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INTERNATIONAL ASSOCIATION OF
INSURANCE SUPERVISORS
GUIDANCE PAPER ON CAPITAL RESOURCES FOR SOLVENCY
PURPOSES
DRAFT, APRIL 2008
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Preamble
The IAIS is committed to the development of a set of cohesive standards and
guidance papers on solvency assessment which build on earlier work in the
Framework, Cornerstones and Structure papers. This guidance paper is an interim
stage in that process.
The key features in this guidance paper are expected to form the basis of proposed
standards. The IAIS acknowledges that there is further work that needs to be
completed as supervisory practice is still emerging, but has published this paper to
express the IAIS’s current positions prior to completion of those standards.
As the IAIS Solvency and Actuarial Issues Subcommittee continues its work to
develop standards and associated guidance, this guidance paper may need to be
reviewed so that the standards, guidance papers, and other papers developed will be
consistent. It is also expected that as further work is completed on solvency papers,
especially work on the standards regarding valuation, additional issues may be
identified that need to be addressed in the standards and guidance papers.
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Guidance paper on Capital Resources for Solvency Purposes
Contents
1.
Introduction
2.
Definition of capital resources for solvency purposes
3.
Valuation of assets and liabilities in the context of capital resources for solvency
purposes
3.1
Relationship between prudential reporting and public financial reporting
4.
Approaches to capital resources for solvency purposes
5.
Assessing the quality of capital elements
5.1
Capital must be available to absorb losses in wind-up or insolvency
5.2
Capital must available for a sufficiently long period
5.3
Capital must normally be paid up
5.4
Capital must have restrictions or limits on mandatory servicing requirements
5.5
Other considerations
6.
6.1
7.
Categories of capital resources
Core and supplementary capital
Transparency of approach to capital resources
Appendix
1
Introduction
1.
Since its inception in 1994, the IAIS has developed a number of principles,
standards and guidance papers to help promote the development, globally, of
well-regulated insurance markets. Central to this objective is the development of
a common framework for insurance supervision that establishes a common
structure within which standards and guidance on insurance solvency
assessment may be developed. Insurer solvency takes a central position in risk
management by insurers and in insurance supervision. Consideration of the
standards and guidance that should apply in relation to capital resources for
solvency purposes, therefore, contributes towards the development of the IAIS
framework for insurance supervision.
2.
A sound solvency regime is essential to the supervision of insurance
companies; regulatory capital requirements are a fundamental part of a
solvency regime. Insurers face uncertainty both as underwriters of risk and as
general business enterprises. In addressing this uncertainty, both insurers and
supervisors recognise that an insurer’s capital functions as a shock absorber
against unforeseen losses. Sufficient capital is critical to an insurer’s ability to
meet its obligations to policyholders and creditors and to finance future growth
in its business.
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3.
The IAIS Insurance core principles and methodology (Oct 2003) provide a
globally-accepted framework for the regulation and supervision of the insurance
sector. Insurance core principle (ICP) 23 states that:
“the supervisory authority requires insurers to comply with the prescribed solvency
regime. This regime includes capital adequacy requirements and suitable forms of
capital that enable the insurer to absorb the unforeseen losses.”1
4.
The IAIS Framework and Cornerstones papers 2 identify some of the main
elements in a regulatory and supervisory regime, comprising both quantitative
(financial) and qualitative (governance and market conduct) components. The
framework for insurance supervision emphasises the interdependence of the
quantitative and qualitative aspects in the assessment of insurer solvency.
5.
This guidance paper provides guidance on the 8 principles-based requirements
for a solvency regime in relation to capital resources for solvency purposes. The
aim of the guidance paper is to support the enhancement, improved
transparency and comparability and convergence of the assessment of insurer
solvency internationally. The pre-conditions in a particular supervisory regime,
among other factors, will determine the specifics of effective supervision within
that regime, including the specific requirements of the solvency regime in
relation to capital resources for solvency purposes.
6.
This guidance paper addresses issues in relation to capital resources for
solvency purposes. This includes criteria for determining the suitability of
elements of capital for inclusion in capital resources for solvency purposes and
also for assessing the quality of the different elements that may comprise
capital resources. Issues related to the structure of regulatory capital
requirements in a supervisory regime for solvency assessment are covered in
the [Guidance Paper on the Structure of Regulatory Capital Requirements (Dec
2007)].
7.
Capital is defined broadly as the value of assets less the value of liabilities. To a
significant extent, therefore, the amount of capital resources for solvency
purposes depends on the valuation of assets and liabilities in the solvency
regime. Standards and guidance on the valuation of assets and liabilities for
solvency purposes is relevant to the approach to capital resources. In this
regard, the IAIS has issued a Position paper3 on the key concepts in regard to
the valuation of technical provisions, which reflects a market-consistent
valuation approach. For illustration, some valuation issues relevant to the
determination of capital resources for solvency purposes are also considered in
section 3 of this paper.
8.
This guidance paper focuses on the insurer as a single entity. Where an insurer
is a member of a group of companies, it is recognised that the solvency regime
should consider the relationship between those companies and the potential
impact on the quality of capital resources at the solo and group level. The
1
ICP 23: Capital adequacy and solvency.
IAIS Framework for insurance supervision (Oct 2005) and Cornerstones for the formulation of regulatory
financial requirements (Oct 2005)
The Summary of IAIS positions on the valuation of technical provisions (Oct 2007) is a summary of
previously stated IAIS positions on this topic.
2
3
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issues of group-wide supervision, however, are not within the scope of this
paper and are the subject of a separate IAIS work. 4
2
Definition of capital resources for solvency purposes
Requirement 1
Technical provisions, other liabilities and regulatory capital requirements should be
covered by adequate assets of appropriate nature and quality.
9.
The IAIS recognises the need to assess the overall financial position of an
insurer based on consistent measurement of assets and liabilities and explicit
identification and consistent measurement of risks and their potential impact on
all components of the balance sheet. In this context, the IAIS uses the term total
balance sheet approach to refer to the recognition of the interdependence
between assets, liabilities, regulatory capital requirements and capital
resources. A total balance sheet approach should also ensure that the impacts
on an insurer’s overall financial position are appropriately and adequately
recognised.
10.
The term capital has a wide variety of meanings in the global financial
marketplace. Broadly defined, however, capital represents the economic
resources held or controlled by an insurer after deducting the amount of
economic resources necessary for the insurer to satisfy its obligations.
11.
In this guidance paper, the term capital resources is defined as the amount of
an insurer’s assets in excess of the amount of its liabilities that is regarded as
available for solvency purposes. Liabilities in this context includes technical
provisions and other liabilities including obligations to capital providers (to the
extent these other liabilities are not treated as capital resources). Assets in this
context refers to the insurer’s economic resources that are regarded as
available for solvency purposes and may include contingent assets.
12.
The total amount of capital resources comprises different capital instruments
and these elements of capital may be regarded differently when determining
the capital resources available for solvency purposes. Each element of capital is
associated with the economic value of the assets or commitments secured
through the capital instrument net of the economic value of the obligations to
capital providers.
13.
Figure 1 conceptually illustrates the above definitions.
4
The IAIS has developed principles on group-wide supervision and is currently developing a draft issues
paper on insurance group solvency as a precursor to IAIS standards and guidance on group issues.
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Figure 1: Assets, Liabilities and Capital Resources
Insurer’s
Assets
Capital
Resources
Liabilities
Total Assets Available
for Solvency Purposes
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Total
Liabilities
6
3
Valuation of assets and liabilities in the context of capital resources for
solvency purposes
Requirement 2
The solvency regime should address the valuation of assets and liabilities for
solvency purposes.. The approach to the valuation of assets and liabilities should be
consistent with the approach to determining capital resources and capital
requirements.
14.
As indicated above, to a significant extent the detailed requirements in relation
to capital resources for solvency purposes depend on the valuation of assets
and liabilities in the solvency regime and the IAIS is developing standards and
guidance on the valuation of assets and liabilities for solvency purposes. Hence
only some of the valuation issues relevant to the determination of capital
resources for solvency purposes are considered in this paper.
3.1 Relationship between prudential reporting and public financial reporting
15.
Capital is defined in public financial reporting as net assets, that is, assets that
are in excess of those needed to satisfy the insurer’s liabilities. Some
jurisdictions have different reporting standards for public financial reporting and
prudential reporting. The stated capital position of an insurer may well differ
between these two financial reporting regimes. Other jurisdictions have only one
set of financial reporting standards. In such jurisdictions prudential reporting and
the supervisory assessment of the solvency of an insurer takes as its starting
point the accounting principles used for public financial reporting.
16.
Given that the IAIS has a clear preference for as much similarity between public
financial reporting and regulatory reporting for solvency assessment purposes
as is appropriate, this paper also assumes that technical provisions and to the
extent relevant and appropriate, the amount of capital resources available for
solvency purposes, would also be determined in a manner that is substantially
consistent with the methodologies used for public financial reporting purposes,
to the extent that public financial reporting in the regime is broadly consistent
with IAIS principles in regard to the valuation of assets and liabilities for
solvency purposes.
17.
In assessing solvency the supervisor should be aware that the amount reported
as capital in public financial reporting is dependent on the degree of recognition
of, and the values placed on, all assets and liabilities on an integrated basis.
Where there are differences in the reporting standards for public financial
reporting and prudential reporting, adjustments or "prudential filters" may be
applied to meet the specific aims of prudential regulation and supervision. Also,
there are liabilities such as subordinated debt that, although recognised as
liabilities under public financial reporting can under certain circumstances be
given credit for regulatory purposes as capital resources.
18.
Some of the considerations in using public financial reporting as the basis for
the valuation of assets and liabilities for solvency purposes include:
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
which assets and liabilities are recognised on the balance sheet;

how they are valued; and

whether some liabilities may be regarded as capital resources for regulatory
purposes.
19.
When determining the amount of capital resources for solvency purposes, it
may be considered to take into account that the value of the assets and
liabilities may be different under different scenarios. For example, some assets
on the balance sheet may lose some or all of their value in the event of a windup or run-off, for example, because of a forced sale. The value of an asset may
also reduce in the event the insurer closes to new business. Similarly, some
liabilities may actually have an increased value if the business will not continue.
For example, senior debt may be valued below par during ongoing operations
but at par in insolvency..
20.
The supervisory regime may take into account these different circumstances
when considering the elements of capital that will be regarded as capital
resources for solvency purposes. Under such an approach, the supervisor may
consider whether and to what extent a potential reduction in the asset values (or
an increase in the value of liabilities) should be reflected in the determination of
capital resources. The circumstances considered should be consistent with
those used for determining regulatory capital requirements (e.g. the approach to
new business).
21.
Alternatively, the determination of capital resources could be based on the
solvency valuation of assets and liabilities without further adjustments to these
values, and the potential variation of assets and liabilities under adverse
scenarios could be captured in the amount of regulatory capital requirements.
22.
Certain assets may not be fully acceptable to be regarded as suitable for
solvency purposes due to their questionable realisable value. However, within
limits, a proportion may be acceptable according to the legislative, accounting
and tax system of the jurisdiction. Examples include:

intangible assets: while they represent a value to the company on an
ongoing basis, their value is uncertain at the time of run-off or wind-up and
may then have no significant marketable value;

implicit accounting assets: under some accounting models, certain items
regarding future income are included, implicitly or explicitly, as asset
values. In the event of run-off or wind-up, such future income may be
reduced. Examples of such items might include the reduced present value
of future profit margins and unamortized acquisition expenses;

future income tax credits: such credits may only be realisable if there are
future taxable profits, which is improbable in the event of insolvency or
wind-up; and

company-related assets: certain assets carried on the accounting
statements of the insurer could lose some of their value in the event of run-
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off or wind-up, for example physical assets used by the insurer in
conducting its business which may reduce in value of there is a need for the
forced sale of such assets. The accounting value of such assets should be
reviewed, and any anticipated loss should be taken into account when
determining an insurer’s capital resources.
23.
4
Examples of other elements that may be fully or partially included as capital
resources depending upon the rules and circumstances of the jurisdiction are:

unrecognised gains and losses and their associated tax liabilities and other
relevant realisation expenses: defined as the difference between current
market values of investments and the value of the investments on the
financial statement balance sheet. This would only apply to the extent that
unrecognised gains and losses on assets backing technical provisions have
not been taken into account in the valuation of technical provisions or other
liabilities;

general provisions: are created against the possibility of future losses not
yet identified. Where they are not ascribed to particular assets and do not
reflect an identified reduction in the valuation of particular assets, these
provisions may qualify for inclusion as capital resources;

equalisation reserves and catastrophe provisions are amounts set aside on
the balance sheet in compliance with legal or administrative requirements
to equalise fluctuations in loss ratios in future years or to provide for special
risks. To the extent such events have not actually happened, these
amounts may qualify for inclusion as capital resources. Under International
Financial Reporting Standards such reserves and provisions are no longer
a liability;

members’ commitments to provide capital when needed, and

investments in related parties: consideration should be given to the
possibility that such investments may become impaired at the same time
that parental support for the insurer within an insurance group is weakened.
Approaches to capital resources for solvency purposes
[Note to SSC: this section needs further discussion and (probably) revision as there
are different views as to the role of internal models in the context of determining
capital resources]
Requirement 3
The solvency regime should include an assessment of the quality of capital resources.
The solvency regime may include criteria for the recognition of different capital
elements in determining capital resources for solvency purposes according to the
quality of those capital elements or include qualitative requirements for the
composition of capital. The approach to capital resources for solvency purposes
should be consistent with the approach for setting capital requirements.
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24.
In a total balance sheet approach to solvency assessment, the impact of risks
associated with all balance sheet items should be taken into account. There are
two aspects to the elements of capital that need to be considered as part of this
process – the appropriate allowance for the quality of the elements of capital
that may comprise an insurer’s capital resources for solvency purposes, and the
level of risk inherent in these items. That is, a distinction needs to be drawn
between the quality of a capital instrument (based on its ability to absorb losses,
permanency and ranking) and the riskiness of the capital instrument (as
represented by assets net of obligations to capital providers). However, it
should be noted that it is not always possible to associate specific assets or
liabilities to individual capital instruments. These two concepts do not
necessarily coincide – for example, an insurer may have a capital instrument
with low risk but still poor quality as a loss absorbing instrument. However a
regime may allow for both aspects in the determination of regulatory capital
requirements, or in the determination of capital resources for solvency
purposes, or partly in each.
25.
Allowance may be made for the quality of, and level of risk inherent in, a capital
element in the determination of the regulatory capital requirements. For
example, where a standardised approach is used for the determination of
regulatory capital requirements, a scale of capital factors may be applied to the
value of the capital element to reflect both its risk and quality. On the other
hand, where internal modelling approaches are used to determine regulatory
capital requirements, allowance for the quality of, and risks inherent in, the
capital elements held by the insurer could be incorporated in the modelling
undertaken. That is, projections of the cash flows associated with the various
elements of capital (and all other assets and liabilities of the insurer) could be
undertaken under a range of scenarios as part of the internal modelling used to
determine the level of required regulatory capital based on the specified
modelling criteria.5
26.
Allowance for the quality of the various elements of capital that comprise capital
resources may be included in the determination of the regulatory capital
requirements as outlined above. Alternatively, it may be allowed for by applying
adjustments (limits or ‘prudential filters’) when determining the elements of
capital that are regarded as capital resources for solvency purposes. It is noted
that some jurisdictions prefer the latter approach or a combination of the two
approaches.
27.
Where internal modelling approaches are used to determine regulatory capital
requirements, allowance for the both the quality of, and level of risk inherent in,
the elements of capital held by an insurer may already be adequately reflected
in the results of the internal modelling undertaken. Further, internal modelling
can be used to provide an indication of the liquidity of an asset so that other
adjustments to reflect the quality of the asset may not be necessary and hence
making prudential filters redundant; however, this depends on the sophistication
and reliability of the models used.
5
Refer to the Standard and Guidance Paper on internal models
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28.
5
However in other cases, including where standard formulae approaches may be
used, allowance for the quality of different elements of capital needs to be
made. This can be done in a number of ways, including:

in the capital charges applied to different elements of capital in determining
regulatory capital requirements;

by setting quantitative limits or adjusting the amount of elements of capital
recognised as capital resources for solvency purposes to reduce or exclude
different elements of capital; or

a combination of these approaches.
Assessing the quality of capital elements
Requirement 4
The solvency regime should define minimum criteria for the elements of capital to be
regarded as capital resources for solvency purposes, including any requirement for
prior approval by the supervisor. The criteria should include:
i. capital must be available to absorb losses in wind-up or insolvency,
ii. capital must be available for a sufficiently long period, and
iii. capital must be paid up unless payment is highly likely when needed according to
specific criteria.
29.
30.
In assessing the quality of elements of capital, the following issues are expected
to be considered:

the extent to which the capital element is available to absorb losses in windup or insolvency;

the extent to which the capital element is available for a sufficiently long
period;

the extent to which the capital element is paid up;

the extent to which the capital element gives rise to mandatory payments;
and

other factors that may affect the availability of the capital element to absorb
unforeseen losses.
In defining capital resources available for solvency purposes, the supervisor
needs to consider the quality of various elements of capital and their ability to
absorb losses. In determining regulatory capital requirements, the regime and
the insurer should take into account the greater risk inherent in lower quality
capital instruments. For example, depending on the quality of capital resources,
losses will trigger insolvency proceedings in different scenarios. Minimum
qualitative requirements should be considered by reference to an insolvency
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threshold so that an appropriate proportion of insurers is expected to recover
from adverse experience without undergoing insolvency proceedings. This may
be a requirement additional to the overall level of safety of policyholders.
31.
From a regulatory perspective, the primary purpose of capital is to enable the
insurer to absorb the unforeseen losses that may occur and to act as a
safeguard for policyholders. Solvency regimes should apply, implicitly and
explicitly, a consistent set of criteria to assess the ability of elements of capital
to absorb losses incurred by an insurer and hence their suitability as capital
resources for solvency purposes.
32.
To the extent possible, efforts should be made to apply criteria which harmonise
the definition of suitability of capital elements for purposes of insurer solvency
assessment with other financial sectors in order to ensure a level playing field in
capital markets and to prevent or minimise regulatory arbitrage opportunities
between financial institutions.
33.
The following sections discuss these criteria in more detail. Figure 2
conceptually illustrates the relationship that may exist between the insurer’s
total economic resources (from a public financial reporting perspective), capital
resources for solvency purposes and regulatory capital requirements.
Figure 2: Economic Resources, Capital Resources and Capital Requirements
Total
Economic
Resources
Capital
Resources
for
Solvency
Purposes
Technical
Provisions
(TP) and
Other
liabilities
Total Assets
on Balance
Sheet
Total Assets
Available for
Solvency
Purposes
Required
Capital
Risk Margin
(RM)
Prescribed
Capital
Requirement
(PCR)
Minimum
Capital
Requirement
(MCR)
Current
Estimate
(CE)
Regulatory
Capital
Requirements
5.1 Capital must be available to absorb losses in wind-up or insolvency
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34.
To ensure that capital is available to protect policyholders, it must be legally
subordinated to the rights (including reasonable expectations) of policyholders
of the insurer in an insolvency or wind-up. This means that the holder of a
capital instrument is not entitled to repayment, dividends or interest once
insolvency or wind-up proceedings have been started until all obligations to the
insurer’s policyholders have been satisfied. In addition, it should not be possible
to defeat the subordination by applying rights of offset (i.e. so that creditors
cannot set off amounts they owe the insurer against the subordinated capital
instrument). Further, the instrument should not be guaranteed by either the
insurer or another related entity unless it is clear that the guarantee is available
subject to the policyholder priority. In some jurisdictions subordination to other
creditors may also need to be taken into account.
35.
The availability and suitability of a capital element for solvency purposes is often
linked to its priority in an insolvency or wind-up situation. Each jurisdiction is
governed by its own laws regarding insolvency and wind-up. In such events,
common equity shareholders normally have the lowest priority in any liquidating
distribution of assets, immediately following preferred shareholders. In some
jurisdictions, insurers can issue subordinated debt that provides protection to
policyholders and creditors in insolvency. While policyholders are often given a
legal priority above other creditors such as bondholders, this is not always the
case; some jurisdictions treat policyholders and other creditors equally. Some
jurisdictions rank obligations to the government (e.g. taxes) and obligations to
employees, ahead of policyholders and other creditors. Where creditors have
secured claims, they may come before policyholders. The determination of
suitable capital elements within a solvency regime is critically dependent upon
the legal environment of the relevant jurisdiction.
36.
The supervisor should evaluate each potential capital element in the context
that its value and suitability, and hence the insurer’s solvency position, may
change significantly in a wind-up or run-off scenario (refer to section 3.1 above).
In most jurisdictions the payment priority in a wind-up situation is clearly stated
in law. However, in order to be acceptable as capital resources for solvency
purposes, the capital element is to be subordinated to policyholders.
5.2 Capital must be available for a sufficiently long period
37.
To be suitable for inclusion as capital resources for solvency purposes, a capital
element must be available to protect against losses in insolvency or wind-up for
a sufficiently long period to ensure that it is available to the insurer if needed. A
minimum period to maturity should therefore be considered for capital
instruments to be regarded as capital resources for solvency purposes. This
minimum period should normally be medium to long-term (for example an
original maturity of at least five years). The appropriate minimum period should
take into account the expected term of the insurer’s liabilities and the time it
might take to replace the capital as on suitable terms as it approaches maturity.
38.
Similarly, if a capital instrument has no fixed maturity date, notice of repayment
should be for the minimum period. The amount regarded as capital resources
for solvency purposes should be amortised if repayment is scheduled within this
minimum period. Capital instruments that have a fixed maturity date may also
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have fixed servicing costs that cannot be waived or deferred before maturity
unless insolvency or wind-up occurs; the presence of such features may make
an instrument ineligible as core capital.
5.3 Capital must normally be paid up
39.
In order to satisfy the primary requirement that capital be available to absorb
unforeseen losses, it is important that capital be fully paid. However, in some
cases where the probability of payment is expected to be high (for example
contributions from members of a mutual insurer) some component of capital
that is not fully paid up may be regarded as capital and recognised for solvency
purposes. Further, in some circumstances, a capital instrument may be paid for
"in kind" i.e. issued for non-cash. The solvency regime should define the extent
to which payment other than cash is acceptable for a capital element to be
treated as fully paid without prior approval by the supervisor and the
circumstances where payment for non-cash consideration, or the unpaid
component of a partly paid capital element, may be considered as suitable
subject to approval by the supervisor. There may, for example, be issues about
the valuation of the non-cash components or the interests of parties other than
the insurer.
5.4 Capital must
requirements
40.
have
restrictions
or
limits
on
mandatory
servicing
The extent to which capital requires servicing in the form of interest payments,
shareholder dividend payments and principal repayments should be considered,
since it will affect the insurer’s ability to absorb losses on an ongoing basis.
Requirement 5
The supervisor should have the ability to restrict the payment of dividends or interest
and any redemption of capital instruments for solvency purposes where appropriate.
An insurer should not be permitted to make discretionary payments if it is in breach of
a solvency control level which is deemed to be sufficiently serious.
41.
In order to ensure that capital is available to protect policyholders when needed,
it is important that the supervisor has the ability to take action, by means such
as the restriction of payment of dividends, interest or redemption of capital
instruments, to prevent the removal or reduction of capital resources in the
event the insurer is getting into financial difficulty. The supervisor should
analyse possible scenarios to ensure that on an ongoing basis, appropriate
rules are in place to prevent the removal of the capital elements by
management or outside investors in the event that the insurer gets into financial
difficulty, prior to insolvency or wind-up.
5.5 Other considerations
42.
When establishing minimum criteria for capital resources, it is recognised that
views about the specific features that are acceptable may differ from jurisdiction
to jurisdiction and will reflect, amongst other things, the extent to which the pre-
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conditions for effective supervision exist within the jurisdiction and the risk
tolerance of the particular solvency regime.
43.
There is a range of other factors that may be considered by the supervisor in
establishing criteria for elements of capital to be regarded as capital resources
for solvency purposes, including the following:

the powers of the supervisor to set and adjust minimum criteria for capital
resources within the regulatory framework;

the way in which the quality of capital resources is addressed in the
solvency regime, specifically whether an approach that categorises capital
instruments according to quality, or a continuum based approach 6 should
be used;

the coverage of risks in the determination of technical provisions and
regulatory capital requirements;

the regulatory treatment of intangible assets,
subordinated debt, reinsurance and other liabilities;

the relative levels of the MCR and the PCR;

how supervisors deal with lower quality assets (as to whether the asset
value is reduced or whether the insurer is required to hold additional
capital);

policyholder priority and status under the legal framework relative to other
creditors in the jurisdiction;

overall quality of risk management and governance frameworks in the
insurance industry in the jurisdiction;

the comprehensiveness and transparency of disclosure frameworks in the
jurisdiction, and the ability for markets to exercise sufficient scrutiny and
impose market discipline;

the accounting and actuarial framework that applies in the jurisdiction (in
terms of the valuation basis and assumptions that may be used and their
impact on the values of assets and liabilities that underpin the
determination of regulatory capital requirements and capital resources);

the development of capital markets in the jurisdiction and its impact on the
ability of insurers to raise capital; and the balance to be struck between
protecting policyholders and the impact on the effective operation of the
insurance industry and considerations around unduly onerous levels and
costs of regulatory capital requirements; and
contingent
capital,
6
This approach involves the setting of characteristics against which individual instruments can be assessed as to
their quality; instruments are not categorised, but are ranked against other instruments to determine whether they
are high or low quality capital instruments.
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
6
the relationship between risks faced by insurers and those faced by banks,
especially in the context of group wide capital management.
Categories of capital resources
Requirement 6
The solvency regime should set an adequate minimum level for core capital resources
that are permanently available to fully absorb losses and meet policyholder
obligations in all circumstances - during ongoing operations, run-off, wind-up or
insolvency.
To be regarded as core capital, elements of capital need to be:
i. free from mandatory fixed charges;
ii. free from requirement or incentives to redeem the nominal sum or convert the title
held into some other lower quality form of capital; and
iii. free and clear of encumbrances.
Requirement 7
The solvency regime should consider the need for appropriate upper limits on the
level of supplementary (i.e. non-core) capital elements that may be regarded as capital
resources for solvency purposes according to the quality of those capital elements.
44.
There is a spectrum of elements of capital, ranging from core capital as defined
in Requirement 6 to capital elements which just meet the minimum suitability
criteria to be regarded as capital resources for solvency purposes. It should be
noted that appropriate requirements relating to capital quality are meaningful
only within the accounting and legal context in a jurisdiction.
45.
In many jurisdictions, capital elements are categorised into distinct levels of
quality when considering criteria for, and limits on, those capital elements for
solvency purposes. For example, one categorisation may be as follows:

core capital - permanent capital that is always fully available to cover
losses of the insurer

higher quality supplementary capital - capital that lacks some of the
characteristics of core capital, but which provides a degree of loss
absorbency during ongoing operations including subordination to the rights
(and reasonable expectations) of policyholders; and

lower quality supplementary capital - capital that provides loss absorbency
in insolvency/ winding-up only.
46.
Core capital typically confers some rights of control over the insurer to the
capital provider.
47.
In other jurisdictions a continuum approach may be used. This approach
involves the setting of characteristics against which individual instruments can
be assessed as to their quality; instruments are not categorised, but are ranked
against other instruments to determine whether they are high or low quality
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capital instruments. Under either the categorisation or the continuum approach,
elements of capital need to be assessed against the criteria set by the regime
for determining the capital resources regarded as available for solvency
purposes.
6.1 Core and supplementary capital
48.
As core capital is (generally) fully available to cover losses, a supervisor should
set a minimum level of core capital and there should be no upper limit on core
capital. What constitutes an adequate minimum may depend on the type of
insurer, and how the requirement interacts with solvency control levels. 7 The
minimum level is often expressed as a percentage of required capital (such as
50 per cent8 of required capital). Alternatively, minimum core capital may be
expressed in terms of total capital resources or using more sophisticated
approaches. [??] .
49.
A strong level of core capital (without servicing or repayment requirements) can
allow the insurer to conserve resources when it is under financial stress, as it
provides the insurer with discretion as to the amount and timing of distributions.
Thus, a higher level of core capital increases the financial robustness of an
insurer against adverse external factors and contributes to the protection for
policyholders.
50.
Core capital normally includes the following issued and fully paid elements that
appear in insurers’ public financial statements and which meet all the criteria
above:
51.

common shareholders’ equity, which includes common shares and
contributed surplus;

retained earnings, which should be calculated on a basis acceptable to the
supervisor; and

participating fund surplus (depending on the rights of policyholders to this
surplus), where appropriate
Common stock or paid in capital is the amount of common share capital injected
into the insurer over time. Common shareholders’ equity provides a basis for
shareholder dividends, but there should be no legal obligation on the insurer to
pay such dividends. There are some actions that could be taken by an insurer’s
board of directors that would reduce common equity. These actions include a
share buyback, transfers to a parent company and payment of non-standard or
exceptional shareholder dividends. In a solvency regime, any such nonstandard movements of capital out of the company should be subject to clear
regulation, including the requirement of the prior authorisation of the supervisory
authority where appropriate. Supervisory approval is generally required before
such capital can be repurchased/redeemed or otherwise reduced in amount. In
some instances, post-approval by the supervisor is allowed to confirm capital
7
Solvency control levels are discussed in the [Guidance Paper on the Structure of Regulatory Capital
Requirements (Dec 2007)].
8
This reflects the approach taken in Australia.
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returns or reallocations. Such capital should not be repurchased or redeemed if
this results in violating key solvency control levels.
52.
In many jurisdictions, retained earnings attributable to a class of policyholders
such as a participating (with-profits) fund are shown separately in the financial
statements. Typically, while an insurer is financially healthy, the surplus, or the
majority of the surplus in a participating fund, can only be paid to participating
policyholders. This is usually done through policyholder dividends or bonuses.
However, the assets represented by the participating fund may, dependent
upon the laws of the jurisdiction, be co-mingled with other assets in the event of
a wind-up. In some jurisdictions, dividends to policyholders can be restricted if
the company breaches solvency control levels. Where the participating fund is
available for policyholders in the event of a wind-up, it may possess all the
characteristics of core capital. It can, however, be subject to the reasonable
expectations of the policyholders and market competition that may limit the
capacity to use the participating fund surplus. Therefore, the participating
policyholder contract terms or other legal obligations should be carefully
examined by the insurer to determine the suitability and quality of unallocated
amounts in a participating fund to absorb losses outside the fund and to
demonstrate compliance with regulatory requirements.
53.
Retained earnings attributable to shareholders can usually be paid out as
dividends, but there may be restrictions on the size of the dividend and a
general condition that the payment of a dividend cannot cause an insurer to
breach solvency control levels.
54.
Supervisors should consider the need for appropriate upper limits on
supplementary (non-core) capital elements based on the level of quality of
different categories of such capital elements. What constitutes an appropriate
upper limit for non-core capital elements may depend on the type of insurer and
how the requirement interacts with solvency control levels. One example of a
broad benchmark upper limit for lower quality supplementary capital might be
[25%] of required regulatory capital. Other forms of limits on supplementary
capital elements may include… There may also be limits set on some specific
types of capital elements. For example, perpetual subordinated loan capital and
perpetual cumulative preference share capital may be limited to [50%] of
required capital.
55.
Higher quality supplementary capital instruments may include undated noncumulative or cumulative preferred shares where dividends may be deferred,
surplus notes, capital notes and subordinated debt. Although their precise
specifications may differ from jurisdiction to jurisdiction, they are likely to meet
the following requirements:

they are undated (no fixed maturity date) but may have features that
encourage an insurer to redeem them, however this redemption would be
after a sufficiently long term and within acceptable limits such that a
reasonable level of permanence is achieved and there is no expectation
from the capital providers that early redemption will occur;
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
if unpaid interest accumulates, the instrument does not permit penal
interest charges as a result of the suspension if the insurer is unable to
pay without breaching capital requirements or putting policyholders at risk
(i.e. the suspension is not regarded as capricious); and

interest payments require the prior consent of the supervisory authority
(e.g. capital/surplus notes).
56.
Lower quality supplementary capital instruments may include dated preferred
shares and dated subordinated debt. The amount of such capital elements able
to be included as capital resources for solvency purposes is normally subject to
amortisation as the maturity date approaches.
57.
The criteria of these forms of capital outlined above are certainly not meant to
be exhaustive or definitive. Capital instruments, sometimes of considerable
complexity, continue to be developed. In forming a definitive view on the criteria
to set and the application of the criteria in practice, supervisors and insurers
should take all specific aspects of a potential element of capital resources into
account and be aware of how those capital elements are treated in other
financial sectors.
58.
The variation in the nature of core and supplementary capital, the risks borne by
insurers and the length of some insurance contracts mean that the appropriate
mix of capital elements may vary to reflect the nature of the insurance business.
Hence it may be appropriate to ensure that there is sufficient flexibility in the
solvency regime for the required mix of capital elements to be tailored to
individual insurers or classes of insurers so as to ensure they are regulated in a
proportionate and risk-sensitive manner.
7
Transparency of approach to capital resources
Requirement 8
The solvency regime should be open and transparent as to the criteria for and
approach to determining capital resources for solvency purposes. It should be explicit
about the objectives of these criteria and the bases on which they are determined.
59.
Transparency of the solvency regime is required to facilitate its effective
operation. It also supports the enhancement, improved transparency and
comparability and convergence of the assessment of insurer solvency
internationally. To this end, supervisors should publicly disclose the capital
criteria that are applied and any ratios or other requirements that the supervisor
may impose around the composition of capital resources. Insurers should also
disclose appropriate information regarding the amount and composition of
capital resources for solvency purposes.
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Appendix
60.
This appendix provides additional background information on different capital
instruments that may need to be considered in relation to the determination of
capital resources for solvency purposes.
Higher quality supplementary capital resources
61.
A regime may classify some capital instruments as higher quality
supplementary capital resources which do not fully meet the definition of core
capital resources but do provide some protection during ongoing operations.
62.
Perpetual non-cumulative preferred shares are shares where the investor has
no option to redeem the shares. Dividends are normally paid on a fixed
schedule when the insurer is operating profitably. However, dividends are
cancellable at the discretion of the board of directors, for example if the
profitability of the insurer does not warrant their payment or if required for other
purposes of the company. Once suspended, the obligation to pay the dividend
must be extinguished.
63.
Some shares that are technically perpetual non-cumulative preferred shares will
trigger unusual restrictions on the issuer when dividends are suspended, acting
as an undue disincentive to dividend suspension, so that economically they may
not sufficiently meet the regime's criteria for loss absorbency to support ongoing
operations. However, dividend stoppers on more junior capital instruments are
not generally considered an unusual restriction on an issuer who has
suspended dividends on more senior capital instruments. Also, in the event of
insolvency, these shares must rank behind all creditors of the insurer if they are
to be regarded as suitable for inclusion as capital resources for solvency
purposes.
64.
The key feature of this class of preferred shares is its permanence. Supervisors
may have rules that restrict the size of the dividend and typically a general
condition that the payment of a dividend cannot cause an insurer to breach
solvency control levels. All features of these types of shares need to be
reviewed closely to ensure they comply with the criteria for inclusion in capital
resources in that jurisdiction. Perpetual non-cumulative preferred shares are
one of the highest quality forms of supplementary capital resources.
65.
A dividend payment on a cumulative preferred share may be postponed, but not
permanently extinguished. The deferred dividends remain a continuing
obligation of the insurer until paid. Hence they are of a lower quality than noncumulative preference shares.
66.
Perpetual subordinated debt instruments may absorb losses on an ongoing
basis without triggering insolvency or wind-up. Subordinated debt with no
maturity date may be regarded as more permanent and therefore of higher
quality than subordinated debt with a stated maturity date.
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67.
Capital notes are capital instruments that are similar to preferred shares.
Surplus notes are another source of capital. Both usually require supervisory
approval for issuance, payment of interest, and redemption if they are to be
treated as higher quality supplementary capital resources. (See section 5.4)
68.
Some non-core capital instruments may also provide for the security holders to
bear losses in the same way as a shareholder if the insurer is in financial
difficulty. This can be achieved, for example, by providing for conversion of the
principal to ordinary share capital, or for payments of principal and unpaid
interest, in whole or part, to be cancelled in order to allow the insurer to
continue in business. Unpaid interest on non-cumulative instruments may be
allowed. The trigger for the loss-bearing provisions is normally a breach of the
solvency requirements.
69.
Innovative instruments are tax-effective forms of capital instruments that have
characteristics of both debt and equity, and are usually treated as higher quality
capital resources for regulatory purposes. Innovative instruments are generally
perpetual, but in some jurisdictions they may include features such as a repricing mechanism, that make them effectively dated. To provide greater
comfort regarding their subordination, innovative instruments often include
features that cause them to convert to other forms of capital, or otherwise affect
their priority, on the occurrence of certain events such as indications of solvency
control level problems. An innovative instrument may also be regarded as lower
quality supplementary capital resources, depending on how it is structured in a
jurisdiction.
Lower quality supplementary capital resources
70.
Lower quality capital instruments can be in the form of dated preferred shares
or dated subordinated debt. However, unlike an ordinary debt obligation, the
instrument contains conditions that remove some of the lender’s usual rights.
71.
Limited life preferred shares are preferred shares with a stated maturity date
and are therefore less permanent than perpetual preferred shares. Under
International Accounting Standards, these shares are reclassified from equity to
debt on the balance sheet. These shares may be cumulative or non-cumulative.
The amount of any outstanding limited life shares included in capital resources
for solvency purposes is normally subject to amortisation as the maturity date
approaches. Additionally, supervisors are able to control the redemption of
limited life preferred shares, but often only until their stated maturity date.
Therefore, this capital instrument is not free from requirements to repay the
capital and should be considered to be lower quality of capital resources for
regulatory purposes.
72.
Dated subordinated debt instruments that do not absorb losses during ongoing
operations can be useful as they are subordinated to policyholders' claims in a
winding up. Such instruments may be included as part of the capital resources
of an insurer for solvency purposes.
73.
The amount of outstanding subordinated debt (and any other limited life capital
instrument) included in capital resources is normally subject to amortisation as
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the maturity date approaches. Supervisors are able to control the redemption of
subordinated debt, but often only until the stated maturity date. The terms of
subordinated debt may allow the insurer to defer interest payments, but in such
a case, they are normally cumulative. In many instances, the supervisor may
require deferral. In the case of a wind-up, subordinated debt is only payable
after all policyholder obligations have been met. Thus long-term subordinated
debt can be considered to be suitable for inclusion in capital resources for
solvency purposes subject to such conditions. The reasonable expectations of
participating policyholders and whether the debt is subordinated to those
expectations would also need to be considered.
Contingent capital
74.
Contingent capital such as letters of credit, members’ calls by a mutual insurer
or the unpaid element of partly paid equity may not be considered suitable for
inclusion in capital resources for solvency purposes. However they may be
accepted in special circumstances such as captive insurers or in other
circumstances such as outlined in section 5.3. Where permitted, the supervisor
should approve the terms of the capital element (e.g. letters of credit) including
renewability, and should assess the extent that the counterparties can
reasonably be relied on to absorb losses.
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