GUERNSEY NEW RISK BASED INSURANCE SOLVENCY REQUIREMENTS

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Thomas Logan
6 years ago
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1 GUERNSEY NEW RISK BASED INSURANCE SOLVENCY REQUIREMENTS Introduction The Guernsey Financial Services Commission has published a consultation paper entitled Evolving Insurance Regulation. The paper proposes a number of changes to the current Guernsey insurance regulations, codes and rules. These changes will cover risk based solvency requirements, corporate governance and the public disclosure of information. Responses to the consultation are required to be submitted to the GFSC by 16 December It is proposed that the new solvency rules will apply to financial years commencing on or after 1 st January 2015 This article focuses on the changes to the solvency requirements and the new requirement included in the new corporate governance rules for the establishment of an actuarial function for general insurers and reinsurers as well as the existing requirement for life insurance companies to appoint an Actuary. Risk based solvency The proposals for the new risk based solvency requirements closely follow both the IAIS Core Principles (ICPs) and the structure of the EU Solvency II solvency regime. In particular they include having two regulatory capital requirements to create a ladder of intervention for taking appropriate regulatory action, a specific mathematical calibration of the solvency requirements and the adoption of a total balance sheet approach. For the first time insurers will be split into distinct categories with a different approach being adopted for each of five categories depending upon the risk tolerance of the GFSC. The fifth category is called Special Purpose Entities but there are no proposals in the paper as to how this category which includes transformer cells, catastrophe cells and fully funded entities should be treated for solvency purposes. The other four categories are commercial life insurers and reinsurers, commercial general insurers, commercial general reinsurers and captive insurers or reinsurers. Since it is explained that the GFSC does not consider a reinsurance subsidiary of a commercial insurer to be a captive, a captive reinsurer is presumably a captive that uses a fronting insurer. The GFSC proposes that there will be two regulatory capital requirements, the lower one being the Minimum Capital Requirement (MCR) and the higher one the Prescribed

2 Capital Requirement (PCR). It is interesting that the GFSC uses the terminology of the IAIS ICP 17 for the upper requirement rather than the EU Solvency II terminology of Solvency Capital Requirement (SCR). If an insurer held capital in excess of the PCR, then the GFSC would generally not intervene whilst if capital was less than the MCR, the GFSC would take the strongest action as the insurer would not then be considered to be viable. If the available capital was between the MCR and the PCR, the GFSC would consider a range of measures depending upon the risks posed by the insurer. Calibration of solvency requirement The GFSC proposes using Value at Risk (VaR) as the risk measure to calibrate the PCR. This is consistent with the Solvency II methodology, but interestingly Bermuda uses a Tail Value of Risk measure which is felt to be more accurate for catastrophe risks. It is suggested that the PCR for commercial insurers and reinsurers is set at a 99.5% VaR level over one year, although respondents to the consultation are asked for feedback as to whether a 97.5% level might be more appropriate for general insurers and reinsurers. For captives the level will be set at 90% VaR over one year to reflect the fact that a captive does not have third (unrelated) party policyholders. The MCR for life insurers and reinsurers will be calculated using a factor of 2.5% of nonlinked policyholder liabilities which is unchanged from the current methodology whilst the MCR for general insurers and reinsurers will be calculated as 12% of net written premium or 12% of claim reserves whichever is higher. This represents a significant change to the current formula and could increase capital requirements particularly for companies in run-off. Since the PCR calculation, unlike the MCR calculation, allows for diversification and could permit the inclusion of additional types of asset, it is possible that the calculated PCR could be less than the MCR. The GFSC will then set the PCR as equal to the MCR. This approach differs from the Solvency II approach of adjusting the calculated MCR so it lies in a corridor of between 25% and 45% of the PCR to ensure that there can be an effective ladder of intervention. Eligible capital resources The GFSC is proposing to apply capital factors to certain types of assets in assessing capital requirements. In some cases different factors will apply when assessing the available assets to meet the MCR and the PCR. For example it will be possible to use unpaid share capital as an asset to meet the PCR but not the MCR. It will also be possible to include deferred acquisition costs as an eligible capital resource.

3 Valuation of assets and liabilities Assets and liabilities can continue to be valued using recognised accounting standards, i.e. IFRS, UK GAAP or US GAAP. Although this could lead to inconsistency between insurers reporting under different standards, the GFSC feels that there no justification in imposing a uniform requirement especially as the larger insurers are already reporting under IFRS. Calculation of the PCR Unless companies adopt an internal model, the PCR is calculated using a standard workbook and takes account of underwriting risk, market risk and counterparty default risk. Unlike Solvency II, concentration risk, liquidity risk and operational risk should be considered as part of the OSCA or ORSA processes rather than forming part of the standard workbook. The capital requirement for general insurers and reinsurers underwriting risk will be calculated using a capital factor approach taking account of both premium risk and reserve risk. Different factors will apply for different classes of business and the sum of the individual capital requirements will be reduced by an allowance for diversification. The diversification allowance is calculated by the standard sum of squares methodology utilising specified correlation coefficients based on the EU Solvency II specification. For captive insurers where a reduced 90% Value at Risk measure applies, the correlation coefficients have been reduced by 0.25 to remove an adjustment included in the Solvency II methodology for non-linear tail correlation. This results in captives having a relatively higher allowance for diversification than conventional insurers or reinsurers. For insurers and reinsurers writing life insurance and other long term business, the capital requirement for underwriting risk is calculated through the application of prescribed stress scenarios. Allowance is made for diversification and potential future management actions. The PCR calculation also takes account of market risk which includes interest rate risk, spread risk, currency risk, equity risk and property risk. For general insurers, the capital for market risk is calculated by applying factors to their asset exposure whilst long term insurers will calculate market risk capital by applying prescribed stresses. This methodology is consistent with the calculation of underwriting risk and the sum of the individual capital requirements are again reduced to allow for diversification.

4 The counterparty default risk charge in respect of accounts receivable is set at zero except for those overdue for more than 90 days where it set at 100%. Although this approach is unchanged from the existing requirements, it is interesting to note that the Solvency II approach is to impose a 15% charge on accounts receivable for less than 90 days and a 90% charge for those overdue more than 90 days. In respect of other counterparty exposures, a capital charge is calculated based on the credit rating of the counterparty. Protected cell companies The application of solvency capital requirements to protected cell companies is an interesting area, particular as cells may or may not have recourse to capital held in the core. The GFSC proposes that the MCR and PCR of the PCC is calculated as the sum of individual notional MCRs and PCRs calculated at the level of each cell and if necessary the core. Any deficits at cell level can only be covered by core capital if there is a recourse agreement in place. A separate workbook will be available to draw together the components of a PCC MCR and PCR calculation. Actuarial function The proposed draft Corporate Governance Rules include the requirement for all insurers and reinsurers (other than captives) to have an actuarial function. The actuarial function should periodically report to the Board on matters such as: Any circumstance that may have a material effect on the insurer from an actuarial perspective The adequacy of the technical provisions and other liabilities The prospective solvency position of the insurer This requirement differs from the Solvency II Directive in that captives are excluded from the requirement. It is also not clear if the actuarial function (other than for companies writing long term business) has to be carried out by a qualified actuary since the draft rules only refer to having access to adequate actuarial skills. OSCA and ORSA The consultation paper explains that the GFSC intends to retain the requirement for all insurers except the large direct writing life insurers to complete an OSCA (Own Solvency Capital Assessment) on an annual basis. The large life insurers would be

5 required to complete a more detailed ORSA (Own Risk and Solvency Assessment). The ORSA would encompass all reasonably foreseeably relevant material risks and would consider the impact of future changes in economic conditions. Issues raised by the proposals The proposals raise a number of interesting issues which could be taken into account when responding to the consultation: Categories of insurer Although there are separate categories for commercial general insurer and commercial general reinsurer, commercial life insurers and commercial life reinsurers are included within in the same category. Since Guernsey is actively trying to expand its reinsurance business, it would send out the right message if there was a separate category of commercial life reinsurer. This would also make it easier if in future there was a need to apply separate regulatory requirements to life insurers and life reinsurers. It is very useful to include a category for Special Purpose Entities but the GFSC needs to clarify the regulatory treatment of these SPEs and in particular publish the requirements for granting a waiver of the normal solvency margin requirements. Confidence levels The GFSC has requested feedback on whether to adopt a 97.5% confidence level for commercial insurers and reinsurers rather than the recommended 99.5%. It is clearly preferable to fix the level at 99.5% for both categories of insurer for the following reasons: The adoption of a lower level for commercial insurers would be inconsistent with the treatment of life insurers and would suggest that Guernsey is adopting a weaker solvency requirement than the emerging international standard. Also it is questionable whether the failure of a general insurer is necessarily always less devastating to policyholders than the failure of a life insurer. The non-payment of a substantial personal injury claim following a motor accident could be more devastating than a policyholder having to take a partial loss on the surrender value of a small insurance savings policy. Whilst the failure of a commercial reinsurer could have less direct impact on policyholders than the failure of a commercial insurer, the a failure of a reinsurer could have a major impact on the financial position of a direct writing commercial insurer, probably based outside of Guernsey and could give rise to damage to the reputation of Guernsey as a reinsurance centre.

6 Relationship between MCR and PCR The consultation paper puts forward the argument that it is important that the MCR is calculated using a simple, auditable methodology and that it should therefore not be linked to the PCR. Although this is a valid point, there will be circumstances where the PCR is set to be equal to the MCR which removes the possibility of operating an effective ladder of intervention. It might be worth considering setting a minimum level for the PCR at say 130% of the MCR to ensure that an effective ladder exists. Calculation of MCR for life insurers Although the method for calculating the MCR for life insurers remains at 2.5% of nonlinked policy liabilities, consideration could have been given to bringing the methodology in line with the current EU Solvency I calculation where allowance is also made for the amount of total sums insured and the expense risk of unit-linked policies Counterparty default risk Should the calculation of the counterparty default risk charge in respect of accounts receivable follow the Solvency II approach by imposing a small charge on accounts receivable for less than 90 days and a higher charge (but less than 100%) for those overdue more than 90 days? Deferred acquisition costs Deferred acquisition costs should only be included as eligible capital resources if the insurer can demonstrate that sufficient profits will emerge in future from the written business to amortise those costs. It is interesting that the similar concept of Zillmerising is permitted under the solvency II Directive for long term business. OSCA and ORSA The approach of requiring the large life insurers to complete a detailed ORSA whilst requiring other insurers to continue to complete an OSCA makes sense. Since the OSCA was originally introduced to act as an informal PCR calculation however, perhaps it would be preferable to cease using the expression OSCA and require all insurers to complete an ORSA in line with the IAIS ICP terminology. The ORSA could be comprehensive for the larger commercial insurers and reinsurers, but less detailed for smaller insurers and captives.

7 Actuarial function The requirement for all insurers other than captives to have access to an actuarial function should be welcomed. Consideration could also be given to requiring the larger captives to also have access to an actuarial function where the captive retains a significant level of risk. The consultation paper refers to adequate actuarial skills but does not specify the required level of skill or experience. The Solvency II Directive by way of contrast refers to the actuarial function being carried out by persons who have knowledge of actuarial and financial mathematics, commensurate with the nature, scale and complexity of the risks inherent in the business of the insurance or reinsurance undertaking, and who are able to demonstrate their relevant experience with applicable professional and other standards. In practice the above requirement means that it would be difficult for the actuarial function to be carried out by a person who was not a qualified actuary. It is important that there is a similar requirement included in the new Guernsey Corporate Governance Rules to ensure that insurers receive an appropriate standard of actuarial advice and oversight. MIKE POULDING November 2013

EVOLVING INSURANCE REGULATION

EVOLVING INSURANCE REGULATION A CONSULTATION PAPER ON THE REVISION OF THE REGULATIONS, RULES AND CODES FOR LICENSED INSURERS 24 September 2013 1 P age The Guernsey Financial Services Commission invites