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
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Agenda
 Overview of group capital adequacy
 Approaches to group capital adequacy assessment
 Components of group capital requirements
 Considerations for group capital resources
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Objectives of Capital Adequacy Requirements
Insurers
Supervisor
• Absorb significant unforeseen losses to reduce:
• likelihood of failure
• losses to policyholders in the event of failure
• Have different degrees of supervisory
intervention
 ULTIMATE AIM: Policyholder obligations continue to be met
as they fall due including in adversity
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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.
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Overview of Capital Adequacy Components
Supervisory Reporting
Public Financial Reporting
Capital =
Assets less
Liabilities
Assessment
Value of assets
for supervisory
purposes
Assets
Technical provisions
Group
Capital
requirements
Group
Capital
resources
Margin over
current estimate
Liabilities
Liabilities*
Current
estimate
Regulatory capital
requirements
Insurer’s
financial position
Assets
Liabilities
* Assuming nil Other Liabilities
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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
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Definition of an “Insurance Group”
Holding
Company
Insurer A
Special
Purpose
Entity
Bank A
Hedge
Fund
Supermarkets
Participation
Reinsurer
Insurer B
Influence
Risk exposure
Interconnectedness
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Sources of Group Risk
Governance
• 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
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Double/Multiple Gearing and Intra-group Creation
of Capital
Group Capital Adequacy
700
1500
Parent Bank
800
With multiple gearing
5500
4000
Participation=500
Invest
900
Asset
Liab.
Cap.Req.
Surplus
100
900
Participation=500
Invest
Insurer
Capital
Resources
8100
Liab.
Cap.Req.
Surplus
Cap.Req.
Surplus
Without multiple gearing
100
100
500
Securities
Firm
800
+800
+400
=2000
800
9000
Asset
1500
+900
+500
=2900
400
4000
3500
Asset
Liab.
Cap.Req.
Surplus
1500
+900
+500
-500
-500
=1900
Capital
Resources
800
+800
+400
=2000
Cap.Req.
Deficit

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
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Excessive Leverage
Use proceeds
to buy shares
(Non-)
Regulated
Parent
Insurer
Issues
debt
Investors
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
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Examples of Intra-group Transactions and
Exposures (ITEs)
Committed
facility
Letter of
credit
Guarantee
Subordinated
loan
Letter of
comfort
• 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
• Legal commitment, usually issued by a bank, that guarantees
payment under specified conditions
• Can be used to provide capital support, particularly internal
reinsurance
• 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
• A type of loan that is junior to other debts should a company be
wound up
• Can be used to provide capital support
• 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
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Risks Arising from ITEs
Pressure on insurers
Contagion
- capital, income
transferred out
- failure of one group entity
can adversely affect other
(insurance) entities
Capital quality
- replace high quality
capital
Supervisory challenge
- opaque and complex
structure
Regulatory arbitrage
- evade capital
requirements
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Agenda
 Overview of group capital adequacy
 Approaches to group capital adequacy assessment
 Components of group capital requirements
 Considerations for group capital resources
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General Approaches to Setting Group Capital
Adequacy Requirements
O R G A N I S AT I O N A L P E R S P E C T I V E
Legal Entity Focus
Group Level Focus
SUPERVISORY PERSPECTIVE
More weight • Capital adequacy assessed for
on groupall relevant legal entities
wide
taking into account group
supervision
impact
• Results binding for host and
group-wide supervisors
• Capital adequacy assessed as
though the group behaves as
a single integrated entity
More weight • Capital adequacy assessed for
on legal
all relevant legal entities
entity
taking into account group
supervision
impact
• Non-binding results - host
supervisors apply insurance
legal entity capital adequacy
requirements
• Capital adequacy assessed as
though the group behaves as
a single integrated entity
• Results binding for host and
group-wide supervisors
• Non-binding results - host
supervisors apply insurance
legal entity capital adequacy
requirements
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Factors to Consider in Selecting an Approach
Legal
Authority
Supervisory
Role
Supervisory
Philosophy
Insurance
Group
Structures
Supervisory
Cooperation
Arrangements
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Group Capital Adequacy Assessment Techniques
Consolidation
Techniques
Deduction
Aggregation
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Sample Group
8
40
32
315
275
Asset
Liab.
Cap.Req. Surplus
Parent Bank
Insurer
Securities Firm
Non-regulated
Entity
5
22
2
12
10
150
7
Liab.
120
203
Cap.Req. Surplus
10
225
138
Asset
3
17
Asset
Liab.
113
Cap.Req. Surplus
Asset
Liab.
Cap.Req. Deficit
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Consolidation Method
Parent Bank
(Consolidated)
Securities Firm
Insurer
5
8
40
32
12
Liab.
Asset
Liab.
315
+ 150
+ 225
+ 120
= 810
Asset
Cap.Req. Surplus
Asset
32+10
+17+
10=69
275
+ 138
+ 203
+ 113
= 729
Liab.
120
203
12
81
Cap.Req.
Consolidated Group
10
225
138
Cap.Req. Surplus
3
17
7
10
150
275
Asset
22
2
315
Non-regulated
Entity
Liab.
113
Cap.Req. Surplus
Asset
Liab.
Cap.Req. Deficit

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
Group
Surplus
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Aggregation Method
Group Aggregation
Parent Bank (Unconsolidated)
67
+12
+ 22
+7
= 108
67
315
+ 10
+ 12
+5
= 342
275
22
12
203
138
Asset
Liab.
Insurer
Asset
Liab.
Securities Firm
81
Group
Surplus

Suitable if:
 Consolidated financial statements
not available
113
 ITEs cannot be netted out
Liab.
Non-regulated
Entity
Capital
Req.
Capital resources adjusted to eliminate
double gearing of down-streamed capital
120
Asset
32+10
+17+
10=69

7
225
150
12
Capital
Down- Adjusted
Resources streamed Capital
capital Resources
Liab.
Asset
10+12
+5
= 27

Issue: Recalculation of capital
requirements for insurers
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Deduction Method
Parent Bank
(Unconsolidated)
Deduct
investments in
dependants
Add
dependant’s
surplus/deficit
67
315
+ 10
+ 12
+5
= 342
Asset
275
Liab.
67
10 +
12 + 5
= 27
Capital
Resources
2+5
-3=4
12
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Adjusted Parent’s
Capital
Capital
Req.
Resources
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
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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.
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Fungibility of Capital and Transferability of Assets
Exchange
controls
Participating
fund
Tax Laws
Reasons
for Lack of
Fungibility
 Adjust capital
resources
Capital holders’
rights
Legal
enforceability
of ITEs
 Stress versus
normal conditions
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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
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Minority Interest
Parent + Insurer
10
Parent
100
90
Capital Capital Surplus
Resources Req.
100%=40
60%=60
=>40 minority interest
Insurer
40
Full Integration
Capital Capital Surplus
Resources Req.


100
25
100
25
Capital Capital Surplus
Resources Req.
90
+25
=
115
15
Capital Particip. Capital Deficit
Resources
Req.
Bank
75
15
40
100
+40
=
140
100
+
40
+
100
=
240
40+
60=
100
140
100
+
40
+
60
=
200
90
+25
+25
=
140
Capital Particip. Capital
Resources
Req.
Pro-rata Integration
Surplus
=0
40+
60=
100
100
90
+25
+15
=
130
Capital Particip. Capital
Resources
Req.
30
Deficit
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
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Agenda
 Overview of group capital adequacy
 Approaches to group capital adequacy assessment
 Components of group capital requirements
 Considerations for group capital resources
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Process of Setting Regulatory Capital Requirements
Determine
approach
Determine PCR
and MCR
Aggregate risks
Identify risks
Calibrate capital
requirements
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General Approaches to Setting Capital Requirements
Standardised
Approach
Internal Model
Approach
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)
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Identify Risks: Material and Relevant
Underwriting Risk
Credit Risk
Market Risk
Operational Risk
• 1918 flu pandemic, hurricane Katrina, Fukushima
earthquake
• E.g.: Sum at risk X 0.23%
• Enron, Lehman Brothers
• E.g.: AAA Corporate bond value X 0.25%
• 1930 Great Depression, Black Monday 1987, 2007
Financial Crisis
• E.g.: Value of equity X 30%
• Barings Bank, London Whale
• E.g.: Gross premium X 3%
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Pause for Thought – Liquidity Risk
Should insurers be required to hold capital to address
liquidity risk?
Answer:
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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
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Calibrate Regulatory Capital Requirements
Confidence
Level
Cost
Safety
?
Target
Criteria
Shock
period
0
?
1
T=1
2
3
…
Effect
period
n
Time
Horizon
Risk
Measure
VaR
TVaR
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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
VaR @ 99%:
1% chance of loss>$10m
TVaR @ 99%:
Average of worst 1% losses
$10m $15m
Losses
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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
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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
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Determine PCR and MCR
Capital
Requirements
Prescribed
Capital
Requirement
(PCR)
 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
Technical
Provisions
Minimum
Capital
Requirement
(MCR)
 Method may be different than for 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
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Example - Solvency Control Levels
Capital Adequacy Ratio
= Capital Resources
_
Capital Requirements
190%
• Prescribed capital requirement (PCR) level
• Group does not need to restore capital resources/reduce risk
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
110%
• Minimum capital requirement (MCR) level
• Winding-up of operation
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Practical Considerations
Risk Capture
Practical
Considerations
Recalibration
Proportionality
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Agenda
 Overview of group capital adequacy
 Approaches to group capital adequacy assessment
 Components of group capital requirements
 Considerations for group capital resources
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Pause for Thought – Ordinary Shares
What are the features of ordinary shares that make them high
quality capital resources?
Answer:
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Criteria to Assess Quality of Capital Elements
•
•
•
•
•
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
Encumbrances
Subordination
Permanence
Availability
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. ringfenced funds
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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
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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
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End of Presentation
Any Questions?
Jeffery.Yong@bis.org
www.bis.org/fsi
www.fsiconnect.org
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