SAM Reporting for Insurance Groups with Participations in Non-equivalent Jurisdictions

SAM Reporting for Insurance Groups with Participations in Non-equivalent Jurisdictions In November 2016 the FSB published the proposed Financial Soundness Standards (FS) for initial public comment. These cover the SAM Pillar 1 requirements for all entities that will be licenced under the Insurance Bill (2016). They include: 1. FSI - Financial Soundness Standards for Insurers; 2. FSG - Financial Soundness Standards for Insurance Groups; 3. FSL - Financial Soundness Standards for Lloyd s; 4. FSM - Financial Soundness Standards for Microinsurers; and, 5. FSB - Financial Soundness Standards for Branches of Foreign Reinsurers. The FS replace the SAM (SA QIS3 and CPR) Technical Specifications. The FS will form part of the subordinate legislation to be termed Insurance Prudential Standards. 01

In this short article, we summarise the FSG and outline some of their potential implications on insurance groups with particular focus on insurance participations in non-equivalent jurisdictions. This is especially relevant to South African insurers with subsidiaries in other African countries. The FSG are structured as follows: FSG 1 - Framework for Financial Soundness of Insurance Groups. FSG 2 - Assessing the Financial Soundness of Insurance Groups using the Deduction and Aggregation Method. FSG 3 - Assessing the Financial Soundness of Insurance Groups using the Accounting Consolidation Method. Prudential Standard FSG 1 FSG 1 applies to all insurance groups that have been designated under Section 10 of the Insurance Act (2016) by the Prudential Authority 1. It sets out the roles and responsibilities of the board of directors, Head of Actuarial Control and auditors of the controlling company of the insurance group. The board of directors are ultimately responsible for the prudent management of financial soundness of an insurance group. They must ensure that the insurance group has systems, procedures and controls in place to monitor the financial soundness of the insurance group on an ongoing basis, including compliance with the FSG. The principles underlying the FSG framework are consistent with ICP23 2 which establishes the fundamental requirements for supervision on a group-wide basis. 1 The enactment of the Financial Sector Regulation (FSR) Bill will lead to the implementation of the Twin Peaks model of financial sector regulation which will see the creation of a prudential regulator - the Prudential Authority - housed in the South African Reserve Bank (SARB), while the FSB will be transformed into a dedicated market conduct regulator - the Financial Sector Conduct Authority. The implementation of the Twin Peaks model in South Africa has two fundamental objectives: to strengthen South Africa s approach to consumer protection and market conduct in financial services, and to create a more resilient and stable financial system. The Prudential Authority s objective will be to promote and enhance the safety and soundness of regulated financial institutions; while the Financial Sector Conduct Authority will be tasked with protecting financial customers through supervising market conduct. Structures will be in place to ensure proper coordination between the two authorities and other regulators. Source: FSB website. 2 The Insurance Core Principles (ICPs) provide a globally accepted framework for the supervision of the insurance sector. They are the highest level in the hierarchy of IAIS supervisory material and prescribe the essential elements that must be present in the supervisory regime in order to promote a financially sound insurance sector and provide an adequate level of consumer protection. Source: IAIS and FSB websites. 02

Amongst the guiding principles, the supervision of an insurance group should take into account, at a minimum, the following elements related to the insurance activities: direct or indirect participation, influence and/or other contractual obligations; interconnectedness; risk exposure; risk concentration; risk transfer; and/or; intragroup transactions and exposures. Two methods are available for assessing insurance group financial soundness under FSG 1: a) The Deduction and Aggregation (D&A) method 3 - this is the default method that insurance groups must use to calculate both group Eligible Own Funds and group SCR; and b) The Accounting Consolidation (AC) method 4 - this method may only be used on approval by the Prudential Authority and on those entities within the insurance group permitted by the Prudential Authority. The application and detail of these methods is covered in FSG 2 and FSG 3 respectively. Use of Internal Models - insurance groups may apply to the Prudential Authority for approval to use an Internal Model to calculate all or part of their group SCR. The scope of entities and risks that are to be included in a group Internal Model is also subject to Prudential Authority approval. 3 The default method that insurance groups must use to calculate both group Eligible Own Funds and group SCR is the D&A method which calculates group Eligible Own Funds and group SCR by aggregating the adjusted solo Own Funds and solo SCRs of the controlling company and its participations. Intragroup transactions between entities within the insurance group, and potential restrictions on certain Own Funds at the group level, must be appropriately accounted for prior to aggregation of solo Own Funds and solo SCRs. 4 Insurance groups that wish to use the alternative AC method to calculate group-wide capital adequacy must apply to the Prudential Authority to do so. Application of the AC method is only permitted for: a) Insurance subsidiaries licensed by the Prudential Authority that are part of the insurance group; and b) The controlling company of the insurance group, if the controlling company is an insurer licensed by the Prudential Authority. All other entities within the insurance group must be assessed using the D&A method. The AC method calculates Eligible Own Funds and SCR using a consolidated balance sheet approach for those entities in the scope of the AC method. The consolidated balance sheet approach involves treating those entities in the scope of the AC method as if it were a single entity, then applying the soloinsurer requirements (i.e. requirements prescribed under the Financial Soundness Standards for Insurers) to that single entity. The Eligible Own Funds and SCR for the remainder of the insurance group (i.e. entities not within the scope of AC method) must be assessed using the D&A method. To calculate the overall Eligible Own Funds and SCR of the insurance group, the respective measures of Eligible Own Funds and SCR for all entities in the group (i.e. entities within the scope of the AC method, and those outside the scope of the AC method) must be aggregated using the D&A method. Source: Prudential Standard FSG 1 03

Regardless of which method is applied, the Prudential Authority may direct an insurance group to apply a capital requirement higher than that prescribed in the Standards (referred to as a capital add-on ). Prudential Standard FSG 2 Other than describing the application of the D&A method, FSG 2 also sets out the treatment of insurance participations domiciled in non-equivalent jurisdictions that are within the scope of the insurance group. 1. All insurance participations of a controlling company will be required to be included in the scope of group capital adequacy calculations regardless of materiality, unless approved by the Prudential Authority to be excluded. 2. For the purposes of assessing group capital adequacy, the solo Own Funds and solo SCRs of all insurance participations in non-equivalent jurisdictions must be assessed using the Financial Soundness Standards for Insurers in South Africa. Insurance groups may apply the simplifications contained within the Financial Soundness Standards for Insurers when calculating the solo SCRs of insurance participations in non-equivalent jurisdictions. 3. If an insurance group is unable to meet the requirements of the Financial Soundness Standards for Insurers for its insurance participations in non-equivalent jurisdictions, the controlling company may apply to the Prudential Authority to use an alternative method. Approval by the Prudential Authority to use an alternative method will depend on a number of factors including: a) The materiality and strategic importance of the insurance participation to the overall group; b) The nature and extent of constraints in being able to perform calculations consistent with South African requirements; c) The extent of differences between local capital requirements in the non-equivalent jurisdiction and South Africa; and d) Any risk-based capital requirement that may be assessed by the insurance group (e.g. using an economic capital model) in relation to the insurance participation. 04

4. The factors mentioned in Section 3... will take into account whether a participation is strategically important. A participation will be regarded as strategically important if: a) The participation uses the brand or name of the South African parent or a brand/ name that is closely associated with the South African parent; b) The South African parent has provided explicit guarantees, commitments, letters of comfort or cross-default commitments to the participation; c) The South African parent has management and/or board control over the participation; d) The South African parent consolidates the financial results of the participation in its accounts; or e) The participation has a significant market share or influence in its local market or markets in the case of cross-border operations. 5. Any approval granted by the Prudential Authority to apply an alternative method for insurance participations in non-equivalent jurisdictions will not be permanent. The Prudential Authority will agree with the insurance group an appropriate transitional plan to satisfy compliance with Section 2 (above)... for those insurance participations that are not assessed using equivalent solo insurer requirements to South Africa. 05

Unless exempted by the Prudential Authority, this implies that subsidiaries of South African insurance groups operating in other jurisdictions, including the rest of Africa, are required to implement and report on the SAM basis. These requirements are similar to the obligations of South African banks in that SARB s banking supervision division requires South African banking parent groups to include their banking operations outside South Africa based on the South African banking capital adequacy requirements. Prior to the FSG, insurance groups followed the FSB s SAM Steering Committee s Position Paper 85 on the Treatment of Insurance groups (in Non-equivalent Jurisdictions) Under the Final Measures to Regulate the Solvency of South African Insurance Groups ( Groups ) where the following three options were available in respect of the treatment of insurance operations in non-equivalent jurisdictions for SAM reporting: Nil approach - i.e. no recognition of Own Funds nor hold an SCR if the insurance operation is not regarded as strategically important 5. SAM based calculation of Own Funds and SCR - this is the most onerous approach. Use equivalent numbers from local risk based capital regime reporting for Own Funds and SCR; however, there don t seem to be any African countries yet, other than South Africa, with Solvency II/SAM equivalent bases. To date, most insurance groups have agreed with the FSB to exclude their relatively small insurance entities outside South Africa from SAM Group reporting on grounds of materiality i.e. adopt a nil approach due to materiality even though these operations may be strategically important. Furthermore, should any of these insurance subsidiaries be in financial distress then any capital to be injected would be subtracted from the Group s Own Funds for SAM Group reporting. 5 An operation in a non-equivalent jurisdiction would be considered as strategically important if: a) The particular operation uses the brand/name of the SA parent or a brand/name that is closely associated with the SA parent, or b) The SA parent has provided explicit guarantees, commitments, letters of comfort or cross-default commitments to the particular operation, or c) The SA parent has management and/or board control over the particular operation; or d) The SA parent consolidates the financial results of the particular operation in its accounts. 06

Practical implications of the FSG for South African insurers with participations outside South Africa The implementation of the proposed FSG for SAM reporting effective H2 2017 would be difficult for most South African insurers entities in other countries for a number of reasons listed below. These have been deliberated by the Actuarial Society of South Africa s Africa Committee s working group on SAM participations and conveyed to the FSB as part of the public consultation process on the proposed FS. Proportionality and Materiality The complexity of the SAM methodology appears to be disproportionate given the relatively small and immaterial size of the operations in other countries. Methodology Due to the considerably differing economic and non-economic conditions from those in South Africa, aspects of applying the SAM methodology (e.g. obtaining yield curves, assessing credit risks, deriving risk calibrations, etc.) will be difficult without additional guidance. For instance, yield curves are either not readily available or non-existent in some countries with less deep bond markets; and, demographic assumptions and/or the associated shocks relevant to South Africa may not be appropriate in other countries. Capacity Entities outside South Africa typically have fewer resources to take on SAM reporting in addition to their current statutory and IFRS reporting obligations. Costs Most operations on the continent have a relatively high expense base. Some, if not all, of the increased costs from having to report on the SAM basis will be passed on to the customer. Hence, this will make the products less competitive and offer poorer value to the clients and shareholders return on capital will be reduced due to the potentially higher SAM capital requirements. 07

Transitional measures and alternative methods Given the foregoing factors, transitional measures will be needed to implement SAM reporting and clarifications sought on what alternative methods the FSB would allow (e.g. the nil approach) and possible exemption on grounds of materiality. Some alternatives to FSG 2 SAM reporting requirement Many countries are developing risk-based regimes which could be considered as equivalent jurisdictions. And many South African insurers use reserving and internal capital models which could also be considered as an alternative. The risk-based global ICS (Insurance Capital Standard) is currently being developed by the IAIS. It aims to achieve cross-border recognition under a simplified capital regime and serve as a minimum standard for a group Prescribed Capital Requirement (PCR). It will be a measure of capital adequacy for Internationally Active Insurance Groups (IAIGs) and Global Systemically Important Insurers (G-SIIs). It will constitute the minimum standard to be achieved and one which the supervisors represented in the IAIS will implement or propose to implement taking into account specific market circumstances in their respective jurisdictions 6. Once developed, this could be considered as an acceptable alternative. Pillar 2 impact In addition to the FSG, the relevant Governance Standards (GR), covering SAM Pillar 2 governance requirements as part of the next phase of the Prudential Standards, will need to be adhered to by insurance groups. However, these could be challenging to enforce if the GR for insurance groups are considerably different to the local Pillar 2 governance standards in other jurisdictions. 6 Source: IAIS website (www.iaisweb.org) 08

Conclusion Whilst it is accepted that a risk-based approach is necessary for supervisory oversight and that the Prudential Authority wants to guard against contagion and reputational risk to SA insurance groups from insurance participations in other countries, limit arbitrage with respect to capital requirements and have a consistent basis for capital calculations, there are a number of undesirable consequences and challenges - some of which are unintended - for SA insurance groups with participations in non-equivalent jurisdictions having to implement and report on the SAM basis in adherence to the FSG. Most SA insurance groups would prefer the option of the nil approach to be retained if entities are solvent locally, or the use of a different basis such as alignment with current risk-based reporting or the IAIS global ICS (once developed) as a proportionately appropriate basis which would provide the FSB/Prudential Authority with some insight into entities financial soundness without placing undue additional pressures on their reporting capacity. It is hoped that following the FSB s review of the feedback on the draft FSG, a pragmatic approach will be adopted with an appropriate transition period for implementation of SAM reporting for South African insurance groups with participations in non-equivalent jurisdictions. In the banking sector, large banking groups have recently taken the decision to sell all their subsidiaries due to onerous capital requirements and resulting lower return on capital. Could these changes, as they currently stand, cause a similar reaction in the insurance sector? If you would like to discuss this article further, please chat to your usual contact at QED or our directors, Craig Falconer or Ritin Chauhan. You can also visit our website to find out more about QED s services and to access other articles of interest. CONTACT US Craig Falconer office +27 038 3705 Ritin Chauhan office +27 038 3718 email craig.falconer@qedactuarial.co.za email ritin.chauhan@qedactuarial.co.za Disclaimer: The information contained in this article is based on our analysis and interpretations of publicly available information obtained from sources believed to be reliable. QED does not guarantee the accuracy of this information and does not accept any liability, loss or damage arising directly or indirectly from reliance upon the information in this article. 09