Solvency margin is a form of cash ratio. It is applicable to the financial and insurance industries. In accounting terms, it refers to the monetary value or assets that an organization is left with after the value of all debts are deducted. In the insurance terms, it is used to denote the value of capital that an insurance firm owns in comparison to the value of probable claims. The term probable claims connote the amount of money that is paid out to those individuals who have purchased insurance. In the strictest definition, solvency margin simply means the value by which assets exceed liabilities of an organization (Gleta & Teplý, 2012).
Solvency margin depicts the organizational capacity to achieve its long term liabilities. In most instances, the solvency margin is set by regulators of an industry at a minimum level. This is to ensure that companies do not go below the set minimum and are thus continually able to meet their financial obligations. The solvency margin indicates the preparedness of a company to meet any exigencies that will be unfrozen in the future. In a more informal manner, it is the extra capital or assets that an organization is required to hold to meet such exigencies. Solvency margin is also known as solvency ratio. For banks, the solvency margin is an adequacy capital requirement. Such requirements assist supervisors of banks to determine whether banks are holding an adequate amount of capital at any given time so as to enable the bank to meet any unexpected losses (Illing & Paulin, 2005).
Solvency margins are set according to the Basle Accords. Basle accords are a set of accords that relate to banking supervision. They are issued by a committee known as the Basel Committee on Banking Supervision. They are regulations that relate to a bank’s capital, operational and market risks. The first Basel Accord was issued in 1988 and the second one in 2004. The first accord concentrated on financial institutions having adequate capital. The risk of capital adequacy categorized risk in five different categories of 0%, 10%, 20%, 50% and 100%. International banks under this accord were required to have a minimum of 8%. The second accord focuses mainly on three pillars. These are market discipline, capital requirements and supervisory review. The concentration of the second accord is to strengthen and supervise banking requirements at an international level (Capital Standards for Banks, 2003).
The minimum capital requirement pillar of the second Basel accord has three concerns, credit risk, operational risk and market risk. Credit risk has three main approaches. This includes the standardized approach. The other approach is the Internal Rating Based strategy. Lastly, there is the Advanced Internal Rating Based strategy. The standardized approach is concerned with the regulatory capital of a bank and the main elements of risks that face a banking institution. The standardized approach assists in the mitigation of risks through various techniques. It is also involved in differentiating the risk weights of a bank. The capital requirement of a financial institution is arrived at by dividing the assets of a bank into different categories. These categories are equity, corporate, bank, retail and sovereign. The risk weight for every category is calculated and is thereafter rated by the credit rating of borrowers. The internal ratings foundation approach concentrates on the probability of loans defaulting. This approach enters a date into a probability formula which then calculates the weight and risk the capital that should be maintained against the loan. On the other hand, the advanced approach prescribes loss at a given default in a formula and also estimates the risk weight, as well as the capital that should be held in view of this (Rodriguez, 2003).
The operational risk refers to the risk that occurs when control processes of an institution are lacking. The pillar of supervisory review has two aspects. The first is a requirement placed on the banks for them to evaluate their risk profile as a whole. The second aspect is a review process that evaluates risk and enforces a prudent capital ratio. The third pillar is market risk/discipline. This is a requirement for the banks to disclose capital position information and the processes they undertake to manage risks. The aim of this is to have a strong market (Petria & Petria, 2009).
Calculation of the Solvency margin for Banks under the Basel II Accord
From the discussion, it is clear that the solvency margin is a requirement for banks to maintain an adequate amount of capital at all times. This will enable the banks to mitigate against unexpected losses. An example of how banks calculate the solvency margin ratio is given below. The financial position statements of Chase Corporation have been used to assist in this (Yahoo Finance, 2012).
Chase Corporation (CCF)
Period Ending Nov 2012
In ‘000 USD
Cash and Cash Equivalents
Other Current assets
Property plant and Equipment
Long Term Liabilities
Long term Debt
Deferred Long Term Liability Charges
Solvency Margin Ratio
Total Assets/Long Term Liabilities
The solvency ratio for Chase is calculated by getting the ratio between the total assets of the bank and the total liabilities. The Firm is sound financially. This is evidenced by a solvency margin of 2.5 times indicating that the Corporation is in a position and able to finance its long term obligations 2.5 times into the future (Gleta & Teplý, 2012).
Solvency Margin under the Basel Accord III for the Bank Management
The Basel III accord was instituted in 2010-2011 by the Basel Committee on Banking Supervision as a regulatory requirement for banks. It is scheduled to be implemented between 2013 and 2018. It was developed due to the shortcomings of the second accord. The third accord strengthens the requirements that banks should meet and also brings with it new regulations on the liquidity and leverage of banks. The third accord requires that financial institutions maintain common equity of 4.5 percent from the previous requirement by the second accord of 2 percent. In 2011, the United States Federal Reserve declared that it would comply with all the rules of the third accord. It also stated that the accord would not only be requiring compliance from banks but from all financial institutions with an excess of 50 billion dollars in assets (Petria & Petria, 2009).
Therefore, this implies that the solvency margin for banks will face tighter regulations. According to the third accord, the Chase Corporation will appear to be financially sound. This is by comparing the total assets of the company and its long term liabilities in the current period. This is given by a solvency margin of 2.5 times. This indicates that the Corporation is able to finance its long term obligations 2.5 times the amounts owed to external stakeholders in the future. The ratio enhances investors, customers and all the stakeholders’ confidence in their dealings with the Company (King & Sinclair, 2003).
Impact of Basel III accord for Banks
The new accord strives to make the financial institutions a safer place to conduct day to day business. More directly the third accord seeks to address the problems that came with the recent financial crisis all over the world. It aims to improve not only the capital depth of banking institutions but also the quality of capital. The third accord also seeks to foster a culture of liquidity management in financial institutions. This will enable the institutions to better manage their capabilities of dealing with any underlying risks. The bottom line for this accord is that banks should better understand the risks that face them. This refers to the paradigm of risk in which they operate in and thus manage the same risks in a manner that is beneficial for all the stakeholders involved (Illing & Paulin, 2005).
Closer to home, the accord is interested in funding and capital. It has outlined target ratios of 7 percent, which is a core requirement for tier 1. This when broken down translates to a 4.5 percent capital requirement and a 2.5 percent buffer requirement for capital conservation. The overall requirement is an 8.5 percent capital requirement. This includes the original 7 percent which is a core tier requirement and an additional 1.5 percent which is a non core requirement. These new rules will require that banking institutions increase their capital reserve and reduce the amount they borrow. The accord also implies that banks will have to change the way they perceive the relative risk of their investments and loans. The impact would be a shortfall of 1.1 trillion Euros in the European markets and 0.6 trillion Euros in the American market in terms of capital. The liquidity shortfall in the short run would be an estimated 1.3 trillion Euros and 0.6 trillion Euros in Europe and America respectively. In the long run, the shortfall in Europe alone would be an estimated 2.3 trillion Euros awhile in America it would be an almost similar estimate of 2.2 trillion Euros (Swartz, 2005).
The impact of all the above is that banking institutions have become more rigorous in accumulating capital, stock funding and minimizing their exposure to risk in different ways. Other methods that the banks can use to pull through the stringent requirements of the third accord include restructuring their financial position statements, managing their capital and liquidity in better ways and adjusting their business models. The task that faces financial institutions is large because compliance with the technical requirements is going to need reorientation of the banking institutions. Another challenge that faces these institutions is the long periods of transition required by the accord. Some of the requirements cannot be implemented until 2019. For this course, banks will need to start monitoring some ratios like the solvency ratio before the period of mandatory compliance arrives (Capital Standards for Banks, 2003).
Some banks have argued that the new rules will reduce the competitive ability of the banking institutions in the global market. For instance, in the case of the JPMorgan Chase, the rules will reduce the incentives that financial institutions have to invest in utilities that are critical and the fundamentals of the trading infrastructure. This has led to some financial institutions seeking exemption from the stringent rules. Another material impact that the third Basel accord may have on banking institutions is that it may alter the developments of their balance sheets in the long run. Such alterations include retained earnings accumulation. Furthermore, it includes doing away with tax assets that are deferred, as well as hidden losses. Another alteration may be for banking institutions to expand their balance sheet so as to be able to meet the expected growth in credit (King & Sinclair, 2003).
The third Basel accord also impacts the different segments of banking institutions in unique ways. The affected segments are the retail, corporate and investment segments. The retail sector is impacted in terms of the increase in liquidity and capital requirements. The banks that carry out retail banking have maintained low capital ratios in the past. This change will mean that acquiring loans will be expensive for retail bankers. Corporate banking will mainly be affected by the new capital ratios that are targeted under the new accord. For corporate banks, this means that the long term loans they offer and the finance businesses that are asset based on the long term will experience an increment in the funding costs by an estimated ten basis points. Liquidity and credit lines that are uncommitted will experience an increment of sixty basis points. This will be in regard to the liquidity requirements and an estimated fifteen to twenty points for capital requirements. Investment banking and particularly the capital markets will perhaps be the most affected of all sectors. This is due to the new framework of the accord that encompasses market risk and securitization, changes in the securities’ liquidity and amendments that have been put in the derivatives sector (Swartz, 2005).
EU solvency II for life and non-life insurance companies
The main purpose of the solvency rule is to make sure that there is soundness in terms of finance within the insurance sector. More specifically the rule aims to shield the insurance companies in times of financial difficulties. The requirement for solvency margin requires an insurance company to hold a specified minimum amount of capital in order to mitigate against unforeseen risks. The solvency two frameworks are similar to the Basel two frameworks because it has three pillars too. The improvements of solvency two are that it leads to an insurance market that is more secure, is transparent and professional. It provides a framework that can identify risks in an easier manner. It also aids in increasing how measurable transfer and diversification of risks are in relation to capital saving (Linder & Ronkainen, 2004). The objectives of solvency II include
Increasing competitiveness in the insurance industry in the EU and also globally
Introduce new methods for capital assessment that are based on the inherent risks, which are consistent in the market
Achieve and maintain a harmonized framework of regulation in the EU
Introduce incentives to the insurance institutions to understand the risks they face and consequently manage them.
Maintain consistency in the financial markets (Vesa et al, 2007).
The three pillars of solvency II are the first pillar, which outlines the capital requirements that need to be met. It also outlines the techniques that are to be used to value assets and liabilities. There are two capital requirements under this pillar, the minimum capital and solvency capital requirement ratios. The second pillar is a supervisory review process. This gives mandate to supervisors to increase the amount of capital that a firm may hold given the risk it inherently faces. Under this pillar, an insurance company carries out an Own Risk and Solvency Assessment (ORSA). The third pillar is about full disclosure and market discipline by all insurance firms (Vesa et al, 2007).
For life insurance firms, the firms are required to hold capital at a minimum of the solvency I margin requirement or the guarantee fund whichever is higher. In addition, the firm should also keep a resilience capital requirement. For any insurer who has reserves to the minimum amount of 500 million Euros, they should employ the same approach for capital requirement. This approach is known as the twin peaks approach. Solvency II for life insurance companies also necessitates them to assess liabilities related to profit. It also helps to determine whether there is a need to hold additional capital. Non-life insurance firms employ the multi approach. This approach requires such firms to hold capital that is adequate to minimum capital requirement on the higher end in correspondence to solvency I. The firms should also hold on an advanced capital requirement, which is more sensitive to risk calculations (Linder & Ronkainen, 2004).
From the discussion on solvency margin, Basel accords, and solvency with regard to insurance companies; it is clear that all these regulations are established to minimize the risk in which financial institutions operate. In addition, if and when the risks do arise, the organizations can handle them without falling into financial crisis like the one that was recently faced globally. Therefore, these regulations are ways of mitigating risk and ensuring all stakeholders are protected.