent assumption is made as regards reinvestment.
Further margins could be taken by assuming a rate of interest lower than these
considerations would imply.
7.3. Accounting implications of discounted claims reserves

7.3.1. If one considers how discounting claims reserves relates to the
fundamental accounting concepts discussed in §3.2.1. one can see that it can be
regarded as consistent with the going-concern concept and. if employed in each
accounting period in the same way, with the consistency concept. Discounting
does not. however. conform with the matching principle. for it spreads part of the
cost of a claim into later years. although this will match investment income
earned on the reserves. If investment income is specifically allowed for in setting
premiums, then it may be argued that discounting is consistent with the accruals
concept.
7.3.2. Discounting appears to be contrary to the concept of prudence, since
provision is being made explicitly for less than a prudent estimate of the expected
eventual liability. However, SSAP2 states that accounting concepts are not
intended to be a substitute for commercial judgement and, the longer the period
taken to complete business transactions, the greater the need for such judgement;
hence the justification for not complying entirely with the prudence concept. In
any case. if prudence is incorporated at every stage of the calculation, the overall
result should be adequately prudent. This is the case in the actuarial approach to
valuing life business and is accepted as perfectly proper and prudent.
7.3.3. The Sandilands report(22) concluded that only current methodology
prevented companies including liabilities as well as assets at their current value,
and cited life offices as an example of where this is already done. If assets are
included at market value. it can be argued that the current (discounted) value of
liabilities should be used. as with life offices.
7.3.4. Under a system of discounting, the amount held for each underwriting
year will, other things being equal. increase in line with the assumed rate of
return. Investment income in excess of the assumed rate will fall into profit.
Profits and losses relative to the valuation basis may also occur as a result of
variation in the speed of settlement.
7.3.5. We agree with Abbott et al.(23) that discounted claims reserves can give a
true and fair view of an insurance company’s affairs. We believe that it can be
consistent with prudent reserving standards, if the provisos outlined in §7.2.4 are
met.
8. THE SCOPE FOR AN ACCOUNTING STANDARD

8.1. Background to accounting standards
8.1.1. In January 1970 the Institute of Chartered Accountants in England and
Wales issued a “Statement of Intent on Accounting Standards in the 1970s” and
later that year the Accounting Standards Committee was established. Non-
mandatory guidelines had been issued since the early 1940s but matters were
brought to a head by a number of much publicized controversies in the late 1960s.
These crises led accountants to fear government intervention and accounting
standards were seen as a demonstration that the profession was able to regulate
itself.
8.1.2. The Statement of Intent mentioned four major objectives: the narrowing
of differences in the variety of accounting principles, the disclosure of accounting
bases, the disclosure of departures from established definitive standards, and the
wider exposure of major new proposals.
8.1.3. The acceptance of the first few standards was straightforward because
many of them dealt with subjects which were related to the earlier crises. Later
proposals have encountered more problems. The original standard on deferred
taxation had to be withdrawn and replaced following criticism. Difficulties with
investment properties delayed the implementation of the depreciation standard.
The problems of a standard on inflation accounting have frequently seemed
particularly intractable.
8.2. The case for and against accounting standards

8.2.1. It has been argued that standards become petrified and impede progress.
Accounting standards may enable accountants to abdicate the responsibility of
making professional judgements and to rely on a ready-made code.
8.2.2. Companies differ widely. A standard aimed at the typical company may
be quite unsuitable for many special circumstances. Standards may lead to
concentration on complying with the rules rather than imparting reliable
information.
8.2.3. The results of companies can, however, be assessed fully only by
comparing them with each other. There needs, from a user’s point of view, to be
some standardization, and disclosure of vital areas where treatment differs.
8.2.4. To assess the results of an individual company over a period of time, the
results need to be prepared on a consistent basis. The value of the auditor’s report
is undermined if accounting methods and policies are not standardized or at least
disclosed.
8.2.5. The consultative processes by which accounting standards are developed
compel accountants and others involved in financial reporting to examine and
justify what they are doing. This should lead to better understanding and greater
efficiency. The development of accounting standards should improve both
financial statements for external users and the quality of information for
managers.
8.2.6. Standard setting is a complex political and social as well as financial
process. A new standard is not lightly to be embarked upon, unless opinion is
strongly in favour of it or there is a threat of government regulation otherwise.
8.2.7. We are convinced that minimum standards are needed in the area of
general insurance reporting, because of the uncertainty over what constitute
generally accepted accounting concepts, bases, and methods for insurance
companies. This is particularly so as far as returns to the Department of Trade
and Industry are concerned, but we believe that standards are also needed
(although these may be somewhat different) for Companies Act accounts.
8.2.8. The mechanisms by which a standard for the statutory returns might be
developed and adopted fall beyond the scope of this paper. We have described it
here as an accounting standard since that is the terminology of Regulation 52 of
the Insurance Companies Regulations 1981. However, much of what we see as
appropriate for inclusion in such a standard goes beyond ordinary accounting
principles and is more closely akin to the reserving standards developed by
actuaries over the years in connection with life insurance. It could be argued that
a similar position to that of appointed actuary is needed in general insurance
companies and that this ‘loss reserving specialist’ within the company would be
responsible for ensuring that reserves are set up in accordance with the agreed
standard, which needs to be developed in consultation between actuarial and
accounting professions and representatives of the insurance industry.
8.2.9. If the professions and the industry cannot develop between themselves
suitable standards for the returns it seems likely that Government regulation will
eventually be made in this area, resulting in a much less flexible solution.
8.3. Scope of a possible standard

8.3.1. The scope of a possible standard for solvency reporting on general
insurance companies must now be considered. Firstly, the relationship to existing
accounting standards must be decided. Present standards relate almost entirely
to factors which are common to all industries and it seems reasonable to propose
that any specific insurance standard would operate within this framework. For
matters such as group accounts. deferred taxation, translation of foreign
currencies etc., the prevailing standards would apply. The specific standard
would cover only those aspects peculiar to general insurance companies.
8.3.2. The context of this paper has been that of demonstrating solvency to
supervisory authorities and other third parties. The principal vehicle for this
is the returns submitted under the Insurance Companies Acts. Although these
are governed by regulations, we have already noted that no rules are prescribed
for valuing general business liabilities except the application of generally
accepted accounting principles. A reserving standard is needed primarily to
provide a basis for these returns, although some parts of such a standard might
be regarded as being appropriate also for accounts prepared under the
Companies Acts.
8.4. Asset valuation
8.4.1. The Insurance Companies Regulations 1981 already prescribe methods
of valuing most types of assets. In this context it would not seem appropriate for
a standard to lay down any modifications to the prescribed values, even though
these values might not be realized if assets had to be sold to pay claims. It would,
however, be entirely consistent with the approach adopted in respect of life
business to require the technical reserves to contain a mismatching reserve,
defined as provision to cover the effects of changes in the value of the assets on
their adequacy to meet the liabilities.
8.5. Valuation of liabilities

8.5.1. As far as the valuation of general business liabilities for the returns is
concerned, there is a need for a more comprehensive standard as a basis for a
consistent and prudent approach to reserving. The absence of any standard, or of
any statutory rules, throws into question the validity of measuring a company’s
declared solvency margin against a clearly prescribed minimum.
8.5.2. One question to consider is whether a purely retrospective approach to
the valuation of liabilities should be permitted or whether some consideration
must be given to prospective valuation. A particular case of this concerns the
conditions under which three year accounting and its variants might be
permitted. We see no reason to outlaw accounting on a funded basis, but we
believe that stricter criteria should be imposed in relation to assessing the
adequacy of the fund in the open years and that there should be full disclosure of
methods used to determine the technical reserves for the closed years and to test
the adequacy of the fund in the open years.
8.5.3. For one year accounting, consideration would need to be given to the
appropriate level of provision for unexpired risks. Matters to be covered might
include:
(a) What bases are acceptable for calculating unearned premiums? What
disclosure about the computation will be required?
(b) What factors should be taken into account in assessing whether any
additional provision, over and above unearned premiums, is required for
unexpired risks? Should a loss ratio be assumed which is prudent in
relation to recent experience and includes a margin against the potential
variance in the ratio? To what extent should unevenness in the incidence of
risk be taken into account? What disclosure requirements should there be?
(c) How should deferred acquisition costs be dealt with? Should they be
netted against unearned premiums or shown gross? What details of the
calculation should be shown?
8.5.4. Some of the most important issues, for our purposes, arise in connection
with the estimation of outstanding claims. A standard would need to address
itself to:
(a) The method of estimation to be used. Should case estimation be permitted
and, if so, should the results be checked by statistical methods? Should a
number of specific statistical methods be recommended or should
complete freedom of choice be left to the company? What disclosure of the
assumptions should be required?
(b) The degree of conservatism in estimation. Should full provision for the
estimated future cost of claims be required? What provision should be
required for future inflation, and what should be disclosed about the
assumptions made in this respect? Should a margin of safety for variability
above the mean estimate be required as discussed above in §4.3.10? What
disclosure should be required in relation to the margins?
(c) Claims incurred but not reported. What methods should be stipulated or
permitted for IBNRs? What disclosures relating to IBNRs and their
calculation should be required?
(d) Discounting. Under what circumstances should discounting be permitted?
What constraints should there be on the assumptions employed? What
disclosures should be required about the assumptions made in discount-
ing?
(e) Mismatching. Should provision be made against the effects of possible
future changes in the value of the assets on their adequacy to meet the
liabilities? What disclosure should there be as to the extent to which the
nature and term of the assets have been taken into account?
(f) Reinsurance. In what circumstances should provision be made in the
technical reserves for the possibility of reinsurance failure?
8.5.5. There are a number of further matters which might be covered by an

accounting standard for Companies Act accounts, in particular in relation to the
treatment of certain items of income and expenditure for the purposes of
demonstrating operating profit. Although it might not be appropriate to require
the same margins in the technical reserves for variability, we consider that a
prudent approach is still required.
8.5.6. The scope of reserving standards for general insurance companies could
be very wide, or could be restricted to certain key aspects. Our principal concern
in relation to solvency has been with the adequacy of the provision made for
outstanding claims and unexpired risks and with the questions of mismatching
and reinsurance security. As a minimum we would want to see an acknowledge-
ment that provisions for outstanding claims and unexpired risks should normally
be tested by statistical methods, that they should include a prudent allowance for
inflation (including ‘social’ inflation, for example resulting from court awards)
and a margin of perhaps 1½ standard deviations above the mean estimate, and
that where discounting is practised it should be on prudent assumptions.
Furthermore, there should be full disclosure of methods and bases used. We
would also like to see proper attention paid to the need for mismatching reserves
and to prudent provision against the possibility of reinsurance failure.
9. THE SOLVENCY MARGIN

9.1. The role of the solvency margin
9.1.1. It remains to be considered what level of minimum solvency margin
would be appropriate, on the assumption that technical reserves meet the
standards outlined in the previous chapter. The solvency margin provides a
contingency reserve to meet the more extreme possible variability in both assets
and liabilities, as well as providing a buffer to enable corrective action to be taken
by the supervisory authority before a real state of insolvency is reached.
9.1.2. In practice, with the standard of technical reserves we are advocating, it
should still be possible to run off the business satisfactorily, even when the
solvency margin has disappeared, in perhaps 9 out of 10 cases. This, we believe, is
how it should be. Technical reserves which only stand a 50% chance of being
sufficient to run off the liabilities in these circumstances can hardly be considered
adequate.
9.2. The components of the solvency margin

9.2.1. We suggest that the solvency margin should be built up out of five
independently calculated components. These would relate to the following risks:
(a) Asset depreciation.
(b) Extreme fluctuations in the claims run-off.
(c) Reinsurance failure.
(d) Underwriting risks.
(e) Other unquantifiable risks.
We consider each of these in turn.
9.3. Asset depreciation

9.3.1. The dangers to a general insurance company of sudden depreciation in
the realizable value of the assets held have been considered in §5.We have argued
there for a mismatching reserve to be included in the technical reserves, as the
effects of changes in the value of the assets on their adequacy to meet the
liabilities are just as important a factor for a company running off as for one still
active in the market. We do not consider it feasible to require margins to be taken
in the value placed upon the assets in the balance sheet, other than those required
by the asset valuation regulations, but a component of the solvency margin
should be designed to give protection against possible falls in the value of assets
which are not covered by the mismatching reserve.
9.3.2. The degree of risk depends upon the assets held and the relevant part of
the solvency margin should reflect this. The considerations in §5suggest that the
overall level of such provision should be substantial, particularly in respect of
equities and property, if not improbable falls in asset values are not to leave the
technical reserves uncovered. For example, the figures in §5.2.4would point to a
mismatching reserve and solvency margin which together would protect the
company against falls in the value of the assets of the following order:
%
Fixed interest (other than very short-dated) 25
Equities 60
Property 50
9.3.3. The balance between provision as a mismatching reserve and as part of
the required solvency margin should be drawn on the basis of the same principles
as we have enunciated generally for technical reserves and solvency margin.
However, the calculation of the mismatching reserve involves consideration of
the inter-relation between the income-flows from assets and the liability-outgos,
and not just the balance sheet effects of a sudden fall in capital values.
9.3.4. This means that the total of the appropriate mismatching reserve and
additional solvency margin would in practice usually be rather less than would be
needed to cover a straight fall in the value of the assets of the magnitude
suggested. It might also be regarded as too stringent to assume a permanent fall
in asset values of this magnitude. In 1975 the market recovered as quickly as it
had fallen in 1974, and the effect on balance sheets was purely temporary.
9.3.5. For purposes of illustration, therefore, we consider what the effect might
be of overall provision sufficient to directly cover a fall in the value of assets
backing technical reserves and required solvency margin of about half the above
level:
%
Fixed interest (other than very short-dated) 10
Equities 30
Property 25
In practice different factors would be appropriate at different times, depending

on market levels at the time. If the market is already historically low the
probability of further falls of this magnitude can be expected to be less.
Consideration would need to be given to a practical way of modifying the factors
to take account of the current market situation.
9.3.6. A significant proportion of this provision should be incorporated in the
technical reserves, but, since present practice is not to set up mismatching
reserves, we illustrate the overall impact of our ideas on solvency margins by
treating the whole of the mismatching provision as additional solvency margin.
9.4. Claims fluctuation

9.4.1. We have suggested in §4that technical reserves should incorporate a
margin for variability in the run-off of outstanding claims equivalent to 1½
standard deviations over the mean. A reasonable criterion for the solvency
margin component intended to cover this aspect might be that it increased the
total provision to 3 standard deviations above the mean. As discussed in §§4.3.7
ff., an alternative approach would have been to express this level of overall
security in terms of a probability of ruin. On the basis of a normal distribution the
criterion of 3 standard deviations above the mean is equivalent to a probability of
ruin of just over 1/1000. With distributions which in practice could be somewhat
more skew than the normal distribution. the corresponding probability of ruin
would be rather higher.
9.4.2. It would in our view present difficulties in practice to have a statutory
solvency margin requirement which depended on characteristics of the claims
distribution for each particular company and risk group, although this is done in
Finland and has been suggested in Norway. The range of types of company and
types of business written makes it difficult to adopt a similar solution in the U.K.
However, some reflection of the variability of different classes of business seems
essential. The most practicable option for statutory purposes appears to be to
establish factors by accounting classes, based on an average of the ratio:
These would be applied to the outstanding claims reserves for respective

accounting classes. The calculations we have carried out (see the Working Party
Report(5)) suggest that the following percentage factors might be appropriate:
Accounting class %
1. Accident and Health 19
2. Motor Vehicle 10
6. Property Damage 13
7. General Liability 14
8. Pecuniary Loss 18
Further work would need to be carried out to ensure that the factors chosen are
suitable for this purpose and, in particular, to indicate appropriate factors for
Marine, Aviation and Cargo business and for Treaty Reinsurance business. For
the sake of illustration we have assumed that the variability of the run-off for
these other classes might be somewhat greater and have taken the factors to be
20%.
9.4.3. The additive combination of these additional solvency margins for
different classes of business would produce overall a significantly more stringent
standard of solvency than envisaged in §4.If the distributions for the different
classes were independent, the effect of convoluting the distributions could be to
reduce the standard deviation of the total distribution to less than half of the sum
of the standard deviations (depending on the mix of the business). In practice
there is likely to be some correlation between underprovision in different classes
both because of the common impact of inflation and because of companies’
reserving practices, and it might be reasonable to reduce the total solvency
margin required in respect of this item to 75% of the total of the individual
solvency margins, where several classes of business are written.
9.4.4. We have not done any research into the impact of variability on
unexpired risk reserves, although we very much doubt whether such reserves are
in general as strong as would be required by the approach sketched out in §4.6.3.
Further work would be needed to indicate what additional solvency margin
might be needed to cover the more extreme adverse development of claims in
respect of unearned premiums, and we have not suggested any specific figures at
this stage, particularly in view of the fact that further work needs to be carried out
on the quantification of the additional solvency margin component discussed in
§9.6.3 below.
9.5. Reinsurance failure

9.5.1. In §6we outlined issues in relation to taking credit for reinsurance
recoveries and concluded that it is not unreasonable for credit to be taken for
reinsurance recoveries, and for variability to be measured in relation to the net
run-off, although consideration should still be given to the need for a general
provision in the technical reserves against the risk of reinsurance failure.
However, whether or not such a provision is made, it seems reasonable that the
required margin of solvency should contain a specific component to cover the
risk of more widespread failures, although for the reasons given in §6.3.6 this can
be no more than a partial provision against catastrophic failure of reinsurance
arrangements.
9.5.2. It is probably not feasible to relate a statutory solvency margin to any
perceived level of security of individual reinsurers. The potential loss is 100% of
reinsurance recoveries but the probability of complete failure of reinsurance will
normally be very small. The only practicable solution seems to be to require a
solvency margin based on a percentage of the total recoveries expected from
reinsurers, with possibly some crude differentiation between reinsurers whose
operations are subject to control by the supervisory authority (or by another
acceptable authority). For the purpose of illustration we have used a factor of
5%. Although a higher factor might be appropriate where there is a preponder-
ance of unsupervised reinsurers, we consider that the question of differential
provision is best dealt with in the technical reserves, where a professional
assessment can more easily be applied.
9.6. Underwriting risks

9.6.1. The previous three factors relate to the reliability of the position shown
in the balance sheet as a representation of the ability of the company to meet its
existing liabilities from its existing resources. This and the next section concern
adverse financial circumstances which may result from continuing to write
further new business. As explained in §2.4.1, the statutory solvency margin must
be sufficient to provide a buffer against the effects of continuing to write business
for at least a further 18 months or so. If premium rates are inadequate, because of
higher claims frequency than usual, higher than expected claim amounts,
inflation, large claims, development of the insurance cycle, inadequate loadings,
etc., this can result in operating losses which could quickly erode the solvency
margin demonstrated at the last balance sheet date.
9.6.2. Consideration of the potential impact of these risks on the company, and
an assessment of a realistic level of solvency margin to provide the required
degree of protection, is a complete subject in itself. We have already noted that
this aspect is central to the Finnish study(4) and it is intended that a study along
similar lines will be carried out in the U.K.
9.6.3. Until the necessary work has been carried out, we can only include a
notional figure for the solvency margin component to cover these risks. From the
results of the Finnish study one would expect appropriate factors to provide
against an 18 months delay to lie generally in the range 30–50% of earned
premiums. A major reason for the factors coming out as high as this is the
importance of insurance cycles in the empirical findings of the Finnish group.
Opinion is divided on whether similar cycles can be identified in the U.K. Some
preliminary analysis of loss ratios carried out by the Working Party failed to
identify such cycles, but any further work in this area would need to look at
unsmoothed internal company data. For the purposes of arriving at an overall
assessment of the minimum solvency margin based on the factors considered in
this paper, we have assumed a solvency margin component of 15% of earned
premiums to cover these underwriting risks. This is of a similar order to the
existing E.C. solvency margin requirement, which was primarily intended to
cover this aspect of solvency.
9.7. Other risks

9.7.1. There are many other potential risks to which a general insurance
operation is subject. Experience has shown that problems can easily arise from
poor management, failure to control expenses, fraud, etc. Such risks are
unquantifiable, both as regards incidence and financial impact, but the solvency
margin should be capable of withstanding them to some degree. The appropriate
solvency margin component is inevitably a matter of judgement and there is some
overlap with the previous item. A fixed component might be thought suitable in
some respects, giving a minimum level of solvency margin even for the smallest
company. If this were to be set at, let us say, £200,000, a further component might
be incorporated, which could be related to the size of the company’s operation by
expressing it as a percentage of the management expenses in the previous year.
We suggest 50% is of the order of magnitude to give the right level of protection,
bearing in mind the other elements of the solvency margin, and the expectation
that some provision for the over-run of management expenses on closure to new
business would have been made as part of the technical reserves.
9.8. Summary
9.8.1. The additive combination of these five components of solvency margin
produces a higher level of security than implied in the consideration of each one
individually, and this is to some extent justification for the reductions we have
suggested in the provisions which theoretical considerations might have
indicated. There is, of course, the argument that excessive solvency margins are
ultimately detrimental to policyholders because of the implications for financing
the necessary capital. We have examined the possible impact as at 31 December
1982 on a selection of companies, making use of the returns to the Department of
Trade and Industry, and importing a number of assumptions where necessary.
Some of the results are shown in the Appendix.
9.8.2. The results show the importance of the asset depreciation element of the
suggested margin of solvency, particularly for companies with a relatively high
proportion of their assets in equities. The run-off fluctuation item assumes
particular significance for some small companies with a high ratio of technical
reserves to earned premiums (usually because the business is long-tailed). The
reinsurance element is not significant in the context of the larger companies,
although it is so for some of the smaller companies in the market.
9.9. Conclusion
9.9.1. Although part of the solvency margin shown in the Appendix should, in
our view, form part of the technical reserves (the mismatching provision) our
suggestions still point to solvency margin requirements considerably greater than
those laid down in the E.C. Non-Life Establishment Directive, although more
sensitive to the particular circumstances of individual companies and, therefore,
in our view more capable of rational justification. We have considered also a
prudent standard for technical reserves which would form a more adequate basis
for assessing the solvency margin available. There is a degree of arbitrariness in
the specific size of some of the factors we have introduced, since more work is
required in some areas, whilst in others, such as reinsurance recoveries, there are
real practical difficulties and wider discussion of the issues is desirable. However,
whilst there is room for discussion over the exact level of the parameters, we do
not think that the values we have taken for illustrative purposes are unreasonable
and we consider that they would give about the right level of security overall. As
we have mentioned, it is hoped that further research will be set in hand in relation
to quantifying the risks of continuing to write new business, and more detailed
work is needed on the variability of technical reserves and the precise application
of the asset fluctuation item.
9.9.2. The topic of solvency is wide-ranging and extremely complex and is not
susceptible to neat mathematical solutions. We have attempted to temper theory
with pragmatism and have put forward our ideas, even though some are at an
early stage of development, to encourage further discussion in the profession, in
the hope that a coherent view might emerge. In particular, we hope that there will
be discussions with the accountancy profession about the possibility of setting
minimum standards for technical reserves, and that, in spite of the weakness of
the solvency margin requirements of the E.C. Non-life Directive, prudent
company management will have regard to the factors we have outlined in
ensuring a reasonable level of free asset cover for the statutory solvency margin.
REFERENCES
(1) GISG Working Party on Solvency Margins (1981).Technical Risks. Papers by Trayhorn,
M., Sanders, D., Clark, M., Ryan, J. and Healy, G.
(2) GISG Working Party on Solvency Margins (1981). Investment Risks. Thomson, A. et al.
(3) GISG Working Party on Solvency Margins (1981). Reinsurance and Other Aspects. Hart,
D, et al.
(4) PENTIKÄINEN, T. & RANTALA J. (1982). Solvency of Insurers and Equalisation Reserves.
Helsinki.
(5) GISG Working Party on Solvency (1983). Report to Bristol Seminar.
(6) NORBERG, R. & SUNDT,B. (1983). Draft of a System for Solvency Control in Non-Life
Insurance (paper submitted to 17th ASTIN Colloquium in Lindau).
(7) Working Party of the Dutch Actuarial Society (1983).Solvabiliteit—WatZijn de Risico’s?
Berkouwer, H. et al.
(8) DEHULLU,A. (1984).A Management Oriented Approach to Solvency(Paper submitted to
22nd International Congress of Actuaries).
(9) DAYKIN,C. D. (1984). The Development of Concepts of Adequacy and Solvency in
Non-Life Insurance in the EEC. (Paper submitted to 22nd International Congress of
Actuaries).
(10) BEARD,R. E., PENTIKÄINEN, T. & PESONEN. E. (1977). Risk Theory (Second Edition)
(Chapman & Hall).
(11) TAYLOR,G. C. (1982). Second Moments of Estimates of Outstanding Claims (Paper
submitted to 16th ASTIN Colloquium in Liège).
(12) BENJAMIN, S. (1980). Solvency and Profitability in Insurance (Transactions of the 21st
International Congress of Actuaries).
(13) BENJAMIN, S. (1983). Illustrating Loss Ratios and Financial Effects (talk to Casualty Loss
Reserve Seminar in September 1983).
(14) DEVITT,E. R. F. (1982). The Construction of Probabilistic Accounting Statements for an
Insurance Company. (Unpublished).
(15) HERTIG, J. (1983).A Statistical Approach to IBNR Reservesin Marine Reinsurance (Paper
submitted to 17th ASTIN Colloquium in Lindau).
(16) COUTTS, S. M., DEVITT,E. R. F. & Ross, G. A. F. (1984). A Probabilistic Approach to
Assessingthe Financial Strength of a General Insurance Company (Paper submitted to 22nd
International Congress of Actuaries).
(17) RYAN,J. P. (1980). An Application of Model OfficeTechniques to the Solvency Question
(Transactions of the 21st International Congress of Actuaries).
(18) RYAN,J. P. (1984). Application of Simulation Techniques to Solvency Testing for a
Non-Life Office(Paper submitted to 22nd International Congress of Actuaries).
(19) Report of the Maturity Guarantees Working Party (1980)J.I.A. 107, 103.
(20) TREEN,W. R. & THOMSON, A. F. (1984). The Effects of Financial Factors on General
Business Solvency(Paper submitted to 22nd International Congress of Actuaries).
(21) CAMPAGNE, C. (1961).Minimum Standards of Solvencyfor Insurance Firms—Report of the
ad hoc Working Party on Minimum Standards of Solvency. O.E.E.C., TP/AS(61)1.
(22) INFLATION ACCOUNTING: REPORTOF THEINFLATION ACCOUNTING COMMITTEE (1975).
(Chairman: F.E.P. (now Sir Francis) Sandilands). Cmnd. 6225. HMSO.
(23) ABBOTT, W. M., CLARKE, T. G. & TREEN, W. R. (1981).Some Financial Aspectsof a Genera1
Insurance Company. J.I.A. 108, 119.
APPENDIX
Required margin of solvency (as % of earned premiums)
Declared
Asset Fluctuations Reinsurance Underwriting Other margin of
Company depreciation in run-off failure risks risks Total solvency
A 19·5 9·1 1·4 15·0 11·4 56·3 136·1
B 36·7 14·4 2·2 15·0 12·3 80·6 113·1
C 12·3 8·2 ·2 15·0 13·4 49·1 100·3
D 17·1 9·3 ·8 15·0 14·8 56·9 81·3
E 26·3 12·3 1·4 15·1 12·6 67·6 121·3
F 12·7 6·6 ·8 15·0 11·9 47·0 66·6
G 8·3 20·5 1·4 15·0 7·8 53·0 12·8
H 2·5 30·0 25·8 15·0 5·3 78·6 739
6·6 4·4 1·6 15·0 9·3 36·9 52·3
17·8 ·9 15·0 14·2 47·8 41·3
ABSTRACT OF THE DISCUSSION

Mr D. M. Hart (opening the discussion):The ideas expressed in the paper should be viewed against
the background of a United Kingdom insurance industry which is supervised on the principle of
‘freedom with publicity’, but in which that freedom has effectively been eroded by statutory
regulations. If these ideas are adopted they would further impinge on the independence of general
insurance companies to make their own decisions on matters affecting their financial well-being.
Before such action is implemented,we must ensure that the benefitsin terms of increased security of
U.K. companies are at least commensurate with the cost incurred.
The paper makes three principal proposals: an overall framework for evaluating a company’s
solvency position, some standardization in the margin contained in technical reserves, and the
inclusion of an asset mismatching reserve within the technical reserves.
The authors emphasize that the solvency margin is the difference between two very large and
variable items, and great stress is laid on the uncertainty surrounding virtually all the major items
involved in the calculation of a solvencymargin. Consequently, an understanding of basic statistical
theory is a prerequisite for comprehension of the stochastic nature of solvencymargins. The current
supervisory and administrative framework lays too great an emphasis on the expected values of the
assets and liabilities without regard to their variability.
Agreement on an appropriate levelfor technical reservesis an essentialprerequisite of any attempt
to adopt stricter regulations on solvency margins, The authors suggest that outstanding claims
reserves should exceed the expected cost of the outstanding claims by a fixed multiple of some
standard deviation. While the fundamental concept involved appears sound, there remain several
unanswered questions. First, the proposal in §4.3.4 that “the methodology for arriving at the mean
estimates and standard deviations would be left to the company” is fraught with danger unless the
Department is able to bring to bear a stringent method of monitoring the results. In §4.4.7the authors
conclude that they can hope for nothing better than “an enhanced ability to detect steady weakening
of reserves”. This cannot be regarded as adequate to enable the Department to act from a position of
knowledge. Even if the methodology could be agreed, there would still be substantial scope for
disagreement on such items as the assumed levelof future inflation appropriate to the claims run-off.
A second difficultyis recognized in §4.3.13 where the authors admit that there is a problem as to
whether adequate methodology exists for measuring the variability of outstanding claims estimates.
Thirdly, the level of the multipliers—the K factors-is not discussed at any length in the paper. A
great deal more work is required if the ideas are to be implemented.
Section 4 is easily the least convincing part of the paper. The authors have missed a good
opportunity to advocate certification of reserves by ‘loss-reservingspecialists’. Such a procedure
would be no universal panacea, but would provide a satisfactory conclusion much more
expeditiously.
The authors’ recommendation to include in the technical reserves a reserve for mismatching of
assets is a significant divergence from the current method adopted to influence the direction of
investment.The principal effectis to establish a link betweenthe valuations of assets and liabilities,so
that the valuation placed on specificassets varies with the appropriateness to the liabilities of the
insurer.
In §9.3.5 the authors refer to the extent to which allowance made for falls in asset values should
depend on the current level of investment markets. It is not clear whether this is a pragmatic
suggestion to prevent the insolvency of all insurers when the stock market is very depressed, as in
1974,or whether it is based on an unstated theory of patterns in asset values.
Any movement towards a greater awareness of the relationship between assets and liabilitiesmust
commend itself to actuaries. We should, however, recognize that market values are no more than
reflexionsof the expected future cashflows.
I support the view that reinsurers should continue to be subject to supervision in a similar way to
direct insurers. Inadequate attention is paid to the ‘outstanding recoveries’under some reinsurance
agreements which are completely worthless since the reinsurer concerned is already known to be
insolvent.
The direct costs of introducing the authors’ proposals would be in two parts—an increase in
technical reserves and an increase in statutory minimum solvency margin.
The Appendix sets out required margins of solvency which indicate that the majority of companies
in the sample would remain solvent under the revised proposals. This would have been less clear-cut if
the arbitrary reduction in the margin required for asset value fluctuations had not been made in
§ 9.3.5. Nevertheless, many managements would not be happy to accept the reduction in the margin
compared with the minimum, and would take steps to increase their capitalization. Given that
criticism has been levelled at some U.K. companies for inadequate utilization of their current capital.
it is unlikely that additional capital would be forthcoming under current conditions.
This problem might be alleviated in two ways. One is the possibility of higher premium rates, but
given the worldwide competition for the business, rating increases seem more likely to price U.K.
companies out of world markets than to provide the higher return required. The other is the general
introduction of discounting of liabilities. The implicit margin introduced by using undiscounted
technical reserves can be justified under current conditions by the lack of provision for many of the
uncertainties inherent in insurance business. If explicit margins are incorporated, I see no reason to
oppose discounting.
Mr S. Benjamin: In the Appendix do the authors assume that the present technical reserves of the
companies that they examined are up to the standard of § 4 of their paper? The split between reserve
and solvency margins is essentially arbitrary.
I do not find accounting concepts very helpful. and I would have found the paper more illuminating
on the subject if, for example, the authors examined the concept of unearned premium in the case of
life assurance. Why not? If it is an accounting principle examine it in that situation, or a regular
premium contract in general insurance. There is no reason why there should not be one but the
accounting would be rather tricky.
For the first time we have an actuarial standard of adequacy—adequacy for the reserves plus the
solvency margin. The Casualty Actuarial Society of the United States and the Canadian Actuarial
Society have pronounced on the subject, but they simply list the areas you should examine, they do
not say why and they do not say what you are aiming at.
The practical result is that the actuary has been boxed into making point estimates of expected
values, and the one thing you can be sure of about point estimates in that situation is that they are
going to be wrong. The professional result is that in the vital matter of discussion with management,
the actuary does not know really what he is supposed to be aiming at, or what the management are
supposed to be aiming at. Within our profession we feel that a professional man should disclose his
method, but this tradition does not exist in the general insurance world. My understanding is that
industry does not want disclosure of methods or assumptions, and that the Department of Trade and
Industry are not interested.
Mr I. L. Rushton: Supervisors have a difficult problem in ensuring the solvency of general insurance
companies. initially. with being sure that technical reserves are adequate. We are still left with the
question of dealing with the company which asserts its technical reserves are adequate, although the
supervisor thinks they are not.
I disagree with Mr Benjamin’s comments. The overall level of solvency suggested by the authors
over and above the technical reserves ranges from 36 to 80% of the earned premiums, which are at
little lower levels with the written premiums for most companies. In the American market, which is
easily the biggest general insurance market in the world with much stronger supervisory intervention
in the business, any company which has 50% solvency margin overall gets the highest financial rating
in the market, and that 50% is a considerably lower figure in our terms in that they are allowed to
amortize their fixed interest stocks. To suggest that a solvency margin of between 36 and 80% is
required as a minimum is completely unrealistic.
The authors have in § 9.4.2 produced suggested percentages to be added for different classes of
business. These look to me to be fairly uncommercial. How do they think we would be allowed to
carry that sort of margin by the taxman, or do we have to put twice that amount aside each year?
When premium income goes up around 10% p.a. to maintain these sort of margins requires after tax
1½–2% extra out of the profit. It is not commercial in the present insurance market.
What worries me in running a substantial general insurance portfolio is what will happen if
inflation goes wrong. That is not a stochastic variation to me; it is a biased variation. I am not
unhappy if inflation comes down, but if it goes up it can really hurt. We prepare our point estimates as
to the amount of outstanding claims and consider those against our actual reserves. I also have a
calculation prepared to show that additional inflation can be coped with before any margins are
exhausted. I find that much more meaningful than any standard deviations.
On the assets side, I was intrigued to read the comments about whether you could or could not
match. It is interesting that there does not seem to be any theory as to the right way to invest general
insurance funds. I know what we do. We have to allow for the fact we do not have all our technical
reserves because brokers keep a few of them in cash! But what we have we put into fixed interest and
try and match them to the length of our liabilities. There is no reason why this cannot be done. It gets
rid of all the asset risk.
Mr F. E. Guaschi: In 1970 Mr C. M. Stewart stated at the ASTIN Colloquium in Denmark “A

concern may be considered solvent if the supervisory authorities allow it to continue operating”!
Thirteen years later, we do not seem to be getting much further forward. I find myself very much in
agreement with Mr Stewart and with some of the comments in the paper itself on the subject of this
powerful concept and that is that you can regard solvency as either static or, as I firmly believe,
dynamic.
The assets, however, must be sufficient in all reasonable circumstances to cover the ultimate
liabilities. This much must be clear to the supervisory authorities. The real problem is how do we
calculate these liabilities? As the authors say, there are no agreed standards for calculating the
allowances to be made in the technical reserves for variability.
We are still a long way from being able to determine variability but I believe that the actuaries
working in general insurance are attempting to evolve sound methods of evaluation of general
insurance business. Until then, it makes little sense to prescribe a precise solvency margin.
The dynamic view of the solvency margin is that we must make the best estimate we can of the
valuation liability, such that the reserves are adequate in all reasonable circumstances to meet the
liabilities. Some kind of certificate will be required by supervisory authorities. They cannot lay down
what the value of K should be or how you should calculate your standard deviation. The solvency
margin becomes a buffer against unusual fluctuations and something which enables the company to
write new business.
In the United States it is the reciprocal of the solvency margin which is taken as an indicator of the
premium income which may be written. For example, if the required solvency margin is 40%, that is,
·4, you may safely write two and a half times your free surpluses.
The only other subject I wish to refer to is discounting. Actuaries on the life and pension side are
used to discounting, but it is regarded with great suspicion by people on the general side. Section 7.2.4
sums it up. It is important to demonstrate quite clearly that prudent assumptions have been made
about the ultimate run-off of liabilities including, where necessary, inflation at a fairly high rate. The
company has to produce a reasonably long historical record of actual experience, from which can be
deduced the mean term of liabilities, and then you discount at a very conservative rate.
Mr B. Alting von Geusau (a visitor): We have built a model about which we are more or less in
agreement. We still have a very major problem ahead. Who will fill in the parameters in the model?
Are the authors of the paper going to do so for all the companies in the U.K.? Is the Institute going to
do so, the supervisory authority or possibly the tax people, or is it a committee of auditors and
actuaries? If we agree on who will do it, then of course we have to agree on how they are going to do it.
Will the parameters they come up with be true for the remainder of the century, or will they be
time-dependent which adds an extra dynamic process to the model?
Mr T. G. Clarke: There are companies, insurers or reinsurers, who value their liabilities on less than a
prudent level for a number of reasons. The authorities have difficulties picking up these weaknesses at
an early stage.
It is important that the authorities and the public can be reasonably sure that the liabilities of the
company and thus its solvency have been assessed professionally and independently. If we are unable
to carry out this task, then who is equipped? There are many others in other professions who believe
they are.
Our greatest strength is the fact that we know how wrong we can be. but this is also our greatest
weakness, because we appear to be reluctant, as a profession, to expose ourselves to such a difficult
task.
Initially, actuarial reporting may not build in the degree of prudence that is advocated in the paper,
as this could well lead to financial difficulties within the industry. In the Appendix three out of ten
companies did not meet the solvency criteria. This suggests that many others within the industry will
not either. Our profession can do the industry a service if by producing actuarial reports we ensure
that there is a minimum of reserve prudence.
Mr W. M. Abbott: Suggestions to modify the existing statutory minimum requirements are probably
a misdirection of effort. Whilst the U.K. is a member State of the European Economic Community,
the probability of generating a consensus to modify the non-life directive in this respect must be
extremely small.
Development of generally accepted accounting concepts is the most productive area for improving
the supervisory framework. The concepts would most beneficially be developed by representatives of
the insurers, reinsurers. supervisors. accountants and actuaries preparing joint proposals.
Currently, there is no standard description of techniques or of the detail which should go into an
actuarial report on reserves. The authors suggest in § 3.3.1 a reporting system which provides enough
information to assess the extent to which the uncertainty in the claims run-off has been provided for. I
have my doubts on this suggestion. Even for a small class of business enough information could be a
40-page report. Reports by professionals on the subject should be considered superior to a mass of
data which, more often than not, raise more questions than they answer.
The authors advocate the use of standard deviation statistics as measuring variability. I would treat
such statistics with considerable caution. Their incorporation into definitive formulae would worry
me, especially where they are used to make quantified statements on the adequacy of the reserves. My
doubts stem from the classification problem. Data has to be classified so that it is both adequate and
sufficiently homogeneous. Standard deviations depend on the period of measurement chosen and can
be manipulable.
I support the concept of an asset mismatch reserve. The problem is where to put the reserve. It
cannot be added to the statutory minimum margin. Nor for competitive reasons, perceptions of
profitability and failure to gain tax relief. can I see it being added to the technical reserves.
In my own company, the mismatch reserve is determined through the preparation of asset
valuations which discount asset cashflow at various rates of interest. The basic assumption is that the
reserve should be sufficient to cover depreciation caused by interest rates increasing from current
levels to a level half-way between that current and 25%. In contrast to the authors’ comments, this
produces greater mismatch reserves when market levels are high and lower reserves after substantial
falls in market value.
Dr G. M. Dickinson (a visitor): The emphasis in the authors’ paper is towards the net assets that a
general insurance company should hold from a supervisory authority’s perspective and not from the
standpoint of corporate policy and corporate planning. Clearly, it is important to distinguish the two
sets of valuation criteria. The analysis is completed against the framework of a closed fund, and does
not view the insurance company as a going concern. The authors suggest that technical reserves
should explicitly allow for fluctuations in experience to a greater extent than is the convention in
practice. Whilst they support the view for a prudential level of discounting of liabilities, they argue for
a more conservative valuation of liabilities.
I am unhappy about including as part of technical reserves a provision for mismatching of assets
and liabilities. This is more appropriately classified along with other investment risks as part of the
statutory mimimum solvency margin. The author’s most controversial suggestion is that the solvency
margin should be significantly higher than that currently required under the Insurance Act as derived
from the non-Life Establishment Directive. Insurance companies do hold solvency margins
significantly above the minimum margin. The authors go one step further by suggesting there should
be an earmarking of the solvency margin for five different sources of risk. I would add a sixth, the
exchange-rate risk.
I am unhappy about the extent to which the authors have tried to incorporate the sources of risk in
the overall criteria, as I feel that the flexibility that management is afforded by viewing the solvency
margin as a whole is reduced. If U.K. insurance companies had been required to hold minimum
solvency margins as suggested by the authors, would the overall solvency margins actually held be
higher or lower?
Dr D. H. Reid. A peculiar difficulty is experienced by general business companies in attempting to

comply with DTI’s reporting structure on claims which do not have a specific origin date. In
industrial disease claims it is quite common for an extensive period of exposure to be followed by a
considerable delay prior to the reporting of such a claim to a government agency, with further delays
occurring before its notification to an insurer who may or may not be responsible for the whole or
part of the liability arising from the disease concerned.
In the classes of business concerned, insurers are in the position of ‘earning’ claims during a period
of operation. Thus, at the end of a particular year a claim may be partly earned on this basis. Clearly,
it would be unreasonable, notwithstanding the accounting principle of prudence, to expect a
company to provide for a claim which was not, as yet, fully earned.
In $54.6 and 8.5.3 the authors mention some of the considerations which need to be taken into
account in connexion with adverse correlation of the adequacy of reserves for outstanding claims and
those for unexpired risks. The point is not made that a company which is underestimating the level of
its claims experience is quite likely also to be underestimating the level of its future claims experience
and thus underestimating the level of an unexpired risk reserve.
Paragraph 4.3 seems to me to be the crux of the authors’ paper. Unless an adequate and rigorous
treatment of the aspects considered here is provided, there is a danger that the entire basis of the
proposals will be unsound.
My first doubt concerns the use of the word ‘best’ in connexion with company estimates. It is far
from clear to me what this term means and I consider the criterion against which goodness is assessed
needs explicit specification. What may be ‘best’ for a company may clearly not be so for the
supervisor!
Paragraph 4.3.3 defines various quantities µi and σi which are apparently intended to represent a
mean and standard deviation of estimates of the company’s liabilities. As well as considering
fluctuation in the estimating process, we have to consider bias in the estimating process. There is little
point in concerning ourselves with fluctuations of the order of, say, 10%, if the estimating process
itself is biased to the extent of, say, 30%, and that 30% has to be added in before we start adding in the
margin for fluctuation.
Miss S. M. Cooper: Given the way legislation is going in this country, some sort of official certification
is bound to be required in the near future. It is therefore absolutely essential that the actuarial
profession establishes its credentials as the loss-reserving specialists.
An important way in which we can contribute is through our technical know-how. In Finland,
actuaries are in a very strong position because they have done a lot of very sound technical work on
reserving standards. Every non-life company writing third-party liability business and workers’
compensation act business must have an actuary reporting on its reserves. An actuary must make sure
that the standard methodology is appropriate to his company. If it is not appropriate to the company,
then the actuary has to develop a new methodology and convince the Ministry of Health and Social
Security that his formula is more appropriate. The strength of the position of the actuary in Finland
should be transferred here. We must demonstrate we are willing to take responsibility for certifying
the adequacy of technical reserves as we already do in life assurance and pensions business.
Dr S. M. Coutts: The traditional reaction of a general insurance actuary to the present E.E.C.
solvency requirements is that they have been reviewed twice and been accepted, and it seems a waste
of energy to try and alter them. Hence the emphasis of any work should be to live within the present
regulations. I have strong views that the present E.E.C. regulations are totally inadequate and do not
recognize the true nature of solvency. Further, I feel the profession should lead rather than follow,
and in this spirit work should be undertaken to assess whether the present regulations are sensible. If
they are proved not to be, analyses of data to support other views should be carried out, and the
profession should be prepared to lobby for alternatives. This approach has already been taken by
non-E.E.C. countries; for example, Finland, Canada and Norway.
The authors have taken the first step forward by rejecting the present regulations and putting
forward alternative ways of setting up solvency information. However, they have not gone anywhere
near far enough.
Solvency is the ability of a company to meet its liabilities as they become due. The traditional
accounting model of solvency is the excess of assets over liabilities. However, in measuring solvency
the prime concern is the cash flow generated from assets and their relationship with the cash outflow
in respect of liabilities. Hence the necessary measure is the net cash flow. The authors continue to
emphasize capital rather than income and this is where I feel they have fallen short.
In a paper to be presented to the International Congress of Actuaries in 1984, Coutts, Devitt and
Ross have set out a net cash flow model to represent solvency and the following algorithm is used.
Four basic assumptions are required to start the process:
A(1) A bivariate probability distribution of claim payments by time and amount, specifying the
distribution family and its parameters.
A(2) The present asset portfolio, showing for fixed interest securities, details of maturity dates and
nominal amount held, and coupon rates together with equity prices, yields and dividends.
A(3) Future investment strategy for reinvestment and disinvestment.
A(4) Models for predicting the selling price of fixed interest securities if sold before maturity and
for equities, future prices, dividends and yields.
THE ALGORITHM
Stage 1
Generate total claim payments for each year of development by using the probability distributions
(assumption A(1)).
Stage 2
From assumption A(2), first year cash inflow (maturities plus income from government bonds known
plus dividends of equities predicted from assumption A(4)). Compare total cash inflow with capital
payments.
Stage 3
If claim payments exceed cash inflow. apply disinvestment strategy (otherwise to Stage 4). (For
example, first sell equities, then longest government bonds.) This will lead to a new set of assets at end
of year 1. Pass to Stage 5.
Stage 4
If claim payments are less than income. apply reinvestment strategy. (For example, purchase in
proportion to present spread of government bond maturities.) This will lead to a new set of assets at
end of year 2. Pass to Stage 5.
stage 5
Repeat process from Stage 2 for years 2, 3 ...n,that is, until liabilities have all run off. If at any stage
the claim payments are so large that they cannot be met from the cash inflows plus the realization of
all investments, then the company is insolvent. If, on the other hand, there are no further claim
payments due to be made, the value of the remaining assets is a measure of the company’s strength.
Stage 6
Repeat process 1,000 times (say) from start, to build up a ‘bundle’ of possible values of the strength of
a company. The proportion of occasions when assets prove inadequate will enable us to estimate the
probability of insolvency.
Having set up the model, it will also be possible to simulate the operation of different investment
strategies. This would enable the company to judge how sensitive the ultimate financial strength is to
the investment strategy.
This approach emphasizes the importance of asset distribution and reinvestment policy. In this
respect the authors do not get to grips with the problem but emphasize the importance of market
values. More work is required, but it should be appreciated that the cash flows are more important
than market value at any point in time.
Mr L. M. Eagles: I welcome the stress on estimating variability both of the reserves for outstanding
claims (including IBNR) and of assets. Frequently the actuary is asked to make a point estimate only.
In this situation it is only natural to apply a battery of methods of analysis to the data supplied.
However, after looking at the results, one must ask the question—how cautious am I being? How
cautious should I be? Is the degree of caution appropriate. This is very difficult with point estimates.
It is necessary when examining the loss ratios which have historically been incurred by a company
to see how these may have been affected by matters outside the company’s control, and to look at the
effects of outward reinsurance. The basic approach is to estimate µi and σi, from past loss ratios and
then look at K. It is interesting that one starts to obtain a feel for the values of K, and I would be
disturbed if K were set as low as the authors suggest, Experience with the method suggests a value of K
of the order of 1 is indicative that a company could be getting into serious financial difficulties.
Distributions in non-life insurance are very skew and I would regard a K of 3 as only giving a weak
margin. I would prefer to see 5 or 6.
I agree with the basic approach of the authors to asset variability set out in § 5.2.4. However, I am
surprised by the suggestion that the margin on property should be less than the margin on equities.
The property market can disappear completely as in 1974, suggesting that the margin on property
should be rather greater than on equities, and I would suggest the margin on property in § 9.3.5 could
well be doubled.
Reinsurance needs to be handled very carefully in the context of solvency. The varieties of
reinsurance cover are very complex and so are reinsurance premium systems. A common form of
rating excess of loss treaties is to set a minimum and maximum rate, the maximum being possibly five
times the minimum, and the rate payable depending on claims paid. This means that when the
reinsurer first becomes liable the immediate result is an increase in premium from the reinsured.
Considerable research is needed as to how such reinsurance treaties affect solvency.
Mr G. B. Hey spoke briefly: his remarks are incorporated in his written contribution.
Mr J. P. Ryan: The authors argue that additional reserves should be held implicitly. I believe there are
strong reasons why they should be held explicitly.
First, the non-life claims reserves are usually utilized elsewhere in a company directly for rating
purposes and estimating mean claim costs. This is not true of the life assurance company, and
therefore the authors’ approach would require the company to keep two different sets of claims
reserves. Secondly, the use of expected values in the actual reserves makes it easier for an outsider or
underwriter to see what is happening, particularly when results are analysed by accident year or
underwriting year. Thirdly, much of non-life work involves underwriters and actuaries making best
estimates of future claims experience, whereas much life assurance work involves actuaries taking
what they believe to be a conservative interest assumption without having a precise best estimate.
Section 4 on the variability of liabilities leaves much to be desired, no doubt due to time pressures
on the authors. It would be helpful if the authors considered a few examples, Consider the case of an
insurer covering a bridge against total loss. The bridge can either be a total loss or there will be no
claim. Assume the bridge is valued at £10 million and there is a 10–7 probability of an IBNR. Thus,
the expected value of the loss would be 1 and the standard deviation would also be 1. Do the authors
mean to imply that the correct reserve to set up in this case is (1 + Ki). This may seem an extreme
example, but there are many companies in the London market writing a limited number of treaties
covering this sort of risk. Marine underwriters underwriting total-loss-only risk is very common in
the marine market and a significant portion of the business as well as wind, storm and catastrophe
covers, This example contradicts the statements in §4.3.5 implying that the standard deviation
measures the variability and at least the third moment should be introduced. A risk-of-ruin approach
may be going a little far but it is essential it is considered.
I am surprised that the authors suggest class parameters. I have seen companies writing similar
classes of business with widely different standard deviations and I strongly come down to the view
that the way of solving this is to have a loss reserve specialist or other professional form of reporting.
I agree with the authors’ approach to assets. It is important to realize that there can be positive
correlations between inflation rates and interest rates which need to be taken into account.
Mr H. J. Jarvis: It is a truism that reinsurance has a greater impact on general insurance than life
insurance. The liabilities assumed are massive and uncertain. and this applies not only to the direct
business, but to reinsurance as well. What must be remembered is the ability of the reinsurer to meet
claims. This needs to be demonstrated wherever the reinsurer happens to be domiciled.
Some reinsurance arrangements talk about deposit of the reinsured reserve with the original
insurer. This gives a semblance of security only. If reserve depositing becomes generalized, then the
central strength of the reinsurer is dispersed to the detriment of the companies reinsured.
Depositing of reserves to demonstrate solvency on a gross basis raises problems of ownership.
Typically these deposited reserves appear as an asset in the balance sheet of the reinsurer and as a
liability in the balance sheet of the reinsured. If the reinsured gets into financial difficulties, the asset of
the reinsurer becomes suspect.
Mr A. R. N. Ratcliff (closing the discussion): It is most important if actuaries are to take part in
discussions with the accountants and the supervisory authorities that we agree a common language,
and actuaries should be prepared, because they are the latecomers in this field, to accept wherever
possible existing terminology where that is adequate and satisfactory.
Secondly, for many actuaries an assessment has only to be stigmatized as subjective to render it
insignificant. But an appreciation of the significance of subjectivity is very important to those who are
working in general insurance, and I would regard it as pons asinorum for such actuaries.
The authors refer to a spectrum of technical provisions ranging from no more than best estimates
of the outstanding liabilities to strong technical provisions containing significant margins. In line with
their philosophy they regard the former—no more than best estimates—as a highly unsatisfactory
state of affairs, and the latter as highly desirable. Not just in relation to the standpoint of supervisory
authorities, but also from the point of view of the company itself. I do not agree with that. This is the
whole nub of my quarrel with the authors. The authors are recommending implicit solvency margins
as well as explicit solvency margins. Implicit solvency margins are only one step removed from the
deliberate tucking away of profits in order to get you over an awkward end of year at some future
date.
I do not believe there was ever an intellectual agreement by the actuarial profession to implicit and
explicit solvency margins in life assurance. For general insurance we should be rejecting the idea of
implicit solvency margins. and we should be firmly pinning our flag to correct explicit solvency
margins.
The most important source of risk for the supervisor is asset depreciation, and I support the
authors in this direction. although I do not think they understand, any more than the supervisory
authority does, the impact of taxation when the shoe actually pinches as it did in 1974.
The second interesting point is in the discussion of fluctuations in run-off, I know of no evidence.
and the authors have produced none. to demonstrate that fluctuations in run-off for a given portfolio
occur in a random manner. In my experience such surpluses or deficiencies emerge either in a constant
manner or they exhibit a constant trend. If that is the case, then the variation is not stochastic. The
supervisory authorities need to analyse the actual as opposed to the theoretical causes of variations,
and to make the companies correct for them.
If we examine the overall results we shall come to the pragmatic conclusion that the
recommendation which the authors have made, for the vast majority of companies practising in this
country today, are totally excessive.
Even though I do not accept the philosophy of implicit solvency margins, I agree with the authors
that an explicit minimum solvency margin should be held over and above adequate technical
provision. The major source of difficulty is in the assets, and the margin for asset depreciation is the
starting point of the whole operation. A margin for deficiency in technical provisions based on what is
known about the company’s reserving policy is absolutely essential, and a margin based on current
underwriting in the light of what we know about that company’s policies is also important. The
supervisory authorities should not be encouraged to demand margins so far-fetched as to shield them
from their proper responsibilities for the supervision of the management and business of insurance
companies, and the exercise of the very wide powers that have been afforded to them for this purpose.
The President (Mr C. S. S. Lyon) proposing a vote of thanks: I think it was Michael Morris, one-time
Under-Secretary at the Department of Trade and Head of the Insurance Division there who said that
insurance companies are only conditionally solvent, a point which I think has emerged time and again
in tonight’s discussion, There is a high degree of uncertainty in this business, and this is a field where
actuaries ought to be able to make a valuable contribution—indeed, are making an increasingly
valuable contribution.
The authors have had a lot to say on a good many points in the field of solvency of general
insurance, but they have not emerged totally unscathed. I do not suppose they expected to.
Nonetheless, the attendance and the quality of the discussion demonstrate that they have done a
thoroughly worthwhile job. I believe it enhances the role of the profession in this field, and I would
like you all to join with me in a vote of thanks.
Mr C. D. Daykin (replying): We were very concerned over the use of the term ‘best estimate’ which has
been referred to by several speakers. What is meant by ‘best estimate’? How can you have a best
estimate which takes into account a prudent assumption about inflation, for instance? If it is your best
estimate then presumably you expect it to be exceeded at least as many times as you expect it to be too
high.
We were also influenced in our thinking by the philosophy which is set out in section 2 of our paper,
particularly in § 2.4.1 where we emphasize the fact that from the practical point of view of solvency
monitoring from the supervisory end it is important that the technical reserves on their own should
stand up to the ability to run-off the company with a high degree of probability even when the
solvency margin is substantially impaired. Many contributors have spoken from the viewpoint of
highly solvent, strong, large companies; this is different from the one which I see when the companies
which are referred to me are those which have lower cover for their solvency margin and a significant
possibility that their reserves are inadequate.
Over the last few years we have seen a period of relative financial stability. However, the risks
remain with the companies which say they are solvent and which may be nothing of the sort, One of
our concerns is that reserving standards should be instituted in some way so that not only those
running the company, but also those responsible for looking at the company’s accounts and auditing
them have a firm baseline against which to say that a company’s provisions are in fact inadequate.
The results which appear at the end of our paper were illustrative only; not very much in the way of
conclusions can be drawn from the actual figures, particularly as they do not take into account all of
the adjustments which might occur in the technical reserves if the total package were to be developed.
We are glad that the discussion was so wide-ranging and so constructive.
WRITTEN CONTRIBUTIONS
The authors subsequently wrote: We remain unrepentant about our proposal for a reserving standard
for outstanding claims which would incorporate a requirement for a margin over and above what we
termed the company’s ‘best estimate’. We were glad that a number of speakers supported us in this
view and that there was evidence that some actuaries have already found these ideas useful in practice.
Whilst we accept that there is scope for further development of the concepts and more precise
definition of what we had in mind, we believe that our essential principle that reserves should be
prudent is not far removed from best practice in the industry at present. Indeed, the existing E.E.C.
solvency margin requirement was established on the presumption that companies’ technical reserves
would incorporate a margin, and the level would undoubtedly have been set higher if the position had
been thought to be otherwise. It is dangerous ground to start arguing that the appropriate level for
technical reserves is such that they can be expected to be inadequate with a probability of ·5, which is
how we would interpret a ‘best estimate’.
We share the views of Dr Coutts that the E.E.C. solvency margin requirement is inadequate and
our proposals go some way towards proposing an alternative framework. However, whilst we believe
that it would be right for the actuarial profession to put forward constructive proposals for changing
the provisions of the E.E.C. Non-Life Establishment Directive, it is unrealistic to suppose that
modifications will be easy to secure. In any case, the fundamental problem of possible inadequacies in
the technical reserves would remain unless the issue of reserving standards is tackled.
We agree with Mr Rushton that a company’s best estimates can be seriously biased. But the
auditors also have a responsibility to accept the reserves as being in accordance with generally
accepted principles. Whilst we cannot entirely rule out the possibility of auditors failing to spot
deliberate under-reserving. we believe that their position would be made more satisfactory if they
knew what principles of reserving they were supposed to be aiming at.
We do not consider that perceptions of how the tax authorities might regard technical reserves set
up in accordance with a reserving standard should be allowed to influence a professional view of what
the standard should be. In any case, where the Inland Revenue chooses to draw the line as far as tax
allowable reserves are concerned is of no direct relevance to where the arbitrary line should be drawn
between technical reserves and solvency margin for supervisory purposes, given that the total of
technical reserves and solvency margin taken together should provide for the necessary overall level
of prudence.
Although we believe that most of the stronger companies do set up their reserves on a prudent
basis, it is not hard to find evidence that many companies’ reserving standards are less satisfactory.
For example, we have examined the development of estimated total gross claims for years of origin
1977 and earlier, as shown in returns to the D.o.T. for the years up to 1980. This showed that 39 out of
the 102 companies considered had to strengthen their overall gross outstanding claims reserves
during this period and that 104 of the 301 separate accounting classes analysed had to be
strengthened. We would regard this sample as being reasonably representative of the market as a
whole.
By contrast, the results shown in the Appendix to the paper were not intended to be in any way
representative of the market. The companies shown include some well-established concerns, but
others were chosen because they illustrated particular points rather than because they were
representative. The figures assume that the technical reserves already satisfy the standard set out in § 4
of the paper, but not the requirement for a mismatching reserve discussed in § 5.
We agree with Dr Coutts that analysis of cash flows and the use of simulation techniques are
essential to a comprehensive analysis of the solvency position of a company. However, we do not see
such methods as a practical alternative to current reporting arrangements in the foreseeable future.
We see the techniques as an essential tool of management, both in establishing the appropriate level of
mismatching reserve, and in determining an appropriate level of solvency margin cover to satisfy
management’s own critieria as to risk of ruin on a going-concern basis.
The introduction of reserving standards for general insurance business would be facilitated if there
were to be a requirement for a suitably qualified professional person to report on the appropriate level
of reserves within each company. We agree with Messrs Guaschi, Abbott, Clarke and Ryan that this
would be a desirable objective, as we emphasized in the paper (e.g. § 8.2.8) although the means by
which our objectives might best be attained fell rather outside the scope of our presentation. In our
view, additional disclosure of methods and assumptions might be more easily attainable in the shorter
term than a requirement for professional reporting as such, still less certification of reserves. Such
developments would, nevertheless, be appropriate longer-term objectives,
Mr G. B. Hey: This is a useful paper in which the authors have set out their ideas very clearly: there is
much common sense in what they say. However, I am afraid that the paper is more a list of problems.
especially in §§ 8.5.3 and 8.5.4, rather than a set of solutions. A paper was submitted to the first GISG
conference in 1974 (a copy is in the library) which contained very nearly the same list of questions: it is
disappointing that virtually no solutions have been found in the intervening 10 years. The first
problem listed in 1974 was “to estimate the mean and variance of outstanding claims”, that is the µ
and σ of § 4.3.3. A colleague at Oslo said, of risk theory, “given λ, but who will give me λ?” May I steal
his words and say “given µ, but who will give me µ?”
In fact the estimation of µ is still very largely a matter of judgement and its verification by an
outsider is still virtually impossible. I doubt if σ has any meaning here, partly because it contemplates
a repetition of something (but you cannot repeat a year’s non-life experience), and partly because the
variations include many things that are by no means stochastic. As for third moments the sooner they
are forgotten the better!
My first contact with the conduct of non-life insurance was on 5 September 1966, and on
19 September I wrote “I must express considerable doubts as to whether the provision of returns or
statistics to the Board of Trade (as it then was) is the right way for them to exercise a supervisory
function. Even if the statistics are compiled honestly there must, especially in the case of a new or
expanding company, be a very wide area of uncertainty as to their true meaning. I cannot see how
control can properly be exercised except by having a competent and honest man on the spot. Whether
he should be from the Department or be a professional man such as an actuary is not important, but
unless there is some such control I cannot see supervision being usefully exercised.” I have never seen
any reason to change this view in any way and I was therefore very pleased to see that the authors have
said much the same thing in §4.4.7. I wonder if that is now the official policy of the Government
Actuary’s department?
This brings me to two important points that the authors have made in regard to supervision. The
first is in the first three words of § 8.2.2. For some reason, Mr Homewood when he was at the D.O.T.
refused to accept this point. in spite of the fact that it should be very clear that there are major
differences between a large U.K. composite and a small local plate-glass mutual. As the authors point
out the minimum solvency margin should depend on at least four factors, namely size (and here the
16–18% difference is far too small), the mix of business, the asset portfolio and the general level of
stock-market prices. For an established insurer, a margin of 20% at the end of 1983 is much more
alarming than 5% would have been at the end of 1974. On the other hand, margins of the size
suggested in the Appendix would be very onerous for a new or expanding company. The essence of
sensible supervision is flexibility not rigidity, and trends and profitability may be far more important
than an unverifiable still picture.
The second point is that, as the authors said at the outset, they are seeking to establish that an
insurer has sufficient funds to be able to continue to write business. But the current rules require it also
to have enough funds to enable it to do just the opposite, namely NOT to continue to write business. At
times the latter is a much larger amount. I see no reason why we should not follow the approach of the
Maturity Guarantees Working Party. Their report, applied as at the end of 1974, was based on the
assumption that the market would recover fairly quickly. This applies equally well to general
insurance, since a going concern rarely has to realize more than a trivial amount, if any, of its invested
assets. If most of the major U.K. general insurers had been unable to show more than 5% at the end of
1974 is it seriously suggested that they should all have been stopped from writing new business? That
would have left many policyholders in the U.K. without cover and the nation without a large amount
of foreign earnings. Of course, we would not have done any such thing; we would have had to protect
existing insurers until they had been able to recoup their losses with larger premiums. I mention this
since I think far too much emphasis has been placed on the margin notionally required to cope with
1974-style falls.
In this connexion the authors talk of ‘a satisfactory run-off’. If this means that there should be a
final surplus for shareholders it seems to me, given the cost of a winding-up, that we should wind-up
many solvent companies, which is almost as undesirable as allowing a failure. If things are getting
rapidly worse there is a case for action. but by the time that such a state can be established with
reasonable certainty, a deficit on a winding-up is probably inevitable.
Reinsurance is a subject on which I disagree with the authors. They talk of retaining premiums
against a failure of the reinsurer, which may be moderately sensible on a proportional ceding.
However, the D.o.T. return of a large U.K. insurer shows a catastrophe XOL treaty on the property
account of £30 million XS of £20 million for a premium of about £¼ million. It will take a lot of years’
retention to cover a potential claim. The absurdity is compounded in § 6.3.2 where it is suggested that
2½% of the premium is a suitable reserve. £6250 to cover £30 million!
This shows up the nonsense of the extension to form 30; the important points to ask about are the
potential liability rather than the debts (if any) due at the end of the previous year and where a major
reinsurer should surely include one FROMwhom a large claim may one day be due. I am sure that the
above-mentioned catastrophe XOL policy would not come within the 2 or 5% limits. The philosophy
behind the 50% rule is suspect. Let no outsider think that he can form a view on the real solvency of a
major reinsurer; as a reinsurance actuary said at Oslo, he would be very happy to be able to forecast
the last 10 years of his company. Another leading actuary agreed with that view after the current
meeting. In my view the ultimate guarantee of the reinsurance market, in the event of some major
disaster, is that direct insurers need reinsurers and would have to do as they did in the early 1970s and
pay sharply increased premiums; no one else is likely to enter the market at such a time.
Discounting seems to cause a great deal of misunderstanding. We have failed to discount in the past
for two very good reasons. One is that it gives a cushion in the claim provisions, the other is that it
defers the payment of tax. We have been able to discount since the amounts have been fairly small
compared with the free reserves. However. if we have high inflation. long tails, a new or expanding
company or all three, then non-discounting becomes a luxury that we simply cannot afford. I
understand that this has already happened in Australia in regard to Workmen’s Compensation and it
will certainly be necessary in the U.K. if we have many indexed annuities. After all, we do it in life
assurance and on a very much larger scale since the amounts are far more than could be provided in
the reserves. But no one says “imprudent—you are anticipating profits”. So why is it regarded as
wrong to do it on so much smaller a scale in non-life insurance? A non-discounted revenue account
puts the receipts in, say, 1979 pounds, and the payments in a mixture of 1979, 1980, 1981, 1982, 1983,
etc., pounds. But the ratio in value between 1979 and 1983 pounds is about If to 1, that is about the
present relation between the pound and the dollar. But no one would dream of putting the receipts in
the account in pounds and the payments partly in pounds and partly in dollars. I wonder if Mr Devitt
or his accountant colleagues can explain this? There is much food for thought in this paper, but what
we now need, as in fact we have needed for years past, is for a cross-section of non-life insurers to
publish methods and results with enough data for us to be able to have some idea of how to calculate µ
and, more important, to be able to verify the result. As for σ, it might at least be interesting to see how
the answers vary from year to year, both the absolute amounts and the differences from the ultimate
outcomes. I must emphasize that the 1980/83 Regulations do not provide the sort of data we need;
they are little different from the 1968 Regulations, except for the separation of reinsurance and the
analysis of the revenue account between the current year and adjustments to previous years. But if a
company is consistently overestimating, the current year’s figures may well be much further from the
truth than those without the separation, simply because the understatement of current year’s profit
would have been offset by releases from past years under the old basis. Unfortunately, it is not easy
for an outsider to tell whether reserving practices have altered or not except after a considerable
time-lag during which things may have gone disastrously wrong. What we need is some further data;
the present regulations give those figures which the insurers can provide, rather than those which are
needed.
Mr S. Benjamin: There is one major subject which I did not have time to develop in the discussion. I
referred to the arbitrary nature of the split between the technical reserves and solvency margin. I
notice, for instance, that in §9.3 the authors give up the problem of splitting the effect of potential
asset depreciation between technical reserves and solvency margin.
The consequence is that any supposed purpose of the solvency margin alone, such as the need to
support future business, is suspect. The item ‘underwriting risks’ in § 9.6 is what we know as ‘new
business strain’ and is the item by which management should control its on-going situation, especially
its volume of new business. That represents the use of capital upon which profitability can be
measured. It is similar to the way in which mismatching between assets and liabilities should be
interpreted by management. Mismatching may be expected to produce a higher yield. On the other
hand, the consequential mismatching reserve, wherever it is held, represents the use of more capital
which will reduce the profitability from the higher yield.
Leaving aside the taxman, the split between technical reserves and solvency margin is misleading
from the point of view of both adequacy and profitability.
Mr I. Reynolds: I welcome this paper, and in particular its discussion of allowance for the variability
of assets. For over six years as investment manager of a major composite office I was concerned with
the formulation of investment policy. We approached the quantification of balance between risk and
reward through the ratio of equity investments (Ordinary shares and property) to surplus.
The acceptable ratio depended upon the territories involved and expectations of market
movements. The mean ratio tended to be 100%. This figure has significance both mathematically and
in relation to shareholders’ expectations. As investors in a quoted company they can be assumed to
accept the risks of equity market movements. The ratio does not provide a simple mathematical
control since if it is above 100% an increase in market levels reduces the ratio and a fall in market
levels increases it. Below 100% movements in the ratio are reversed.
In order to assess how investment risk should vary with solvency margin, one can use some simple
algebra together with the author’s provisions against asset falls, which might be better termed ‘asset
risk margins’.
To obtain a relationship between solvency margin and the equity:surplus ratio I assume that
company management sets a minimum solvency margin which should be exceeded after the asset risk
margins have been deducted. This gives a necessary solvency margin for a given investment policy as
some simple results may indicate.
With a minimum solvency margin net of asset risk margins set at 25% and the less stringent margins
of §9.3.5, no equity investment requires a solvency margin of 39% and equity investment equal to
surplus requires a solvency margin of 50%. So in order to have the more risky but probably more
rewarding investment policy an additional 11% solvency margin is required.
Using the more stringent asset risk margins of § 5.2.4 a solvency margin of 67% is required with no
investment in Ordinary shares and 125% with all surplus invested in equities.
I think this represents a constructive approach for company management to set investment policy
and discuss it with shareholders, bearing in mind that a lower solvency margin means more effective
use of capital in the insurance business and the higher return on that capital, provided the business is
profitable.
Profit and premium levels are very significant and the paper barely alludes to them in § 5.4.4. I had
assumed, although from the discussion it was clear that others had not, that the authors envisaged
accounts or reporting statements to demonstrate the solvency of the general insurance company in
line with their approach, separate from a report on profit to shareholders. Without this it will take a
long time to convince shareholders in general insurance companies that the prudence involved in the
authors’ suggestions and with it the deferred release of profits leaves general insurance companies as
attractive an investment as life insurance companies and without this acceptance there must be a
danger of take-avers at prices which penalize existing shareholders.
Mr J. P. Ryan: In §4.5.3, there are usually positive correlations between large future premium
receipts and large claims allowances on much funded business; this would include retrospectively
rated contracts and reinstatements for excess of loss premiums as well as burning-cost contracts,
where the correlations would also be between different underwriting years. Consequently, the reserve
as suggested by the authors could be much too high for most companies where the premium
development is material.
In § 5.3.2, where discussion of matching is considered, no mention is made of the fact that there is
some correlation between short-term interest movements and inflation, which is of some significance
in determining the investment policy of a non-life company. It is these correlations that can be
explored by way of a model office simulation as described in my congress papers, I should perhaps
add, though, that unlike my views on the liabilities, I do not think it necessary to go into much detail
on the investments for statutory solvency purposes and that the broad industry average approach
suggested by the authors is reasonable.
I would suggest that the asset margins are only taken on the assets held to off-set liabilities and the
minimum explicit solvency margins. While the authors’ approach does not in fact create any
theoretical problems, the taking of margins on excess capital requirements will create some political
problems even though companies would be ranked for solvency in the same order as the authors’
approach.
In many cases, specific provision against reinsurance recoveries is not required, especially as the
paper still envisages a large non-specific solvency margin. Certainly, I believe that most companies
would not believe that they need take margins against reinsurance recoveries where they were covered
by one of the top-class reinsurers. Paragraph 6.3.3 suggests such specific provisions. If it were to be
significant and not related to the security of the reinsurer, it could actually encourage companies to
use sub-standard reinsurers. This is also true of §6.3.6 referring to catastrophic covers and if applied
at anything other than a minimal level. would have disastrous consequences for the future of London
as a market and so would not help the Institute’s reputation in this area. If applied at a minimal level it
would not solve the authors’ problems.
However, while it is clearly an important point, it has counterparts in the bad-debt experience of
any industrial company which auditors seem to be able to live with and some professional judgement
would seem justifiable.
The section on discounting is perfectly reasonable. In §7.2.3, it is broadly true, that the longer tail
lines need bigger margins and those are where discounting has most effect and therefore provides the
biggest implicit margin. There are a number of short-tail lines where there is very considerable
fluctuation, such as high-level windstorm covers and most LMX business. Here discounting would
have a negligible impact on reserves but where very considerable fluctuation margins are required.
Paragraph 7.2.6 refers to the appropriate tax rate to be used but a gross rate only applies if the
discounted reserves are less than the undiscounted amount and the Inland Revenue has no objection
to the company setting up full undiscounted reserves. Otherwise there may be some problems due to
acceleration of tax payments.
Mr W. R. Treen: I, too, would like to congratulate the authors on a paper which makes a great deal of
progress in bringing a sense of coherence to this complex subject of solvency.
I also welcome the authors’ call for consultation with the insurance industry. I suspect that the first
problem that such consultations will encounter is the view of the authors that the variability of the
liabilities should be segregated into two parts. The first one-and-a-half standard deviations are to be
included directly in the reserves, while a further one-and-a-half standard deviations are to be included
in the solvency margin.
I would suggest that the insurance industry considers the solvency margin to be the appropriate
place for the whole variability. It is difficult to see how the industry could operate in a commercial
sense other than on a mean-value basis. For instance, reinsurance arrangements, treaty arrange-
ments, experience rating. retro-plans. profit-sharing, etc., all presuppose mean values. Equally, when
large accounts are broken down into homogeneous policy categories, mean-value case estimates are
often the only way, and indeed the best way. to proceed. Numerically, most insurance companies in
the U.K. and elsewhere are small. specialized, and hence of limited statistical robustness. Thus a
sound case can be made for dealing with all the variability of the liabilities through an albeit higher
solvency margin. This, after all. is the method illustrated for the other items subject to variability,
including the significant one of asset variability. It would seem to me that prudent mean values,
ideally reported upon by an actuary, is a more practical way forward as it avoids getting involved too
directly with the complexities and uncertainties of standard deviations.
I was pleased to read that the concept of discounting claims was acceptable to the authors. I have
previously argued that, properly used, discounting is an essential part of understanding the
mechanism of general insurance. There need be nothing inherently imprudent in discounting claims
but the events, or rather the reinsurance arrangements, that are currently coming to light in the
U.S.A. show how dangerous it is to continue in a clandestine way and allow adverse financial
circumstances, rather than analytical assessment, to be the pressure that breaks the present
convention of undiscounted reserves.
The section of the paper dealing with the variability of the assets is well thought out and is most
important since it is an area that has hitherto received insufficient attention. The authors refer to a
forthcoming paper to the 22nd Congress by Andrew Thomson and I. This work reinforces the view
that very substantial margins are required to deal with asset fluctuations. Because of availability of
data at the time, that part of the work on fixed-interest securities was based on irredeemable gilts.
Subsequent work has shown the expected sharp reduction in variability when short-dated securities
were considered. Thus it is probable that the approach suggested by the authors needs to be refined so
as to deal fairly with fixed-interest securities of different durations.
This Congress paper also examined the variability of what the Finnish study called the extended
stochastic variables, namely inflation and interest rates. The results, based on U.K. experience during
the last 25 years, were somewhat surprising in that the variability levels were very modest indeed and
were most certainly swamped by the variability of the assets.
The authors, not surprisingly, baulk at applying the full margins to the assets but as they point out
equities have consistently outperformed gilts and cash and hence the need for additional solvency in
order to invest in equities is offset by improved financial returns. It would then be up to each
management to select the policy most suited to its own view.
My reaction to the margins suggested for underwriting risks and other risks is that they are very
much on the full side. One reason for this view is a feeling that the tax relief associated with some of
these losses has not been fully considered. I would also be concerned at an approach that weakens the
margins on assets only to put them back under some other heading. There have been endless examples
of potential insolvency being most detectable through changes in assets. It may well be that these asset
movements are the indirect and desperate response to poor underwriting judgements. Asset changes
are then sought as a way out the dilemma, often followed by malfeasance. Thus adequate margins and
the closest watch should be kept on the assets.
Mr F. R. Wales: As one who qualified before general insurance was included in the syllabus and who
has spent his entire working life in the life assurance field, I would not normally have the temerity to
comment on a paper on the subject of general insurance.
However, the paper does consider the question of asset matching, a familiar subject to all life office
actuaries. Little attention was given to this aspect of the paper during the discussion at Staple Inn.
However, I feel that the authors are open to criticism for tending to underplay the dangers of
mismatching by use of unsound comparisons.
In § 5.4.5, a comparison is shown between the return on equities and the return on gilts over a
20-year period. This highly superficial comparison does not indicate what is being compared with
what. I assume it is between an investment in an equity share index rolled up at the index dividend
yield and an investment in a long-dated or irredeemable gilt-edged security with dividends reinvested.
The illustration, therefore, merely shows that mismatching in gilts would have been less satisfactory
than mismatching in equities. If the return on a matched portfolio of gilts had been shown, a much
more satisfactory average return would have resulted.
The comparison shown by the authors is also unfair as it has been given on a net of tax basis, The
effect of tax is, of course, to penalize gilt-edged investment with a 52% tax rate applicable, rather than
the 30% for franked investment income. Since technical reserves can be built-up out of pre-tax
income, the comparison should be made on gross returns.
Another factor ignored is the movement in asset values during the intervening period. Consider the
situation in 1974—a matched portfolio of gilts would, of course, have shown a substantial
depreciation, but in these circumstances there would have been strong arguments in favour of
discounting liabilities. On the other hand, a fund mismatched in equities and with inadequate free
reserves would have been placed in a quandary. Indeed, it is well known that one major composite
sold its equity portfolio at the bottom of the market in order to cut its losses and it has never really
recovered from that traumatic event.
To sum up, higher investment returns can only be obtained at higher risk. The extent of risk to
which an office can be exposed is governed by the size of its free reserves and, therefore, the message of
§5.6.2. cannot be emphasized too strongly.
Mr W. R. Rowland: Congratulations to the authors on an excellent thought-provoking paper, which

if used properly does, in my view, take us significantly further forward in this important field—and I
say this despite the criticisms which follow.
There is a distinct lack of material worldwide on the practical measurement of a variety of factors
affecting solvency.
On the face of it this is particularly surprising perhaps for North America—it could be the effect of
guarantee funds and the use of batteries of test. I wonder if the Policyholders Protection Act is
relevant to us as well.
Anyone who has tried to read up the background to E.E.C. solvency will know the disappointment
in finding that politics and horse trading were major influences on how the work of Campagne and
others was used.
But is it so surprising?
Consider investment fluctuations, Despite 1974. how many general insurance companies
worldwide have collapsed in the last 10 years due to this? Indeed. how many companies have actually
had to sell investments in this time? I believe the up-front cash flow nature of insurance has a far
greater influence in keeping companies afloat in bad times than has ever been recognized. The
problem here, in relation to this paper. is that cash flow is at first sight only relevant while a company
is a going concern so no mention has been made of it by the authors of this paper. However, in my
view it does beg the question as to whether we are right to seek a margin which covers all eventualities
and whether we should not in fact be linking a lower margin with a battery of tests, or adopting a
discounted cash-flow basis as outlined in a paper which one of the authors has been involved in for the
forthcoming Congress in Sydney.
We will also have, if the authors’ ideas are developed further, a major problem of explanation to
shareholders and policyholders. As far as they can see there is no major problem at the present time.
Outwardly new capital appears totally unnecessary (unless living in the Republic of Ireland) and
competitors for such capital are many in the real world whether they be I.C.I., I.C.L. or Tricentrol.
Financial commentators are already questioning whether the present levels of quoted insurance
companies are excessive.
Perhaps the answer is for the D.T.I. to implement their Minister’s recent offers of sponsorship for
the service industries and for them to change their attitude from the past to one of active support for
the industry for tax relief on solvency margin requirements. Also support for claims expenses and
equalization reserves as received on the continent would probably do more to ensure companies were
adequately provided in their reserves than anything else. I am convinced that the present lack of such
tax relief is responsible for the majority of any problems which do exist as regards current reserving
practice. Yet our German colleagues, for instance. get very active support from their own supervisors
when dealing with the fiscal authorities, If there is another solution to a massive margin covering all
risks, then it needs to be considered very carefully. I doubt whether it is necessary to go for overkill.
While greater allowance may be needed than at present and certainly all the risks need to be
understood, I doubt very much if they all need to be added together, as in this paper.
I am also surprised that the authors. having discussed the subject of discounting, make no
allowance in their example for the fact that almost certainly none of the companies they have looked
at are actively discounting their outstanding claims. How about an asset for supervisory purposes
relating to any lack of discounting—to me this is just as reasonable and viable as a liability for
mismatching? Incidentally, perhaps this is another practical reason why the general insurance
industry has not done so badly over the last 100 years, compared with many other industries.
Incidentally, statements of standard accounting practice are not now the recommended procedure
by the accountancy bodies. They have agreed that for specialist industries a S.O.R.P. (Statement of
Recommended Practice) are the answer and that S.O.R.P. should be produced by the industry itself
with involvement of interested parties. The point is that generally accepted practice cannot be
imposed and must be accepted to be of any use.
Finally, I think the authors are defeatist in §9.4.2 in not accepting that any margin which is
established should in fact take account of the companies’ own portfolio mix, etc. With modern
electronic data bases it really should not be beyond the powers of the regulators to come up with
company profiles.
Mr W. T. L. Barnard: I warmly welcome the recommendation for a revised approach to the

calculation of reserves. There are a number of weaknesses in the present arrangement. For example, if
the premium rates charged on recent business are inadequate the solvency margin, based as it is on
premium income, is reduced. Also the unearned premium reserve on the twenty-fourths basis will be
inadequate.
Where the need is greatest the reserve is least.
I would like to add to §4.2.4. ‘(iv) Seasonal Variations’. A large part of the general insurance
portfolio has a peak risk period at the beginning of the calendar year. Where the accounting periods
ends at 31 December, the unearned premium reserve on a proportionate basis may be inadequate.
This paper takes us on our first steps along the road to reserves based upon experience and away
from those based upon premiums which have insecure foundation.
Mr J. Plymen: Table 1, § 5.4.5 shows the distribution of assets, investments, cash and deposits, but
excludes the important item of ‘other net assets’ or agents’ balances, This item, largely for premiums
due and unpaid is usually some 20% of the premium income, or say 10% of the assets, and is clearly an
‘investment’ derived from the technical reserves. Including this item would increase the ‘cash’ line of
Table 1 from 5 to 8% of assets to say 15% of the amended total. A corresponding adjustment would be
needed in the ‘assets’ table on page 301, With the adjustment, technical reserves are usually more than
covered by gilts, deposits and agents’ balances (i.e. non-risky investments). This practice is confirmed
by the remarks of Mr Rushton to the effect that the technical reserves of Royal are largely invested in
British and American Government Securities with a term up to 5 years. Such investments combined
with the deposit and agents’ balances can be regarded as well matched to the short-term liabilities,
with little need for any mismatching reserve.
The shareholders’ capital and reserves, however, are usually invested about 100% in equities and
property as a hedge against inflation. For these investments, suitable reserves will be needed to cover
price fluctuations.

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JIA 111 (1984) 279-336

THE SOLVENCY OF GENERAL INSURANCE COMPANIES

BY C. D. DAYKIN, M.A., F.I.A., F.S.S.,

[Submitted to the Institute, 27 February 1984]

2. THE NATURE OF SOLVENCY

2.2. The need for solvency margins

2.4. Relationship between technical reserves and solvency margins

2.5. The company view

3. ACCOUNTING FOR GENERAL BUSINESS LIABILITIES

3.2. Generally, accepted accounting concepts

3.3. Generally accepted accounting practice

3.4. The need for standards

4.2. The scope of the problem

4.3. Estimating variability

In practice the situation is between these two extremes (assuming no negative

In bringing together the proposals for an overall solvency margin in § 9, we

4.4. Monitoring the margin factor

4.5. Funded business

4.6. Unexpired risk reserve

4.7. Expense reserve

5.2. Changes in asset values

Sector Change in value

5.4. The effect on solvency

5.5. Further problems with investments

5.6. A practical solution

6.2. Gross or net provisions?

6.3. Reinsurance and the solvency margin

(a) The reinsurance premiums may be inadequate to cover the risks.

7.3. Accounting implications of discounted claims reserves

8. THE SCOPE FOR AN ACCOUNTING STANDARD

8.2. The case for and against accounting standards

8.3. Scope of a possible standard

8.5. Valuation of liabilities

8.5.5. There are a number of further matters which might be covered by an

9. THE SOLVENCY MARGIN

9.2. The components of the solvency margin

9.3. Asset depreciation

In practice different factors would be appropriate at different times, depending

9.4. Claims fluctuation

These would be applied to the outstanding claims reserves for respective

9.5. Reinsurance failure

9.6. Underwriting risks

9.7. Other risks

ABSTRACT OF THE DISCUSSION

Mr F. E. Guaschi: In 1970 Mr C. M. Stewart stated at the ASTIN Colloquium in Denmark “A

Dr D. H. Reid. A peculiar difficulty is experienced by general business companies in attempting to

Mr W. R. Rowland: Congratulations to the authors on an excellent thought-provoking paper, which

Mr W. T. L. Barnard: I warmly welcome the recommendation for a revised approach to the

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