April 2014 Summary of technical specifications for QIS 1 Singapore RBC 2 Review
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Introduction The Monetary Authority of Singapore (MAS) recently issued a second consultation paper on the review of the Risk-Based Capital framework for insurers in Singapore (RBC 2). This paper was issued together with the detailed technical specifications required for insurers to conduct a Quantitative Impact Study (QIS 1). Insurers are expected to conduct QIS 1 based on data with the valuation date of 31 December 2013, with results for Scenarios 1 and 2 due by 30 May 2014 and results for Scenario 3 by 30 June 2014. The MAS expects to finalize the risk calibration and features of the RBC 2 framework by the end of 2014, with likely implementation from 1 January 2017. Key observations and challenges The second consultation paper contains 43 proposals and 16 consultation questions. Key changes and challenges include: Gradual phaseout of the Long-Term Risk Free Discount Rate (LTRFDR): The impact of using market yield curves will depend on how the market for the 30 year Singapore Government Securities (SGS) develops over the next five years and the future interest rate environment. Introduction of a matching adjustment: It will provide relief to insurers, but significant efforts will be required to demonstrate its applicability. For products where this is not applicable, RBC 2 does not provide any smoothing mechanism. As such, the volatility of the capital charge due to interest rate changes may be high, leading the industry to reconsider its investment strategy and risk appetite. Revision of risk modules and sub-modules: Risk charges have been calibrated on a 99.5% VaR basis. Some of charges are new (e.g. operational risk charge) and some are significantly higher than the current ones. However, diversification benefit is included. Insurers should consider ways to optimize risk adjusted return via different investment and product strategies. Treatment of negative reserves: Insurers will benefit from in the available capital calculation through the inclusion of a portion of negative reserves as an offbalance-sheet item. Treatment of available capital: RBC 2 intends to align the classification of capital instruments (tiering) on the banking rules. This might lead insurers to review their current resources and reconsider their financing options. This could result in higher price and lower return on capital in the future. Internal reinsurance: For QIS 1, insurers cannot take credit for reinsurance arrangements between related entities. This could lead the head office or insurers to review their internal and external reinsurance programs in order for the branch/subsidiary to receive credit for it. Inclusion of certain reinsurers business under RBC 2: The MAS has proposed that the Offshore Insurance Fund (OIF) of locally owned locally incorporated reinsurers be subject to full RBC 2 requirements. Appropriate transitional arrangements will be provided for affected reinsurers. Intervention level: The MAS proposes two solvency intervention levels: Prescribed Capital Requirement (PCR) and Minimum Capital Requirement (MCR). If capital falls below the PCR, an undertaking has three months to restore it. Practically, the companies need to integrate into their Enterprise Risk Management (ERM) framework a recovery plan, management actions and processes to anticipate such stress scenarios. Updates for general insurance: The MAS and the industry are still working on the development of the non-life catastrophe risk module. Key considerations for insurers and reinsurers Insurers need to consider the implementation issues for carrying out detailed QIS 1. In particular, insurers should consider required efforts and resourcing of the following: Sourcing of information for the matching adjustment calculation Modeling implementation issues for calculating certain items such as C1 risk charges, credit spread risk charges and negative reserves Setup of spreadsheet calculations to calculate the diversified capital requirements at both fund and company level Reclassification of available capital to align it with the tiering requirements Completion of QIS templates along with preparation of a consultation response Discussion with management and the board on the possible implications of the RBC 2 proposals 2
Overview of RBC 2 and QIS 1 CET1 Free surplus C1 Insurance Life insurance Policy liability Available capital AT1 T2 PCR C2 Asset General insurance Equity investment Premium liability Claims liability Mortality (nonannuity) Mortality (annuity) Disability Dread disease Adjustments MCR RBC2 risk modules for PCR calculation Interest rate mismatch Insurance catastrophe Other insured events Expense Assets Credit spread Lapse Conversion of options Policy liability Property investment Foreign currency mismatch Insurance catastrophe Surrender value condition C3 Asset concentration Counterparty default C4 Operational New risk modules The valuation of policy liability is proposed to be carried out in a similar way to current processes under RBC except that certain investigations will be carried out in QIS on the use of a different discounting approach. In addition, insurance companies will be allowed to use a matching adjustment to increase the valuation discount rate for certain portfolios meeting the required conditions. The MAS has proposed two solvency intervention levels: Prescribed Capital Requirement (PCR) calculated at 99.5% VaR Minimum Capital Requirement (MCR) calculated at 90% VaR and expressed as a fixed percentage of PCR Both PCR and MCR will be applicable at both the fund and company level. Insurers are expected to conduct QIS 1 based on the valuation date of 31 December 2013. The three scenarios to be tested are shown in the table below. Scenario RBC 2 proposals Relevant for Discount rate Matching Others ( 30 years) adjustment changes Scenario 1 Scenario 2 Scenario 3 Weighted average* Market yield of 30-year SGS Weighted average* No Apply All insurers No Apply Insurers who discount liabilities Yes Apply Insurers writing par and/or nonpar *A weighted average of existing LTRFDR and the market yield of the 30- year SGS 3
Valuation of assets and liabilities The MAS has proposed to change the valuation framework for solvency purposes in two key ways: i. Via the discounting approach for policy liabilities ii. Introduction of a matching adjustment Discounting approach for policy liabilities The MAS has proposed to phase out the use of Long-Term Risk-Free Discount Rates (LTRFDR) for liabilities denominated in Singapore dollars (SGD) of duration 30 years or more over the next five years. (a) For life business Under QIS 1, insurers are required to change the risk-free discount rate used for SGD denominated liabilities, as outlined in the following chart: Duration of a liability A B Apply A 20 - Market yield of SGS of matching duration as at valuation date > A and < B 20 30 A yield that is interpolated from market yield of X-year SGS and a specific discount rate B - 30 A specific discount rate For Scenarios 1 and 3, the specific discount rate is calculated using the weighted average of X% of the existing LTRFDR under the current RBC regime and Y% of the market yield of the 30 year SGS, where X and Y are specified in the following table. Valuation date X% Y% 31 December 2013 90% 10% 31 December 2014 70% 30% 31 December 2015 50% 50% 31 December 2016 30% 70% 31 December 2017 10% 90% 31 December 2018 and beyond 0% 100% For Scenario 2, the discount rate to be used for liabilities with durations of 30 years and above is the market yield of the 30 year SGS. (b) For general business Under QIS 1, no discounting is required for liability duration of above one year if the impact is immaterial. However, if an insurer decides to perform discounting, the same approach as (a) will be adopted. Overall, insurers in general are not expected to face major difficulties in incorporating the proposed discounting approach for policy liabilities. However, the impact of using 30 year market yield curve will depend on how well the market for the 30 year SGS will build up in the next five years and on the future interest rate environment. The impact may well be bigger for insurers with long-term liabilities, e.g. whole life and annuity. Introduction of a matching adjustment (MA) The MAS intends to introduce a MA mechanism to the riskfree discount rate used in valuing life insurance policy liabilities where the liability cashflows can be predicted with reasonable certainty. The objective is to reduce the volatility of an insurer s solvency position to market movements. Insurers are required to consider the conditions laid out in Annex A of the second consultation paper before MA can be applied. The MAS has issued a workbook to help insurers select eligible products and perform the MA calculation. Once MA is applied to a portfolio of products, such treatment cannot be reversed. In the event that the conditions for MA no longer apply, insurers will be given three months to restore compliance. The reinstatement of MA can take place only after 24 months. The MA will be applied as a parallel shift to the entire riskfree yield curve for a portfolio of matched assets and liabilities of products denominated in SGD or USD. The formula for MA is as follows: MA = Yield to maturity of actual bond portfolio weighted average liability discount rate spread for default and downgrade Insurers should note that C1, C2 (except for credit risk module ), C3 and C4 requirements are to be computed assuming that MA does not apply. From our experience with Solvency II, demonstrating predictable cashflows and ring-fencing of assets and liabilities for MA purposes would have its own challenges. It is likely that diversification benefit with other funds may not be allowed for portfolios where MA applies, as they will be ring fenced. 4
Available capital The MAS has proposed to align the capital framework to be in line with the framework for banks. As a result, the MAS has proposed the following amendments to the available capital: i. Classification of current Tier 1 capital into Common Equity Tier 1 (CET1) capital and Additional Tier 1 (AT1) capital ii. iii. iv. Transitional requirements Allowance of negative reserves as a positive regulatory adjustment Changes to the calculation of reinsurance adjustments v. Reclassifying the allowance for provisions for nonguaranteed benefits as a regulatory adjustment CET1 and AT1 CET1 capital comprises all Tier 1 capital under the current framework except the approved Tier 1 capital, which will now be classified as AT1 capital. The MAS further proposes to do away with the approval regime for insurers planning to issue AT1 and Tier 2 capital instruments that meet the criteria set out in Sections 3 and 4 of Annex C of the consultation paper. Minimum floors on CET1 and Tier 1 capital The MAS has proposed minimum floors on CET1 and Tier 1 capital as a percentage of the total risk requirements of insurance funds excluding the participating funds: The total CET1 must not be lower than 65% (only for licensed insurers in Singapore) Total Tier 1 Capital must not be lower than 80%. AT1 capital will have the principal loss absorption feature, meaning that they will either be converted into equity or written down upon a significant breach of CET1 capital (defined as 70% of total risk requirement excluding participating fund). Transition arrangements Preapproved capital instruments not meeting the new criteria will be recognized up to 90% at the RBC implementation, reducing by 10% every year. Treatment of negative reserves The MAS has proposed to allow part of the negative reserves to be recognized as a regulatory adjustment in the calculation of available capital for solvency purposes only, noting that it will be an off-balance-sheet item. The amount of negative reserves to be allowed will be calculated after applying insurance stresses as per the C1 risk charge calculation and will be adjusted by the following factors: Insurance fund Percentage (%) Participating 50 Non-participating 50 Investment-linked 25 Reinsurance adjustments For QIS 1, the MAS has asked insurers not to recognize the reinsurance arrangement between a head office and its Singapore branch and between an insurer and its downstream entities. For general insurance, the MAS proposed to include claim liabilities in the reinsurer s share of liabilities to calculate reinsurance adjustments. The MAS also proposed to remove the licensing status of reinsurance counterparty from adjustment formula. The new reinsurance adjustment table is as follows: Rating Default risk charge AAA 0.5% AA- to AA+ 1.0% A- to A+ 2.0% BBB- to BBB+ 5.0% BB- to BB+ 10.5% B- to B+ 20.0% CCC+ and below 48.5% Allowances for provisions for non-guaranteed benefits (APNGB) The MAS proposed to reclassify APNGB as a form of regulatory adjustment to the available capital, rather than one of the components along with Tier 1 and Tier 2 Capital. Allowance of negative reserves in the available capital provides a relief to insurers (especially the ones with large portfolio of unit linked business and some forms of protection business) in meeting solvency requirements. However, the approach adopted for the calculation of negative reserves is expected to be under greater scrutiny from the MAS. 5
Required capital Component 1 (C1) requirement (a) For life business The MAS has recalibrated the risk requirements using the VaR measure of 99.5% confidence level over a one year period. The MAS has determined the new risk factors and a correlation matrix by performing statistical analysis on Singapore data and checking against results generated by other jurisdictions (e.g. Solvency II) and industry studies. (b) For general business The factors and methodology to derive C1 risk requirement remains the same as specified in the Insurance (Valuation and Capital) Regulations 2004. This will change once the catastrophe risk has been defined, probably post RBC 2 implementation. Modeling implementation needs to be considered for calculating the C1 risk charges separately and applying the correlation matrix. Some out-of-model calculations may be required. C1 risk requirement () Old factor (current RBC regime) New factor (QIS 1) Mortality (non-annuity) Mortality (annuity) Disability Dread disease and other insured events (accident and health) Lapse Conversion of options 125% of rates in prescribed mortality standard table for the full policy duration in which premium rates are guaranteed; 112.5% of BE mortality rates otherwise 100% of rates in prescribed standard table for annuities with a five year setback 125% of BE disability incidence rates for the full policy duration in which premium rates are guaranteed; 112.5% of BE disability incidence rates otherwise 140% of BE DD incidence rates for the full policy duration in which premium rates are guaranteed; 120% of BE DD incidence rates otherwise The higher policy liability value produced from either 75% of BE lapse rates or 125% of BE lapse rates The higher policy liability value produced from either 90% of BE conversion rates or 110% of BE conversion rates 120% of BE mortality (non-annuity) rates 75% of BE mortality (annuity) rates 120% of BE disability incidence rates 140% of BE DD incidence rates if premium rates are guaranteed for full policy duration; 130% of BE DD incidence rates if premium rates are not guaranteed for full policy duration The higher policy liability value produced from either 50% of BE lapse rates or 150% of BE lapse rates The higher policy liability value produced from either 50% of BE conversion rates or 150% of BE conversion rates Expense 110% of BE of future experience for all years 120% in first year and 110% thereafter of BE of future experience Insurance catastrophe None One-year mortality shock: +0.5 death per 1,000 to mortality rates across all ages One-year morbidity shock: +40 hospitalization claims per 1,000 to rates across all ages Correlation matrix Mortality Mortality Other insured Catastrophe risk Dread disease (non-annuity) (annuity) events Mortality risk Morbidity risk Mortality (non-annuity) 1-0.25 0.5 0.5 0.25 0.75 Mortality (annuity) -0.25 1 0.25 0.25 0 0.25 Other insured events 0.5 0.25 1 0.5 0.75 0.5 Dread disease 0.5 0.25 0.5 1 0.5 0.25 Catastrophe risk Mortality risk 0.25 0 0.75 0.5 1 0.75 Morbidity risk 0.75 0.25 0.5 0.25 0.75 1 6
Required capital (cont d) Component 2 (C2) requirement The MAS has proposed to remove debt investment and duration mismatch risk requirements and replace them with interest rate mismatch risk requirement and credit spread risk requirement. Further it has combined the counterparty risk requirements for different asset classes into one single module. According to the MAS, any potential diversification benefit between different risks has been implicitly allowed for in risk calibration. In QIS, C2 can be assumed fully independent of C1. C1 and C2 risk charges have been calibrated on a 99.5% VaR basis, and some of them are significantly higher than the current charges. However, diversification benefit is proposed to be included. Insurers should consider investment and product strategies to optimize the risk adjusted return. C2 risk requirement () Approach Factor Equity investment risk requirements Interest rate mismatch risk requirements Apply risk factors to the market value of each equity exposure, and sum up the total risk requirements. The MAS is consulting industry on the allowance of countercyclical adjustment to equity stress. Calculate NAV from interest rate sensitive assets and liabilities in both upward interest rate scenario and downward interest rate scenarios; the larger of the reduction in NAV is the risk requirement. Equities listed in Singapore and developed markets 40% Equities listed in other markets 50% Unlisted equities (including private equity and hedge funds) 60% Upward adjustment(%): 100% - 30% for durations from 3M to 20Y+ Downward adjustment(%): 70% - 30% for duration from 3M to 20Y+ All absolute changes in interest rates are capped below 200 basis points. Credit spread risk requirements Note: Also applicable to debt securities issued by governments or central banks that have a credit rating lower than A- 1. For assets, apply bps credit spread adjustment to yield curve, and calculate the reduced security values 2. For liabilities, apply revised Matching Adjustment ( MA ) to risk free discount rates used in valuing liabilities, and calculate the reduced liabilities 3. The change in NAV is the credit spread risk requirement Short term ratings (by outstanding maturity term): 140 580 basis points for rating from A1+ to B and below Long term ratings (by outstanding maturity term): Up to 5 years: 140 580 basis points for rating from AAA to B+ and below Between 5 to 10 years: 130 540 basis points for rating from AAA to B+ and below More than 10 years: 100 490 basis points for rating from AAA to B+ and below Property investment risk requirements Foreign currency mismatch risk requirements Counterparty default risk requirements Includes all property investments. Apply risk factors to the market value of each property. Formula remains the same, except for the removal of 10% concession for SIF. Apply risk factors to each counterparty exposure and sum up total risk requirements. For facultative reinsurance business, the table is applicable only for one year or less; 100% risk charge for over one year. For treaty reinsurance business, the table is applicable for two years or less; 100% risk charge for over two years. Immovable property for both investment and self-occupied purpose: 30% Collective real estate investment vehicles: 35% Foreign currency mismatch risk charge: 12% SIF concession: 0% OIF concession: 20% Rating Default risk charge AAA 0.5% AA- to AA+ 1.0% A- to A+ 2.0% BBB- to BBB+ 5.0% BB- to BB+ 10.5% B- to B+ 20.0% CCC+ and below 48.5% Treatment of collective investment schemes (CIS) Look through each asset class in the collective investment schemes. Under current RBC, it is just limited to CIS for debt securities. If look through approach is not chosen, a 50% charge will be applied. Treatment of structured products Look through approach will be required. We note that credit spread stress are higher than those for corporate bonds. 7
Required capital (cont d) Component 3 (C3) requirement For QIS 1, there is no change from the Insurance (Valuation and Capital) Regulations 2004. Component 4 (C4) requirement This is a new risk module proposed for the RBC 2 framework. For each insurance fund, the operational risk requirement is computed as: X% of the higher of the past three years averages of Gross written premium income Gross (of reinsurance) policy liabilities where X = 4% (except for investment-linked business, where X = 0.25%) C4 risk charge is capped to 10% of the total risk requirements (after diversification benefit and excluding operational risk requirement) of the same fund. The MAS may refine this approach in the future. Insurers are not expected to be facing major difficulties in incorporating the calculation of C4. The percentage factors applied in the C4 formula seem to be in line with Solvency II requirements, while the cap seems to be lower. Diversification benefit for PCR calculation Some diversification benefits are explicitly allowed as follows: In C1 risk charge calculations at the fund level Between C1 risk charge and C2 risk charge at the fund level Between funds (excl. par fund) for interest rate mismatch risk requirement The C3 and C4 requirements are not considered in the calculation of the diversification benefit. Prescribed Capital Requirement and Minimum Capital Requirement These two new solvency intervention levels are different from the existing financial resources warning event (CAR below 120%) and minimum CAR requirement at 100%. Under the PCR, insurers are required to hold sufficient financial resources to meet the total risk requirements that correspond to a VaR of 99.5% confidence level over a one-year period. The total risk requirements under the PCR are determined as C1 2 + C2 2 + C3 + C4. By concept, MCR correspond to a VaR of 90% confidence level over a one-year period. The MAS will calibrate the MCR level after reviewing the results of QIS 1. It is likely that the MCR will be calibrated as a fixed percentage of the PCR for ease of computation and future monitoring. There will be modeling implications with the calculation of PCR, in particular on the diversification benefits. The PCR formula is largely in line with the Solvency II approach in that diversification benefits between asset and insurance related risks are recognized. Further, similar to Solvency II, participating funds are ring fenced and no diversification is allowed with this fund. 8
EY contacts For more information or support, please contact: Jonathan Zhao Asia Pacific Insurance Leader and Head of Actuarial Services +852 2846 9023 jonathan.zhao@hk.ey.com Sumit Narayanan Partner +65 6309 6452 sumit.narayanan@sg.ey.com Ranjit Jaswal Partner +852 2849 9468 ranjit.jaswal@hk.ey.com Patrick Menard Partner +65 6309 8978 patrick.menard@sg.ey.com Glossary William Liang Associate Director +65 6309 6634 william.liang@sg.ey.com Abhishek Kumar Associate Director +65 6309 6895 abhishek.kumar@sg.ey.com Abbreviation MAS RBC QIS LTRFDR SGS PCR MCR VaR ERM SGD OIF MA Definition Monetary Authority of Singapore Risk-Based Capital Quantitative Impact Study Long-Term Risk Free Discount Rate Singapore Government Securities Prescribed Capital Requirement Minimum Capital Requirement Value at Risk Enterprise Risk Management Singapore dollar Offshore Insurance Fund Matching adjustment Risk requirement 9
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