Explaining the solvency margin

Updated: Oct 31 2005, 06:38am hrs
State-owned Life Insurance Corporation (LIC) has been facing problems in meeting the solvency margin stipulation which came into effect from April 1, 2001. The problems are owing to its financial structure, and not because there is a likelihood of the corporation becoming insolvent. LICs capital base has remained unchanged at Rs 5 crore since 1956, though the premium earned and assets owned have grown manifold. Its total assets are reported to be in excess of Rs 3 lakh crore.

After the opening up of the insurance sector, LIC, like any private insurer, needs to adhere to Insurance Regulatory Development Authority (Irda) norms, including those with regard to solvency margins. So it wants to raise funds from the public to fulfil these norms. In a recent presentation to Parliaments standing committee on finance, LIC made a case for amending the LIC Act so that it could raise the required funds to meet the solvency margin norm. fe takes a Closer Look at the solvency margin and its facets:

What is the solvency margin

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

Why is the solvency margin needed

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

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

Does it mean that insurance companies can never fail

The solvency margin is designed to take care of problems that are usually not anticipated. It also provides elbow room to the managers of insurers to rectify problems and take precautionary measures. However, whether an insurance company will fail will also depend upon the magnitude of the crisis. Ordinarily, an insurance company with the requisite solvency margin is not likely to fail.

However, insurance is a risky business and there can be no absolute guarantee. Events such as the terrorist attack on the World Trade Centre in New York can create unexpected liabilities of a magnitude difficult to anticipate and cover. Liabilities can also increase manifold as a result of fraud by employees. No insurance regulator or company can completely guard against fraud, solvency margin norms notwithstanding. Such occurrences, however, are rare. Insurance failure in the past two decades have been rare.

How is the solvency ratio worked out

All insurers in India have to determine the solvency margin as per the guidelines laid down under Irda Rules. The process involves valuation of the assets and determination of the liabilities. The value is assigned to assets as per the provisions laid down in Irda Rules.

For instance, advances of unrealisable character, deferred expenses, preliminary expenses in the formation of the company, etc are to be assigned zero value. Assets also include the insurance companys investment in approved securities, non-man-dated investments, etc.

The determination of liabilities is more complicated. Irda Rules have prescribed a detailed method for the determination of liability by both life insurance as well as general insurance companies. In the former case, a company also has to take into account the options available to the insured while determining the liability.

After working out the assets and liabilities, the insurer works out the available solvency margin, which is basically the difference between the value of assets and that of insurance liabilities. Thereafter, the company works out a solvency ratio, which is the ratio of the available solvency margin to the amount of required solvency margin.