Solvency Assessment and Management: Steering Committee Position Paper 44 1 (v 4) Concentration Risk EXECUTIVE SUMMARY This document discusses the structure and calibration of the concentration risk sub-module of the market risk module. It includes discussion of the Solvency II developments, considers the approaches within other jurisdictions, highlights issues, considers alternatives, derives stresses based on historical market data, and recommends an approach for use in the Solvency Assessment and Management standard formula The task group recommends that an approach based on Solvency II be adopted for the concentration risk sub-module. In line with feedback from SA QIS 1, QIS 2 and QIS 3 as well as new developments in Solvency II, it is proposed that the Solvency 2 approach be retained with the following amendments /additions / clarifications: The concentration risk module should include all assets. The concentration risk for debt instruments, cash deposits and risk-mitigating contracts should reflect the expected loss-given default rather than the full value of the assets. The LGD factor should be applied to the exposure (E i ) rather than to the shock factors (g i ). Where it isn t possible to look-through to the underlying assets of a collective investment scheme then the exposure should be treated as an equity exposure to the issuer of the scheme. The table of g i factors should be expanded for each rating class rather than providing a formula and assumed solvency ratios for lower credit ratings. The concentration threshold of 10% for properties should be reduced to 5%. When setting appropriate management actions a concentration risk to a South African bank should be considered to be industry-wide and a concentration risk to any other counterparty to be company-specific. The treatment of participations in the concentration risk sub-module is referred to in both the participations risk module and in the concentration risk sub-module. These two separate descriptions should be replaced by a single description of the treatment of participations in the concentration risk sub-module. Insurers have continued to express concerns regarding the concentration risk arising as a result of the limited number of counterparties in South Africa for cash and money market instruments. The working group does not propose to make any changes to the treatment of banks within the concentration risk sub-module. However, we feel that the FSB should give further consideration to these concerns and decide on whether special dispensation should be made on this issue. 1 Position Paper 44 (v 4) was approved as a FINAL Position Paper by the SAM Steering Committee on 30 June 2015.
It is important that the treatment of assets within the concentration risk sub-module is consistent with their treatment in the credit spread and default risk sub-module. For example, in the type and granularity of credit ratings used, the treatment of sovereign risk, use of lossgiven defaults etc. The concentration risk sub-module should therefore be reviewed in the event of changes to the credit spread and default risk sub-module. Up to this point, calibrations were based on ratings from various credit rating agencies. Unfortunately, this cannot be used for the purposes of secondary legislation as the work around using mapping tables between different agencies would not be appropriate. Concentration risk charges are thus applied to a number of credit quality steps. This approach is in line with Solvency II, but places additional onus on insurers to ensure that credit rating information is applied appropriately in assigning entities and instruments to various credit quality steps. The exception to this is non-sa government exposure where the S&P rating scale is used. Further detail on the use of credit quality steps can be found in the SCR Credit and Counterparty Default Risk discussion document. Any changes to the treatment of participations under SAM should also be reflected in the concentration risk sub-module. Page 2 of 32
1. INTRODUCTION AND PURPOSE This document sets out the recommendations of the market risk working group with respect to the calculation of concentration risk for the Solvency Assessment and Management (SAM) standard formula. 2. INTERNATIONAL STANDARDS: IAIS ICPs ICP17 (Capital Adequacy), the relevant ICP, states that solvency requirements should include any significant risk concentrations to individual counterparties but does not consider the details of concentration risk specifically. 3. EU DIRECTIVE ON SOLVENCY II: PRINCIPLES(LEVEL 1) Relevant extracts from the Solvency II level 1 principles are provided below. These requirements are in nature of a higher level than required for the establishment of detailed principles in the concentration risk sub-module of the market risk module within the capital requirements. Article 13 Definitions concentration risk means all risk exposures with a loss potential which is large enough to threaten the solvency or the financial position of insurance and reinsurance undertakings; credit risk means the risk of loss or of adverse change in the financial situation, resulting from fluctuations in the credit standing of issuers of securities, counterparties and any debtors to which insurance and reinsurance undertakings are exposed, in the form of counterparty default risk, or spread risk, or market risk concentrations; Article 105 Calculation of the Basic Solvency Capital Requirement The market risk module shall reflect the risk arising from the level or volatility of market prices of financial instruments which have an impact upon the value of the assets and liabilities of the undertaking. It shall properly reflect the structural mismatch between assets and liabilities, in particular with respect to the duration thereof. It shall be calculated, in accordance with point (3) of Annex IV, as a combination of the capital requirements for at least the following sub-modules: (f) additional risks to an insurance or reinsurance undertaking stemming either from lack of diversification in the asset portfolio or from large exposure to default risk by a single issuer of securities or a group of related issuers (market risk concentrations). Article 132 Prudent person principle Assets shall be properly diversified in such a way as to avoid excessive reliance on any particular asset, issuer or group of undertakings, or geographical area and excessive accumulation of risk in the portfolio as a whole. Investments in assets issued by the same issuer, or by issuers belonging to the same group, shall not expose the insurance undertakings to excessive risk concentration. Page 3 of 32
4. MAPPING ANY PRINCIPLE (LEVEL 1) DIFFERENCES BETWEEN IAIS ICP & EU DIRECTIVE No differences. 5. STANDARDS AND GUIDANCE (LEVELS 2 & 3) 5.1 IAIS standards and guidance papers This was covered in section 2. 5.2 CEIOPS CPs (consultation papers) CEIOPS-DOC-40/09 (formerly CP 47) Concentration risk is considered in section 4.7 of the CEIOPS advice on the structure and design of the market risk module. For concentration risk this document covers both the structure and design of the sub-module and the calibration of the submodule. This has been included in full in appendix A. CEIOPS-DOC-66/10 (formerly CP 70) The calibration of the concentration risk sub-module is not covered in CEIOPS-DOC- 66/10 because it is covered in CEIOPS-DOC-40/09. CEIOPS-DOC-73/10 (formerly CP 77) No simplifications are proposed in CEIOPS-DOC-73/10 because: 3.75 The process of calculation is already simple. The bulk of the analysis lies in the identification of all the exposures borne, directly or indirectly, explicit or hidden, by the undertaking. This analysis and identification of the exposures is necessary to achieve an appropriate risk management and to allow for a risk-oriented SCR. The simplicity of the calculation makes that no simplification is foreseen for the concentration sub-module. 5.3 Other relevant jurisdictions (e.g. OSFI, APRA) Canadian Approach (OSFI) The current methodology, as specified in the document Minimum Continuing Capital and Surplus Requirements(MCCSR) for Life Insurance Companies, does not require capital to be held in respect of concentration risk. Australian approach (APRA) The Australian approach requires additional capital to be held where there are excessive concentrations of investments in individual assets or in exposures to single counterparties. The capital requirement is the full amount by which the exposure exceeds the limit. Page 4 of 32
Assets guaranteed by an Australian State or Federal government have no limit and therefore do not incur concentration risk capital. 5.4 Mapping of differences between above approaches (Level 2 and 3) The Solvency II approach seems to be the most explicit, but the Australian approach seems to cover a wider range of types of concentration. The limits in the Australian approach might be a bit subjective to determine and are to be at a higher level than used in Solvency II. However, no factor is applied to the amount exceeding the threshold for the Australian approach, so it could result in a higher capital requirement for large concentrations. 6. ASSESSMENT OF AVAILABLE APPROACHES GIVEN THE SOUTH AFRICAN CONTEXT 6.1 Discussion of inherent advantages and disadvantages of each approach The Solvency II approach should result in companies avoiding excessive concentration sooner than would be the case for the Australian regime since capital requirements would be incurred sooner, which is desirable. Lessons learned from the financial crisis are incorporated in Solvency II. 6.1.1 Scope For QIS 2 the scope of the concentration risk module was extended from the QIS 1 definition: The scope of the concentration risk sub-module extends to assets considered in the equity, spread risk and property risk sub-modules, and excludes assets covered by the counterparty default risk module in order to avoid any overlap between both elements of the standard calculation of the SCR. to: The scope of the concentration risk sub-module extends to all assets including all assets relating to risk mitigating contracts, but not strategic participations captured in the SCR Part module and non-strategic participations in financial and credit institutions that are excluded from Own Funds. The scope of the concentration risk sub-module therefore includes non-strategic participations in undertakings that are not classified as financial and credit institutions. The effect of extending the scope of the sub-module was to increase the concentration risk capital as a percentage of market risk capital from 4.9% to 11.2% for life insurers and from 12.5% to 18.2% for non-life insurers. These assets were included in the concentration risk module in QIS2 because the default risk was moved into the market risk module from the counterparty default risk module and the nature of the default risk calculation changed from a loss distribution across all counterparties to a per instrument calculation. However, QIS 3 has reverted to a loss distribution approach for counterparty default risk though not to a separate counterparty default risk sub-module. This means that there is some allowance for concentration by counterparty within the counterparty default risk sub-module but this is only for cash & money-market assets. Including these assets in the concentration risk means that we will better capture concentration Page 5 of 32
risk across all assets with a particular counterparty but there may be some double counting of concentration within cash and money-market instruments. There was some confusion among QIS 3 participants because the QIS 3 technical specification included a footnote stating that "Risks derived from concentration in cash held at a bank are captured in the counterparty default risk module and are therefore not subject to the spread risk sub-module.". This footnote is linked to SCR.5.127 which relates to the treatment of bank deposits that are covered by a government guarantee scheme. The QIS 3 errata then changed this footnote to read "Risks derived from concentration in cash held at a bank are captured in the counterparty default risk module and are therefore not subject to the concentration risk sub-module." However, this footnote directly contradicts the concentration risk specification which states that the sub-module extends to all assets. The footnote should therefore be removed from this sub-module. The QIS 3 results indicate an average concentration risk capital requirement on a stand-alone basis of 2.8% of own funds for life insurers and 5.5% for non-life insurers. The table below shows how this ratio varies across companies: Life Non-Life 25% -> 9 5 20% - 25% 2 3 15% - 20% 3 5 10% - 15% 2 6 5% to 10% 8 13 0% to 5% 48 49 72 81 Concentration risk is assumed to be uncorrelated to all other market risks so the diversified impact of concentration risk is likely to be significantly lower. Furthermore and following industry comment, the future of the SCRpart module may be unclear and there should therefore only be reference to participations captured in the SCR. 6.1.2 Loss Given Default (LGD) In QIS 1 the concentration risk sub-module only covered assets in the equity, property and spread sub-modules and there was an implicit assumption of 100% LGDs. For QIS 2 the concentration risk sub-module was extended to assets covered by the default risk sub-module. An implicit 100% LGD was therefore applied to illiquid bonds and money-market instruments. A 25%/50% factor was applied for bank deposits to reflect the higher recovery rate of cash deposits in the event of a default: For cash deposits at a bank, the above factors may be multiplied by 25% if the counterparty s rating is BBB or higher, else by 50%. Page 6 of 32
In the QIS 2 there was feedback that these multiplies should be extended to moneymarket instruments or that the concentration risk exposures should reflect the expected loss-given default for debt instruments and bank deposits. The working group believes that allowing for the expected LGD on debt instruments, cash deposits and risk-mitigating contracts better reflects the concentration risk. The expected LGD should be determined based on the specification provided in the credit spread/default risk sub-module. For QIS 3the concentration risk calculation was changed to remove the 25%/50% factor for bank deposits and instead allow for the expected LGD on all assets falling under the credit spread/default sub-module. The working group subsequently reconsidered the most appropriate approach to allowing for the expected LGD on debt instruments, cash deposits and risk-mitigating contracts. In applying the LGD factor to the shock factor it is necessary to make an assumption for which type of assets make up the excess exposure, which leaves it open for interpretation. Adjusting the requirements to allow for this would also make the specifications unnecessarily complex. By adjusting the exposure (E i ) by the LGD factor, the calculation better reflects the risk adjusted exposure of a counterparty. The unadjusted shock factor should then be applied to the amount of this risk adjusted exposure in excess of the concentration threshold. The working group recommends that the specification be changed to require the LGD factor to be applied to the exposures rather than to the shock factors. 6.1.3 Thresholds In both SA QIS 1 and SA QIS 2 the thresholds above which concentration risk capital applies were set to be consistent with the Solvency II approach at: A concentration risk calculation was first included in EU QIS3 where the concentration thresholds were set to be 5% for assets rated A or higher and 3% for assets rated BBB or lower. These were retained for EU QIS 4 but changed to the above values for EU QIS 5. The reduction in thresholds was recommended in the CEIOPS Level 2 Advice document on the Structure and Design of Market Risk Module (CEIOPS-DOC- 40/09). This referred to evidence from the 2008/09 financial crisis that "should QIS 4 thresholds be used, the impact of failures (such as for example Lehman Brothers), or downfalls of equities prices (such as for example Fortis or AIG), would have had devastating consequences". Page 7 of 32
The recommendation was to reduce the thresholds to 2% for assets rated A or higher and 1% for assets rated BBB or lower. However, this wasn't implemented and instead the thresholds were reduced to 3% and 1.5% respectively. The analysis was based on an average own funds of 25% of total assets. On this assumption the thresholds could permit an insurer to risk up to 12% of own funds assets with higher-rated counterparties and 6% with lower-rated counterparties before there is any concentration risk capital requirement. See sections 4.123 to 4.125 in Appendix A for further details. The thresholds are specified in relation to the total assets considered within the concentration risk submodule. For QIS 1 this was assets considered in the equity, spread risk and property risk sub-modules but excluding assets held in respect of life insurance contracts where the investment risk is borne by the policyholders. For QIS 2 this was extended to all assets but again excluding assets where policyholders bear the investment risk. In the QIS 2 and QIS 3 feedback a number of insurers commented that the concentration thresholds were too low. In particular, they referred to the fact that there are only 4 major banks in South Africa and that is therefore difficult to achieve diversification for short-term cash and money-market assets. One insurer commented that this would encourage insurers to place funds with lower credit rated institutions and that it is unduly cumbersome for a small insurer to spread assets among a large number of counterparties. The lack of available counterparties in South Africa means that it is difficult to achieve a high level of diversification and therefore to avoid incurring a concentration risk charge. However, this reflects a real risk that a single default could have a very significant impact on insurance companies. The concentration risk sub-module aims to capture this risk. The QIS 3 draft specification changed the concentration threshold for BBB from 1.5% to 3%. These thresholds were deemed to be more suitable to the South African market where the majority of the available counterparties are rated BBB or BB. Factors based on the ratings from the various credit rating agencies cannot be used for the purposes of secondary legislation. The table has therefore been revised to use credit quality steps. 6.1.4 Exposure to South African Banks In the QIS 3 qualitative questionnaire feedback there have been further comments on the treatment of South African banks within the concentration risk sub-module. There was feedback that because there are only 4 major banks in South Africa the concentration risk calculation results in significant capital requirements. It was felt that if insurers were to avoid this concentration risk by spreading their assets across a greater number of counterparties then their risk could be increased rather than reduced. The feedback suggested that the exposure thresholds for the 4 main banks could be increased to reflect the lack of available counterparties or that the gi factors for banks could be lowered to reflect a view that they are lower risk as a result of the Basel requirements. The working group noted these concerns. However the current concentration risk specification is capturing the risk arising from the limited number of available counterparties in South Africa that results in insurers being more likely to be heavily exposed to the risk of default of a single counterparty. We don't feel that banks Page 8 of 32
should be considered to be lower risk than other companies because there are many recent examples of bank defaults. The working group does not feel it is in a position to increase the concentration risk thresholds for banks because we believe this is a real risk that both insurers and the regulator should be aware of. We feel that the FSB should give further consideration to concerns around the concentration risk arising as a result of limited number of counterparties and decide on whether special dispensation should be made on this issue. 6.1.5 Stress Factors In both QIS 1 and QIS 2 the stress factors are set to be consistent with the Solvency II approach at: One insurer commented that the stress factors are too high (in addition to the thresholds being too low) but provided no justification for the view. The QIS 3 draft specification retained the above factors for BBB or higher but moved to a formula based approach for BB or lower: Where the solvency ratio should be assumed to be 110% for BB, 105 for B, 100 for CCC and unrated. Otherwise g i = 0.73. In the QIS 3 draft specification feedback one insurer commented that the table should be expanded for each rating class rather than a formula provided. The insurer also commented that they believe solvency ratios are poor indicators of default probability for insurance companies but even more so for unregulated corporates. The working group recommends that the formula be replaced with an extended table and that the granularity is increased to be consistent with the credit & spread risk sub-module. There is little available data or research from which to derive the appropriate factors and therefore a pragmatic approach has been taken to extend the existing table: Rating i g i AAA 0.12 AA+ 0.12 AA 0.12 AA- 0.12 A+ 0.12 Page 9 of 32
A 0.12 A- 0.12 BBB+ 0.19 BBB 0.27 BBB- 0.36 BB+ 0.45 BB 0.53 BB- 0.56 B+ 0.58 B 0.61 B- 0.63 CCC+ 0.66 CCC 0.68 CCC- 0.71 Unrated or lower rated 0.73 Factors based on the ratings from the various credit rating agencies cannot be used for the purposes of secondary legislation. The table has therefore been revised to use credit quality steps. 6.1.6 Credit Ratings The Solvency II Level 2 draft implementation measures have removed the references to credit ratings in the thresholds and stress parameters and now refer to the equivalent credit quality step. The QIS 2 specification allowed the use of internal ratings where an external rating is not available. The credit and spread risk sub-module in QIS 2 had a mixed approach. It allowed the use of internal ratings but also specified factors for unrated entities and, for the impairment of risk-mitigating impacts, specified that unrated banks should be assumed to be BBB. The QIS 3 draft specification again allows the use of internal ratings in the credit and spread risk sub-module where an external rating is not available but requests additional information on the credit and spread risk if no internal ratings were used. The concentration risk sub-module currently allows the use of external ratings but should be guided by the credit and spread risk sub-module in this respect. Any changes to the approach in respect of credit ratings should also be reflected in the concentration risk sub-module. The concentration risk section of the QIS 3 specification made reference to credit quality step because this was used in the spread and credit default risk section at the time of writing. However, the credit and spread later removed these references so the concentration risk sub-module also removed the references to credit quality step and refer only to credit ratings. It has been determined that it would not be appropriate to use the ratings from the various credit rating agencies for the purposes of secondary legislation. The credit and counterparty default risk sub-module will therefore be changed to be based on credit quality steps. The concentration risk sub-module must also be changed to use a consistent approach. Page 10 of 32
The exception to this is non-sa government exposure where the S&P rating scale is used. 6.1.7 Total Assets The calculation of the concentration risk is based on thresholds relative to an amount of total assets. The QIS 2 specification states that these should not include: a. assets held in respect of life insurance contracts where the investment risk is borne by the policyholders; b. exposures of an insurer or reinsurer to a counterparty which belongs to the same group, provided that the following conditions are met: the counterparty is an insurer or reinsurer or a financial holding company, asset management company or ancillary services undertaking subject to appropriate prudential requirements; the counterparty is included in the same consolidation as the insurer on a full basis; there is no current or foreseen material practical or legal impediment to the prompt transfer of own funds or repayment of liabilities from the counterparty to the insurer. Under the second bullet above and followingindustry comment, it is proposed to add: on a full basis in a prudential jurisdiction equivalent to SAM. The specification for the European Long-Term Guarantees Assessment has additional clauses under (b): the counterparty is subject to the same risk evaluation, measurement and control procedures as the undertaking; the counterparty is established in the Union; The concentration risk sub-module should be updated to include the first of these clauses. 6.1.8 Participations The QIS 2 specification stated that...the concentration risk sub-module extends to all assets... but not strategic participations captured in the SCR Part module and non-strategic participations in financial and credit institutions that are excluded from Own Funds. The scope of the concentration risk sub-module therefore includes non-strategic participations in undertakings that are not classified as financial and credit institutions. This was retained for the QIS 3 draft specification. However the participations risk section of the QIS 3 draft specification (SCR 2) now also explicitly refers to the treatment of participations in the concentration risk sub-module. These two separate descriptions should be replaced by a single description of the treatment of participations in the concentration risk sub-module. The participations section of the concentration risk sub-module should be covered by discussion document 53. 6.1.9 Investment Funds The QIS 2 specification states that: Page 11 of 32
Exposures via investment funds or such entities whose activity is mainly the holding and management of an insurer s own investment need to be considered on a lookthrough basis. In addition, the specification for the recent European Long-Term Guarantees Assessment QIS explicitly states that: The concentration risk module should not be applied at the level of an investment fund but at the level of each sub-counterparty, after aggregation of exposures to each sub-counterparty at the portfolio level. If the underlying single name exposures of the investment fund cannot be determined, the concentration risk should be applied at the level of the investment fund. For this strict interpretation to be applied it is necessary for insurers to be able to look-through to the underlying assets for 3 rd party investment funds. However, in the QIS 2 feedback a number of insurers reported difficulties in obtaining look-through assets for investment funds. The look through section (SCR 5.4) in the QIS 2 specification stated that: Where a collective investment scheme is not sufficiently transparent to allow a reasonable allocation of the investments, reference should be made to the investment mandate of the scheme. It should be assumed that the scheme invests in accordance with its mandate in such a manner as to produce the maximum overall capital requirement. For example, it should be assumed that the scheme invests assets in each rating category, starting at the lowest category permitted by the mandate, to the maximum extent. If a scheme may invest in a range of assets exposed to the risks assessed under this module, then it should be assumed that the proportion of assets in each exposure category is such that the overall capital requirement is maximised. As a third choice to the look-through and mandate-based methods, insurers should consider the collective investment scheme as an equity investment. The mandate approach is not appropriate for concentration risk. It would be complex to determine the counterparty exposure limits for each fund and then to determine the most onerous asset mix. This could also become a complex optimisation calculation if additional exposures via investment funds result in breaching the threshold or change the diversification between counterparties. The working group therefore recommends that if it isn t possible to look-through to the assets then the collective investment scheme should be treated as an equity investment to the issuer of the fund. 6.1.10 Exposures to Governments The QIS 2 specification stated that: No capital requirement should apply for the purposes of this sub-module to borrowings by or demonstrably guaranteed by the national government of South Africa issued in South African Rand or a state with AA credit rating or better, issued in the currency of the government, or issued by a multilateral development bank as listed in Annex VI, Part 1, Number 4 of the Capital Requirements Directive (2006/48/EC) or issued by an international organisation listed in Annex VI, Part 1, Number 5 of the Capital Requirements Directive (2006/48/EC) or issued by the European Central Bank or South African Reserve Bank in South African Rand. The principle that South-African government guaranteed debt instruments should not incur credit risk capital has been retained for the credit and spread risk sub-module in Page 12 of 32
the QIS 3 draft specification so no changes are proposed for the concentration risk sub-module. However, the references to other Governments and to the European Central Bank were not deemed to be relevant for South Africa, and the paragraph was changed to the following as was done for the credit & spread risk module in QIS 3: No capital requirement should apply for the purposes of this sub-module to borrowings by or demonstrably guaranteed by the South African Government or Reserve Bank in South African Rand. Subsequent discussions have indicated that these exposures may be relevant for subsidiaries of South African insurers, for whom SAM calculations may also be performed, and the reference to states with AA credit rating or better has therefore been reintroduced. The wording should revert to the QIS 2 wording. 6.1.11 Unrated Insurance Counterparties The QIS 2 specification stated that: For unrated counterparties that are (re)insurers that will be subject to SAM and that would meet their MCR, the parameter g, depending on the solvency ratio (own funds/scr), is determined as follows: For other unrated counterparties, the parameter g should be 0.73. The specification for the recent European Long-Term Guarantees Assessment QIS was updated from the QIS5 specification and now states: For counterparties without credit quality steps that meet the following requirements, a. are (re)insurance undertakings, b. meet their MCR, c. the Solvency ratios are determined according to the requirements set out in these specifications (Solvency II ratios), d. the Solvency ratios are determined consistently to the scenario under consideration. the parameter gi, depending on the solvency ratio is determined as follows: Page 13 of 32
Where the eligible amount of own funds of a (re)insurance undertaking to cover the SCR falls in between the eligible amount values specified above, the value of the risk factor gi for market risk concentration shall be linearly interpolated from the eligible amount (solvency ratio) and risk factor values specified in the table right above. For other unrated counterparties, the parameter gi should be 0.73. For QIS 3 a formula based approach was also used for unrated counterparties that are (re)insurers that will be subject to SAM, that would meet their MCR and where 90% <= Solvency ratio <= 330%. Below 90% solvency ratio, the gi as at 90% should be used, and similarly for solvency ratios above 330% the gi at 330% should be used. Further analysis has identified that the formula does not work well at higher solvency ratios and, in any case, the working group agreed that it was somewhat spurious to try to parameterise a formula for this. The working group recommends reverting back to a tabular approach with the following parameters to be consistent with Solvency II: 6.1.12 Concentration risk capital in case of properties The Solvency II specification requires that a concentrated property exposure be treated differently to exposures in financial instruments. It states that: Insurers should identify the exposures in a single property higher than 10 per cent of total assets...the concentration risk shock on a property 'i' is the immediate effect on the Basic Own Funds expected in the event of an instantaneous decrease of values of 0.12 XSi in the concentrated exposure. The CEIOPS-DOC-47/09 explains that the concentration threshold is higher for properties because they do not bear the risk of losses of value due to the default of an issuer. The working group agreed with this assessment of the reduced risk for properties but there was discussion of the appropriate threshold level for properties relative to the threshold levels for financial instruments of 3% and 1.5% depending on credit rating. Page 14 of 32
The Solvency II threshold of 10% for properties was initially set when the proposed thresholds for financial assets were 5% and 3% depending on credit rating. When the Solvency II thresholds were reduced to 3% and 1.5% respectively the property threshold was not similarly reduced. There was no justification given in the CEIOPS advice as to why this was the case. The working group believes that, although this is not likely to a significant risk across South African insurers, a threshold of 10% for properties is high relative to the thresholds for financial instruments. We therefore recommend that the property threshold be reduced to 5%. 6.1.13 Simplification There was feedback from QIS 1 and QIS 2 that the calculation methodology was too onerous. There is currently no simplified approach offered either in the current Solvency II documentation or in the SA QIS 2 specification. However, as stated in CEIOPS-DOC-73/10 it is the data collection and consolidation process that is likely to be onerous rather than the calculation itself. There will therefore not be a simplified approach available for concentration risk. There was further feedback from QIS 3 on the difficulty of classifying exposures by counterparty group. The working group feels that where there are material exposures it is important that insurers understand the risk arising from the accumulation of exposures to multiple counterparties that belong to the same group. Where exposures are not material then insurers should consider the principle of proportionality and apply approximations where necessary. 6.2 Impact of the approaches on EU 3 rd country equivalence Demonstrating equivalence would be easier using an approach similar to the Solvency II approach. The deviations from the Solvency II approach that are proposed in this document would not be expected to affect 3 rd country equivalence. 6.3 Comparison of the approaches with the prevailing legislative framework Within the current calculation of the OCAR (Ordinary CAR) for Life insurers, a provision is made for the actuary to increase the credit risk capital requirement for a portfolio which is not well diversified, but no particular method is prescribed. 6.4 Conclusions on preferred approach The Solvency II approach with adjustments is preferred. 7 RECOMMENDATION The proposed text for the concentration risk sub-module is shown below: Market risk concentrations (Mkt conc ) Description The scope of the concentration risk sub-module extends to all assets including all assets relating to risk mitigating contracts, but not strategic participations captured in the SCR and Page 15 of 32
non-strategic participations in financial and credit institutions that are excluded from Own Funds. The scope of the concentration risk sub-module therefore includes non-strategic participations in undertakings that are not classified as financial and credit institutions. An appropriate assessment of concentration risks needs to consider both the direct and indirect exposures derived from the investments included in the scope of this sub-module. For the sake of simplicity and consistency, the definition of market risk concentrations regarding financial investments is restricted to the risk regarding the accumulation of exposures with the same counterparty. It does not include other types of concentrations (e.g. geographical area, industry sector, etc.). According to an economic approach, exposures which belong to the same group should not be treated as independent exposures, where a company should be considered as part of a group if it would be considered as such under either IFRS or SAM. The legal entities of the group or the conglomerate considered in the calculation of own funds should be treated as one exposure in the calculation of the capital requirement. Input Risk exposures in assets need to be grouped according to the counterparties involved. E i = Assets xl = CQS i = Risk adjusted exposure at default to counterparty i Total amount of assets considered in this sub-module (including government bonds). the credit quality step to which exposure i is assigned. For debt instruments, cash deposits and risk-mitigating contracts the risk adjusted exposure (E i ) should be calculated as the exposure at default multiplied by the loss given default (LGD) factor as per the spread/credit default risk sub-module. The total assets (Assets xl ) should not include any allowance for the LGD. Where an insurer has more than one exposure to a counterparty then E i is the aggregate of those exposures at default. CQS i should be a weighted average of the credit quality of the exposures, calculated as: Weighted average credit quality step = rounded average of the credit quality step of the individual exposures to that counterparty, weighted by the net exposure at default in respect of that exposure to that counterparty The exposure at default to an individual counterparty i should comprise assets covered by the concentration risk sub-module, including hybrid instruments, e.g. junior debt, mezzanine CDO tranches. Exposures via investment funds or such entities whose activity is mainly the holding and management of an insurer s own investment need to be considered on a look-through basis. The same holds for CDO tranches and similar investments embedded in structured products. The concentration risk module should not be applied at the level of an investment fund but at the level of each sub-counterparty, after aggregation of exposures to each sub-counterparty at the portfolio level. If a look-through for a collective investment scheme is not possible, and hence the (re)insurer has applied either the mandate-based method or treated the scheme as an equity for the look- Page 16 of 32
through in other market risk sub-modules, then the concentration risk should be applied at the level of the investment fund. Concentration risk should be assumed to be company specific, except for concentration risk to South African banks, where it can be assumed to be industry-wide. This assumption should be taken into account when deciding on appropriate assumptions around management action or policyholder behaviour when recalculating liabilities following the concentration risk shock for each counterparty, i. The guidance on company specific versus industry wide shocks is there to help companies decide what management action they may take. It is possible to have management action in response to either company specific events or industry wide events, but the actual management action may differ in these two scenarios. Output The module delivers the following outputs: Mktconc = Total capital requirement for the concentration risk sub-module Calculation The calculation is performed in three steps: (a) excess exposure, (b) risk concentration capital requirement per name, (c) aggregation. The excess exposure is calculated as: ( ) where the concentration threshold CT, depending on the credit quality of counterparty i, is set as follows: CQS i Concentration Threshold (CT) 9 and above 3% 10 and below 1.5% Ei and Assets xl should not include: a. assets held in respect of life insurance contracts where the investment risk is borne by the policyholders; b. exposures of an insurer or reinsurer to a counterparty which belongs to the same group, provided that the following conditions are met: the counterparty is an insurer or reinsurer or a financial holding company, asset management company or ancillary services undertaking subject to appropriate prudential requirements; the counterparty is included in the same consolidation as the insurer on a full basis in a prudential jurisdiction equivalent to SAM; there is no current or foreseen material practical or legal impediment to the prompt transfer of own funds or repayment of liabilities from the counterparty to the insurer. Page 17 of 32
the counterparty is subject to the same risk evaluation, measurement and control procedures as the undertaking; The risk concentration capital requirement per name i is calculated as the result of a predefined scenario: Conc i = ΔBOF concentration shock The concentration risk shock on a name 'i' is the immediate effect on the Basic Own Funds expected in the event of an instantaneous decrease of values of XSi g i in the concentrated exposure. The parameter g, depending on the credit quality of the counterparty, is determined as follows: CQS i g i 1 0.12 2 0.12 3 0.12 4 0.12 5 0.12 6 0.12 7 0.19 8 0.27 9 0.36 10 0.45 11 0.53 12 0.56 13 0.58 14 0.61 15 0.63 16 0.66 17 0.68 18 0.71 Unrated or lower rated 0.73 No charges should be applied to entities with the highest possible international rating, e.g. AAA in the case of Standard & Poor s. For unrated counterparties that are (re)insurers that will be subject to SAM and that would meet their MCR, the parameter g, depending on the solvency ratio (own funds/scr), is determined as follows: Page 18 of 32
For other unrated counterparties, the parameter gi should be 0.73. The capital requirement for concentration risk is determined assuming no correlation among the requirements for each counterparty i. This sub-module (as for the whole of the market risk module) is in the scope of the approach for the loss absorbency of technical provisions Special reference to mortgage covered bonds and public sector covered bonds In order to provide mortgage covered bonds and public sector covered bonds with a treatment in concentration risk sub-module according their specific risk features, the threshold applicable should be 15% when the asset has a credit quality step 3 or better. Concentration risk capital in case of properties Insurers should identify the exposures in a single property higher than 5 percent of total assets (concentration threshold) considered in this sub-module according to paragraphs above (subsection description). Government bonds should be included in this amount, notwithstanding the exemption specified below. For this purpose the insurer should take into account both properties directly owned and those indirectly owned (i.e. funds of properties), and both ownership and any other real exposure (mortgages or any other legal right regarding properties). Properties located in the same building or sufficiently nearby should be considered a single property. The risk concentration capital requirement per property i is calculated as the result of a predefined scenario: Conc i = ΔBOF concentration shock The concentration risk shock on a property 'i' is the immediate effect on the Basic Own Funds expected in the event of an instantaneous decrease of values of0.12 XSi in the concentrated exposure. Special reference to exposures to governments, central banks, multilateral development banks and international organisations No capital requirement should apply for the purposes of this sub-module to borrowings by or demonstrably guaranteed by the national government of South Africa issued in South African Rand or a state with AA credit rating or better, issued in the currency of the government, or issued by a multilateral development bank as listed in Annex VI, Part 1, Number 4 of the Page 19 of 32
Capital Requirements Directive (2006/48/EC) or issued by an international organisation listed in Annex VI, Part 1, Number 5 of the Capital Requirements Directive (2006/48/EC) or issued by the European Central Bank or South African Reserve Bank in South African Rand. To determine the concentration risk capital requirement for exposures to governments or central banks denominated and funded in the domestic currency, other than those mentioned in the previous paragraph, the following parameters g*should be used. The table below denotes credit quality steps that should not be compared to the credit quality steps in the main calculation which are significantly more granular. As such they are denoted by the G- prefix. Concentration risk factors for exposures to non-rsa governments and central banks denominated and funded in the domestic currency Credit quality step (SAM) International local scale S&P local currency sovereign rating (SAM) G0 AAA 0 G1 AA 0.12 G2 A 0.12 G3 BBB 0.27 G4 BB 0.53 G5 B 0.61 G6 CCC 0.68 Unrated or lower rated g i Unrated or lower rated 0.73 Special reference to exposures to bank deposits Bank deposits considered in the concentration risk sub-module can be exempted to the extent their full value is covered by a government guarantee scheme in South Africa (in Rand), the guarantee is applicable unconditionally to the insurer and provided there is no doublecounting of such guarantee with any other element of the SCR calculation. Special reference to participations This section should be covered by discussion document 53 Page 20 of 32
APPENDIX A Concentration risk section from CEIOPS advice on the structure and design of the market risk module (CEIOPS-DOC-40/09): Page 21 of 32
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