Session 3 Solvency Capital Requirements Regional Training Seminar IAIS-ASSAL San Salvador, El Salvador, November 2010 Takao Miyamoto, IAIS Secretariat

Agenda 1 Assessment of financial solvency Valuation of assets & liabilities for solvency purposes Available capital resources –Broadly given as excess of assets over liabilities –Subject to fungibility & transferability aspects –Subject to quality criteria Required regulatory capital –Reflects potential adverse change of excess of assets over liabilities over time

Total Balance Sheet Approach 2 Solvency is assessment of overall financial position –Consistent measurement of assets & liabilities –Explicit identification & consistent measurement of risks –Potential impact of risks on all components of balance sheet Recognise interdependence – cannot be considered in isolation –Assets –Liabilities –Regulatory capital requirements –Capital resources

Assets & Liabilities – Quick Look 3 Assets –Security –Liquidity –Diversification Liabilities –Technical provisions: Amount required to fulfill insurance obligations & settle all commitments to policyholders –Other liabilities Asset-liability management (ALM) –Manage risk & business under coordinated decisions

Agenda 4 Assessment of financial solvency Valuation of assets & liabilities for solvency purposes Available capital resources –Broadly given as excess of assets over liabilities –Subject to fungibility & transferability aspects –Subject to quality criteria Required regulatory capital –Reflects potential adverse change of excess of assets over liabilities over time

Role of Capital 5 Serve as safety cushion against adverse environment & financial fluctuation –Reduce probability of insolvency –Reduce losses to policyholders in event of insolvency Enhance safety & soundness of insurance (& other financial) sector –Macroprudential perspective Meet strategic & operational needs of capital –Start-up, growth (into new products, market segments etc.) –Allocation of capital for decision & performance review

Stakeholders 6 Policyholders ↑ Prefer sufficient capital to protect their interests Shareholders ↓ Care about rate of return ↓ Existing shareholders want to maintain control ↑ Avoid worst scenario (insolvency & wipe-off all shares) Supervisors ↑ More focus on policyholder protection & financial stability ↑ Insolvency may put job & reputation at risk Board & senior management ↓ Under pressure from market for return ↓ Salary dependent on share prices or rate of return ↑ Insolvency may put job & reputation at risk ↑ Care about ratings agency ↑ Attract more customers by providing sense of safety

Different Perspectives 7 Going concern –Carry on business as going concern and continue to take on new business Run-off –Stop new business and manage only existing business until they are settled or expired Winding (Break)-up: –Stop new business and settle or transfer existing business as soon as possible

Quality & Suitability of Capital Resources 8 –Extent to which and in what circumstances capital element is subordinated to policyholders rights in insolvency or winding-up Subordination –Extent to which capital element is fully paid & available to absorb losses Availability –Period for which capital element is available Permanence –Extent to which capital element is free from mandatory payments or encumbrances Encumbrance

Quality & Suitability of Capital Resources 9 Quality of capital Loss absorbency Loss absorbency under going concern Loss absorbency under winding-up Subordination Availability Permanence Absence of encumbrance

Adjustment for Solvency Purpose 10 Broadly regarded as assets over liabilities –Based on recognition & valuation for solvency purpose Certain types of liabilities (+) –e.g. subordinated debt –Act buffer to reduce loss to policyholders Contingent assets (+) –e.g. letters of credit, members’ calls by mutual, unpaid element of partly paid capital Certain types of assets (–) –e.g. intangible assets, deferred tax assets –Realisable value under winding-up may be significantly lower than economic value under going concern –Adjustment through deduction of capital resources or addition to capital requirements

Group Issues 11 Multiple (Double) gearing –Insurer invests in capital instrument of subsidiary Intra-group creation of capital –Insurer holds shares in or makes loans to another entity, which holds capital instrument of insurer Life insurance subsidiary (A) Assets22,700Life fund20,000 Debt to B700 Equity2,000 General insurance subsidiary (B) Assets3,500Insurance liability 1,800 Debt800 Equity900 Holding company (P) Assets2,400Debt to A1,000 Equity1,400 (500 owned by B) Own 75% of shares Own 100% of shares Loan 1,000 Loan 700 Own 500 shares

Agenda 12 Assessment of financial solvency Valuation of assets & liabilities for solvency purposes Available capital resources –Broadly given as excess of assets over liabilities –Subject to fungibility & transferability aspects –Subject to quality criteria Required regulatory capital –Reflects potential adverse change of excess of assets over liabilities over time

Approaches 13 Range of approaches allowed –Reflect nature, scale & complexity of risk & business Standard formula –Feasible for small & medium sized insurers –Should be designed to reasonably reflect overall risks Internal models (partial or full) –More tailored to individual insurers –Subject to prior approval & ongoing validation by supervisors –Criteria: statistical quality test, calibration test, use test, documentation

Process 14 Identify all material risk sources Assess & characterise distributions Aggregate risks Measure capital requirements Redistribute & use for management Underwriting, credit, market, operational, liquidity etc, Correlation Dependency

Required Capital and Technical Provision 15 Probability Loss Technical provision (current estimate & risk margin) Required capital Solvency level (e.g. VaR (1 year, 99%)

Quantify or Not 16 Some risks may be less readily quantifiable –Due to its nature, lack of data, lack of well developed model –e.g. strategic, reputational, liquidity, operational risks Alternative treatment –Simple proxies –Stress & scenario testing –Exposure limits –Qualitative requirements (e.g. systems, controls)

Diversification Effect 17 Diversification effect exists –Horizontal (within risks) –Vertical (between different risks) –Business lines –Geographical –Across entities Whether & to what extent should it be allowed? –Dependencies increase in times of stress –Limited availability of data, especially stressed situation –Lack of fungibility of capital & transferability of assets –Robustness and reliability for supervisory actions

Example 18 (Source) Joint Forum “Developments in Modelling Risk Aggregation”

Example 19 (Source) Joint Forum “Developments in Modelling Risk Aggregation”

Agenda 20 Assessment of financial solvency Valuation of assets & liabilities for solvency purposes Available capital resources –Broadly given as excess of assets over liabilities –Subject to fungibility & transferability aspects –Subject to quality criteria Required regulatory capital –Reflects potential adverse change of excess of assets over liabilities over time

Demand vs. Supply 21 Assets Other liabilities Current estimate Risk margin Capital requirement Liabilities Available capital Technical provision Supervisory assessment of financial position –Could be different from public financial reporting due to prudential filter

Solvency Control Levels 22 Prescribed Capital Requirement (PCR) –Above PCR, supervisor would not intervene on capital adequacy grounds Minimum Capital Requirement (MCR) –If breached, supervisor would invoke strongest actions, in absence of corrective actions Additional control levels –Range of different intervention actions between PCR & MCR

ComFrame Update 23 Common Framework for the Supervision of Internationally Active Insurance Groups (“ComFrame”)

Background 24 Current state of play IAIS solvency regime (ICPs, standards & guidance) remains high-level, not so concrete Various approaches exist in different jurisdictions & regions Challenges Difficult to implement and assess Difficult for cross-border cooperation Difficult for efficient global management

25 Five Modules

26 Timeline 1 July 2010 We are here – ComFrame is off to a good start!

27 ¡Muchas gracias!