Solvency Assessment and Management (SAM)

Transcription

1 Solvency Assessment and Management (SAM) 1. Solvency Assessment and Management (SAM) The FSB is in the process of developing a new risk-based solvency regime for South African shortterm and long-term insurers, including reinsurers, known as the Solvency Assessment and Management (SAM) regime, to align the South African insurance industry with international standards. SAM is expected to be fully implemented in 2017, together with the Twin Peaks regulations. SAM will be based on the Solvency II capital adequacy, risk governance, and risk disclosure regime that was implemented for European insurers and reinsurers. SAM will share the same broad features as Solvency II. SAM is based on the following principles It is a principles-based regulatory framework. It is based on an economic balance sheet view. It is structured in three pillars: capital adequacy (Pillar 1), systems of governance (Pillar 2), and reporting requirements (Pillar 3). The primary purpose of the regime, as stated by the Financial Services Board in its SAM Roadmap, is the protection of policyholders and beneficiaries. The SAM Roadmap can be found on the FSB s website. Additional objectives are: To align capital requirements with the underlying risks of an insurer. To develop a proportionate, risk-based approach to supervision with appropriate treatment for all insurers ranging from small insurers to large, cross border groups. To provide incentives to insurers to adopt more sophisticated risk monitoring and risk management tools this could include the development of full or partial internal capital models and increased use of risk mitigation and risk transfer tools. To maintain financial stability. The FSB has communicated that it requires SAM to be consistent with international best practice in insurance supervision specifically the Insurance Core Principles (ICPs) as set by the International Association of Insurance Supervisors (IAIS) and meet the criteria for Solvency II third-country equivalence, while at the same time be appropriate for the characteristics of the South African insurance industry. The introduction of SAM will result in the redrafting of many sections of the Short-term Insurance Act as well as associated regulations and board notices mentioned in this section. At the time of writing the specific changes have not been finalised, and so this section contains a high level description of the solvency assessment, governance, risk management and reporting requirements 1

2 under SAM. Some of the requirements in these sections may change once the regulations are finalised IAIS developments Current insurance regulation and supervision in South Africa does not fully comply with all the criteria of the ICPs of the IAIS (see Unit 6, Section 5). Part of the mandate given to the various SAM task groups and working groups was that the SAM discussion documents and position papers must consider and be consistent with the ICPs, appropriately applied to the South African context. In addition, the IAIS is developing a Common Framework for Supervision of Internationally Active Insurance Groups (ComFrame). The term Internationally Active Insurance Groups (IAIGs) encompasses the major global insurance and reinsurance groups. As part of ComFrame, the IAIS is committed to pursue a global capital standard for IAIGs, termed the Insurance Capital Standard (ICS). In order to test the development of the ICS, the IAIS is currently conducting field testing with approximately 30 IAIGs. The FSB is closely involved in the development of the ICS and the initial principles of the ICS are aligned with the principles underlying the SAM framework Solvency II transitional equivalence arrangements Third-country equivalence gives recognition that a supervisory regime provides a similar level of protection to that provided by Solvency II, and has particular implications for: South African groups operating in the EU. EU groups operating in South Africa. EU insurers with reinsurance arrangements to South African reinsurers. Equivalence is defined in terms of the high level Solvency II principles. Adherence to such principles does not restrict the SAM framework to being identical to the Solvency II framework by any means and it is important that the SAM framework remains appropriate to the South African insurance environment. The European Commission has indicated that they will follow a two-phased approach to assessing the equivalence of a third-country s insurance supervisory regime. Prior to the European Commission being able to conduct a full assessment of whether the equivalence criteria are being met, they have indicated a willingness to consider jurisdictions as being deemed to be equivalent to Solvency II for a period of time. There are a number of countries, including South Africa, that have indicated their interest in their insurance solvency regime being deemed equivalent. To this end, the FSB has been working with the European Insurance and Occupational Pensions Authority (EIOPA) on behalf of the European Commission to conduct a technical analysis of South Africa s current regulatory regime as well as future planned enhancements to the regime. 2

3 EIOPA has prepared a Factual Report on their findings based on the answers received by the FSB and discussions held and this report will be considered by the European Commission in due time Implementation SAM implementation began with a light parallel run from January 2014, followed by a comprehensive parallel run (CPR) from January 2015, with full implementation expected to take place from early From 1 January 2015 until SAM is fully implemented, insurers are expected to complete quarterly as well as annual returns on the SAM basis in addition to their normal reporting. For reporting from 2016 onwards the annual SAM CPR returns will need to be audited, and the normal reporting on the current statutory basis will be reduced. Certain aspects of Pillar 2 have been implemented via BN158 (see Unit 20), and companies are required to submit a mock ORSA as part of the CPR. SAM will be implemented through the Insurance Act with supporting subordinate legislation in the form of Insurance Prudential Standards covering the following areas: General Standards (GS) Fit and Proper Standards (FP) Governance Standards (GR) Financial Soundness Standards (FS) Auditing Standards (AU) Reporting and Disclosure Standards (RD) 1.4. Overview of SAM Requirements Pillar I Pillar I of SAM stipulates the quantitative requirements that insurers must satisfy to demonstrate they have adequate financial resources. The economic balance sheet approach to be adopted under SAM allows for a consistent treatment of all assets and liabilities, calculated at market consistent values. Own Funds, equal to the excess of assets over liabilities, adjusted for certain items, need to be sufficient to cover the solvency capital requirement (SCR). The minimum capital requirement (MCR) establishes a lower bound for the required solvency capital, below which policyholders and beneficiaries would be exposed to an unacceptable level of risk if the insurer were allowed to continue its operations. The MCR and SCR are intended to enable a supervisory ladder of intervention, basically enabling the FSB to intervene with measures appropriate to the degree of insolvency. The MCR is the minimum amount of capital below which no insurer will be allowed to operate. The SCR is a much higher amount and indicates the first trigger point at which the regulator would start to intervene in the affairs of an insurer. 3

4 Despite the existence of a lower bound for the solvency level in the form of the MCR, the SCR remains the primary measure of solvency. The SCR is required to be continuously maintained. Insurers will be required to inform the FSB in the event that there are insufficient own funds to cover the SCR, or in the event that this is a possibility within the near term. Long-term insurers are also required to calculate the Liquidity Shortfall Indicator. This is a high level assessment of the magnitude of liquidity risk that an insurer may be exposed to following an SCR event. Refer to section 2 below for more details of the Pillar 1 requirements Pillar II A shortcoming in regulatory frameworks highlighted by the global financial crisis has been the lack of sufficient mechanisms to provide supervisors with an early warning of a potential solvency concern, or sufficient powers to intervene. Pillar 2 addresses this issue by assessing the effectiveness of corporate governance and risk management. Pillar 2 serves as a major link between Pillar 1 and Pillar 3 of SAM by considering the extent to which the corporate governance structure is embedded in the day-to-day running of the business. The systems of governance that insurers are required to maintain as proposed in Solvency II, and under consideration for adoption in SAM, address the following areas: General governance Fit and proper requirements Risk management system Internal control Internal audit Actuarial function Outsourcing Compliance SAM requires an insurer s systems of governance and risk management to be commensurate to the nature, scale and complexity of its risks (this is referred to as the principle of proportionality ). SAM will necessitate the integration of risk management and capital management. Insurers will be required to demonstrate that risk management is embedded in the business and decision making processes, which is sometimes referred to as the Embedment Test or Use Test. In addition, insurers wishing to use an internal model will have to ensure that the internal model is embedded in the day-to-day running of the business. The Use Test is a particularly crucial governance concept for internal models. The two main elements contained in Pillar 2 of Solvency II are the Own Risk and Solvency Assessment (ORSA) and the Supervisory Review Process (SRP). It is unclear as yet to what extent the final SAM regulations will emulate the Solvency II requirements, but the rationale 4

5 and approach followed will be similar in principle. Further guidance will be provided as to the detailed nature of the requirements as these are finalised by the FSB. The ORSA is defined as the entirety of the processes and procedures employed to identify, assess, monitor, manage, and report the long and short term risks an insurance undertaking (and insurance group) faces or may face and to determine the own funds necessary to ensure that insurers (and groups) overall solvency needs are met at all times and are sufficient to achieve its business strategy. Maintenance of the risk management system, demonstration of the Use Test, forward looking capital planning and management, stress and scenario testing, and emerging risk management are evaluated via the ORSA process, the outcomes of which are documented in the ORSA report. Under the ORSA process, insurers are required to conduct at least annually, and at any instance of a material change in the risk profile of the business, a self-assessment of their risks and the level of solvency needed to cushion those risks. The ORSA is intended to identify, assess, monitor, manage, and report all material and complex risks that the insurer faces; it is intended to enable the insurer to determine the own funds necessary to ensure its solvency needs are met at all times. To fulfil its function in the assessment of prospective risks, the ORSA should include at least a three year capital projection, and relevant key performance and key risk indicators consistent with economic scenario and growth assumptions made by the board and senior management. Although ORSA is an on-going process, a report is required at least annually for the supervisor. The FSB will use the SRP to assess the ability of an insurer s system of governance to identify, assess, monitor, and manage the risks and potential risks it faces. The SRP considers an insurer s: System of governance and risk assessment Technical provisions Capital requirements Investment rules Quality and quantity of own funds Use of a full or partial internal models On the basis of the SRP the FSB may compel insurers to remedy any deficiencies identified in their systems of governance. The goal of such remedies is to establish greater confidence in the overall solvency position. In exceptional circumstances this may necessitate the imposition of a capital add-on, which will require the insurer to hold capital in addition to the SCR, until such time as the identified weaknesses have been remedied. 5

6 Pillar III Pillar III specifies the public and confidential disclosures under SAM. It seeks to create transparency with the aim of harnessing market discipline in support of regulatory objectives. Pillar III includes both quantitative and qualitative reporting requirements. Pillar III reporting will require insurers to describe how risks are managed. The new disclosure documents required as part of Pillar III of Solvency II are the confidential Report to Supervisor (RTS) and the public Solvency and Financial Condition Report (SFCR). Both reports are required for each regulated solo insurer, as well as at an insurance group level. The requirements for SAM are expected to achieve similar objectives but are likely to differ in structure. The reporting requirements will, however, exceed current reporting requirements. Insurers may be required to disclose capital management details annually in the SFCR, including any material breaches of the MCR and SCR, even if subsequently resolved, and the imposition of any capital add-ons. Other information that may be required to be disclosed may include: The basis of and valuation methods for assets and technical provisions, including any significant differences between those presented in the financial statements; A description of the risk exposure, concentration, and mitigation for each risk category; Financial performance; Governance; and Certification of compliance with investment requirements. Sensitive information, disclosure of which would result in significant undue competitive disadvantage, or which is subject to policyholder or other counterparty confidentiality obligations, may be reported confidentially to the FSB in the equivalent of the RTS. The FSB and Industry Reporting Working Group (FIRe), which consists of representatives from the FSB, the insurance industry and audit firms, has focussed on the development of the SAM Quantitative Reporting Templates (QRTs). These templates have been used for the comprehensive parallel run in 2015 and 2016 and will form the basis of the final QRTs when SAM is enacted into legislation in Some of the key areas of change from the current statutory returns are: Significantly greater disclosure on non-linked assets, including instrument level disclosure. Greater detail on the calculation of the capital requirements. Additional analyses of change in excess assets and reconcilaitions to IFRS results The results of the Liquidity Shortfall Indicator calculation Detail on operational risk events 6

7 Additional detail on reinsurance arrangements Additional reporting requirements for cell captives 1.5. Group regulation In the main, the FSB supervises insurers on a solo basis, as no group legislation presently exists. As discussed above, effective supervision of insurance groups is an essential element of a third country equivalence assessment under Solvency II, and hence a regulatory framework for insurance group supervision will form a critical part of SAM. This is likely to be implemented as part of the legislative changes to introduce a Twin Peaks model of financial regulation. Insurance groups benefit from the pooling and diversification of risk, intra-group financing, and integrated governance structures. However, being part of a group also presents a range of risks to an insurer. These may include, for example, direct or indirect risk exposures to other group entities, conflicts of interest, and inadequate risk assessment. The recent global financial crisis has demonstrated that the failure of one entity within a financial conglomerate may damage, or even cause the failure of, related entities (known as contagion risk). These considerations need to be assessed in order to move towards more effective regulatory practice The role of the Head of Actuarial Control The term Statutory Actuary falls away following SAM implementation, with the role effectively replaced by the individual taking responsibility for heading up the Actuarial Function. To avoid confusion between an individual who may head up an actuarial division not deemed to be part of the actuarial function defined under the control functions, this individual will be referred to as the Head of Actuarial Control (HAC). The HAC is required to attest to the accuracy of the calculations and the appropriateness of the assumptions with regards to the technical provisions, the SCR calculations, and the technical provisions and capital requirements forming part of the ORSA projections. Position Paper 83 of the Financial Services Board proposed the following for SAM primary legislation (some of which have already been legislated through BN158, as described in Unit 20): Insurance and reinsurance undertakings shall provide for an effective actuarial function, headed up by the Head of Actuarial Control, insofar as the following functions are concerned, to: (a) review and attest to the reliability and adequacy of technical provisions, the SCR calculation (whether internal model or standard formula), and the technical 7

8 provisions and capital requirements forming part of the projections in the ORSA, including to: i. ensure the appropriateness of the methodologies and underlying models used as well as the assumptions made; ii. assess the sufficiency and quality of the data used in the calculations; iii. compare best estimates against experience when evaluating technical provisions; iv. inform the Board of the reliability and adequacy of the calculations; and v. oversee the calculations in the cases set out in Article 82; (b) express an opinion on the overall underwriting and ALM policies; (c) express an opinion on the reinsurance policy and the adequacy of reinsurance arrangements; (d) express an opinion on the actuarial soundness of premiums, benefits, and any other values thereof, including the awarding of bonuses to policyholders. The HAC, in fulfilling the role of a head of control function, will be required to meet fit and proper requirements as stipulated in the Insurance Laws Amendment Bill and current draft SAM primary legislation. While the onus is on the Board to assess the control function heads with respect to fit and proper requirements, the expectation is that the function holder will be a suitably qualified actuary. Further details regarding requirements for minimum qualifications specific to the HAC will be prescribed in subordinate legislation. The FSB will be engaging with ASSA regarding the establishment of these minimum qualifications. The HAC will be subject to a periodic peer review. This is anticipated to be conducted at least every three years, and that the FSB would at its discretion specify the frequency, scope and/or timing of the review. The FSB may furthermore specify a reviewer if required. The FSB will be engaging ASSA to develop standards for actuaries who undertake a peer review. SAM Primary legislation will provide that the role and functions will be prescribed. Whistleblowing requirements are placed on all heads of control functions 1.7. Impact on business culture and strategy Engagement with SAM is important throughout the business, including at senior management and Board level. This is the case for all insurance companies and not just those opting to use an internal model although being able to demonstrate full integration of SAM into the business is a key part of the internal model approval process. 8

9 SAM is not just a reporting framework, but a risk management framework with implications for capital allocation, risk mitigation activities and performance management. The regime may also have an impact on the optimal product mix for the company, and on product design. It is also likely to impact the optimal asset mix for the company, since some asset classes will become relatively more attractive as a result of their lower capital requirements. The availability, or otherwise, of risk diversification benefits may also affect corporate structures and generate merger and acquisition activity. Management information is likely to align SAM metrics with the business and strategic decision-making process. The impact on the market of the external disclosures also needs to be considered Twin Peaks and the FSB s market conduct mandate On 23 February 2011, the National Treasury (NT) published a policy document entitled A safer financial sector to serve South Africa better (NT Policy Document). In it, proposals to strengthen financial sector regulation, both in response to lessons learnt from the recent global financial crisis and to South Africa s own domestic financial sector challenges, are set out. Some of the key policy priorities for financial sector regulation identified in the NT Policy Document are consumer protection and market conduct. Other key policy priorities are financial stability, expanding access through financial inclusion and combating financial crime. The NT Policy Document also stresses the importance of market conduct regulation s role in complementing prudential (financial soundness) regulation. Market conduct malpractices contributed palpably to sustainability and systemic risks in the recent global financial crisis. Given the policy priorities of strengthening both prudential and market conduct regulation, South Africa will move towards a Twin Peaks model of financial regulation with one regulator tasked with prudential regulation of the sector, and another tasked with market conduct regulation. A first draft of the Financial Sector Regulation Bill (the Twin Peaks Bill) was published on 31 January The South African Reserve Bank is seen as best placed to play the role of macro prudential regulator (i.e. solvency supervision), while the FSB will focus on market conduct regulation, with its mandate extended to include market conduct regulation of retail banking. The Twin Peaks regulatory model will therefore mean substantially stronger market conduct regulation at the FSB. 9

10 2. Pillar 1 in more detail SAM is expected to fully replace the current statutory basis for insurers in Until then, companies are required to report on both the SAM and the current statutory basis as part of the comprehensive parallel run. Pillar 1 of SAM stipulates the quantitative requirements that insurers must satisfy to demonstrate they have adequate financial resources. The economic balance sheet approach to be adopted under SAM allows for the interdependencies between all assets and liabilities, calculated at market consistent values. Own funds need to be sufficient to cover technical provisions, other liabilities, and the solvency capital requirement (SCR). The minimum capital requirement (MCR) sets a minimum lower capital boundary for an insurer s capital requirement. Full technical specifications on the requirements of the comprehensive parallel run are available on the FSB s website (see section 3 below). Once SAM is finalised the specific requirements for Pillar 1 calculations will be contained in Prudential Standards FSI 1 to FSI 6. At the date of writing these have not been finalised and are only expected to be finalised towards the end of This section contains a high level description of the expected requirements based on the comprehensive parallel run technical specifications, but these may change once the final Prudential Standards are released. The SAM balance sheet is summarised graphically below. Figure 1 The SAM balance sheet 10

11 2.1. Assets The valuation of assets mainly follows International Financial Reporting Standards (IFRS) and the main requirement is that of market consistency and an economic (or fair value) valuation approach. There are some minor deviations from IFRS with the intention of bringing the treatment of assets and liabilities, excluding technical provisions, closer to an economic valuation approach, including: Goodwill should be valued as zero. Other intangible assets should only be included to the extent that a fair value can be placed on them. Property should be valued at fair value. Participations in subsidiaries, associates and joint ventures are valued using a market value approach, being a quoted market value or, if this is not available, a market consistent valuation. Reinsurance assets (i.e. recoveries expected from reinsurance in future) are shown as an asset on the balance sheet and should also allow for expected losses due to default of the reinsurer Liabilities other than technical provisions. Liabilities consist of technical provisions and other liabilities. Technical provisions are the insurance obligations due to policyholders and beneficiaries, and are calculated on a market consistent basis.. Other liabilities are non-insurance liabilities such as tax liabilities (both current and deferred) and other creditors and can include subordinated debt. These are generally valued using IFRS fair value principles Technical Provisions Introduction The specific requirements for the valuation of technical provisions under SAM will be contained in Prudential Standards FSI 2 (Valuation of assets, liabilities and own funds) and FSI 2.2 (Valuation of technical provisions). At the date of writing, these have not been finalised and are only expected to be finalised towards the end of This section contains a high level description of the expected requirements based on the comprehensive parallel run technical specifications, but these may change once the final Prudential Standards are released. 11

12 Valuation method Technical provisions are calculated using market consistent principles. They consist of bestestimate liabilities and a risk margin. The best-estimate liability is equal to the probability-weighted average of future cash flows, taking account of the time value of money by discounting using a risk free yield curve. The risk margin represents the premium over and above the best-estimate liabilities that a third party would be willing to pay to assume the obligations to the policyholders. Furthermore, best-estimate liabilities should be calculated gross of reinsurance, with reinsurance recoverables (net of best-estimate counterparty default risk) reflected explicitly as an asset in the balance sheet. Simplifications can be used when calculating technical provisions and reinsurance recoverables to ensure that actuarial and statistical methodologies applied are proportionate to the nature, scale and complexity of the underlying risks Best-estimate liabilities The best-estimate liability is determined as the discounted value of projected cash flows under each policy up to the contract boundary, calculated on a policy-by-policy basis. It is possible for the best-estimate liability to be negative. The assumptions underlying the best-estimate liability should be best-estimate with no additional margins for prudence. The projections should allow for all expected decrements and policyholder actions, including lapses. Companies must take into account all relevant available data, both internal and external, when arriving at assumptions that best reflect the characteristics of the underlying insurance portfolio. For the purpose of determining which insurance obligations arise in relation to an insurance contract, the boundary of the contract is currently defined by the FSB in the following manner: (a) Where the insurer or reinsurer has: i. a unilateral right to terminate the contract; ii. a unilateral right to reject the premiums payable under the contract; or iii. a unilateral right to amend the premiums or the benefits payable under the contract at a future date in such a way that the premiums fully reflect the risks, then, any obligations which relate to insurance cover which might be provided by the insurer after that date do not belong to the existing contract, unless the insurer can compel the policyholder to pay the premium for those obligations. 12

13 (b) Where the insurer has a unilateral right referred to in point (a) that relates only to a part of the contract, the same principle as defined in point (a) above shall be applied to this part. (c) All other obligations relating to the contract, including obligations relating to unilateral rights of the insurer to renew and extend the scope of the contract, belong to the contract Risk-free discount rate The risk-free discount rate used in the calculation of the technical provisions shall in general be the government bond curve Risk margin The risk margin represents the premium over and above the best-estimate liabilities that one insurer would require to take on the obligations of another insurer. It represents the theoretical compensation for the risk of future experience being worse than that assumed in the calculation of the best-estimate liabilities, and the cost of having to hold regulatory capital against this risk. The risk margin should be calculated by determining the cost of providing an amount of eligible own funds equal to the SCR necessary to support the insurance obligations over the lifetime thereof, assuming that the business is transferred to a third party. For more information on own funds and the SCR, refer to sections 2.4 and 2.5 below. The rate used in the determination of the cost of providing that amount of eligible own funds is called the cost of capital rate (prescribed at 6%). This can be thought of as the frictional cost to a company of locking in the SCR instead of being able to invest it freely. The 6% cost of capital rate is taken from Solvency II and is a conservative estimate of market practice. The risk margin is therefore calculated as 6% of the projected SCR at each future year-end, discounted using risk-free rates of return. When projecting the SCR, approximate methods can be used, subject to proportionality and materiality. Although companies are required to calculate the risk margin per line of business, allowance can be made for diversification benefits between lines of business, and hence the risk margin must first be calculated for all lines of business together and then allocated to the underlying lines of business. 13

14 Own funds Capital resources under SAM are referred to as own funds. A distinction is made between basic own funds and ancillary own funds. Basic own funds are defined in the market consistent value balance sheet as the excess of assets over liabilities, plus subordinated liabilities, less any regulatory adjustments. Regulatory adjustments are made for certain ineligible assets, holdings in own shares, holdings in own holding company shares, cash and deposits at a bank in the same financial conglomerate, restricted reserves, participations in financial and credit institutions, and for any ring-fenced funds. Ancillary own funds are off-balance sheet capital resources that can be called upon to absorb losses. Such contingent capital items would include instruments such as letters of credit and guarantees. The sum of basic own funds and ancillary own funds make up available own funds. Available own funds are split into three tiers. The tiering of assets is performed according to a strict range of criteria, such as whether the instrument is immediately available to absorb losses at its full value. Limits apply as to the proportion of Tier 1, Tier 2 and Tier 3 own funds that can be used to cover the SCR and the MCR. These limits may result in some of the own funds being regarded as ineligible for the purposes of determining solvency Solvency capital requirement (SCR) The SCR should correspond to the Value-at-Risk of the basic own funds of an insurer or reinsurer subject to a confidence level of 99,5% over a one-year period. The parameters and assumptions used for calculation of SCR should reflect this calibration objective. SAM will make provision for the calculation of the SCR using an approved internal model or the standardised formula. The standardised formula is designed to be relatively simple to apply, and should in general be suitable for companies with normal risk exposures, a stable book, and standard risk management techniques. However, the simplifications underlying the standardised formula may make it less suitable for complex or specialised insurers, in which case an internal model may be preferred. SAM follows a modular structure under the standardised formula approach. This structure is based on Solvency II but adapted for South Africa. The structure and calibration of the SAM standardised formula are based on the results of a series of quantitative impact studies (QIS) conducted by the FSB, supplemented by the calibration of the Solvency II standard formula. Under the SAM project, three QISs were performed in order to understand the implications of the new SAM framework on insurers and to get feedback from the industry of the proposed methodology. The parameters and methodology for these QISs are detailed in technical specification documents released by the FSB. The results of these impact studies have been 14

15 released and can be found on the FSB website. The QIS exercises were supplemented by a light parallel run performed in 2014 and a comprehensive parallel run performed from 2015 onwards. The standardised formula calculation is in some respects similar to that of the current Capital Adequacy Requirement (CAR) for short term insurers. However, it covers more risks and has a more complex aggregation methodology (i.e. allowance for correlation between risks). Another key difference between the SCR and the CAR is that the SCR allows for market risk on all assets, including free assets, which means that the more own funds a company has, the larger the SCR becomes. Therefore the SCR cover typically increases as own funds increase. The CAR, however, remains unchanged when the net asset value increases. The following graph illustrates the modular approach to the standardised formula SCR 1 : SCR Adjustment BSCR Operational Risk Participations Market Life Non-life Interest Rate Mortality Premium and Reserve Equity Longevity Lapse Property Disability/ Morbidity CAT Spread and Default Lapse Currency Expenses Concentration Retrenchment Illiquidity CAT AdjSES 1 Taken from the FSB s Comprehensive Parallel Run technical specifications 15

16 Figure 2 The modular approach to the standardised formula SCR In general for the standardised formula approach, the capital requirement within each risk module is quantified as the effect on the basic own funds of a pre-specified shock scenario or number of scenarios. For example: An instantaneous decrease of 25% in property values A large natural catastrophe event occurs affecting properties across certain geographic regions. These individual capital requirements are then combined using pre-specified correlation matrices, in order to allow for diversification between different risks. Separate correlation matrices are used to aggregate capital requirements, first within specific risk modules (for example, combining the capital requirements for global, SA and other equities to get the diversified equity price risk capital requirement), then across risk modules within the broad risk categories (for example, combining the capital requirements for all risk modules within market risk to give the diversified market risk capital requirements), and then finally across market risk, life underwriting risk and non-life underwriting risk to give the basic SCR (BSCR). The overall SCR is obtained by adding the capital requirements for insurance participations within the same sector (i.e. any short term insurance participations) and operational risk, and adjusting for the loss absorbing capacity of deferred taxes. The loss absorbing capacity of deferred taxes arises as a result of companies being able to reduce any existing deferred tax liabilities or establishing a deferred tax asset following a loss as a result of the SCR event. The capital requirements for other participations (i.e. insurance participations in a different sector and any non-insurance participations) are included under equity risk. The SCR has been designed in such a way that appropriate risk mitigation techniques and risk management procedures that meet certain criteria can be used to reduce the capital requirements, thereby rewarding the insurer for sound risk management practices. The standardised formula SCR calculation may in time be replaced by a partial or full internal model, certain parameters in the standard formulae may be replaced by undertaking specific parameters (subject to regulatory approval), and/or certain simplifications may be used if they are proportional to the nature, size and complexity of the risk. A partial or full internal model would enable a broader understanding of the range of risks that the company faces, the opportunity to take risk where it is likely to be advantageous and avoid/manage danger areas. The key difference to the standardised formulae is that such a model would not provide only a point estimate, but a much more comprehensive range of scenarios. The use of a partial or full internal model is subject to regulatory approval, and would be required to satisfy the following key requirements: 16

17 Insurers must have an effective system of governance for the internal model. Insurers must demonstrate via the Use Test that the model is widely-used in risk management and decision-making, and plays an important role in their system of governance. Insurers must meet requirements relating to statistical quality, data quality, model calibration and validation. Insurers must adequately document the design and operational details of their internal model. Partial models may be approved provided they are sufficiently justified and integrated into the remaining standardised formula. The Use Test includes the use of the model in decision-making processes, business planning, risk management, capital assessment and allocation processes, and the Own Risk and Solvency Assessment (ORSA). This, together with collecting sufficient data to calibrate extreme events and dependency structures, is expected to be one of the most challenging aspects of the approval process. In order to keep the standardised formula relatively easy to apply and understand, it does have several shortcomings which insurers should be aware of, and which would need to be addressed in an internal model. These include (but are not limited to): The use of multiple correlation matrices is theoretically invalid and can result in inaccuracies in the correlations between risks. It may not be appropriate for fast growing or closed books. Operational risk is modelled at a very high level with no link to the insurer s actual risk management framework. It does not allow for non-linearity between risks. This refers to situations where the capital required for two risks occurring simultaneously is greater than the sum of the capital required for each risk individually. Complex risk management techniques such as dynamic hedging and certain reinsurance structures cannot be allowed for in the standardised formula. The allowance for the risk sharing inherent in cell captive business between third party cells and the promoter cell is allowed for on an approximate basis, which may overstate the SCR for this business Minimum capital requirement The minimum capital requirement (MCR) establishes a lower bound for the required solvency capital, below which policyholders and beneficiaries would be exposed to an unacceptable level of risk if the insurer were allowed to continue its operations. The MCR and SCR are intended to enable a supervisory ladder of intervention, basically enabling the FSB to intervene with 17

18 measures appropriate to the degree of insolvency. The MCR is the minimum amount of capital below which no insurer will be allowed to operate, and is calibrated (at a high level) at the Valueat-Risk of the basic own funds of an insurer or reinsurer, subject to a confidence level of 85% over a one-year period. The SCR is a much higher amount and indicates the first trigger point at which the regulator would start to intervene in the affairs of an insurer. This differs from the minimum capital requirement under the current statutory basis, which represents the minimum underpin to the CAR, rather than a separate, lower level of regulatory capital. Despite the existence of a lower bound for the solvency level in the form of the MCR, the SCR remains the primary measure of solvency. The SCR is required to be continuously maintained. Insurers will be required to inform the FSB in the event that there are insufficient own funds to cover the SCR, or in the event that this is a possibility within the near term. The MCR is a simple-to-apply formula equal to technical provisions, annual written premium and/or capital-at-risk measures multiplied by specified factors, with upper and lower bands linked to the SCR. It is subject to a minimum overall value of R15 million (R30 million for composite reinsurers) or 25% of gross annualised operational expenses. 3. Further background reading The following documents provide valuable information on international solvency developments, and a good framework for understanding solvency. Solvency Assessment and Management The IAIS Common Structure for The Assessment Of Insurer Solvency temp/common_structure_paper_for_assessment_of_insurer_solve ncy.pdf 18