nz solvency requirements – a practical apra lite approach…

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July 2009 The Reserve Bank of New Zealand has released draft Solvency requirements for non-life insurers. The purpose of this note is to outline the key aspects of the draft standard, and suggest what insurers should be doing to assess their position. A copy of the draft standard can be found here. NZ Solvency requirements – a practical APRA lite approach….

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Page 1: NZ Solvency requirements – a practical APRA lite approach…

July 2009

The Reserve Bank of New Zealand has released draft Solvency requirements for non-life insurers. The purpose of this note is to outline the key aspects of the draft standard, and suggest what insurers should be doing to assess their position.

A copy of the draft standard can be found here.

NZ Solvency requirements

– a practical APRA lite approach….

Page 2: NZ Solvency requirements – a practical APRA lite approach…

July 2009 2

1. Features of the new regulatory framework

On 30 June we published our article on the new insurance regime in the New Zealand marketplace ‘New Zealand insurance meets Prudential Regulation’ (click to review our previous article). The new framework is structured around the following pillars:

On 7 July the Reserve Bank of New Zealand (RBNZ) published the draft solvency standard, allowing companies to see the full picture of the new regime for the first time. The draft standard was broadly consistent with what was expected, but there are many details still to be worked through.

Page 3: NZ Solvency requirements – a practical APRA lite approach…

3July 2009

2. The solvency standard

The solvency standard aims to make sure each insurer holds enough capital to have a 99.5% probability of meeting it’s liabilities over a 12 month time frame. It does this by requiring insurers to hold minimum capital for solvency purposes, based on the insurer’s risk profile.

3. Actual Solvency Capital

The Actual Solvency Capital is the capital that can count towards meeting your minimum requirement. It is essentially the net assets from the balance sheet, or net assets in New Zealand if you are a branch, with certain identified elements deducted.

Using the IFRS balance sheet as a starting point we think is an advantage – eliminating the need for a pseudo RBNZ balance sheet that can’t be easily reconciled to accounts.

The deductions from capital are primarily aimed at ensuring that the quality of capital that is available to meet regulatory requirements is satisfactory to RBNZ.

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July 2009 4

3.1 Capital

The types of items that count as capital are clearly identified. The capital base is equity based (or Tier One capital from an Australian perspective), with limits on the contribution made by perpetual non-cumulative preference shares. Subordinated debt is not allowed as capital in the draft standard.

3.2 Deductions from Capital

There are a series of identified deductions from capital listed in the standard. We recommend that insurers read these deductions carefully to ensure they do not give rise to any particular issues. The identified deductions include:

• Goodwillandotherintangibles• Futuretaxbenefits• Equityinandloanstorelatedparties• Equity/subordinateddebtissuesbyotherfinancialinstitutions• CapitalisedITinexcessofsale/disposalvalue• Dividendsdeclaredbutnotpaid

In our view most of these deductions are sensible. The deduction of equity and debt holdings in other financial institutions however, does not make sense to us, and we suspect that there will be significant pushback on this issue by the industry.

Related party assets are another area that may potentially cause issues for insurers - particularly where groups have intercompany arrangements that make commercial sense. Related party obligations are also dealt with in the asset risk section.

The requirement for insurers to use consolidated accounts for the purpose of the solvency standard

makes it particularly important that insurers with subsidiaries pay close attention to these provisions.

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4. Minimum solvency Capital

The Minimum Solvency Capital is the aggregate of a series of charges (reflecting risk) against the insurance business metrics, assets held and any other non-insurance business activity. In addition there will be a minimum capital amount (which was previously flagged as likely to be between $2m and $5m), but the RBNZ has not yet made a decision on the level. The drivers of the risk charges are summarised below:

4.1 Insurance Risk charges

The insurance risk charges cover 3 primary risks. The insurance charges are primarily devised to cover the risks of:

• insufficientpremiumstocoverfutureclaims(underwriting)• insufficientprovisionstocoverpastclaims(runoff),and• futureextremeclaimevents

The risk around the recoverability of reinsurance assets is considered under ‘assets’ below.

July 2009

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July 2009 6

Underwriting and runoff

The capital charges for underwriting risks are applied to the prior financial year’s Net Written Premium, and runoff charges are applied to balance sheet Outstanding Claims (OSC) provisions. The relevant charge is applied to each class of business and the total capital charge is the sum of the charge for each individual class. The specific charges are shown below:

The choice of applying the risk charges to last year’s NWP is a pragmatic one. It allows for the use of known (and audited) numbers from a prior years accounts, but will potentially understate the risk for a growing portfolio. The use of forecast premium levels may have been more appropriate to ensure a rapidly growing portfolio is dealt with sensibly, however forecasts are subject to levels of management judgement, and are also frequently inaccurate. The additional risk caused by growth is addressed by requiring the appointed actuary and directors to certify future compliance with all solvency requirements. This is an area where the RBNZ is seeking feedback.

The charges are applied to the balance sheet OSC provisions, assuming a risk margin to achieve a 75% probability of sufficiency has been included. If a sufficiency level of less than 75% is included in the provisions, then an adjustment is required to bring the starting provision up to the 75% level. If a higher margin is held, then credit for the difference is allowed for solvency purposes.

Catastrophe

In addition to the underlying insurance risk charges, insurers will be required to hold capital against a catastrophe risk. For insurers with significant property exposure, the charge is likely to be the net cost (after reinsurance recoveries) of one catastrophe event, including the cost of one reinsurance reinstatement. For non-property insurers, it will be twice the largest per claim net cost (after reinsurance).

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4.2 Asset Risk charges

Asset values

The capital charges for asset risks are applied after assigning assets to a relevant class. Where investments are held in a professionally managed collective investment vehicle, classification is on a “look through” basis to underlying assets. The relevant charge is applied to each class of asset and the total capital charge is the sum of the charge for each individual class. The specific charges are shown below:

These risk charges broadly mirror the Australian APRA charges, although at the upper end they are more onerous.

Insurers with intercompany investment arrangements may need to give this special consideration. Related party arrangements (covered below) may create additional capital requirements as in many instances they will be completely or substantially inadmissible.

Unlisted and unrated assets (whether fixed interest or growth) are also hit with high capital charges. Manyinsurersarelikelytoreassessthecost/benefitoftheseinvestmentsbecauseofthecapitalimpact.

NBDealingwithderivativesnotyetfinalised,andreinsuranceassetsaredealtwithspecificallybelow

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July 2009 2009 8

Liquidity and concentration limits

In addition to the specific asset charges there are additional requirements around overall asset structure reflecting liquidity, and charges against excessive concentration with any single counterparty. The liquidity charge requires insurers to hold assets equivalent to 20% of insurance liabilities in readily realisable assets. We do not expect this to cause any concerns, however, the concentration limits may require some insurers (particularly those that are part of a group with shared investment services) to consider their position. The concentration limits are based on a % of total assets, and are:

• 100%forassetsheldwiththeNZnationalGovernment(orequivalent)• 50%(or$5m,whicheverisgreater)forassetsheldwithNZlocalGovernmentor StateOperatingEnterprises

• 25%(or$5m,whicheverisgreater)forassetsheldinNZbankbillsordeposits• 10%(or$2m,whicheverisgreater)foranyotherassets.

Reinsurance recoveries

Specific capital charges are applied to reinsurance recoveries – and legitimate reinsurance recoveries from intercompany arrangements are dealt with here rather than as related party assets. The level of charge depends on the credit rating of the counter party. We have shown below the factors for ratings from the major rating agencies.

While RBNZ have not yet confirmed the thresholds, higher loadings will apply above some level to assets below A grade. We also note that some prudentially regulated reinsurance entities may (quite legitimately) be unrated – NZ insurers will need to consider whether this is an issue for them, and may wish to make submissions to the RBNZ.

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July 2009 9

Related party issues

Related party assets are essentially nil for capital purposes, with some exceptions. These include:

• Reinsurancerecoveries(coveredabove)• Abankthatissubjecttoprudentialsupervision,and• Assetsthatareimmaterial,andconductedatarmslength.The definition of a ‘related party’ is broader than the normal accounting concept of an ‘associated person’, and we recommend that insurers give consideration to this area of the standard.

4.3 Non-insurance activities

Special consideration is needed if an insurer undertakes material non insurance activity. This applies whether it is undertaken through a subsidiary, or directly by the insurer.

If through a subsidiary:

• acapitalchargeisonlyrequiredifthesubsidiaryisundercapitalisedforthebusiness-thechargeifneeded is the amount recommended by the actuary

If directly through the insurer:

• aseparateactuarialassessmentofassetsandliabilitiesisrequired-thismustincludeanassessmentof ‘normal’ capital levels

• thechargeisthesumofthenormalcapitallevelsfortherelevantbusiness,plustheliabilitiesofthebusiness less any assets held.

4.4 Discussion points

In the draft standard, the Bank has asked for specific feedback on a number of areas – we have itemised some of the major ones below and also recommend you read the standard for yourself

• Thedefinitionofwhatisallowedtocountascapital• Thetreatmentofderivatives• Dealingwithagrowingportfolio• Isthetreatmentofrelatedpartyassetstoharsh?• Isthetreatmentofliquiditysufficient?• TheapproachtoLATandDAC• Thescopeoftheappointedactuaryrole,inparticulartherequirementtocommentonmanyofthe

issues above.

Page 10: NZ Solvency requirements – a practical APRA lite approach…

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Contacts

For further information on either the changes in NZ, or on the support we can provide, please contact any of the following:

GeoffAtkins [email protected] Burningham [email protected] Curley [email protected] [email protected]

4.5 Next steps

We think the most important thing is for insurers to ‘run the numbers’ to make sure you understand your position. This should be done with enough time to prepare a submission to the RBNZ by 31st August.

Absolute accuracy is not needed for such an assessment, and it should be sufficient to start with the position from your last financial reporting period, and update with new numbers when they are available. In other jurisdictions we have found it useful to analyse any movement in the solvency position between two periods – this often provides insights into the drivers of solvency. It would also be useful to identify any ‘wrinkles’ in the standard itself, and include these items in any submission to be made to the RBNZ. It is likely that when assessing the issues, RBNZ will place high priority on those with real practical examples.