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14.04.2017 Regional Seminar for Insurance Supervisors in Latin America on Supervision of Insurance Groups Group-wide Solvency and Fungibility of Capital.

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Presentation on theme: "14.04.2017 Regional Seminar for Insurance Supervisors in Latin America on Supervision of Insurance Groups Group-wide Solvency and Fungibility of Capital."— Presentation transcript:

1 Regional Seminar for Insurance Supervisors in Latin America on Supervision of Insurance Groups Group-wide Solvency and Fungibility of Capital Jeffery Yong Senior Financial Sector Specialist, FSI 19 November 2013

2 Agenda Overview of group capital adequacy
Agenda Overview of group capital adequacy Approaches to group capital adequacy assessment Components of group capital requirements Considerations for group capital resources

3 Objectives of Capital Adequacy Requirements
Objectives of Capital Adequacy Requirements Absorb significant unforeseen losses to reduce: likelihood of failure losses to policyholders in the event of failure Insurers Have different degrees of supervisory intervention Supervisor ULTIMATE AIM: Policyholder obligations continue to be met as they fall due including in adversity

4 ICP 17 Capital Adequacy The supervisor establishes capital adequacy requirements for solvency purposes so that insurers can absorb significant unforeseen losses and to provide for degrees of supervisory intervention. Group-wide requirements do not replace legal entity/solo requirements Aim: to avoid overstating capital adequacy of insurance legal entities due to multiple gearing, leverage, group risks etc.

5 Overview of Capital Adequacy Components
Overview of Capital Adequacy Components Supervisory Reporting Public Financial Reporting Assessment Capital = Assets less Liabilities Group Capital requirements Group Capital resources Value of assets for supervisory purposes Technical provisions Margin over current estimate Liabilities* Liabilities Current estimate Assets Regulatory capital requirements Insurer’s financial position Assets Liabilities * Assuming nil Other Liabilities

6 Lessons from the 2007 Financial Crisis - AIG
“… AIG failed and was rescued … because its enormous sales of CDS were made without … setting aside capital reserves … a profound failure in corporate governance, particularly its risk management practices.” “If (the CDS) had been regulated as insurance contracts, AIG would have been required to maintain adequate capital reserves… AIG would have been prevented from acting in such a risky manner.” Source: US Financial Crisis Inquiry Commission

7 Definition of an “Insurance Group”
Holding Company Insurer A Bank A Hedge Fund Super-markets Special Purpose Entity Reinsurer Insurer B Participation Influence Risk exposure Interconnectedness

8 Sources of Group Risk Governance Financial Group Structure
Conflict of interest - risk appetite, shareholders versus policyholders Incompetent Board and Management Lack of ability to impose regulatory requirements Financial Financial contagion – regulated entities supporting non-regulated entities/parent (liquidity) Intra-group transactions and exposures Risk concentration Group Structure Complex organisational structure – non-regulated entities Regulatory arbitrage Reputational contagion Lack of transparency

9 Double/Multiple Gearing and Intra-group Creation of Capital
Group Capital Adequacy Capital Resources Cap.Req. 800 +800 +400 =2000 1500 +900 +500 -500 =1900 100 Deficit =2900 900 Surplus With multiple gearing Without multiple gearing Parent Bank Insurer Securities Firm Invest Participation=500 5500 4000 Asset Liab. Cap.Req. 800 1500 700 Surplus 9000 8100 900 100 3500 400 500 Aim: Avoid over-estimating the solvency position of an insurance legal entity through multiple use of the same capital and minimise contagion from large intra-group holding of capital May occur via downstream/upstream/sidestream capital

10 (Non-) Regulated Parent Use proceeds to buy shares
Excessive Leverage (Non-) Regulated Parent Issues debt Investors Use proceeds to buy shares Risks to insurer: Undue stress placed on insurer due to obligation of parent to service capital instrument Ineligible (low quality) capital transformed into eligible (high quality) capital – regulatory arbitrage Insurer

11 Examples of Intra-group Transactions and Exposures (ITEs)
Committed facility A form of credit extension where the lender agrees to lend up to a pre-defined specific sum Can be used by a parent to provide liquidity to subsidiaries Letter of credit Legal commitment, usually issued by a bank, that guarantees payment under specified conditions Can be used to provide capital support, particularly internal reinsurance Guarantee A bond that guarantees timely payment of interest and repayment of principal to the buyers of a debt security Can be used to support non-rated subsidiaries Subordinated loan A type of loan that is junior to other debts should a company be wound up Can be used to provide capital support Letter of comfort A letter issued to a lender by a parent acknowledging the approval of a subsidiary's attempt for financing Not legally binding, but provides reassurance from the parent

12 Risks Arising from ITEs
- capital, income transferred out Pressure on insurers - failure of one group entity can adversely affect other (insurance) entities Contagion - replace high quality capital Capital quality - opaque and complex structure Supervisory challenge - evade capital requirements Regulatory arbitrage Risks Arising from ITEs

13 Agenda Overview of group capital adequacy
Agenda Overview of group capital adequacy Approaches to group capital adequacy assessment Components of group capital requirements Considerations for group capital resources

14 General Approaches to Setting Group Capital Adequacy Requirements
ORGANISATIONAL PERSPECTIVE Legal Entity Focus Group Level Focus SUPERVISORY PERSPECTIVE More weight on group-wide supervision Capital adequacy assessed for all relevant legal entities taking into account group impact Results binding for host and group-wide supervisors Capital adequacy assessed as though the group behaves as a single integrated entity More weight on legal entity supervision Non-binding results - host supervisors apply insurance legal entity capital adequacy requirements

15 Factors to Consider in Selecting an Approach
Legal Authority Insurance Group Structures Supervisory Cooperation Arrangements Supervisory Philosophy Supervisory Role

16 Group Capital Adequacy Assessment Techniques
Consolidation Aggregation Deduction

17 Sample Group 315 275 Asset Liab. Cap.Req. 32 40 8 Surplus 225 203
Parent Bank Insurer Securities Firm Non-regulated Entity 225 203 Asset Liab. Cap.Req. 17 22 5 Surplus 120 113 Asset Liab. Cap.Req. 10 7 3 Deficit 150 138 Asset Liab. Cap.Req. 10 12 2 Surplus

18 Parent Bank (Consolidated)
Consolidation Method Parent Bank (Consolidated) Non-regulated Entity Insurer Securities Firm 315 275 Asset Liab. Cap.Req. 32 40 8 Surplus 225 203 Asset Liab. Cap.Req. 17 22 5 Surplus 120 113 Asset Liab. Cap.Req. 10 7 3 Deficit 150 138 Asset Liab. Cap.Req. 10 12 2 Surplus 315 + 150 + 225 + 120 = 810 275 + 138 + 203 + 113 = 729 Asset Liab. Cap.Req. =69 81 12 Group Surplus Uses consolidated balance sheet Consolidated parent bank’s balance sheet adjusted to exclude investments in subsidiaries Issue: Group may not behave as single entity in times of stress Consolidated Group

19 Parent Bank (Unconsolidated)
Aggregation Method Parent Bank (Unconsolidated) Group Aggregation Capital Resources =69 12 Capital Req. 67 +12 + 22 + 7 = 108 Down-streamed capital = 27 81 Adjusted Capital Resources 315 + 10 + 12 + 5 = 342 275 Asset Liab. 67 Group Surplus Capital resources adjusted to eliminate double gearing of down-streamed capital Suitable if: Consolidated financial statements not available ITEs cannot be netted out Issue: Recalculation of capital requirements for insurers 225 203 Asset Liab. 22 150 138 Asset Liab. 12 120 113 Asset Liab. 7 Non-regulated Entity Insurer Securities Firm

20 Parent Bank (Unconsolidated)
Deduction Method 315 + 10 + 12 + 5 = 342 275 Asset Liab. 67 Parent Bank (Unconsolidated) Deduct investments in dependants Capital Resources = 4 Adjusted Capital Resources = 27 44 Add dependant’s surplus/deficit 32 Parent’s Capital Req. 12 Group Surplus Analysis performed from the perspective of the parent company Assess amount and transferability of capital available to the parent and the group Uses unconsolidated financial statements

21 Factors Affecting the Choice of Techniques
(Non-)Availability of financial data, e.g. consolidated financial statements Ability to identify and net out ITEs Specific circumstances of the insurance groups Regardless of the techniques followed, the outcomes should be the same if not similar.

22 Fungibility of Capital and Transferability of Assets
Reasons for Lack of Fungibility Exchange controls Participating fund Legal enforceability of ITEs Capital holders’ rights Tax Laws Adjust capital resources Stress versus normal conditions

23 Partial Ownership Participation
Effective Control (e.g. >50% to 100% participation) Subsidiaries are fully consolidated In general, excess capital recognised Shared Control (e.g. 20% to 50% participation) Only pro-rated surplus recognised Recognise potential need for capital support from parent if in deficit No Control/Significant Influence (e.g. <20% participation) Treat like any other investments - apply capital requirements for similar investments Test of significant influence - no right to board membership, no coordination of business plans

24 Minority Interest Parent Insurer Bank Need to decide between:
100 Capital Resources Capital Req. 90 +25= 115 = 140 15 Deficit Parent + Insurer 40 Particip. Capital Resources Capital Req. 90 100 10 Surplus Parent Insurer Bank 100%=40 60%=60 =>40 minority interest 140 Capital Resources Capital Req. = 140 100+ 40 + 100 = 240 Surplus=0 Full Integration 40+60=100 Particip. 100 Capital Resources Capital Req. = 130 100+ 40 + 60 = 200 Deficit Pro-rata Integration 40+60=100 Particip. Capital Resources Capital Req. 25 100 75 Surplus Capital Resources Capital Req. 25 40 15 Surplus 30 Need to decide between: Full integration – may amplify surplus/deficit because minority interest regarded as available to the group Pro-rata integration Even if each entity is solvent, group solvency position may be different

25 Agenda Overview of group capital adequacy
Agenda Overview of group capital adequacy Approaches to group capital adequacy assessment Components of group capital requirements Considerations for group capital resources

26 Process of Setting Regulatory Capital Requirements
Process of Setting Regulatory Capital Requirements Determine approach Identify risks Calibrate capital requirements Aggregate risks Determine PCR and MCR

27 General Approaches to Setting Capital Requirements
Standardised Approach Internal Model Approach General Approaches to Setting Capital Requirements Features Factor-based, standardised formula Insurer’s own model -embedded in business Precision Calibrated for “average” insurer risk profile Tailored to the individual insurer’s risk profile – better for groups? Complexity Easy to apply – certainty for insurers Usually more complex Supervisory Resource Less resource-intensive More resource-intensive - prior and on-going approval Supervisory Risk Conservative insurers penalised, narrow risk capture, measurement error (data, model) Cherry-picking, manipulation, errors, measurement error (data, model)

28 Identify Risks: Material and Relevant
Identify Risks: Material and Relevant Underwriting Risk 1918 flu pandemic, hurricane Katrina, Fukushima earthquake E.g.: Sum at risk X 0.23% Credit Risk Enron, Lehman Brothers E.g.: AAA Corporate bond value X 0.25% Market Risk 1930 Great Depression, Black Monday 1987, 2007 Financial Crisis E.g.: Value of equity X 30% Operational Risk Barings Bank, London Whale E.g.: Gross premium X 3%

29 Pause for Thought – Liquidity Risk
Pause for Thought – Liquidity Risk Should insurers be required to hold capital to address liquidity risk? Answer:

30 Pause for Thought – Liquidity Risk
Pause for Thought – Liquidity Risk Should insurers be required to hold capital to address liquidity risk? Answer: No. It is more appropriate to control these risks via qualitative requirements such as exposure limits or additional systems and controls.

31 Dealing with Risks from Non-regulated Entities
Capital Proxy Determine proxy capital requirement for the non-regulated entities Suitable only if there is a comparable regulated entity/activity Total Deduction On the parent’s balance sheet, deduct value of investments in non-regulated entities Assumes that non-regulated entities are unable to financially support the group Total Exclusion Entity is excluded in group capital adequacy assessment Usually appropriate for non-financial entities if their failure does not impact the regulated entities or the group as a whole Non-Capital Measures Impose limits on risk exposure to non-regulated entities Governance and risk management requirements on parent and/or insurance legal entities

32 Calibrate Regulatory Capital Requirements
Calibrate Regulatory Capital Requirements Target Criteria Confidence Level Risk Measure Time Horizon Cost Safety ? ? Shock period T= … n Effect period VaR TVaR

33 Example - Risk Measures
Example - Risk Measures Value at Risk (VaR): A measure of maximum loss at a certain confidence level over a certain period of time Tail Value at Risk (TVaR): Expected loss conditional on losses being above a given percentile over a certain period of time Probability 99%: 1% chance of loss>$10m 99%: Average of worst 1% losses Losses $10m $15m

34 Diversification and Concentration of Risks
Groups may have diversification benefits (product lines, geographical locations, asset classes, counterparties etc.) Reasons to limit recognition of diversification in group capital adequacy assessment: Difficult to quantify precisely especially under stress conditions Constraints on transfer of diversification benefit across group – lack of fungibility of capital Offset by concentration risk that may not be explicitly quantified

35 Group Solvency Control Levels
Purpose: Timely identification and mitigation of weakening parts of an insurance group Minimise risk of contagion to insurance legal entities Trigger process of coordination among different supervisors of group entities Actions taken on: Parent (if have powers) Insurance legal entities Need to be consistent with solvency control levels of insurance legal entities – e.g., group PCR > sum of legal entity MCRs

36 Prescribed Capital Requirement (PCR) Minimum Capital Requirement (MCR)
Determine PCR and MCR Control level above which supervisor does not intervene on capital grounds Could be single group PCR or a set of inter-dependent PCRs Going concern basis Method may be different than for MCR Capital Requirements Prescribed Capital Requirement (PCR) Minimum Capital Requirement (MCR) Control level below which strongest supervisory action is taken – group context, restructuring Ultimate safety net for policyholders Lower bound for PCR Subject to minimum bound below which insurer cannot operate viably – critical mass, nominal floor Different from accounting insolvency (assets still > liabilities) Going concern basis up until MCR level Technical Provisions

37 Example - Solvency Control Levels
Example - Solvency Control Levels 190% Prescribed capital requirement (PCR) level Group does not need to restore capital resources/reduce risk Capital Adequacy Ratio = Capital Resources _ Capital Requirements 160% Submission of business plan to improve capital resources Increased on-site supervision Additional stress and scenario testing 130% Replace group’s management Limit shareholder dividends Restrict mergers and acquisition Increase capital in insurance legal entities Can be explicit/implicit. 110% Minimum capital requirement (MCR) level Winding-up of operation

38 Practical Considerations
Risk Capture Proportionality Recalibration

39 Agenda Overview of group capital adequacy
Agenda Overview of group capital adequacy Approaches to group capital adequacy assessment Components of group capital requirements Considerations for group capital resources

40 Pause for Thought – Ordinary Shares
Pause for Thought – Ordinary Shares What are the features of ordinary shares that make them high quality capital resources? Answer:

41 Pause for Thought – Ordinary Shares
Pause for Thought – Ordinary Shares What are the features of ordinary shares that make them high quality capital resources? Answer: Insurer has full discretion on amount and timing of dividend distribution – maximum ability to conserve capital in times of stress Permanently available under both going concern and run-off Rank as the most subordinate instrument in winding-up – shareholders get paid last

42 Criteria to Assess Quality of Capital Elements
Criteria to Assess Quality of Capital Elements Encumbrances Subordination Availability Permanence Free from mandatory payments and encumbrances Fixed servicing costs can accelerate insolvency Ability to restrict repayment/dividends Subordination to policyholders’ rights in insolvency/winding-up Holder not entitled to repayment/dividends until policyholders’ obligations are met Period over which capital element is available Careful on incentives to redeem – e.g. step-up coupon rate at certain date Capital element fully paid, usually in cash If non-cash, assess likelihood of payment Fungibility of capital – e.g. ring-fenced funds

43 Key Challenges in Setting Group Capital Adequacy Requirements
Lack of legal authority and supervisor powers - non-regulated entities Cross-jurisdictional entities – cooperation with other supervisors Responsibilities and mandate of group-wide and host supervisors - different “risk tolerance” Distribution of capital among group entities and geographical locations Different valuation and capital adequacy bases for entities located in different jurisdictions Group disintegrates in times of crisis

44 Summary The additional group risks arising from an insurer being part of a group should be addressed – a legal entity view alone is not sufficient Group-wide capital adequacy assessment is crucial to supplement legal entity view of solvency Group-wide capital adequacy assessment techniques should minimise multiple gearing, intra-group creation of capital and excessive leverage Limits to fungibility of capital and transferability of assets should be recognised

45 Any Questions? End of Presentation Jeffery.Yong@bis.org
End of Presentation Any Questions?


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