FSA Consultation Paper 190 - enhanced capital requirements and individual capital assessments for non-life insurers 1 Introduction This consultation paper provides draft rules in relation to the calculation of capital requirements for non-life insurers under the Integrated Prudential Sourcebook (PSB). It explains the enhanced capital requirement (ECR), redefines the capital resources of an insurer within the terminology currently used for banks and then updates on the individual capital assessments which were consulted on in CP136 and provides draft rules in relation to these. It is proposed that the PSB will provide different layers of capital resources: the minimum capital requirement (MCR) being what we currently know as the required minimum margin (RMM) as increased pursuant to the Solvency 2 Directive (see our summary of CP181 in the May s Insurance Update); the ECR (if higher than MCR): this will replace the FSA s current typical requirement for a buffer above RMM with a very different, risk-based, calculation which may need to be amended again for the implementation of the Solvency 2 Directive; and individual capital guidance (ICG) which would require an additional buffer of capital if the FSA feels that the result of the ECR for a particular insurer does not provide sufficient capital, for example because its lines of business are more risky than the average or its systems and controls are lacking. Firms will be required to carry out individual capital assessments each year on which the FSA will base any decision in relation to ICG. FSA intends to issue a consultation paper in relation to enhanced capital requirements for life insurers next month but it is stated that this will, as expected, involve the use of realistic reporting such as is being carried out by many life insurers already on a voluntary basis. Individual capital assessments, ICG and the capital resources rules for life insurers will be much as set out in CP190 for non-life insurers. The proposed increased capital requirements will have implications for the calculation of group capital under the Insurance Groups Directive (implemented in the UK in Chapter 10 of IPRU(INS)) as assets equal to the increased capital requirements referred to above will have to be left out of account in determining the surplus assets of a group for that purpose. In other words, the group will require more capital in order to avoid running at a deficit on a group basis. CP190 also explains the different tiers of capital that will now apply to insurers, being Tier 1 (divided into Core Tier 1, non-ordinary shares and Innovative Tier 1) and Tier 2 (divided into Upper Tier 2 (perpetual), and Lower Tier 2 (term) (very similar to the hybrid capital explained in FSA s Guidance Note 2.1)). Other capital may only be included with FSA s permission. Limits apply to all forms of capital other than Core Tier 1.
2 Timing The proposals consulted on really amount to a formalisation of the FSA s general move to a risk-based approach to regulation. Under existing rules, it is already open to the FSA to use the requirement for adequate resources in the Threshold Conditions and the Principles for Business to require a firm to retain assets (i.e. stop distributions to shareholders) or to obtain additional capital. The first formal increase in capital requirements is the increase in the MCR with effect from 1 January 2004, on the implementation of the Solvency 2 Directive. ECR and ICG will be introduced with the PSB later in 2004. Initially ECR will need to be calculated and provided privately to FSA only as part of the requirement to consider an individual capital assessment. FSA will then use this and other factors such as the result of the firm s Arrow review as the basis on which to set the ICG for that firm. If the firm does not comply with the ICG then the FSA may consider using its powers under section 45 of the Financial Services and Markets Act 2000 (FSMA) to vary a firm s Part IV permission, on its own initiative, so as to require it to hold capital in accordance with the FSA s view of the capital necessary. However, FSA expects that firms will wish to calculate the ECR requirements as at 31 December 2003 and to back-test it for the last several years. FSA acknowledges that some firms may need time to satisfy ECR requirements and that some firms such as those in runoff with limited opportunity to raise or create new capital may need a grandfathering provision. Once the ECR has become a prudential requirement (from a date expected to be announced in 2004 but giving the industry at least 12 months notice), assuming it is higher than the MCR, it will effectively become the MCR so that there will be no debates with the FSA as to whether the ECR was the appropriate amount (although there would remain the opportunity to apply for a waiver under section 148 of FSMA if it could be shown that the ECR really did produce too high a capital requirement for a particular business). FSA will not (necessarily) await Solvency 2 before making ECR a prudential requirement, although FSA does recognise that ECR may need to be adjusted in due course for Solvency 2. 3 ECR FSA states that it has devised the ECR calculation so as to be extremely easy to perform using values which are already calculated for the current form of FSA returns. The basic calculation of the ECR follows the form: Asset related values x relevant asset factors (%) = Insurance related values x relevant technical provisions factors (%) = Net written premium x relevant premium factors (%) = Total ECR (before equalisation adjustment) = The factors have been devised to require more capital where the perceived risk is greater.
The asset related values involve relevant factors being applied to assets after the rules on valuation and admissibility have been applied. For example, shares carry a factor of 16%, shares in non-insurance undertakings and participating interests a factor of 7.5% and fixed interest securities a factor of only 3.5%. Insurance related values comprise, for each class of business, the total technical provision (the sum of outstanding claims reserves, reserves for incurred but not reported, or not enough reported, unearned premium reserves, and additional reserves for unexpired risks). Claims reserves are calculated net of reinsurance recoveries anticipated for each class of business. Unearned premium reserves are calculated net of deferred acquisition costs apportioned to each class of business. 4 Individual capital assessments and ICG The fundamental principal for capital/financial resources is set out in the draft PSB paragraph Pru 1.2.13 R as a firm must at all times maintain overall financial resources, including capital and liquidity resources, which are adequate, both as to amount and quality, to ensure that there is no significant risk that liabilities cannot be met as they fall due. The guidance notes indicate that the requirement is to ensure that, on any realistic worse case scenario, liabilities can be paid, not that any particular solvency margin or minimum capital requirement can always be met throughout the projection. The new rules require that a firm must carry out regular assessments of the adequacy of its financial resources using processes and systems which are proportionate to the nature, scale and complexity of the firm s activity. These systems must enable the firm to identify the major sources of risk to its ability to meet its liabilities as they fall due, including the major sources of risk in each of the following categories: credit risk; market risk; liquidity risk; operational risk; and insurance risk. For each of these risks the firm must carry out stress tests and scenario analyses that are appropriate to the nature of those risks to identify the likelihood of the risk crystallising and the likely cost if it does so. These tests must be run at least annually and the FSA will require the records to be kept for three years. The FSA will use the ECR as a benchmark for its consideration of the appropriateness of the firm s own capital assessment. It will expect to see the tests which the firm has carried out in order to assess the adequacy of its capital resources. The particular way in which the individual capital assessment adds value to the ECR is that it requires the firm to take into account its future business plans and projections. The ECR, in contrast, is based upon historic data. The draft guidance sets out much more detail as to the factors to be considered when assessing the various risks referred to above. The guidance also draws firms attention to
particular risks which may mean that capital will be required in excess of the ECR (on the basis that the ECR assumes that a firm s business is well diversified, well managed with assets matching its liabilities and good controls and stable with no large, unusual or high risk transactions). The ICG will involve: the FSA assessing the firm s capital positions for the first two or three years (at or above the ECR) and will include guidance as to how to calculate the ECR; and assessment as part of the regular Arrow risk assessments. On a group basis, the consultation paper states that the existence of enforceable unlimited cross guarantees may help. 5 Groups Until the ECR becomes a prudential requirement (expected to be announced in 2004 with at least 12 months notice), insurance groups must maintain at least the aggregate MCR. If ICG is required by virtue of use of FSA s own initiative powers under Section 45 FSMA in relation to particular insurers within the group this effectively increases the MCR for that company meaning an increased deduction from the parent undertaking solvency calculation and therefore a greater capital requirement. Once the ECR has become a prudential requirement, insurance groups will be required to maintain the aggregate ECR. Again, if ICG above the level of ECR is required in relation to particular insurers within the group this effectively increases the ECR for that company meaning an increased group capital requirement. In addition, where FSA has specified ICG for an insurer, it expects to specify ICG for that insurer s group and the extent to which only capital in excess of the group undertakings ICG is to be taken into account in meeting that requirement. The consultation paper expressly notes that having a strong parent is insufficient. Instead, the capital must be in place to meet any possible risks. 6 Capital resources The FSA maintains that the change to requiring particular capital resources to meet the capital requirement produces no different result from the old assets less liabilities plus RMM test. This requires the introduction of a concept of capital being made through retained profits or used up in losses. The sources of Tier 1 capital and deductions in the draft rules do this. The proposal would codify the expected alignment of insurance capital with banking capital. Share capital and retained reserves will form part of the Tier 1 capital. Capital instruments (i.e. debt securities which have been developed so as to have the characteristics of equity) are proposed as Innovative Tier 1. The principal amount of such instruments must not exceed 15% of the total amount of Tier 1 capital for the relevant firm. Another limit is that Innovative Tier 1 plus non-ordinary shares (essentially preference shares) may comprise no more than 50% of the MCR. (It is unclear whether this will become ECR once ECR becomes a requirement.) Half of a firm s capital resources may be
made up of Tier 2 instruments, of which no more than half (or 25% of the total capital resources) may be Lower Tier 2. The change from requirement (the current RMM) to available capital resources will increase headroom for Tier 2 in insurance firms. The effect of any increased capital resources once the ECR has been introduced as a prudential requirement would also mean that firms will have considerable additional headroom for raising Tier 2 capital. Firms may also wish to take advantage of the scope for using Innovative Tier 1 capital. Tier 2 capital for insurers has, pursuant to the various insurance directives, historically consisted of two different forms, perpetual securities and subordinated debt. The terms of the former are required to provide for the loss-absorption capacity of the debt and any unpaid interest, whilst enabling the firm to continue trading. The terms of the latter were not subject to this requirement. FSA is proposing that this requirement should apply to all Tier 2 capital for insurers. The guidance states that this could be achieved through the conversion of the capital instrument or subordinated debt into shares at a predetermined trigger event. Copies of this consultation paper can be found on the FSA s website at: www.fsa.gov.uk/pubs/cp/190/index.html. This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts at Linklaters, or contact the editors. Linklaters. All Rights Reserved 2003 Please refer to www.linklaters.com/regulation for important information on the regulatory position of the firm. We currently hold your contact details, which we use to send you special reports such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this special report or other marketing communications, please let us know by emailing us at marketing.database@linklaters.com