Capital Requirements for Insurers - Part 4

8/16/2019 Capital Requirements for Insurers - Part 4

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Capital Requirements for

Insurers

Nairobi, Kenya

Part 4

29 October 2009


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4. Aggregate capital requirement


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Ris !"arin# $it" Policy"ol%ers

( In participating insurance, t"e companyse/perience $it" respect to t"eir line of businessis s"are% $it" t"e policy"ol%er

( &"e si1e of a policy"ol%ers %i'i%en% or bonus isa matter of %iscretion for t"e insurers %irectors orsenior mana#ement

( &"e %e#ree of s"arin# of e/perience $it"policy"ol%ers t"at actually taes place is a matterof t"e insurers operatin# p"ilosop"y


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( It is often ar#ue% t"at in t"e e'ent of poor e/perience,policy"ol%ers %i'i%en%s or bonus can be re%uce% t"esa'in#s t"ereby #enerate% can be use% to absorb someof t"e a%%itional cost of t"e unfa'ourable e/perience

( Is it appropriate to reco#ni1e t"e potentially lossabsorbin# qualities of %i'i%en%s $"en %eterminin# capitalrequirements for particular riss

( If so, "o$ s"oul% suc" reco#nition be #i'en


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( In some +uris%ictions, t"e bonus is t"e main instrument inprice competition 6 It follo$s t"at some insurers $ill be quicer to increase t"e

bonus $"en e/perience is 'ery fa'ourable an% slo$er to re%uce

t"e bonus an% pass on poor e/perience

( In #eneral, mana#ement action to c"an#ebonus7%i'i%en% scales occurs $ell after t"e time ac"an#e in e/perience "as been reco#ni1e%

( &"ese consi%erations ar#ue a#ainst allo$in# a full cre%itfor t"e effects of profit s"arin# $it" policy"ol%ers to$ar%scapital requirements


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The Canadian approach is to reduce required capital by 50% in these cases provided certainconditions are met:

( The policies must pay meaningful dividends

( The companys participating dividend policy must be publicly disclosed and must ma!e it

clear that policyholder dividends "ill be ad#usted to reflect actual e$perience. Thecompany must publicly disclose the elements of actual e$perience that are incorporated inthe annual dividend ad#ustment process

( The company must regularly at least once a year& revie" the policyholder dividend scalein relation to the actual e$perience of the participating account. 't must be able todemonstrate to ()*'+ for e$ample+ "hich individual elements of actual e$perience+ to thee$tent that they are not anticipated in the current dividend scale+ have been passedthrough in the annual dividend ad#ustment. *urthermore+ it must be able to demonstratethat shortfalls in actual overall e$perience "ith regard to the ris! component aresubstantially recovered "ithin a period not e$ceeding five years

( The company must be able to demonstrate that it follo"s the dividend policy and practicesreferred to above


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:n%er !ol'ency II t"e specification of t"e stan%ar% formulacalculation taes into account t"e ris absorption abilityof future profit s"arin#; &"is is ac"ie'e% by a t"ree step


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!ol'ency II cont%-

( &"e secon% step is to a##re#ate bot" in%s of

capital requirement separately, usin# t"e rele'antcorrelation matrices

( &"e final step is to %etermine an a%+ustment to t"ebasic capital requirement

6 ?enerally, t"e a%+ustment is #i'en by t"e %ifferencebet$een t"e basic capital requirement an% t"ea##re#ate of t"e a%+uste% requirements


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Adjustable life insurance policies are non)participatin# policies in $"ic" t"einsurer "as t"e option to a%+ust certain elements t"at affect t"epolicy"ol%ers financial 'alues

( *%+ustable factors most often are

6 Premium rates 6 Interest rates use% to cre%it earnin#s to policy"ol%ers accounts

( &"ese a%+ustment factors are often contractually limite% 6 Aa/imum premium rate 6 Ainimum interest cre%itin# rate

( Bo$ s"oul% t"ese features be reco#ni1e% in capital requirements 6 If any a%+ustment is ma%e, it must tae into account t"e %ifference bet$een

current factors an% limitin# 'alues, as $ell as t"e insurers propensity to intro%ucea%+ustments


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Certain life insurance contracts often labele% asUniversal Life or Unit-linked - "a'e si#nificantin'estment features un%er $"ic" policy"ol%ers

accounts are cre%ite% $it" t"e rate of earnin#s%eri'e% from some e/ternal in%e/

( Policy"ol%ers t"erefore s"are %irectly in cre%it an%maret riss

( Bo$ s"oul% t"is be reco#ni1e% in capitalrequirements


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( &"e Cana%ian approac" is to #i'e cre%it for t"ein'estment pass)t"rou#" sub+ect to a restrictionrelate% to t"e companys efficiency in s"arin# its

e/perience $it" policy"ol%ers

( &"e normal capital requirements for cre%it rison t"ese pro%ucts is multiplie% by t"e factor@ 6 $"ere is t"e correlation bet$een t"ecompanys earne% interest rate on assetssupportin# t"is DOE an% t"e rate cre%ite% topolicy"ol%ers accounts


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In !ol'ency II FI!4- $e fin%


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Experience rating in group insurance is a form ofprofit s"arin#

( It may be %ifficult to reco'er past losses e'en$"en a contract is nominally fully e/periencerate%

( Certain arran#ements $"ere t"e client %epositsfun%s $it" t"e insurer t"at can be %ra$n upon int"e e'ent of se'ere losses may be an offset torequire% capital


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*utomobile policies sub+ect to bonus)malus appear tos"are in profit

( Bo$e'er, a%+ustments are usually ma%e to premiums insuccee%in# years

( &"ese arran#ements %o not #i'e t"e insurer access toany a%%itional financial resources to absorb t"e cost ofunfa'ourable claims e/perience

( No allo$ance for t"ese policies is ma%e in require%capital


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Ris Aiti#ation

Insurance companies "a'e t"e ability to transfer orot"er$ise miti#ate some of t"e ris t"ey bear

( &"e t$o principal met"o%s are 6 Reinsurance

6 Ginancial "e%#in#

( &o t"e e/tent t"at ris is re%uce%, it isappropriate to reco#ni1e ris miti#ation t"rou#"re%uctions in require% capital


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Ris Aiti#ation

!ol'ency II FI!4 states a number of usefulprinciples $it" respect to t"e reco#nition of rismiti#ation in capital requirements

( Require% capital s"oul% allo$ for t"e effects ofris miti#ation t"rou#"> 6 a re%uction in requirements commensurate $it" t"e

e/tent of ris transfer 6 appropriate treatment of any correspon%in# riss t"at

are acquire% in t"e process


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Ris Aiti#ation Principles

( &"e un%erlyin# impact on ris associate% $it" ris miti#ation s"oul% betreate% consistently, re#ar%less of t"e le#al form of t"e protection; Rismiti#ation arran#ements s"oul% be le#ally effecti'e an% enforceable

( Ris miti#ation arran#ements s"oul% pro'i%e appropriate assurance as to

t"e ris miti#ation ac"ie'e%, "a'in# re#ar% to t"e approac" use% to calculatet"e e/tent of ris transfer an% t"e %e#ree of reco#nition in require% capital

( &"e stan%ar% !CR calculation s"oul% reco#nise financial ris miti#ationtec"niques in suc" a $ay t"at t"ere is no %ouble countin# of miti#atin#effects

( H"ere t"e ris miti#ation instrument re%uces ris, t"e capital requirements"oul% be no "i#"er t"an if t"ere $ere no reco#nition in t"e stan%ar% capitalcalculation of suc" miti#ation instruments $"ere t"e ris miti#ationinstrument actually increases ris, t"en require% capital s"oul% be increase%


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( &o be eli#ible for reco#nition, financial ris miti#ation instrumentsrelie% upon s"oul% "a'e a 'alue o'er time sufficiently reliable topro'i%e appropriate certainty as to t"e ris miti#ation ac"ie'e%

( &"e insurer s"oul% "a'e $ritten #ui%ance re#ar%in# liqui%ityrequirements t"at financial ris miti#ation instruments s"oul% meet,accor%in# to t"e ob+ecti'es of t"e o$n insurers ris mana#ementpolicy

( Pro'i%ers of financial ris miti#ation s"oul% "a'e an a%equate cre%itquality to #uarantee $it" appropriate certainty t"at t"e insurer $ill

recei'e t"e protection in t"e cases specifie% by t"e contractin#parties; Cre%it quality s"oul% be assesse% usin# ob+ecti'etec"niques accor%in# #enerally accepte% practices


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*inancial mitigating instruments only can reduce the capital requirements if:

( They provide the insurer a direct claim on the protection provider directfeature&

( They contain e$plicit reference to specific e$posures or a pool of e$posures+

so that the e$tent of the cover is clearly defined and incontrovertible e$plicitfeature&

( They do not contain any clause+ the fulfilment of "hich is outside the directcontrol of the insurer+ that "ould allo" the protection provider unilaterally tocancel the cover or that "ould increase the effective cost of protection as aresult of certain developments in the hedged e$posure irrevocable feature&

( They do not contain any clause outside the direct control of the insurer thatcould prevent the protection provider from being obliged to pay out in atimely manner in the event that a loss occurs on the underlying e$posureunconditional feature&.


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Ris Aiti#ation

Reinsurance is usually reco#ni1e% $it"in

capital requirements as lon# as it is $ell

formulate% i;e; effecti'ely transfers ris-

( &"is reco#nition is partially offset by a

pro'ision for counterparty i;e; t"ereinsurer- %efault ris


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Ris Aiti#ation

Hedging is a ris mana#ement strate#y use% in limitin# or offsettin#probability of loss from fluctuations in t"e prices of commo%ities,currencies or securities 6 Ginancial "e%#in# often in'ol'es t"e purc"ase or sale of 'arious

financial %eri'ati'e contracts

( In t"e calculation of t"e ris capital c"ar#e, "e%#in# an% ris transfermec"anisms s"oul% be taen into account if t"ey satisfy #eneral rismiti#ation principles

( *s a #eneral rule, "e%#in# instruments s"oul% only be reco#ni1e%

$it" t"e a'era#e protection le'el o'er t"e ne/t year 6 for e/ample, $"ere an equity option pro'i%es protection for t"e ne/t si/

mont"s, as a simplification, it s"oul% be assume% t"at t"e option onlyco'ers "alf of t"e current e/posure;


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Ris Aiti#ation

( Gor re#ulatory capital, many super'isors $oul%

not accept an assumption of t"e purc"ase

a%%itional "e%#in# instruments for e/ample, as

part of a %ynamic "e%#in# pro#ram- beyon%t"ose in force at t"e balance s"eet %ate

( In some cases, t"is restriction only applies $"ena stan%ar% calculation approac" is taen


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Ris epen%encies

( Aany of t"e ran%om 'ariables t"at #i'e rise tot"e riss $e are consi%erin# are, in some sense,relate%

( &"ese relations can ser'e to ma#nify or re%ucetotal ris an% t"erefore also total require% capital

( He use t"e lan#ua#e of probability to attempt to%escribe t"ese relations"ips, in particular $e uset"e notion of correlation


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Ris epen%encies

( Consi%er, for e/ample, $"at is implie% by a statement t"at in lifeinsurance, policy lapse an% mortality are positi'ely correlate%

( &"is coul% e/press t"e obser'e% p"enomenon t"at it is t"e "ealt"ierli'es t"at "a'e "i#"er lapse rates, so t"e remainin# insure%population "as poorer "ealt" an% "i#"er mortality rates

( Note t"at t"is is not a symmetric relations"ip since "ere lapseinfluences mortality but mortality %oes not necessarily influencelapse

( Correlation may be a con'enient %e'ice to use an% con'enientlan#ua#e to e/press t"ese relations"ips, but it may not preciselycapture t"e situation $e see to mo%el an% measure


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Ris epen%encies

( *ssume $e "a'e n %istinct riss J@, , Jn $it" require%capital C for ris J

( *ssume +- is t"e symmetric n / n matri/ of correlationsbet$een t"e riss, so L @ for all L @, ,n

( &"e total require% capital usin# t"e met"o% ofcorrelations is C L M + + / C + / C-N

( If all + L @, C L J@ Jn -2-N L J@ Jn


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Ris epen%encies

( In Cana%a, require% re#ulatory capital C is %efine% to bet"e sum of t"e Cs $"ic" is equi'alent to assumin# allriss are perfectly correlate% 6 !eemin#ly, a 'ery conser'ati'e approac"

( &"e :;!; REC requirement uses correlations t"at areeit"er 0 or @ 6 &"e effect of t"is use of correlation is si#nificant 6 Gor similar companies in t"e :;!; an% Cana%a, t"e :;!; require%

capital is as lo$ as Q of Cana%ian requirements t"e re%uction isprimarily %ue to to t"e correlation factor

( !ol'ency II maes e/tensi'e use of correlations


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Ris epen%encies

( !ol'ency II employs a t$o)le'el correlation

structure

6 Girst, correlation is applie% to all requirements of t"e

same ris type to #i'e total require% capital for t"at

ris type

6 !econ%ly, correlation is applie% to t"e results of t"efirst le'el to obtain t"e total require% capital


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!ol'ency II Correlations


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Ris epen%encies

( *ll correlations in !ol'ency II are multiples of 0;2

( &"is is an in%ication t"at $e %o not really no$ "o$ to%etermine correlations 6 &"ey are sub+ecti'e, base% upon e/perience 6 %ri'en +u%#ment

( * si#nificant %ifficulty is t"at correlations are not stable 6 In particular, correlations bet$een e/treme or


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Ris epen%encies

( &"e !ol'ency II t$o)tier correlation structure

may not be lo#ically consistent

6 c;f; amir Gilipo'ic", :ni'ersity of ienna

( Gurt"er, relations"ips bet$een %ifferent sources

of ris often 'ary by many factors inclu%in#

pro%uct %esi#n

6 Reflection of correlation as bet$een ma+or sources of

ris is liely a %istortion of t"e real nature of riss


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Ris epen%encies

*not"er met"o% to e/press t"e relations"ip bet$een se'eral ran%om 'ariablesis t"rou#" t"e use of copulas

( Det J@, , Jn be t"e n ran%om 'ariables t"at represent our sources of ris

( !uppose G/- is t"e cumulati'e %istribution function of J

( * +oint %istribution of J@, , Jn is a probability %istribution function0 S G/@, ,/n- S @

( *n n)%imensional copula is a real)'alue% function $it" 'alues in T0, @U,Cy@, yn-

( &"ere is a correspon%ence bet$een +oint %istributions an% copulas #i'en byG/@, ,/n- L CG@/@-, , Gn/n--


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Ris epen%encies

( &"e complete relations"ip bet$een 'arious ran%om'ariables is %escribe% by t"e +oint %istribution function, G

( He can use copulas an% t"e mar#inal %istributions of t"ein%i'i%ual Js to #enerate t"ese relations"ips

( He must c"oose a particular copula from a collection ofa'ailable copulas $it" no$n properties

( &otal capital require% $oul% be base% upon t"e e/treme


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Ris epen%encies

( *n alternati'e $ay to %escribe relations"ips bet$een ris 'ariablesis a'ailable $"en one %etermines require% capital un%er ana%'ance% met"e% usin# internal mo%els

( In t"is case, one $oul% buil% into t"e %escription of t"e company,particularly into t"e assumptions #o'ernin# financial e/perience,e/plicit relations"ips bet$een %ifferent ris factors

( ./amples> 6 Eot" inci%ence an% reco'ery rates for %isability income replacement

insurance are influence% by economic 'ariables

6 In some pro%ucts, policy"ol%er be"a'ior "as a stron# influence on futuremortality

6 In some pro%ucts, policy"ol%er be"a'ior is influence% by financialin%ecies


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*'ailable *ssets

In a%%ition to specifyin# t"e capital require% by an insurer to bear itsriss, it is important for a capital sc"eme to specify $"ic" of t"ecompanys assets may be admitted in satisfyin# t"e requirement

( *ssets an% t"e 'alues attribute% to t"em in t"e companys financialstatements are lar#ely %etermine% by accountin# rules

( Not all t"e 'alue of t"ese assets can necessarily be easily reali1e%,particularly in times of stress

( Certain assets are not a%mitte% for t"ese purposes since t"ey %onot "a'e ob'iously reali1able 'alues e/amples inclu%e 6 Gurniture an% equipment 6 eferre% acquisition costs 6 eferre% ta/ assets


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*'ailable *ssets

( Not all a%mitte% assets "a'e 'alues t"at can bereali1e% $it" equal ease

6 Aany bon%s may be rea%ily maretable

6 Real estate is not as rea%ily sol% an% if sol% un%er%istress, may not reali1e t"e 'alue for $"ic" it is "el%on t"e balance s"eet

( He t"erefore classify assets as to quality $it"respect bein# a'ailable to meet t"e companysfinancial nee%s in times of stress


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*'ailable *ssets

&"e t"ree primary consi%erations for %efinin# t"e capital ofa company for purposes of measurin# capital a%equacyare>

( its permanence

( its bein# free of man%atory fi/e% c"ar#es a#ainstearnin#s

( its subor%inate% le#al position to t"e ri#"ts of

policy"ol%ers an% ot"er cre%itors of t"e institution


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*'ailable *ssets

( It is no$ common for assets to be classifie% inTiers $it" respect to t"eir suitability in supportin#require% capital

( &"is sc"eme $as first %e'elope% un%er t"eEasel *ccor% for international banin# capitalrequirements

( It "as been a%opte% for insurance in a number of +uris%ictions, particularly t"ose t"at "a'einte#rate% financial re#ulators


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*'ailable *ssets

( &"e Cana%ian system, for e/ample, uses t$otiers

( &ier @ Vcore capitalV- comprises t"e "i#"estquality capital elements

( &ier 2 Vsupplementary capitalV- elements fall

s"ort in meetin# eit"er of t"e first t$o capitalproperties liste% abo'e permanence an% free offixed charges-, but contribute to t"e o'erallstren#t" of a company as a #oin# concern


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*'ailable *ssets

&ier @ capital elements are restricte% to t"e follo$in#>

( Common s"are"ol%ersW equity, %efine% to inclu%e common s"ares,contribute% surplus, an% retaine% earnin#s

( Fualifyin# non)cumulati'e perpetual preferre% s"ares

( Fualifyin# inno'ati'e tier @ instruments( Participatin# account( Non)participatin# account for mutual companies-( *ccumulate% net after)ta/ forei#n currency translation a%+ustment( Net %eferre% #ains7losses on real estate t"at "a'e not been taen into

account in t"e 'aluation of policy liabilities less 4X on t"e portion of

#ains7losses on $"ic" no income ta/es payable "as been accounte% for, ort"e future income ta/ amount

( Fualifyin# non)controllin# interests in subsi%iaries arisin# on consoli%ationfrom tier @ capital instruments


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*'ailable *ssets

( &ier @ capital instruments are inten%e% to be permanent

( H"ere tier @ preferre% s"ares pro'i%e for re%emption by

t"e issuer after fi'e years, $it" super'isory appro'al, t"eOffice $oul% not normally pre'ent suc" re%emptions by"ealt"y an% 'iable companies $"en t"e instrument is or"as been replace% by equal or "i#"er quality capitalinclu%in# an increase in retaine% earnin#s, or if t"e

company is %o$nsi1in#; &"e re%emption or purc"ase forcancellation of tier @ instruments requires t"e priorappro'al of t"e !uperinten%ent


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*'ailable *ssets

&ier 2 is %i'i%e% in t"ree sub)tiers

( &ier 2*> Bybri% %ebt7equity- capital instruments

6 Bybri% capital inclu%es instruments t"at are essentiallypermanent in nature an% t"at "a'e certain c"aracteristics of bot"equity an% %ebt

( &ier 2E> Dimite% life instruments

6 Dimite% life instruments are not permanent an% inclu%esubor%inate% term %ebt an% term preferre% s"ares

( &ier 2C> Ot"er capital items


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*'ailable *ssets

Common shareholders equity i.e.+ common shares and retained earnings& andpolicyholders equity mutual companies& should be the predominant form of acompanys tier , capital

The follo"ing limitations apply to capital elements after the specified deductionsand ad#ustments:

( a strongly capitali-ed company should not have innovative instruments andnoncumulative perpetual preferred shares that+ in aggregate+ e$ceed 40% ofnet tier , capital

( innovative instruments shall not+ at the time of issuance+ comprise more than,5% of net tier , capital

( the amount of capital elements+ net of amorti-ation+ included in tier / shall note$ceed ,00% of net tier , capital

( limited life instruments+ net of amorti-ation+ included in tier / shall not e$ceeda ma$imum of 50% of net tier , capital


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Capital Ratios

( It is common to measure a firms capital ratio as

a'ailable assets- 7 require% capital-

( Certain capital tar#ets are often e/presse% asminimum ratios 6 t"e Cana%ian minimum is @20X 6 t"e Cana%ian super'isory tar#et is @0X 6

companies are encoura#e% to establis" t"eir o$ntar#et ran#es( a common c"oice is @8X ) 200X

6 t"e Cana%ian in%ustry a'era#e is in e/cess of 220X


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Capital Ratios

*sset quality requirements can also be

e/presse% in terms of capital ratios

( Cana%a "as a minimum tier @ ratio of 50X

( &"e minimum super'isory tier @ ratio is@0X represents 80X of t"e @0X total

super'isory tar#et ratio


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Capital Ratios

( In banin#, t"e Easel *ccor% $as initiallyfocuse% on assets an% cre%it ris inparticular

( !ubsequent re'isions to t"e Easel *ccor%e/ten%e% co'era#e to maret ris

associate% $it" t"e portfolio of assets aban "ol%s for tra%in# an% to operationalris


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Capital Ratios

( Require% capital is e/presse% in terms of a fi/e%percent of assets

6 &"e same factor, X, is applie% to all assets

6 &o account for %ifferin# asset quality, assets are ris)$ei#"te%

6 Require% capital for ot"er riss is multiplie% by @2;t"e reciprocal of X-, t"e result is inclu%e% in ris)$ei#"te% assets, to $"ic" t"e X factor is applie% tot"e %etermine total require% capital


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Capital Ratios

( :n%er t"e Easel *ccor%, a bans minimum capital ratio isrequire% capital e/presse% as a percent of ris $ei#"te%assets

( &"e minimum ratio is X

( &"e minimum &ier @ ratio is 4X

( O!GI requires Cana%ian bans to "ol% a minimum &ier @ratio of 8X an% a minimum total ratio of @0X 6 &"at t"is is a soun% policy "as been %emonstrate% by t"e stren#t"

of t"e Cana%ian banin# system %urin# t"e current $orl% financialcrisis


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Fuestions an% iscussion

Capital Requirements for Insurers - Part 4

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