June May 2014 Insights Review of the Risk-Based Capital Framework in Singapore Review of the Risk-Based Capital Framework in Singapore The details emerge emerge The Monetary Authority of Singapore ( MAS ) published a second consultation paper on its review of the Risk Based Capital ( RBC ) framework in March 2014. This consultation paper sets out more specific proposals for RBC 2, following the first consultation period in mid-2012, and also provides the detailed specifications for the first Quantitative Impact Study ( QIS ) to enable the MAS and insurers to fully understand the potential impact of RBC 2. The second consultation paper revisits some of the earlier proposals some of which have been modified following insurers responses and the MAS subsequent discussions with the industry and also introduces some new proposals. The primary objective is unchanged however - to enhance the RBC framework to improve the risk coverage and the sensitivity of the framework, in light of evolving market practices and global regulatory developments. Towers Watson continues to see the RBC 2 Review as a positive step forward that has the potential to ensure that the Singapore market continues to be seen as strongly regulated, whilst maintaining its international competitiveness. It is pleasing to see from the second consultation paper that further attention has been given to the overall consistency of the revised framework as well as to the detail of individual proposals. There also is a clear message that the MAS fully intends to ensure that there is ample opportunity for the industry to provide feedback and to influence the final revised framework. The latest consultation paper contains 43 proposals and 16 explicit consultation questions and it is not the aim of this note to cover all of them. Rather, we have focussed on summarising the main features, highlighting the key changes from the first consultation paper, and on providing an initial view on what impact this may have on Singapore insurers if the proposals were implemented in their current form. Key developments The essence of the original proposals is unchanged and so at a high-level, the framework will comprise: An assessment of capital adequacy based on a comparison of available Financial Resources ( FR ) against a Total Risk Requirement ( TRR ) at both a fund and a company level; Supervision to be based on two transparent trigger points a Prescribed Capital Requirement ( PCR ) based on a Value at Risk ( VaR ) at a confidence level of 99.5% over a one-year period; and a Minimum Capital Requirement MCR ) based on a VaR at a confidence level of 90% over a one-year period (in practice the MCR will be expressed as a percentage of the PCR); Policy liabilities valued on best estimate ( BE ) assumptions with a provision for adverse deviation ( PAD ) and assets valued at market value (or net realisable value where there is no market value); TRR to be based on the combined effect of a number of risk components and FR to be the sum of a number of tiers of capital with varying levels of quality. This similarity at a high-level however belies a number of important changes once we look beneath the surface. Some of these involve a refinement of the original proposals whereas others involve new proposals. We outline the main points below.
Discounting of policy liabilities For Singapore dollar-denominated liabilities, the discount rate at which policy liabilities for life business are to be determined will gradually move over a five year period to a basis solely derived from the market yield of Singapore Government Securities ie the current use of a stable risk free discount rate (known locally as the long-term riskfree discount rate, or LTRFDR ) will be phased out over that period. This is likely to lead to results being more volatile over time but is arguably a more market consistent approach and in line with global developments. For liabilities denominated in other currencies, the MAS has dropped its original proposal that insurers should use the discount rate specified by the corresponding regulator. In response to feedback it now agrees that this would be over-complex and could result in inconsistent assessments of liabilities (for example in jurisdictions using a Net Premium Valuation method). Instead, the MAS will consult with the industry with the aim of agreeing a basis for an appropriate yield to be prescribed for key markets, such rates then to be being published periodically. Additionally, for all eligible policy liabilities, a Matching Adjustment (increase) to the discount rate can be applied to reflect the fact that corresponding matching assets held to maturity are not subject to spread risk. The conditions under which the matching adjustment can be applied and the definition of eligible policy liabilities is the subject of its own Annex to the consultation paper but in essence it requires a high level of predictability of the cash flows of both the policy liabilities and the matching (and ring-fenced) assets. For general insurers, no discounting will be required unless it would have a material impact. In such a case, the discounting follows the same approach as for life business. Matching Adjustment The introduction of the Matching Adjustment is primarily targeted at the long-term savings market, where fixed interest assets are typically used to back sufficiently predictable liabilities. In Singapore, participating products form a significant part of the long-term savings market. Under current economic conditions, the benefit of the Matching Adjustment could be limited as the Minimum Condition Liability ( MCL ) that the Matching Adjustment affects does not typically bite for many life insurers, either in the determination of the policy liabilities or the allowance for nonguaranteed benefits as part of the financial resources of the fund. However, applying the Matching Adjustment will help reduce the credit spread risk charge, and could potentially be more beneficial to solvency ratios in times of severe market stress. The use of the Matching Adjustment will also help insurers who offer other nonparticipating savings products. At the same time, life insurers will have to consider the operational requirements of applying the Matching Adjustment, such as any requirements to ring fence funds, and potential limitations to their investment strategy in order to meet the cash-flow requirements. A high degree of cash-flow matching is required before the Matching Adjustment can be applied. This means that some portfolios will be excluded even though the assets backing predictable liabilities can be held to maturity. For example, a portfolio where a nine-year zero coupon bond is held to back a single ten-year guaranteed maturity payout will not qualify for the Matching Adjustment. More generally, for life insurance liabilities with very long terms, fixed interest assets of the appropriate terms might not be available. A typical investment strategy would be to invest in assets of a shorter term, and rollover the maturity proceeds. Such strategies would not qualify for the matching adjustment, even if the assets are not at risk of early sale. 2 towerswatson.com
Insights June May 2014 Risk requirements and diversification For life insurers, the components of the TRR will change with the separation of the C1 (insurance risk) risk requirement into explicit sub-components such as mortality (annuity), mortality (nonannuity), disability, expense, lapse and conversion of options, the addition of a catastrophe risk requirement and a new C4 operational risk requirement. For general insurers, the MAS intends to review the current C1 risk charges for the premium liability and claims liability when the format of the newly introduced catastrophe risk requirement becomes clearer. Therefore the MAS has proposed no changes to the current risk charges. The catastrophe risk requirement for general business is being considered separately by an industry working group and is not expected to be advised until 2015. Importantly, the MAS has advanced its thinking on a number of matters since the first consultation paper was issued and now proposes to allow for diversification benefits. This will be done through the application of a correlation matrix approach when aggregating the C1 risk requirements for life business. The diversification benefits will be accounted for implicitly in calibrating the C2 risk requirements. Risk Requirement Risk requirement calculated as C1 2 + C2 2 + C3 + C4 C1 C2 C3 C4 Insurance Castastrophe Policy Liability Surrender Value Equity Investment Asset Concentration Operational Mortality (nonannuity) Mortality (annuity) Interest Rate Mismatch Credit Spread Replaces Debt General and Liability Adjustment Replaces Debt Specific Apply separately and aggregate Disability Dread Disease Property Investment FX Other Insured Event Expense Counterparty Default Replaces Loan Investment, Derivative Counterparty, Miscellaneous Lapse New risk requirements Conversion of Options There will be a reclassification and streamlining of the C2 asset-related risk requirements. No change is proposed to the C3 concentration risk requirement. The revised approach to the risk requirement for life insurers is illustrated below. As indicated above, the risk requirements will be calibrated to a VaR of 99.5% over a one-year period and in the second consultation paper the MAS has provided the results of its initial assessment of the corresponding factors. For the C1 risk requirement, the references to prescribed tables have been removed, while there is a notable increase in the stresses to be applied for lapses (50% of BE rather than 25% of BE) and for option conversion (50% of BE rather than 10% of BE). The new catastrophe risk requirement for life business will be based on a +0.5 per mille mortality shock and 40 hospitalisation claims per mille across all ages. The proposed calibration of the C2 risk requirements includes some of the potentially more significant changes for life insurers. Notably, the equity risk requirement will increase from broadly 16% of market value under the current framework to between 40% and 60% of market value depending on the category of equities held (whether listed in Singapore, in other markets or unlisted). Similarly, the proposed shock to be applied to property-related assets has more than doubled. An explicit credit spread shock will also be applied, which varies by the credit rating and term of each bond, and this generally represents a significant increase over the equivalent debt specific risk requirement that it would replace. And for structured products a new explicit risk charge will be applied in a similar manner as for corporate bonds, although with generally higher shocks. towerswatson.com 3
Correlation Matrix The proposed correlation matrix for the C1 risk charge is not internally consistent and might lead to counter-intuitive results such as diversified capital requirements being higher than total undiversified capital requirements. Explicit consideration of assets and liabilities under market stresses With the exception of the interest rate stress, there is generally limited explicit consideration of the impact of market movements on the liabilities. In some cases, indirect adjustments are allowed, such as recognising 50% of the non-guaranteed benefits and provisions for adverse deviation as available capital. We believe that an explicit consideration of the impact on both assets and liabilities under various market stresses would be more appropriate as it will help ensure that the entire balance sheet is valued on a consistent basis under a stress. This will adequately capture the interactions between assets and liabilities, and in particular, better encourage companies to give due consideration to their management actions and risk management practices under stressed conditions. Such an approach will arguably produce a risk charge that is more reflective of the risks that insurers are exposed to, and reward companies with good risk management practices. Implicit vs explicit allowance for diversification Diversification benefits have been allowed for implicitly within the calibrated C2 risk requirements, and insurers whose risk exposures differ significantly from the industry average used in the calibration could have additional capital requirements imposed. Without disclosure of the industry average, the incidence and magnitude of such additional capital requirements could potentially come as a surprise, and insurers may find it challenging to proactively manage this risk. At the same time, the combination of using: an implicit allowance for diversification; and determining the deviations from the industry average portfolio and calculating the relevant additional capital requirements (where applicable) seems to be lending itself towards an explicit allowance for diversification. It may therefore be worth considering the usage of an explicit diversification approach from the outset. Available capital Available capital is typically classified into several capital tiers based on asset quality. The MAS has proposed to refine the capital tiers to better align with the banking industry, by creating the following sub-categories within Tier 1 capital: Common Equity Tier 1 ( CET1 ) (higher quality Tier 1 assets) Additional Tier 1 ( AT1 ) (remaining Tier 1 assets) The changes in capital tiers are typically considered in conjunction with limits on capital tiers and the MAS has proposed that at least 65% of the required capital should be represented by CET1 and that total Tier 1 capital should cover at least 80% of the required capital. This compares with at least 67% of required capital being met by Tier 1 capital currently (Tier 2 must be no more than 50% of Tier 1). Surplus of insurance funds (excluding Par Fund) Par Surplus Account Surplus of overseas branch operations Paid-up capital Tier 1 CET1 65% TRR (excl. Par) Retained earnings (unappropriated profit loss) Irredeemable and Non-cumulative Preference Shares 30% Tier 1 AT1 80% TRR (excl. Par) Other Approved Tier 1 15% TIer 1 Irredeemable and Cumulative Preference Shares Tier 2 50% Tier 1 Tier 2 4 towerswatson.com
Negative reserves arise when the present value of the expected future income for a policy exceeds the expected outgo from the same policy. Allowing negative reserves as available capital therefore takes advance credit for income that is expected to arise on the policy in the future. As there is uncertainty over whether these income streams will materialise, some jurisdictions have limited the amount of negative reserves that an insurer can recognise as available capital and currently there is no recognition in Singapore. Under the latest proposals however, up to 50% of negative reserves (25% for investment-linked business) can be allowed as a positive regulatory adjustment to FR. For this purpose, the negative reserves are those calculated after allowing for the RBC2 insurance shocks to best estimate assumptions. In contrast, the current reinsurance adjustment to FR will be tightened such that reinsurance arrangements with a branch s head office or with downstream entities will not be recognised, unless it can be demonstrated that there is effective risk transfer. Our discussions with industry players indicate that the calculation of the negative reserves at a policy level may pose some challenges depending on the precise definition of negative reserves that are allowed as available capital. While this can be overcome by using approximate methods, for example, by calculating the negative reserves at an aggregate level, these could produce results that are different to that if calculated at a policy level. Treatment for reinsurers Under the current RBC framework, the Singapore Insurance Fund ( SIF ) business of reinsurers is subject to the same requirements as direct writers but the Offshore Insurance Fund ( OIF ) business is either exempted (for branches) or subject to a simplified approach (if locally incorporated). The MAS proposes to continue this approach with the important exception that local-incorporated reinsurers that are locally owned will be subject to the full RBC 2 requirements. This could have a material impact on the affected reinsurers and so there will be some (as yet unspecified) transitional arrangements. Quantitative Impact Study The MAS also has released the technical specifications for the first QIS, designed to gather information to help evaluate the impact of the RBC 2 proposals and to give insurers an opportunity to identify any potential implementation issues. All insurers (except captives, Lloyd s insurers and marine mutuals) need to conduct QIS 1. This will be done under three scenarios all based on a valuation date of 31 December 2013 and each assuming some subset of the full RBC 2 proposals: 1. Reflecting all RBC 2 proposals except the proposed Matching Adjustment; 2. Reflecting all RBC 2 proposals except the proposed Matching Adjustment and also assuming that there immediately is no LTRFDR (rather than this being phased out); 3. Reflecting all RBC 2 proposals including the proposed Matching Adjustment. Timing The results of Scenarios 1 and 2 were submitted by insurers by 31 May 2014. Insurers have until 30 June 2014 to submit the results of Scenario 3, this date also being the deadline for the submission of written responses to the consultation paper. The MAS intends to conduct a further period of consultation and a second QIS during 2014 with a view to finalising the calibration of the various factors by the end of the year. It also will be working in parallel on the proposed regulatory and legislative wordings with the aim of the new framework being effective from 1 January 2017. It is clear that in preparing the second consultation paper the MAS has expended a lot of hard work and has genuinely listened to feedback from the industry on the first consultation paper. It is good that this has been thought through carefully and that the MAS has stated its intention that ample time will be provided to study and test the impact. This is a message recently emphasised by the Executive Director of the MAS, Ms Loo Siew Yee, during her address to the Life Insurance Association of Singapore, where she assured the audience that the implementation schedule will be practical and realistic. That said, aiming to have the calibration finalised within nine months of the second consultation paper being issued is arguably still very ambitious and both the MAS and the insurers will have a lot of work to complete during 2014 to achieve this. towerswatson.com 5
Next steps Based on our internal research and market feedback, we expect the proposed changes under RBC 2 to reduce the regulatory solvency ratio for many life insurers. The potential impact of the current calibrations on the different product types in the market could be as summarised on the table below. For general insurers, a significant contribution to their total risk requirements will be from the C1 insurance risks. Since the calibration of these charges has not yet been reviewed, there is still significant uncertainty regarding the overall effects RBC 2 will have on general insurers, particularly with the introduction of the new catastrophe risk requirement. As part of good risk governance, we would encourage insurers to start considering the potential implications of this regulatory change on their operations now as part of their ongoing risk management efforts and their on-going work in developing and embedding their ORSA process. Plans can be prepared and firmed up along the way as the destination to which RBC 2 is heading becomes clearer over time. Product type Potential key impact and considerations Participating Universal Life Non-participating (Savings) (excluding Universal Life) Non-participating (Protection) Unit-Linked Expected increase in required capital, driven by higher C2 risk requirements. Impact of management actions on liabilities not explicitly allowed for and indirectly restricted to 50% of nonguaranteed liabilities and provision for adverse deviation. Expected increase in required capital, driven primarily by higher credit spread risk charge. Liabilities are not revalued under credit spread risk shock. Potential improvement in capital position for shorter term savings products from adopting the Matching Adjustment. Cashflow matching requirement may be difficult to achieve for longer term products. Need to consider operational requirements to ring fence funds. Expected increase in available capital from allowance of negative reserves. Allowance of negative reserves could help improve overall capital position. ILLUSTRATIVE 6 towerswatson.com
Please feel free to contact us or your usual Towers Watson consultant if you wish to discuss how the proposed changes under RBC 2 could affect you. About the Authors Mark Birch Office Leader & Director, Risk Consulting & Software South East Asia +65 6880 5682 Alan Merten Market Leader & Director, Risk Consulting & Software South East Asia +65 6880 5684 Goh Siew Shin Consulting Actuary Life Insurance South East Asia +65 6880 5683 About Towers Watson Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. With more than 14,000 associates around the world, we offer consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. Copyright 2014 Towers Watson. All rights reserved. AP-2014-June towerswatson.com