restricted regional seminar for insurance supervisors in latin america on supervision of insurance...
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Regional Seminar for Insurance Supervisors in Latin America on Supervision of Insurance Groups
Group-wide Solvency and Fungibility of Capital
Jeffery Yong
Senior Financial Sector Specialist, FSI
19 November 2013
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Agenda
Overview of group capital adequacy Approaches to group capital adequacy assessment Components of group capital requirements Considerations for group capital resources
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Objectives of Capital Adequacy Requirements
ULTIMATE AIM: Policyholder obligations continue to be met as they fall due including in adversity
• Absorb significant unforeseen losses to reduce:• likelihood of failure• losses to policyholders in the event of failure
Insurers
• Have different degrees of supervisory interventionSupervisor
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ICP 17 Capital Adequacy
Group-wide requirements do not replace legal entity/solo requirements
Aim: to avoid overstating capital adequacy of insurance legal entities due to multiple gearing, leverage, group risks etc.
The supervisor establishes capital adequacy requirements for solvency purposes so that insurers can absorb significant unforeseen losses and to provide for degrees of supervisory intervention.
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Overview of Capital Adequacy Components
Supervisory Reporting
Assets Regulatory capital requirements
Insurer’s financial position
Assets Liabilities
Tec
hn
ica
l p
rov
isio
ns
Current estimate
Value of assets for supervisory
purposes
Group Capital
requirements
Liabilities*
Group Capital
resources
Liabilities
Capital = Assets less Liabilities
Margin overcurrent
estimate
Public Financial Reporting
* Assuming nil Other Liabilities
Assessment
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Lessons from the 2007 Financial Crisis - AIG
“… AIG failed and was rescued … because its enormous sales of CDS were made without … setting aside capital reserves … a profound failure in corporate governance, particularly its risk management practices.”
“If (the CDS) had been regulated as insurance contracts, AIG would have been required to maintain adequate capital reserves… AIG would have been prevented from acting in such a risky manner.”
Source: US Financial Crisis Inquiry Commission
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Definition of an “Insurance Group”
Holding Company
Insurer A Bank AHedge Fund
Super-markets
Special Purpose
EntityReinsurer Insurer B
Participation
Influence
Risk exposure
Interconnectedness
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Sources of Group Risk
Governance• Conflict of interest - risk appetite, shareholders versus
policyholders• Incompetent Board and Management• Lack of ability to impose regulatory requirements
Financial• Financial contagion – regulated entities supporting non-
regulated entities/parent (liquidity)• Intra-group transactions and exposures• Risk concentration
Group Structure• Complex organisational structure – non-regulated entities• Regulatory arbitrage• Reputational contagion • Lack of transparency
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Double/Multiple Gearing and Intra-group Creation of Capital
Aim: Avoid over-estimating the solvency position of an insurance legal entity through multiple use of the same capital and minimise contagion from large intra-group holding of capital
May occur via downstream/upstream/sidestream capital
Parent Bank
Insurer
Securities Firm
Inve
stIn
vest
Participation=500
Participation=500
5500
4000
Asset Liab. Cap.Req.
8001500
700
Surplus
9000
8100
Asset Liab. Cap.Req.
800900
100
Surplus
4000
3500
Asset Liab. Cap.Req.
400500
100
Surplus
Group Capital Adequacy
Capital Resource
s
Cap.Req.
800+800+400=2000
1500+900+500-500-500
=1900
100
Deficit
Capital Resource
s
Cap.Req.
800+800+400=2000
1500+900+500=2900
900
Surplus
With multiple gearing
Without multiple gearing
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Excessive Leverage
Risks to insurer: Undue stress placed on insurer due
to obligation of parent to service capital instrument
Ineligible (low quality) capital transformed into eligible (high quality) capital – regulatory arbitrage
(Non-) Regulated
Parent
Insurer
Us
e p
roc
ee
ds
to
bu
y s
ha
res
Issues debt Investors
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Examples of Intra-group Transactions and Exposures (ITEs)
• A form of credit extension where the lender agrees to lend up to a pre-defined specific sum
• Can be used by a parent to provide liquidity to subsidiaries
Committed facility
• Legal commitment, usually issued by a bank, that guarantees payment under specified conditions
• Can be used to provide capital support, particularly internal reinsurance
Letter of credit
• A bond that guarantees timely payment of interest and repayment of principal to the buyers of a debt security
• Can be used to support non-rated subsidiariesGuarantee
• A type of loan that is junior to other debts should a company be wound up
• Can be used to provide capital support
Subordinated loan
• A letter issued to a lender by a parent acknowledging the approval of a subsidiary's attempt for financing
• Not legally binding, but provides reassurance from the parent
Letter of comfort
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Risks Arising from ITEsPressure on insurers
- capital, income transferred out
Contagion - failure of one group entity can adversely
affect other (insurance) entities
Capital quality - replace high quality capital
Supervisory challenge - opaque and complex structure
Regulatory arbitrage- evade capital requirements
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Agenda
Overview of group capital adequacy Approaches to group capital adequacy assessment Components of group capital requirements Considerations for group capital resources
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General Approaches to Setting Group Capital Adequacy Requirements
O R G A N I S AT I O N A L P E R S P E C T I V E
Legal Entity Focus Group Level Focus
SUPERVISORY PERSPECTIVE
More weight on group-wide supervision
• Capital adequacy assessed for all relevant legal entities taking into account group impact
• Results binding for host and group-wide supervisors
• Capital adequacy assessed as though the group behaves as a single integrated entity
• Results binding for host and group-wide supervisors
More weight on legal entity supervision
• Capital adequacy assessed for all relevant legal entities taking into account group impact
• Non-binding results - host supervisors apply insurance legal entity capital adequacy requirements
• Capital adequacy assessed as though the group behaves as a single integrated entity
• Non-binding results - host supervisors apply insurance legal entity capital adequacy requirements
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Factors to Consider in Selecting an Approach
Legal Authorit
y
Insurance Group
Structures
Supervisory Cooperation Arrangemen
ts
Supervisory
Philosophy
Supervisory Role
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Group Capital Adequacy Assessment Techniques
Techniques
Consolidatio
n
Aggregation
Deduction
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Sample Group
Parent Bank
Insurer Securities FirmNon-regulated
Entity
315
275
Asset Liab. Cap.Req.
3240
8
Surplus
150
138
Asset Liab. Cap.Req.
1012
2
Surplus
225
203
Asset Liab. Cap.Req.
1722
5
Surplus
120113
Asset Liab. Cap.Req.
107
3
Deficit
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Consolidation Method
Uses consolidated balance sheet
Consolidated parent bank’s balance sheet adjusted to exclude investments in subsidiaries
Issue: Group may not behave as single entity in times of stress
315
275
Asset Liab. Cap.Req.
3240
8
Surplus
150
138
Asset Liab. Cap.Req.
1012
2
Surplus
225
203
Asset Liab. Cap.Req.
1722
5
Surplus
120113
Asset Liab. Cap.Req.
107
3
Deficit
Parent Bank (Consolidated) Insurer Securities
Firm
Non-regulated Entity
315 + 150 + 225 + 120= 810
275+ 138+ 203+ 113= 729
Asset Liab. Cap.Req.
32+10+17+ 10=69
81
12
Group Surplus
Consolidated Group
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Aggregation Method
Capital resources adjusted to eliminate double gearing of down-streamed capital
Suitable if: Consolidated financial
statements not available ITEs cannot be netted out
Issue: Recalculation of capital requirements for insurers
150
138
Asset Liab.
12
225
203
Asset Liab.
22
120113
Asset Liab.
7
Parent Bank (Unconsolidated)
Insurer Securities Firm
Non-regulated Entity
315 + 10 + 12 + 5
= 342 275
Asset Liab.
67
Group Aggregation
Capital Resource
s
32+10+17+ 10=69
12
Capital Req.
67+12+ 22+ 7
= 108
Down-streame
d capital
10+12 +5 = 27
81
Adjusted Capital
Resources
Group Surplus
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Deduction Method
Analysis performed from the perspective of the parent company
Assess amount and transferability of capital available to the parent and the group
Uses unconsolidated financial statements
315 + 10 + 12 + 5
= 342 275
Asset Liab.
67
Parent Bank (Unconsolidated
)
Deduct investments in
dependants
Capital Resource
s
2 + 5 - 3 = 4
Adjusted Capital
Resources
67
10 + 12 + 5
= 27 44
Add dependant’s surplus/defici
t
32
Parent’s Capital
Req.
12
Group Surplus
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Factors Affecting the Choice of Techniques
(Non-)Availability of financial data, e.g. consolidated financial statements
Ability to identify and net out ITEs Specific circumstances of the insurance groups
Regardless of the techniques followed, the outcomes should be the same if not similar.
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Fungibility of Capital and Transferability of Assets
Adjust capital resources
Stress versus normal conditions
Reasons for Lack of Fungibility
Exchange
controls
Participating fund
Legal enforceability of ITEs
Capital holders’ rights
Tax Laws
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Partial OwnershipP
arti
cip
atio
n
Effective Control (e.g. >50% to 100% participation)• Subsidiaries are fully consolidated• In general, excess capital recognised
Shared Control (e.g. 20% to 50% participation)• Only pro-rated surplus recognised• Recognise potential need for capital support from parent if in deficit
No Control/Significant Influence (e.g. <20% participation)• Treat like any other investments - apply capital requirements for
similar investments• Test of significant influence - no right to board membership, no
coordination of business plans
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Minority Interest
Need to decide between: Full integration – may amplify surplus/deficit because minority interest
regarded as available to the group Pro-rata integration
Even if each entity is solvent, group solvency position may be different
Parent
Insurer Bank
100%=40
60%=60 =>40 minority interest
Capital Resource
s
Capital Req.
90100
10
Surplus
Capital Resource
s
Capital Req.
2540
15
Surplus Capital Resource
s
Capital Req.
25
100
75
Surplus
100
Capital Resource
s
Capital Req.
90 +25
= 115
100+40
= 140
15
Deficit
Parent + Insurer
40
Particip.
140
Capital Resource
s
Capital Req.
90 +25+25
= 140
100+40+
100 =
240
Surplus=0
Full Integration
40+60=100
Particip.
100
Capital Resource
s
Capital Req.
90 +25+15
= 130
100+40+ 60 =
200
Deficit
Pro-rata Integration
40+60=100
Particip.
30
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Agenda
Overview of group capital adequacy Approaches to group capital adequacy assessment Components of group capital requirements Considerations for group capital resources
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Process of Setting Regulatory Capital Requirements
Determine
approach
Identify risks
Calibrate capital
requirements
Aggregate risks
Determine PCR and
MCR
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General Approaches to Setting Capital Requirements
Features Factor-based, standardised formula
Insurer’s own model -embedded in business
Precision Calibrated for “average” insurer risk profile
Tailored to the individual insurer’s risk profile – better for groups?
Complexity Easy to apply – certainty for insurers
Usually more complex
Supervisory Resource
Less resource-intensive More resource-intensive - prior and on-going approval
Supervisory Risk
Conservative insurers penalised, narrow risk capture, measurement error (data, model)
Cherry-picking, manipulation, errors, measurement error (data, model)
Standardised Approach
Internal Model Approach
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Identify Risks: Material and Relevant
•1918 flu pandemic, hurricane Katrina, Fukushima earthquake•E.g.: Sum at risk X 0.23%
Underwriting Risk
•Enron, Lehman Brothers•E.g.: AAA Corporate bond value X 0.25%Credit Risk
•1930 Great Depression, Black Monday 1987, 2007 Financial Crisis•E.g.: Value of equity X 30%
Market Risk
•Barings Bank, London Whale •E.g.: Gross premium X 3%
Operational Risk
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Pause for Thought – Liquidity Risk
Should insurers be required to hold capital to address liquidity risk?
Answer:
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Dealing with Risks from Non-regulated Entities
• Determine proxy capital requirement for the non-regulated entities
• Suitable only if there is a comparable regulated entity/activity
Capital Proxy
• On the parent’s balance sheet, deduct value of investments in non-regulated entities
• Assumes that non-regulated entities are unable to financially support the group
Total Deduction
• Entity is excluded in group capital adequacy assessment
• Usually appropriate for non-financial entities if their failure does not impact the regulated entities or the group as a whole
Total Exclusion
• Impose limits on risk exposure to non-regulated entities
• Governance and risk management requirements on parent and/or insurance legal entities
Non-Capital Measures
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Calibrate Regulatory Capital Requirements
Target Criteria
VaR TVaR
? ?
T=1 2 3 … n
Shock period
Effect period
0 1
SafetyCost
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Example - Risk Measures
Value at Risk (VaR): A measure of maximum loss at a certain confidence level over a certain period of time
Tail Value at Risk (TVaR): Expected loss conditional on losses being above a given percentile over a certain period of time
Probability
Losses$10m
VaR @ 99%: 1% chance of
loss>$10m
TVaR @ 99%: Average of worst 1% losses
$15m
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Diversification and Concentration of Risks
Groups may have diversification benefits (product lines, geographical locations, asset classes, counterparties etc.)
Reasons to limit recognition of diversification in group capital adequacy assessment: Difficult to quantify precisely especially under stress
conditions Constraints on transfer of diversification benefit
across group – lack of fungibility of capital Offset by concentration risk that may not be
explicitly quantified
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Group Solvency Control Levels
Purpose: Timely identification and mitigation of weakening
parts of an insurance group Minimise risk of contagion to insurance legal entities
Trigger process of coordination among different supervisors of group entities
Actions taken on: Parent (if have powers) Insurance legal entities
Need to be consistent with solvency control levels of insurance legal entities – e.g., group PCR > sum of legal entity MCRs
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Determine PCR and MCR
Technical Provisions
Capital Requirements P
res
cri
be
d
Ca
pit
al
Re
qu
ire
me
nt
(PC
R)
Min
imu
m
Ca
pit
al
Re
qu
ire
me
nt
(MC
R)
Control level above which supervisor does not intervene on capital grounds
Could be single group PCR or a set of inter-dependent PCRs
Going concern basis Method may be different than for MCR
Control level below which strongest supervisory action is taken – group context, restructuring
Ultimate safety net for policyholders Lower bound for PCR Subject to minimum bound below which
insurer cannot operate viably – critical mass, nominal floor
Different from accounting insolvency (assets still > liabilities)
Going concern basis up until MCR level
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Example - Solvency Control Levels
• Prescribed capital requirement (PCR) level
• Group does not need to restore capital resources/reduce risk
Capital Adequacy Ratio
= Capital Resources _
Capital Requirements
190%
160%
110%
130%
• Submission of business plan to improve capital resources
• Increased on-site supervision
• Additional stress and scenario testing
• Replace group’s management
• Limit shareholder dividends
• Restrict mergers and acquisition
• Increase capital in insurance legal entities
• Minimum capital requirement (MCR) level
• Winding-up of operation
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Practical Considerations
Practical Consider
ations
Risk Capture
Proportionality
Recalibration
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Agenda
Overview of group capital adequacy Approaches to group capital adequacy assessment Components of group capital requirements Considerations for group capital resources
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Pause for Thought – Ordinary Shares
What are the features of ordinary shares that make them high quality capital resources?
Answer:
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• Subordination to policyholders’ rights in insolvency/winding-up
• Holder not entitled to repayment/dividends until policyholders’ obligations are met
• Capital element fully paid, usually in cash
• If non-cash, assess likelihood of payment
• Fungibility of capital – e.g. ring-fenced funds
• Period over which capital element is available
• Careful on incentives to redeem – e.g. step-up coupon rate at certain date
• Free from mandatory payments and encumbrances
• Fixed servicing costs can accelerate insolvency
• Ability to restrict repayment/dividendsEncumbran
cesSubordinati
on
AvailabilityPermanence
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Criteria to Assess Quality of Capital Elements
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Key Challenges in Setting Group Capital Adequacy Requirements
Lack of legal authority and supervisor powers - non-regulated entities
Cross-jurisdictional entities – cooperation with other supervisors
Responsibilities and mandate of group-wide and host supervisors - different “risk tolerance”
Distribution of capital among group entities and geographical locations
Different valuation and capital adequacy bases for entities located in different jurisdictions
Group disintegrates in times of crisis
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Summary
The additional group risks arising from an insurer being part of a group should be addressed – a legal entity view alone is not sufficient
Group-wide capital adequacy assessment is crucial to supplement legal entity view of solvency
Group-wide capital adequacy assessment techniques should minimise multiple gearing, intra-group creation of capital and excessive leverage
Limits to fungibility of capital and transferability of assets should be recognised
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End of Presentation
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