Download FSA Consultation Paper 190 - enhanced capital requirements and

FSA Consultation Paper 190 - enhanced capital requirements and individual capital
assessments for non-life insurers
1
Introduction
This consultation paper provides draft rules in relation to the calculation of capital
requirements for non-life insurers under the Integrated Prudential Sourcebook (PSB). It
explains the enhanced capital requirement (ECR), redefines the capital resources of an
insurer within the terminology currently used for banks and then updates on the individual
capital assessments which were consulted on in CP136 and provides draft rules in relation
to these.
It is proposed that the PSB will provide different layers of capital resources:
•
the minimum capital requirement (MCR) being what we currently know as the
required minimum margin (RMM) as increased pursuant to the Solvency 2 Directive
(see our summary of CP181 in the May’s Insurance Update);
•
the ECR (if higher than MCR): this will replace the FSA’s current typical requirement
for a buffer above RMM with a very different, risk-based, calculation which may need
to be amended again for the implementation of the Solvency 2 Directive; and
•
individual capital guidance (ICG) which would require an additional buffer of capital if
the FSA feels that the result of the ECR for a particular insurer does not provide
sufficient capital, for example because its lines of business are more risky than the
average or its systems and controls are lacking. Firms will be required to carry out
individual capital assessments each year on which the FSA will base any decision in
relation to ICG.
FSA intends to issue a consultation paper in relation to enhanced capital requirements for
life insurers next month but it is stated that this will, as expected, involve the use of realistic
reporting such as is being carried out by many life insurers already on a voluntary basis.
Individual capital assessments, ICG and the capital resources rules for life insurers will be
much as set out in CP190 for non-life insurers.
The proposed increased capital requirements will have implications for the calculation of
group capital under the Insurance Groups’ Directive (implemented in the UK in Chapter 10
of IPRU(INS)) as assets equal to the increased capital requirements referred to above will
have to be left out of account in determining the “surplus assets” of a group for that purpose.
In other words, the group will require more capital in order to avoid running at a deficit on a
group basis.
CP190 also explains the different tiers of capital that will now apply to insurers, being Tier 1
(divided into Core Tier 1, non-ordinary shares and Innovative Tier 1) and Tier 2 (divided into
Upper Tier 2 (perpetual), and Lower Tier 2 (term) (very similar to the hybrid capital explained
in FSA’s Guidance Note 2.1)). Other capital may only be included with FSA’s permission.
Limits apply to all forms of capital other than Core Tier 1.
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2
Timing
The proposals consulted on really amount to a formalisation of the FSA’s general move to a
risk-based approach to regulation. Under existing rules, it is already open to the FSA to use
the requirement for adequate resources in the Threshold Conditions and the Principles for
Business to require a firm to retain assets (i.e. stop distributions to shareholders) or to
obtain additional capital.
The first formal increase in capital requirements is the increase in the MCR with effect from
1 January 2004, on the implementation of the Solvency 2 Directive.
ECR and ICG will be introduced with the PSB later in 2004. Initially ECR will need to be
calculated and provided privately to FSA only as part of the requirement to consider an
individual capital assessment. FSA will then use this and other factors such as the result of
the firm’s Arrow review as the basis on which to set the ICG for that firm. If the firm does not
comply with the ICG then the FSA may consider using its powers under section 45 of the
Financial Services and Markets Act 2000 (FSMA) to vary a firm’s Part IV permission, on its
own initiative, so as to require it to hold capital in accordance with the FSA’s view of the
capital necessary.
However, FSA expects that firms will wish to calculate the ECR requirements as at 31
December 2003 and to back-test it for the last several years. FSA acknowledges that some
firms may need time to satisfy ECR requirements and that some firms such as those in runoff with limited opportunity to raise or create new capital may need a grandfathering
provision.
Once the ECR has become a prudential requirement (from a date expected to be
announced in 2004 but giving the industry at least 12 months’ notice), assuming it is higher
than the MCR, it will effectively become the MCR so that there will be no debates with the
FSA as to whether the ECR was the appropriate amount (although there would remain the
opportunity to apply for a waiver under section 148 of FSMA if it could be shown that the
ECR really did produce too high a capital requirement for a particular business).
FSA will not (necessarily) await Solvency 2 before making ECR a prudential requirement,
although FSA does recognise that ECR may need to be adjusted in due course for Solvency
2.
3
ECR
FSA states that it has devised the ECR calculation so as to be extremely easy to perform
using values which are already calculated for the current form of FSA returns. The basic
calculation of the ECR follows the form:
Asset related values x relevant asset factors (%) =
X
Insurance related values x relevant technical provisions factors (%) =
X
Net written premium x relevant premium factors (%) =
X
Total ECR (before equalisation adjustment) =
X
The factors have been devised to require more capital where the perceived risk is greater.
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The asset related values involve relevant factors being applied to assets after the rules on
valuation and admissibility have been applied. For example, shares carry a factor of 16%,
shares in non-insurance undertakings and participating interests a factor of 7.5% and fixed
interest securities a factor of only 3.5%.
Insurance related values comprise, for each class of business, the total technical provision
(the sum of outstanding claims reserves, reserves for incurred but not reported, or not
enough reported, unearned premium reserves, and additional reserves for unexpired risks).
Claims reserves are calculated net of reinsurance recoveries anticipated for each class of
business. Unearned premium reserves are calculated net of deferred acquisition costs
apportioned to each class of business.
4
Individual capital assessments and ICG
The fundamental principal for capital/financial resources is set out in the draft PSB
paragraph Pru 1.2.13 R as “a firm must at all times maintain overall financial resources,
including capital and liquidity resources, which are adequate, both as to amount and quality,
to ensure that there is no significant risk that liabilities cannot be met as they fall due”. The
guidance notes indicate that the requirement is to ensure that, on any realistic worse case
scenario, liabilities can be paid, not that any particular solvency margin or minimum capital
requirement can always be met throughout the projection.
The new rules require that a firm must carry out regular assessments of the adequacy of its
financial resources using processes and systems which are proportionate to the nature,
scale and complexity of the firm’s activity. These systems must enable the firm to identify the
major sources of risk to its ability to meet its liabilities as they fall due, including the major
sources of risk in each of the following categories:
•
credit risk;
•
market risk;
•
liquidity risk;
•
operational risk; and
•
insurance risk.
For each of these risks the firm must carry out stress tests and scenario analyses that are
appropriate to the nature of those risks to identify the likelihood of the risk crystallising and
the likely cost if it does so. These tests must be run at least annually and the FSA will
require the records to be kept for three years.
The FSA will use the ECR as a benchmark for its consideration of the appropriateness of
the firm’s own capital assessment. It will expect to see the tests which the firm has carried
out in order to assess the adequacy of its capital resources. The particular way in which the
individual capital assessment “adds value” to the ECR is that it requires the firm to take into
account its future business plans and projections. The ECR, in contrast, is based upon
historic data.
The draft guidance sets out much more detail as to the factors to be considered when
assessing the various risks referred to above. The guidance also draws firms’ attention to
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particular risks which may mean that capital will be required in excess of the ECR (on the
basis that the ECR assumes that a firm’s business is well diversified, well managed with
assets matching its liabilities and good controls and stable with no large, unusual or high risk
transactions).
The ICG will involve:
•
the FSA assessing the firm’s capital positions for the first two or three years (at or
above the ECR) and will include guidance as to how to calculate the ECR; and
•
assessment as part of the regular Arrow risk assessments.
On a group basis, the consultation paper states that the existence of “enforceable unlimited
cross guarantees” may help.
5
Groups
Until the ECR becomes a prudential requirement (expected to be announced in 2004 with at
least 12 months’ notice), insurance groups must maintain at least the aggregate MCR. If
ICG is required by virtue of use of FSA’s own initiative powers under Section 45 FSMA in
relation to particular insurers within the group this effectively increases the MCR for that
company meaning an increased deduction from the parent undertaking solvency calculation
and therefore a greater capital requirement.
Once the ECR has become a prudential requirement, insurance groups will be required to
maintain the aggregate ECR. Again, if ICG above the level of ECR is required in relation to
particular insurers within the group this effectively increases the ECR for that company
meaning an increased group capital requirement.
In addition, where FSA has specified ICG for an insurer, it expects to specify ICG for that
insurer’s group and the extent to which only capital in excess of the group undertakings’ ICG
is to be taken into account in meeting that requirement.
The consultation paper expressly notes that having a strong parent is insufficient. Instead,
the capital must be in place to meet any possible risks.
6
Capital resources
The FSA maintains that the change to requiring particular capital resources to meet the
capital requirement produces no different result from the old assets less liabilities plus RMM
test. This requires the introduction of a concept of capital being made through retained
profits or used up in losses. The sources of Tier 1 capital and deductions in the draft rules
do this.
The proposal would codify the expected alignment of insurance capital with banking capital.
Share capital and retained reserves will form part of the “Tier 1” capital. “Capital
instruments” (i.e. debt securities which have been developed so as to have the
characteristics of equity) are proposed as “Innovative Tier 1”. The principal amount of such
instruments must not exceed 15% of the total amount of Tier 1 capital for the relevant firm.
Another limit is that Innovative Tier 1 plus “non-ordinary shares “ (essentially preference
shares) may comprise no more than 50% of the MCR. (It is unclear whether this will
become ECR once ECR becomes a requirement.) Half of a firm’s capital resources may be
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made up of Tier 2 instruments, of which no more than half (or 25% of the total capital
resources) may be Lower Tier 2. The change from requirement (the current RMM) to
available capital resources will increase headroom for Tier 2 in insurance firms.
The effect of any increased capital resources once the ECR has been introduced as a
prudential requirement would also mean that firms will have considerable additional
headroom for raising Tier 2 capital. Firms may also wish to take advantage of the scope for
using Innovative Tier 1 capital.
Tier 2 capital for insurers has, pursuant to the various insurance directives, historically
consisted of two different forms, perpetual securities and subordinated debt. The terms of
the former are required to provide for the loss-absorption capacity of the debt and any
unpaid interest, whilst enabling the firm to continue trading. The terms of the latter were not
subject to this requirement. FSA is proposing that this requirement should apply to all Tier 2
capital for insurers. The guidance states that this could be achieved through the conversion
of the capital instrument or subordinated debt into shares at a predetermined trigger event.
Copies of this consultation paper can be found on the FSA’s website at:
www.fsa.gov.uk/pubs/cp/190/index.html.
This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of
law, please contact one of your regular contacts at Linklaters, or contact the editors.
© Linklaters. All Rights Reserved 2003
Please refer to www.linklaters.com/regulation for important information on the regulatory position of the firm.
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