1. INTRODUCTION AND PURPOSE

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1 Solvency Assessment and Management: Pillar 1 - Sub Committee Capital Requirements Task Group Discussion Document 75 (v 4) Treatment of risk-mitigation techniques in the SCR EXECUTIVE SUMMARY As per Solvency II risk-mitigation techniques should be allowed for in the calculation of the Solvency Capital Requirement provided that the risk-mitigation techniques meet certain criteria and provided that the credit risk and other risks which arise as a result of the risk mitigation are also properly captured in the capital requirement. The proposed secondary legislation contained in this document (included in section 7) is broadly consistent with the requirements as laid down in the Solvency II regulations. 1. INTRODUCTION AND PURPOSE This document sets out the recommendations of the SCR Structure working group with respect to the treatment of risk-mitigating techniques in the SCR. This document has been written with reference to the recommendations made in the latest available version of discussion document 55 (Internal models: Statistical quality and calibration) and discussion document 87 (Management actions and risk mitigation). In particular, the definition and treatment of risk-mitigation techniques are consistent. 2. INTERNATIONAL STANDARDS: IAIS ICPs ICP 13 Reinsurance and Other Forms of Risk Transfer: The supervisor sets standards for the use of reinsurance and other forms of risk transfer, ensuring that insurers adequately control and transparently report their risk transfer programmes. The supervisor takes into account the nature of reinsurance business when supervising reinsurers based in its jurisdiction. Link to capital assessment The cedant should ensure that the characteristics of its reinsurance programme, including associated counterparty risk, are adequately reflected in any assessment of riskbased solvency capital. Where risk transfer to the capital markets is permitted...

2 Risk transfer to the capital markets can occur by making use of a wide variety of arrangements. These usually entail the creation of a dedicated entity, specifically constituted to carry out the transfer of risk. These are variously referred to as Special Purpose Vehicles, Special Purpose Reinsurance Vehicles, Special Purpose Insurers, Special Purpose Entities (SPE), etc... However, risk transfer to the capital markets is not limited to the use of SPEs It should be noted that, in many respects, these transactions are the same as traditional reinsurance arrangements, and therefore the guidance throughout this paper 1 will be applicable. These transactions do, however, have special features that supervisors will need to bear in mind in order to assess the appropriateness and effectiveness of their use by cedants Supervisors will need to understand the extent to which SPE arrangements give rise to basis risk. This arises where the trigger for indemnity under the SPE arrangement is different from the basis on which underlying protected liabilities can arise. Where SPEs contain indemnity triggers (i.e. recovery from the SPE is based on the actual loss experience of the cedant) this is less likely to be an issue. Many SPEs, however, contain parametric (driven by objectively measurable events) or modelled (driven by the outcome of modelled, industry-wide losses) triggers. In these cases, there may be events whereby the cedant will remain exposed to its underlying policyholders without having recourse to the SPE. Any basis risk should be considered with reference either to the amount of credit given by the supervisor for the SPE arrangement or in the cedant s risk-based capital requirement, where such mechanisms are used. ICP 17 Capital Adequacy: 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. Allowance for risk mitigation Any allowance for reinsurance in determining regulatory capital requirements should consider the possibility of breakdown in the effectiveness of the risk transfer and the security of the reinsurance counterparty and any measures used to reduce the reinsurance counterparty exposure. Similar considerations would also apply for other risk mitigants, for example derivatives. Intra-group transactions Intra-group transactions may result in complex and/or opaque intra-group relationships which give rise to increased risks at both insurance legal entity and group level. In a group-wide context, credit for risk mitigation should only be recognised in group capital requirements to the extent that risk is transferred outside the group. For example, the transfer of risk to a captive reinsurer or to an intra-group insurance special purpose vehicle should not result in a reduction of overall group capital requirements. The above extracts are not complete. The extracts demonstrate that the IAIS principles allow for risk mitigation in the calculation of capital requirements provided that the risks associated with the risk mitigation technique have been appropriately allowed for. 1 Insurance core principles, standards, guidance and assessment methodology International association of insurance supervisors 1 October 2011 Page 2 of 28

3 3. EU DIRECTIVE ON SOLVENCY II: PRINCIPLES (LEVEL 1) The following recital and articles of the Solvency II Framework Directive - DIRECTIVE 2009/138/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II) make mention of risk-mitigating techniques: Recital (64) In order to promote good risk management and align regulatory capital requirements with industry practices, the Solvency Capital Requirement should be determined as the economic capital to be held by insurance and reinsurance undertakings in order to ensure that ruin occurs no more often than once in every 200 cases or, alternatively, that those undertakings will still be in a position, with a probability of at least 99,5 %, to meet their obligations to policy holders and beneficiaries over the following 12 months. That economic capital should be calculated on the basis of the true risk profile of those undertakings, taking account of the impact of possible risk-mitigation techniques, as well as diversification effects. Article 13 Definitions (36) risk-mitigation techniques means all techniques which enable insurance and reinsurance undertakings to transfer part or all of their risks to another party; Article 101 Calculation of the Solvency Capital Requirement. The Solvency Capital Requirement shall be calculated in accordance with paragraphs 2 to 5. Where paragraph 5 is as follows: 5. When calculating the Solvency Capital Requirement, insurance and reinsurance undertakings shall take account of the effect of risk-mitigation techniques, provided that credit risk and other risks arising from the use of such techniques are properly reflected in the Solvency Capital Requirement. Article 111 Implementing measures 1. In order to ensure that the same treatment is applied to all insurance and reinsurance undertakings calculating the Solvency Capital Requirement on the basis of the standard formula, or to take account of market developments, the Commission shall adopt implementing measures providing for the following: (e) where insurance and reinsurance undertakings use risk-mitigation techniques, the methods and assumptions to be used to assess the changes in the risk profile of the undertaking concerned and to adjust the calculation of the Solvency Capital Requirement; (f) the qualitative criteria that the risk-mitigation techniques referred to in point (e) must fulfil in order to ensure that the risk has been effectively transferred to a third party; Page 3 of 28

4 4. MAPPING ANY PRINCIPLE (LEVEL 1) DIFFERENCES BETWEEN IAIS ICP & EU DIRECTIVE The IAIS ICPs and the EU Directive both allow for the recognition of risk-mitigation techniques in the calculation of the Solvency Capital Requirement. Both require that any additional risks which emerge as a result of the risk-mitigation technique should also be allowed for in the calculation of the SCR. There appears to be no contradiction between the IAIS ICPs and the EU Directive. 5. STANDARDS AND GUIDANCE (LEVELS 2 & 3) 5.1 IAIS standards and guidance papers Completed in section 2 above. 5.2 CEIOPS CPs (consultation papers) The QIS5 Technical specification includes the following: Scenario-based calculations SCR.1.7. The scenario should be interpreted in the following manner: The recalculation of technical provisions to determine the change in NAV should allow for any relevant adverse changes in option take-up behaviour of policyholders under the scenario. Where risk mitigation techniques meet the requirements set out in subsections SCR.12 and SCR.13, their risk-mitigating effect should be taken into account in the analysis of the scenario. Where the scenario results in an increase of NAV, and therefore does not reflect a risk for the undertaking, this should not lead to a "negative capital requirement". The corresponding capital requirement in such a situation is nil. SCR.12. Financial Risk mitigation SCR Scope SCR This subsection covers financial risk mitigation techniques. For the purposes of QIS5, financial risk mitigation techniques include the purchase or issuance of financial instruments (such as financial derivatives) which transfer risk to the financial markets. SCR The use of special purpose vehicles and reinsurance to mitigate underwriting risks are not considered to be financial risk mitigation techniques and are covered in subsection SCR.13. SCR The following are examples of financial risk mitigation techniques covered by this subsection: Put options bought to cover the risk of falls in assets, Protection bought through credit derivatives or collateral to cover the risk of failure or downgrade in the credit quality of certain exposures, Currency swaps and forwards to cover currency risk in relation to assets or liabilities, Swaptions acquired to cover variable/fixed risks. Page 4 of 28

5 SCR The allowance of the above financial risk mitigation techniques is subject to the requirements in this subsection and the principles in Annex P being met. SCR Financial risk mitigation techniques do not include the risk mitigating effect provided by discretionary profit participation. Processes and controls that an undertaking has in place to manage the investment risk are also excluded. This does not preclude the allowance for future management actions in the calculation of technical provisions subject to the requirements in section V.2. SCR Conditions for using financial risk mitigation techniques SCR The risk mitigation technique must be legally effective and enforceable in all relevant jurisdictions and there must be an effective transfer of risk to a third party. SCR Undertakings should have a direct claim on the protection provider and there should be an explicit reference to specific exposures or a pool of exposures, so that the extent of the cover is clearly defined and incontrovertible. SCR The calculation of the SCR using the standard formula should allow for the effects of financial risk mitigation techniques through a reduction in requirements commensurate with the extent of risk mitigation and an appropriate treatment of any corresponding risks embedded in the use of financial risk mitigation techniques. These two effects should be separated. SCR There should be no double counting of mitigation effects. SCR All material risks arising from the use of the financial risk mitigation techniques should be reflected in the SCR, regardless of whether that financial risk mitigation technique is considered admissible. SCR Undertakings should not in their use of financial risk mitigation techniques anticipate the shocks considered in the SCR calculation. The SCR is intended to capture unexpected risks. SCR The calculation should be made on the basis of assets and liabilities existing at the date of reference of the solvency assessment. SCR With the exception of rolling hedging programmes see subsection SCR.12.5., risk mitigation techniques (for example financial stop-loss processes) not in place at the date of reference of the solvency assessment should not be allowed to reduce the calculation of the SCR with the standard formula. SCR Basis risk SCR Where the underlying assets or references of the financial mitigation instrument do not perfectly match the exposures of the undertaking, the financial risk mitigation technique should only be allowed in the calculation of the SCR with the standard formula if the undertaking can demonstrate that the basis risk is either not material compared to the mitigation effect or, if the risk is material, that the basis risk can be appropriately reflected in the SCR. SCR The following financial risk mitigation techniques should be considered to involve material basis risk: equity derivatives whose underlying equities or indexes have not a correlation nearby 1 with the hedged asset or liability, especially in case of stressed situations. Page 5 of 28

6 CDS referred to names different than the hedged name, or with a correlation not nearby 1, with a different tenor or a different nominal. SCR Shared financial risk mitigation SCR Shared financial risk mitigation techniques which provide simultaneous protection to various parties and where the activation of one of them means the loss of protection (totally or partially) for the rest of parties should not be treated as a financial risk mitigation technique in QIS5. SCR Rolling and dynamic hedging SCR Where a risk mitigation technique covers just a part of the next twelve months it should only be allowed with the average protection level over the next year (i.e. pro rata temporis). For example, where an equity option provides protection for the next six months, undertakings should assume that the option only provides half of the risk mitigating effect that it does if the shock takes place immediately. Where the exposure to the risk that is being hedged will cease before the end of the next year with objective certainty, the same principle should be applied but in relation to the full term of the exposure. SCR Where a risk mitigation technique covers only a part of the next twelve months, but a rolling hedge programme exists, this should be permitted as a risk mitigation technique if the following conditions are met: a. There is well-documented and established process for the rolling forward of hedges; b. The risk that the hedge cannot be rolled over due to an absence of liquidity in the market is not material (no material liquidity risk); c. The costs of renewing the same hedge over a one year period are reflected in the SCR calculation by reducing the level of protection of the hedge; and d. Any additional counterparty risk that arises from the rolling over of the hedge is reflected in the SCR. SCR Dynamic hedging should not be treated as a risk mitigation technique. SCR Credit quality of the counterparty SCR For QIS5 purposes, only financial protection provided by counterparties with a credit rating equal or equivalent to at least BBB should be allowed in the assessment of the SCR. For unrated counterparties, the undertaking should be able to demonstrate that the counterparty meets at least the standard of a BBB rated company. SCR In the event of default, insolvency or bankruptcy of the provider of the financial risk mitigation instrument or other credit events set out in the transaction document the financial risk mitigation instrument should be capable of liquidation in a timely manner or retention. SCR Where a provider of protection was downgraded below BBB or became unrated at the end of 2009, but its rating was restored in 2010, the financial mitigation technique may be considered admissible for QIS5 purposes. SCR If the financial risk mitigation technique is collateralized, the assessment of the credit quality of the protection should consider the collateral if the requirements Page 6 of 28

7 set out in subsection SCR.12.8 are met and the risks arising from the collateral are appropriately captured in the SCR (i.e. the counterparty default risk module for standard formula users). SCR Credit derivatives SCR The reduction of the SCR based on the mitigation of credit exposures by using credit derivatives should only be allowed where undertakings have in force generally applied procedures for this purpose and consider generally admitted criteria. Requirements set out in other financial sectors for the same mitigation techniques may be considered as generally applied procedures and admitted criteria. SCR In order for a credit derivative contract to be recognised, the credit events specified by the contracting parties must at least cover: Failure to pay the amounts due under the terms of the underlying obligation that are in effect at the time of such failure (with a grace period that is closely in line with the grace period in the underlying obligation); Bankruptcy, insolvency or inability of the obligor to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as they fall due, and analogous events; and Restructuring of the underlying obligation, involving forgiveness or postponement of principal, interest or fees that results in a credit loss event. SCR In the event that the credit events specified under the credit derivative do not include restructuring of the underlying obligation, the protection offered by the risk mitigation technique may be partially recognised as follows: where the amount that the protection provider has undertaken to pay is not higher than the exposure value, the value of the credit protection should be reduced by 40%; or where the amount that the protection provider has undertaken to pay is higher than the exposure value, the value of the credit protection should be no higher than 60% of the exposure value. SCR Where the amount that the protection provider has undertaken to pay is higher than the exposure value then undertaking should provide further information on the nature of the risk mitigation technique. SCR A mismatch between the underlying obligation and the reference obligation under the credit derivative or between the underlying obligation and the obligation used for purposes of determining whether a credit event has occurred is permissible only if the following conditions are met: the reference obligation or the obligation used for the purposes of determining whether a credit event has occurred, as the case may be, ranks pari passu with or is junior to the underlying obligation; and the underlying obligation and the reference obligation or the obligation used for the purposes of determining whether a credit event has occurred, as the case may be, share the same obligor (i.e. the same legal entity) and there are in place legally enforceable cross-default or cross-acceleration clauses. SCR Collateral SCR A collateralized transaction is a transaction in which an undertaking has a credit exposure or potential credit exposure which is hedged in whole or in part by collateral posted by a counterparty or by a third party on behalf of the counterparty. Page 7 of 28

8 SCR The legal mechanism by which collateral is pledged or transferred should ensure that the undertaking has the right to liquidate or take legal possession of the collateral, in a timely manner, in case of any default event related to the counterparty. SCR Where applicable, the legal mechanism by which collateral is pledged or transferred should ensure that the undertaking has the right to liquidate or take possession of the collateral, in a timely manner, in case of any default event related to a third party custodian holding the collateral. SCR Segregation of assets SCR Where the liabilities of the counterparty are covered by strictly segregated assets under arrangements that ensure the same degree of protection as collateral arrangements then the segregated assets should be treated as if they were collateral with an independent custodian. SCR The segregated assets should be held with a deposit-taking institution with a credit rating equal or equivalent to at least BBB. SCR The segregated assets should be individually identifiable and should only be changed subject to the consent of the insurance or reinsurance undertaking. SCR The insurance or reinsurance undertaking should have a right in rem on the segregated assets and the right to directly obtain ownership of the assets without any restriction, delay or impediment in the event of the default, insolvency or bankruptcy of the counterparty or other credit event set out in the transaction documentation. SCR.13. Insurance risk mitigation SCR Scope SCR This subsection covers insurance risk mitigation techniques. For the purposes of QIS5, insurance risk mitigation techniques include the use of reinsurance contracts or special purpose vehicles to transfer underwriting risks. SCR Conditions for using insurance risk mitigation techniques SCR The risk mitigation technique must be legally effective and enforceable in all relevant jurisdictions and there must be an effective transfer of risk to a third party. SCR The mere fact that the probability of a significant variation in either the amount or timing of payments by the reinsurer is remote does not by itself mean that the reinsurer has not assumed risk. SCR The calculation of the SCR using the standard formula should allow for the effects of insurance risk mitigation techniques through a reduction in requirements commensurate with the extent of risk mitigation and an appropriate treatment of any corresponding risks embedded in the use of insurance risk mitigation techniques. These two effects should be separated. SCR There should be no double counting of mitigation effects. SCR All material risks arising from the use of the insurance risk mitigation should be reflected in the SCR, regardless of whether that insurance risk mitigation technique is considered admissible. Page 8 of 28

9 SCR The allowance of insurance risk mitigation techniques is subject to the requirements in this subsection and the principles in Annex P being met. SCR Basis Risk SCR When an insurance risk mitigation technique includes basis risk (for example as might happen where payments are made according to external indicators rather than directly related to losses) the insurance risk mitigation instruments should only be allowed in the calculation of the SCR with the standard formula if the undertaking can demonstrate that the basis risk is either not material compared to the mitigation effect or if the risk is material that the basis risk can be appropriately reflected in the SCR. SCR For the non-life premium and reserve risk module under the standard formula SCR, one of the underlying assumptions of the design of the non-life premium and reserve risk sub-module (and the corresponding health risk submodule) is that for a reinsurance arrangement, the ratio of net risk to gross risk (on a 99.5% Value-at-Risk level) is less than (or at least not significantly greater than) the net-to-gross ratio of best estimate provisions and premiums. Where this assumption is not valid, the sub-module produces a wrong estimate of the net risk and as a result: Recoverables and premiums for reinsurance should only be taken into account in the determination of the volume measures net best estimate and net premiums of the non-life premium and reserve risk sub-module, if the ratio of net to gross risk is in proportion with the reinsurance part of the best estimate and the premium. This would mean that the ratio of net to gross risk does not significantly exceed the net-to-gross ratio of premiums and best estimate provisions. In particular, no allowance should be made for finite reinsurance or comparable SPV constructions of the non-life premium and reserve risk submodule in the standard formula. SCR Credit quality of the counterparty SCR For the purposes of QIS5, providers of insurance risk mitigation should meet the following requirements: Reinsurance entities should meet their current capital requirements or have a credit rating equal or equivalent to at least BBB EEA SPVs that are currently authorised should meet the requirements set out in the national law of the Member States in which they are authorised Non-EEA SPVs should fully fund their exposure to the risks assumed from the undertaking through the proceeds of a debt issuance or other financing mechanism and the repayments rights of the providers of such debt or financing mechanism should be subordinated to the reinsurance obligations of the undertaking SCR The assessment of the above should be based on the latest available information, which should be no more than 12 months old. SCR Notwithstanding the above, to the extent that collateral, meeting the requirements in subsection SCR.12.8 has been provided, the reinsurance should be recognised up to the amount of the collateral. Page 9 of 28

10 SCR Risk mitigation may be used to mitigate the credit risk arising from reinsurance counterparties, subject to the requirements in subsection SCR.12 being met. Annex P of the QIS5 technical specification is as follows: Principles for recognising risk mitigation techniques in the SCR standard formula Principle 1: Economic effect over legal form Risk mitigation techniques should be recognised and treated consistently, regardless of their legal form or accounting treatment, provided that their economic or legal features meet the requirements for such recognition. Where risk mitigation techniques are recognised in the SCR calculation, any material new risks shall be identified, quantified and included within the SCR. Where the risk mitigation technique actually increases risk, then the SCR should be increased. The calculation of the SCR should recognise risk mitigation techniques in such a way that there is no double counting of mitigation effects. Principle 2: Legal certainty, effectiveness and enforceability The transfer of risk from the undertaking to the third party shall be effective in all circumstances in which the undertaking may wish to rely upon the transfer. Examples of factors which the undertaking shall take into account in assessing whether the transaction effectively transfers risk and the extent of that transfer include: o whether the relevant documentation reflects the economic substance of the transaction; o whether the extent of the risk transfer is clearly defined and beyond dispute; o whether the transaction contains any terms or conditions the fulfilment of which is outside the direct control of the undertaking. Such terms or conditions may include those which: would allow the third party unilaterally to cancel the transaction, except for the non-payment of monies due from the undertaking to the third party under the contract; would increase the effective cost of the transaction to the undertaking in response to an increased likelihood of the third party experiencing losses under the transaction; would oblige the undertaking to alter the risk that had been transferred with the purpose of reducing the likelihood of the third party experiencing losses under the transaction; would allow for the termination of the transaction due to an increased likelihood of the third party experiencing losses under the transaction; could prevent the third party from being obliged to pay out in a timely manner any monies due under the transaction; or could allow the maturity of the transaction to be reduced. An undertaking shall also take into account circumstances in which the benefit to the undertaking of the transfer of risk could be undermined. For instance, where the undertaking, with a view to reducing potential or actual losses to third parties, provides support to the transaction, including support beyond its contractual obligations. Page 10 of 28

11 In determining whether there is a transfer of risk, the entire contract shall be considered. Further, where the contract is one of several related contracts the entire chain of contracts, including contracts between third parties, shall be considered in determining whether there is a transfer of risk. In the case of reinsurance, the entire legal relationship between the cedant and reinsurer shall be taken into account in this determination. The undertaking shall take all appropriate steps, for example a sufficient legal review, to ensure and confirm the effectiveness and ongoing enforceability of the risk mitigation arrangement and to address related risks. Ongoing enforceability refers to any legal or practical constraint that may impede the undertaking from receiving the expected protection. In the case of financial risk mitigation, the allowance in the SCR of the counterparty default risk derived from the financial risk mitigation technique does not preclude the necessity of satisfying the ongoing enforceability. In the case of financial risk mitigation, instruments used to provide the risk mitigation together with the action and steps taken and procedures and policies implemented by the undertaking shall be such as to result in risk mitigation arrangements which are legally effective and enforceable in all jurisdictions relevant to the arrangement and, where appropriate, relevant to the hedged asset or liability. Procedures and processes not materialized in already existing financial contracts providing protection at the date of reference of the solvency assessment, shall not be allowed to reduce the calculation of the SCR with the standard formula. Principle 3: Liquidity and certainty of value To be eligible for recognition, the risk mitigation techniques shall be valued in line with the principles laid down for valuation of assets and liabilities, other than technical provisions. This value shall be sufficiently reliable and appropriate to provide certainty as to the risk mitigation achieved. Regarding the liquidity of the financial risk mitigation techniques, the following applies: o the undertaking should have written internal policy regarding the liquidity requirements that financial risk mitigation techniques should meet, according to the objectives of the undertaking s risk management policy; o financial risk mitigation techniques considered to reduce the SCR have to meet the liquidity requirements established by the undertaking; and o the liquidity requirements shall guarantee an appropriate coordination of the liquidity features of the hedged assets or liabilities, the liquidity of the financial risk mitigation technique, and the overall policy of the undertaking regarding liquidity risk management. Principle 4: Credit quality of the provider of risk mitigation Providers of risk mitigation instruments should have an adequate credit quality to guarantee with appropriate certainty that the undertaking will receive the protection in the cases specified by the contracting parties. Credit quality should be assessed using objective techniques according to generally accepted practices. The assessment of the credit quality of the provider of protection shall be based on a joint and overall assessment of all the features or contracts directly and explicitly linked to the financial risk mitigation technique. This Page 11 of 28

12 assessment shall be carried out in a prudent manner, in order to avoid any overstatement of the credit quality. The correlation between the values of the instruments relied upon for risk mitigation and the credit quality of their provider shall not be unduly adverse, i.e. it should not be materially positive (known in the banking sector as wrong way risk ). As an example, exposures in a company belonging to a group should not be mitigated with CDS provided by entities of the same group, since it is very likely that a failure of the group will lead to falls in the value of the exposure and simultaneous downgrade or failure of the provider of protection. This requirement does not refer to the systemic correlation existing between all financial markets as a whole in times of crisis. Principle 5: Direct, explicit, irrevocable and unconditional features Financial risk mitigating techniques can only reduce the capital requirements if: o they provide the undertaking with a direct claim on the protection provider; o they contain an explicit reference to specific exposures or a pool of exposures, so that the extent of the cover is clearly defined and incontrovertible; o they are not subject to any clause, the fulfilment of which is outside the direct control of the undertaking, that would allow the protection provider to unilaterally cancel the cover or that would increase the effective cost of protection as a result of certain developments in the hedged exposure; and o they are not subject to any clause outside the direct control of the undertaking that could prevent the protection provider from its obligation to pay out in a timely manner in the event that a loss occurs on the underlying exposure. 5.3 Other relevant jurisdictions (e.g. OSFI, APRA) While every effort has been made to ensure that the information reflected below is complete and accurate as far as possible, a lack of an in-depth knowledge of the regulations of other jurisdictions may result in omissions in the information below. In addition, this section has focused upon the long term regulations of the supervisors considered OSFI guidance Guidance for the development of a models based solvency framework for Canadian Life Insurance companies Clarifying Information on the Basic Solvency Framework The new framework for determining regulatory capital requirements for life insurance companies will have two basic components: a Standard Approach, which is to be used by all companies to determine the company s minimum capital requirement and by companies without approval to use internal models to determine the company s supervisory target required capital amount, and an Internal Models Approach, which is to be used by companies with approval to use internal models to determine the company s supervisory target required capital amount subject to OSFI-defined floors. Page 12 of 28

13 Risk Mitigation Consistent with the December 2008 advisory Recognition of Hedge Contracts in the Determination of the Segregated Fund Guarantee Capital Requirement for Life Insurance Companies : a company may recognize contracts that it has entered into as of the valuation date, but may not recognize contracts that have not yet been entered into; and the only management action that may be recognized in the calculation of the supervisory target capital requirement is: o the exercise of options that the company holds as of the valuation date and o the implementation of a standard investment strategy at the end of the initial time period. In this context: contracts includes reinsurance contracts and other contracts entered into for the purpose of risk mitigation and exercise of options includes: o the filing of claims under reinsurance contracts that are in force as of the valuation date and o the exercise of privileges under contracts entered into for the purpose of risk mitigation that are in force as of the valuation date Revised MCCSR for 2011 This guideline describes the minimum continuing capital and surplus requirements (MCCSR) for a life insurance company to operate in Canada. The tenth chapter of the guideline contains details of the credit that can be taken for risk mitigation and risk transfer when calculating the MCCSR. Below are some extracts from this text: Introduction The risk mitigation arrangements for which it is possible to obtain credit in the MCCSR, and the risk components to which they may be applied, are: reinsurance (mortality, morbidity, lapse, C-3 and segregated fund guarantee components); collateral (C-1 component for fixed-income and reinsurance assets); guarantees and credit derivatives (C-1 component for fixed-income and reinsurance assets); other derivatives serving as hedges (C-1 component for equities, and foreign exchange component); and asset securitization (C-1 component). Any arrangement (including securitization) under which a third party assumes, or agrees to indemnify a company for, any obligation or risk that would normally be reflected in policy liabilities or MCCSR required capital, with the exception of C-1 risk, is treated as reinsurance for MCCSR purposes and is subject to the requirements in sections 10.2 to 10.6 below. Page 13 of 28

14 Although asset risk mitigation techniques and reinsurance have some features in common, the markets they refer to and their respective specific characteristics are sufficiently different to require distinct capital treatments. Calculation of required capital/margin Necessary conditions for credit In order for a ceding company to obtain a reduction in required capital or margin on account of any registered or unregistered reinsurance arrangement, the arrangement must conform to all of the principles contained in Guideline B-3: Sound Reinsurance Practices and Procedures. The arrangement must also meet all of the conditions necessary for effective risk transfer specified in this section. The ceding company must be able to demonstrate that the change in risk it is exposed to as a result of the arrangement is commensurate with the amount by which it reduces its required capital or margin. Risk transfer must be effective in all circumstances under which the ceding company relies on the transfer to cover the capital/margin requirement. In assessing an arrangement, the ceding company must take into account any contract terms whose fulfilment is outside the ceding company s direct control, and that would reduce the effectiveness of risk transfer. Such terms include, among others, those which: would allow the reinsurer to unilaterally cancel the arrangement (other than for non-payment of reinsurance premiums due under the contract); would increase the effective cost of the transaction to the ceding company in response to an increased likelihood of the reinsurer experiencing losses under the arrangement; would obligate the ceding company to alter the risks transferred for the purpose of reducing the likelihood that the reinsurer will experience losses under the arrangement; would allow for the termination of the arrangement due to an increased likelihood of the reinsurer experiencing losses; could prevent the reinsurer from being obligated to pay out any amounts due under the arrangement in a timely manner; or could allow for early maturity of the arrangement. The ceding company must also take into account circumstances under which the benefit of the risk transfer could be undermined. For example, this may occur if the ceding company provides support (including non-contractual support) to the arrangement with the intention of reducing potential or actual losses to the reinsurer. In determining whether there is effective risk transfer, the reinsurance arrangement must be considered as a whole. Where the arrangement consists of several contracts, the entire set of contracts, including contracts between third parties, must be considered. The ceding company must also consider the entire legal relationship between itself and the reinsurer. No reduction in required capital or margin is allowed for a reinsurance arrangement that has material basis risk with respect to the reinsured business (for example if payments under the arrangement are made according to an external indicator instead of actual losses). Reinsurance assets arising from arrangements containing Page 14 of 28

15 basis risk may be subject to capital charges for insurance risk in addition to the capital charge for C-1 risk. In assessing the effectiveness of risk transfer, the economic substance of an arrangement must be considered over the legal form or accounting treatment. Retained loss positions Where a company has taken credit in its capital or margin (required or available) on account of a registered or unregistered reinsurance arrangement that does not cover all losses up to the level of the ceded actuarial liability plus 100% of the marginal MCCSR capital requirement for the ceded business, the ceding company is required to add to its MCCSR/TAAM required capital/margin the total amount of losses at or below this level for which it remains at risk54. Such an addition to required capital or margin is necessary where a reinsurance arrangement contains any provision under which the reinsurer is required to cover losses only in excess of a certain amount, regardless of accounting treatment. Such provisions include, but are not limited to: experience rating refunds, claims fluctuation reserves and reinsurance claims fluctuation reserves, and variable risk transfer mechanisms other than a) or b) above whereby the level at which losses are reinsured depends upon prior experience55. The amount of the loss position that a ceding company retains under a reinsurance arrangement must be recalculated, according to the treaty, at each reporting date. Registered reinsurance 2 All capital requirement calculations may be performed net of registered reinsurance. For example, policy liabilities ceded to registered reinsurers should be subtracted from the policy liabilities used to calculate an MCCSR component. Unregistered reinsurance 3 Where the credit available for an unregistered reinsurer under section exceeds the credit that has been applied towards the requirements for liabilities ceded to the reinsurer under section , the amount of the excess, divided by 1.5 or another factor if specifically required by the Superintendent, may be used to reduce the following components of required capital for the reinsured policies: mortality risk morbidity risk lapse risk changes in interest rate environment risk, 22 OSFI defines registered insurance as per section of chapter 10 as follows: An arrangement is deemed to constitute registered reinsurance if it is conducted with a registered reinsurer. OSFI considers a reinsurer to be registered if it is: a) A reinsurer that is either: i. Incorporated federally and has reinsured the risks of the ceding company; or ii. A foreign company that has reinsured in Canada the risks of the ceding company, and is authorised by order of the Superintendent to do so; or b) A provincially/territorially regulated insurer that has been approved by the Superintendent OSFI considers an entity to be an unregistered reinsurer if it is not a registered reinsurer as defined in section above. Page 15 of 28

16 segregated fund guarantee risk, and foreign exchange risk. Chapters 4, 5, 8 and 9 describe the treatment of unregistered reinsurance in the MCCSR for these particular components, and specify additional conditions necessary to take credit for excess deposits. If a deposit used to obtain credit for a policy component is not contractually available to cover all losses arising from the component risk that are not provided for in the ceded policy liability (e.g. tranched protection), then the amount of credit for the deposit is limited to: the marginal component requirement for the ceded business; minus the highest component loss for the ceded business, net of contractually permitted recoveries from the deposit, that would be borne by the ceding company under any scenario in which unexpected losses for the component risk of the ceded business do not exceed the marginal component requirement. The credit taken in any of the specified components may not exceed the marginal capital requirement for the risks specifically reinsured, and may not exceed the reduction that would have been available had a company entered into an agreement on the same terms with a registered reinsurer. Page 16 of 28

17 5.3.2 APRA existing regulations Life Insurance (prudential standard) determination No. 8 of 2010 Prudential Standard LPS 3.04 Capital Adequacy Standard Section 2: Scenarios of adverse conditions Overview In assessing the Capital Adequacy Requirement of a statutory fund consideration is given to: the risks which may affect the value of the liabilities under policies; and the risks which may affect the value of the assets supporting those liabilities. The Capital Adequacy Requirement broadly comprises the following components: the Capital Adequacy Liability; the Other Liabilities; the Inadmissible Assets Reserve; the Resilience Reserve; and the New Business Reserve. Section 3: Liability Risks... Section 3.5 Reinsurance In order for the credit and inadmissible asset risks involved with reinsurance arrangements to be properly identified and assessed, the requirements of this Standard are to apply on a gross of reinsurance basis, with the gross liability requirements and any related reinsurance values separately quantified. That is, the Capital Adequacy Liability and the impact of the risks, adverse scenarios and termination value minimums are to be assessed on a gross of reinsurance basis Any reinsurance arrangements are to be valued consistent with their associated gross liabilities under the scenario or test being considered. For example, if the related gross liability requirement is assessed under a termination value scenario, a similar approach is to be taken with the reinsurance Where a reinsurance arrangement gives rises to an asset of the fund in the context of the scenario or test applicable, the value of the arrangement is to be treated as an asset of the fund within this Standard. The credit that can be taken for that reinsurance asset is then subject to the asset inadmissibility rules of this Standard (see paragraph 5.1.5) A corresponding treatment is to apply in the context of other similar risk mitigating arrangements and contracts, that while not legally reinsurance, have similar effects. Section 5: Asset Risks Section 5.1 Reserve for Inadmissable Assets The Capital Adequacy Requirement must provide a reserve the Inadmissible Assets Reserve - in respect of: a) holdings in an associated or subsidiary entity which is a Financial Services entity; b) non-realisable (in the context of the capital adequacy tests) intangible assets; c) the risks arising from asset concentration; Page 17 of 28

18 d) reinsurance assets which may not be fully recoverable in the context of the scenarios of adverse experience; and e) alignment necessary to ensure assets and liabilities are based on net market value Allowance for Reinsurance To the extent that a reinsurance arrangement represents an asset of the statutory fund under the scenarios of adverse experience being considered, then it is to be treated as such and is to be subject to the asset inadmissibility and resilience reserve rules of the Standard. In applying the asset concentration limits of the Standard: a) All exposures to a reinsurer or reinsurance group are to be considered a single counterparty exposure (within the practical context of the application of the limits concerned); and b) Where arrangements with a reinsurer involve both liability and asset components, these may be taken as a single net exposure to the extent they are subject to a legally enforceable right of offset. Explicit reference to financial risk-mitigation techniques other than reinsurance is not mentioned in the APRA prudential standard. APRA draft regulations (currently open for consultation) make reference to the treatment of collateral and guarantees held as risk mitigants. This is reflected in section below APRA draft regulations currently open for consultation Prudential Standard LPS 114 Capital Adequacy: Asset Risk Charge Default stress This stress applies to reinsurance assets, over the counter derivatives, unpaid premiums, and all other credit or counterparty exposures that have not been affected by the credit spreads stress. This stress includes the risk of counterparty default. A life company must determine risk charges for the default stress for the risk of counterparty default on exposures that include (but are not limited to) reinsurance assets, unpaid premiums, futures and options, swaps, hedges, warrants, forward rate and repurchase agreements. Treatment of collateral and guarantees as risk mitigants The impact of applying the asset risk stresses may be reduced where the fund holds certain types of collateral against an asset, or where the asset has been guaranteed, as a means of reducing risk. Collateral Collateral held against an asset may be considered in place of the asset if this would reduce the asset risk charge. Where the fair value of the collateral does not cover the full value of the asset, the collateral can only replace that part of the asset that is covered by the collateral. Collateral can be recognised in place of an asset only to the extent that it takes the form of a registered charge, registered mortgage or other legally enforceable security interest in, or over, an Eligible Collateral Item. Eligible Collateral Items are cash, government securities, or debt obligations (i.e. loans, deposits, placements, interest rate securities and other receivables) where the counterparty has a counterparty Page 18 of 28

19 grade of 1, 2 or 3. The Eligible Collateral Item must also be held for a period not less than that for which the asset is held. Guarantees The stresses applied in the credit spreads and default stresses may be determined using the counterparty grade of a third-party guarantor if the guarantee is explicit, unconditional, irrevocable and legally enforceable for the remaining term to maturity of the related asset. The guarantor must have a counterparty grade (or for governments, a long-term foreign currency credit rating) of 1, 2 or 3. Guarantees provided by the life company s parent or related entities are not eligible for this treatment. 5.4 Mapping of differences between above approaches (Level 2 and 3) As per OSFI and the new proposed APRA requirements, risk-mitigation techniques should be allowed for in the calculation of the capital requirements provided that the risk-mitigation techniques meet certain criteria and provided that the credit risk and other risks which arise as a result of the risk mitigation are also properly captured in the capital requirement. Not all risk-mitigation techniques are allowed for in the current APRA requirements. 6. ASSESSMENT OF AVAILABLE APPROACHES GIVEN THE SOUTH AFRICAN CONTEXT 6.1 Discussion of inherent advantages and disadvantages of each approach (1) Should the impact of risk-mitigation techniques be allowed for in the SCR? Solvency II allows the impact of risk-mitigating techniques to be allowed for in the SCR provided that the risk has been effectively transferred to a third-party and provided that the credit and other risks (e.g. basis risk) arising from the use of such techniques are properly reflected in the SCR. (2) To what extent can risk-mitigating techniques be allowed for in the SCR? In Solvency II, the risk mitigating technique can only be allowed for to the extent that it is already in place at the relevant balance sheet date. A risk-mitigating technique that is only in place for part of the year at the balance sheet date may be permitted to be allowed for over the whole year if the undertaking has a written policy in place on the replacement of that risk mitigating technique. Article 184 and Article 185 of the draft Level II Commission Regulation provides greater detail on the issues (1) and (2). (3) What does and does not constitute a risk-management technique? Solvency II divides risk management techniques into four main categories, namely insurance risk mitigation (e.g. through the use of risk reinsurance contracts or special purpose vehicles), financial risk-mitigation (e.g. through the use of financial reinsurance or the purchase or issuance of financial instruments), collateral arrangements and segregation of assets. Page 19 of 28