Capital Requirements for

Insurers
Nairobi, Kenya
Part 4
29 October 2009

4. Aggregate capital requirement

Risk Sharing with Policyholders

There are several situations where insurance companies
have the ability to share or pass on to policyholders
some of the risk inherent in their policies
Participating or with-profits life insurance
Adjustable life insurance
Certain life insurance products with significant
investment features (Universal Life or Unit Linked)
Experience-rated group insurance
Automobile policies subject to bonus-malus
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Risk Sharing with Policyholders

In participating insurance, the companys
experience with respect to their line of business
is shared with the policyholder
The size of a policyholders dividend or bonus is
a matter of discretion for the insurers directors or
senior management
The degree of sharing of experience with
policyholders that actually takes place is a matter
of the insurers operating philosophy
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Risk Sharing with Policyholders

It is often argued that in the event of poor experience,
policyholders dividends or bonus can be reduced; the
savings thereby generated can be used to absorb some
of the additional cost of the unfavourable experience
Is it appropriate to recognize the potentially loss
absorbing qualities of dividends when determining capital
requirements for particular risks?
If so, how should such recognition be given?

Risk Sharing with Policyholders

In some jurisdictions, the bonus is the main instrument in
price competition
It follows that some insurers will be quicker to increase the
bonus when experience is very favourable and slower to reduce
the bonus and pass on poor experience

In general, management action to change

bonus/dividend scales occurs well after the time a
change in experience has been recognized
These considerations argue against allowing a full credit
for the effects of profit sharing with policyholders towards
capital requirements
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Risk Sharing with Policyholders

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

The policies must pay meaningful dividends

The companys participating dividend policy must be publicly disclosed and must make it
clear that policyholder dividends will be adjusted to reflect actual experience. The
company must publicly disclose the elements of actual experience that are incorporated in
the annual dividend adjustment process

The company must regularly (at least once a year) review the policyholder dividend scale
in relation to the actual experience of the participating account. It must be able to
demonstrate to OSFI, for example, which individual elements of actual experience, to the
extent that they are not anticipated in the current dividend scale, have been passed
through in the annual dividend adjustment. Furthermore, it must be able to demonstrate
that shortfalls in actual overall experience with regard to the risk component are
substantially recovered within a period not exceeding five years

The company must be able to demonstrate that it follows the dividend policy and practices
referred to above

Risk Sharing with Policyholders

Under Solvency II the specification of the standard formula
calculation takes into account the risk absorption ability
of future profit sharing. This is achieved by a three step
bottom up approach as follows:
The first step is to calculate the capital requirements for
individual sub-risks under two different assumptions
that the insurer is able to vary its assumptions on future bonus
rates in response to the shock being tested, based on
reasonable expectations and having regard to plausible
management decisions (reduced requirement)
that the insurer is not able to vary its assumptions on future
bonus rates in response to the shock being tested (basic
requirement)
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Risk Sharing with Policyholders

Solvency II (contd)
The second step is to aggregate both kinds of
capital requirement separately, using the relevant
correlation matrices
The final step is to determine an adjustment to the
basic capital requirement
Generally, the adjustment is given by the difference
between the basic capital requirement and the
aggregate of the adjusted requirements
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10

Risk Sharing with Policyholders

Adjustable life insurance policies are non-participating policies in which the
insurer has the option to adjust certain elements that affect the
policyholders financial values

Adjustable factors most often are

Premium rates
Interest rates used to credit earnings to policyholders accounts

These adjustment factors are often contractually limited

Maximum premium rate
Minimum interest crediting rate

How should these features be recognized in capital requirements?

If any adjustment is made, it must take into account the difference between
current factors and limiting values, as well as the insurers propensity to introduce
adjustments

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Risk Sharing with Policyholders

Certain life insurance contracts (often labeled as
Universal Life or Unit-linked) have significant
investment features under which policyholders
accounts are credited with the rate of earnings
derived from some external index
Policyholders therefore share directly in credit and
market risks
How should this be recognized in capital
requirements?
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Risk Sharing with Policyholders

The Canadian approach is to give credit for the
investment pass-through subject to a restriction
related to the companys efficiency in sharing its
experience with policyholders
The normal capital requirements for credit risk
on these products is multiplied by the factor
1 where is the correlation between the
companys earned interest rate on assets
supporting this LOB and the rate credited to
policyholders accounts
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Risk Sharing with Policyholders

In Solvency II (QIS4) we find
For policies where the policyholders bear the investment risk (such as
unit-linked policies), the undertaking will remain exposed to market
risks where the value of the charges taken from these policies is
dependent on fund performance. Exposure to interest rates will
occur where fixed charges are received in the future. The value of
any options and guarantees embedded within these contracts may
also be exposed to market risk.
There are no adjustments for funds with policyholder pass-through in
the interest risk and equity risk components
these assets are excluded from the spread risk component
an item is added to the spread risk component for associated risk
that remains with the company
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Risk Sharing with Policyholders

Experience rating in group insurance is a form of
profit sharing
It may be difficult to recover past losses even
when a contract is nominally fully experience
rated
Certain arrangements where the client deposits
funds with the insurer that can be drawn upon in
the event of severe losses may be an offset to
required capital
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Risk Sharing with Policyholders

Automobile policies subject to bonus-malus appear to
share in profit
However, adjustments are usually made to premiums in
succeeding years
These arrangements do not give the insurer access to
any additional financial resources to absorb the cost of
unfavourable claims experience
No allowance for these policies is made in required
capital
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Risk Mitigation
Insurance companies have the ability to transfer or
otherwise mitigate some of the risk they bear
The two principal methods are
Reinsurance
Financial hedging

To the extent that risk is reduced, it is

appropriate to recognize risk mitigation through
reductions in required capital
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Risk Mitigation
Solvency II QIS4 states a number of useful
principles with respect to the recognition of risk
mitigation in capital requirements
Required capital should allow for the effects of
risk mitigation through:
a reduction in requirements commensurate with the
extent of risk transfer
appropriate treatment of any corresponding risks that
are acquired in the process
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Risk Mitigation Principles

The underlying impact on risk associated with risk mitigation should be

treated consistently, regardless of the legal form of the protection. Risk
mitigation arrangements should be legally effective and enforceable

Risk mitigation arrangements should provide appropriate assurance as to

the risk mitigation achieved, having regard to the approach used to calculate
the extent of risk transfer and the degree of recognition in required capital

The standard SCR calculation should recognise financial risk mitigation

techniques in such a way that there is no double counting of mitigating
effects

Where the risk mitigation instrument reduces risk, the capital requirement
should be no higher than if there were no recognition in the standard capital
calculation of such mitigation instruments; where the risk mitigation
instrument actually increases risk, then required capital should be increased

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Risk Mitigation Principles

To be eligible for recognition, financial risk mitigation instruments

relied upon should have a value over time sufficiently reliable to
provide appropriate certainty as to the risk mitigation achieved

The insurer should have written guidance regarding liquidity

requirements that financial risk mitigation instruments should meet,
according to the objectives of the own insurers risk management
policy

Providers of financial risk mitigation should have an adequate credit

quality to guarantee with appropriate certainty that the insurer will
receive the protection in the cases specified by the contracting
parties. Credit quality should be assessed using objective
techniques according generally accepted practices

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Risk Mitigation Principles

Financial mitigating instruments only can reduce the capital requirements if:

They provide the insurer a direct claim on the protection provider (direct
feature)

They contain explicit reference to specific exposures or a pool of exposures,

so that the extent of the cover is clearly defined and incontrovertible (explicit
feature)

They do not contain any clause, the fulfilment of which is outside the direct
control of the insurer, that would allow the protection provider unilaterally to
cancel the cover or that would increase the effective cost of protection as a
result of certain developments in the hedged exposure (irrevocable feature)

They do not contain any clause outside the direct control of the insurer that
could prevent the protection provider from being obliged to pay out in a
timely manner in the event that a loss occurs on the underlying exposure
(unconditional feature).

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Risk Mitigation
Reinsurance is usually recognized within
capital requirements as long as it is well
formulated (i.e. effectively transfers risk)
This recognition is partially offset by a
provision for counterparty (i.e. the
reinsurer) default risk
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Risk Mitigation
Hedging is a risk management strategy used in limiting or offsetting
probability of loss from fluctuations in the prices of commodities,
currencies or securities
Financial hedging often involves the purchase or sale of various
financial derivative contracts

In the calculation of the risk capital charge, hedging and risk transfer
mechanisms should be taken into account if they satisfy general risk
mitigation principles

As a general rule, hedging instruments should only be recognized

with the average protection level over the next year
for example, where an equity option provides protection for the next six
months, as a simplification, it should be assumed that the option only
covers half of the current exposure.
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Risk Mitigation
For regulatory capital, many supervisors would
not accept an assumption of the purchase
additional hedging instruments (for example, as
part of a dynamic hedging program) beyond
those in force at the balance sheet date
In some cases, this restriction only applies when
a standard calculation approach is taken

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Risk Dependencies
Many of the random variables that give rise to
the risks we are considering are, in some sense,
related
These relations can serve to magnify or reduce
total risk and therefore also total required capital
We use the language of probability to attempt to
describe these relationships, in particular we use
the notion of correlation
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Risk Dependencies

Consider, for example, what is implied by a statement that in life

insurance, policy lapse and mortality are positively correlated

This could express the observed phenomenon that it is the healthier

lives that have higher lapse rates, so the remaining insured
population has poorer health and higher mortality rates

Note that this is not a symmetric relationship since here lapse

influences mortality but mortality does not necessarily influence
lapse

Correlation may be a convenient device to use and convenient

language to express these relationships, but it may not precisely
capture the situation we seek to model and measure

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Risk Dependencies
Assume we have n distinct risks X1, , Xn with required
capital Ck for risk Xk
Assume (jk) is the symmetric n x n matrix of correlations
between the risks, so kk = 1 for all k = 1, ,n
The total required capital using the method of
correlations is C = (jk jk x Cj x Ck)
If all jk = 1, C = (( X1 + + Xn )2) = X1 + + Xn
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Risk Dependencies
In Canada, required regulatory capital C is defined to be
the sum of the Cks which is equivalent to assuming all
risks are perfectly correlated
Seemingly, a very conservative approach

The U.S. RBC requirement uses correlations that are

either 0 or 1
The effect of this use of correlation is significant
For similar companies in the U.S. and Canada, the U.S. required
capital is as low as of Canadian requirements; the reduction is
primarily due to to the correlation factor

Solvency II makes extensive use of correlations

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Risk Dependencies
Solvency II employs a two-level correlation
structure
First, correlation is applied to all requirements of the
same risk type to give total required capital for that
risk type
Secondly, correlation is applied to the results of the
first level to obtain the total required capital

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Solvency II Correlations

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Risk Dependencies
All correlations in Solvency II are multiples of 0.25
This is an indication that we do not really know how to
determine correlations
They are subjective, based upon experience driven judgment

A significant difficulty is that correlations are not stable

In particular, correlations between extreme or tail events are
not likely to be the same as correlations in the normal central
range of most distributions
This is n important shortcoming of correlation since the focus of
capital requirements is on providing for loss as the result of
extreme events
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Risk Dependencies
The Solvency II two-tier correlation structure
may not be logically consistent
c.f. Damir Filipovich, University of Vienna

Further, relationships between different sources

of risk often vary by many factors including
product design
Reflection of correlation as between major sources of
risk is likely a distortion of the real nature of risks
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Risk Dependencies
Another method to express the relationship between several random variables
is through the use of copulas

Let X1, , Xn be the n random variables that represent our sources of risk

Suppose Fk(xk) is the cumulative distribution function of Xk

A joint distribution of X1, , Xn is a probability distribution function

0 F(x1, ,xn) 1

An n-dimensional copula is a real-valued function with values in [0, 1],

C(y1, yn)

There is a correspondence between joint distributions and copulas given by

F(x1, ,xn) = C(F1(x1), , Fn(xn))

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Risk Dependencies
The complete relationship between various random
variables is described by the joint distribution function, F
We can use copulas and the marginal distributions of the
individual Xks to generate these relationships
We must choose a particular copula from a collection of
available copulas with known properties
Total capital required would be based upon the extreme
tail of the copula
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Risk Dependencies

An alternative way to describe relationships between risk variables

is available when one determines required capital under an
advanced methed using internal models

In this case, one would build into the description of the company,
particularly into the assumptions governing financial experience,
explicit relationships between different risk factors

Examples:
Both incidence and recovery rates for disability income replacement
insurance are influenced by economic variables
In some products, policyholder behavior has a strong influence on future
mortality
In some products, policyholder behavior is influenced by financial
indecies
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Available Assets
In addition to specifying the capital required by an insurer to bear its
risks, it is important for a capital scheme to specify which of the
companys assets may be admitted in satisfying the requirement

Assets and the values attributed to them in the companys financial

statements are largely determined by accounting rules

Not all the value of these assets can necessarily be easily realized,
particularly in times of stress

Certain assets are not admitted for these purposes since they do
not have obviously realizable values; examples include
Furniture and equipment
Deferred acquisition costs
Deferred tax assets
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Available Assets
Not all admitted assets have values that can be
realized with equal ease
Many bonds may be readily marketable
Real estate is not as readily sold and if sold under
distress, may not realize the value for which it is held
on the balance sheet

We therefore classify assets as to quality with

respect being available to meet the companys
financial needs in times of stress
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Available Assets
The three primary considerations for defining the capital of
a company for purposes of measuring capital adequacy
are:
its permanence
its being free of mandatory fixed charges against
earnings
its subordinated legal position to the rights of
policyholders and other creditors of the institution
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Available Assets
It is now common for assets to be classified in
Tiers with respect to their suitability in supporting
required capital
This scheme was first developed under the
Basel Accord for international banking capital
requirements
It has been adopted for insurance in a number of
jurisdictions, particularly those that have
integrated financial regulators
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Available Assets
The Canadian system, for example, uses two
tiers
Tier 1 ("core capital") comprises the highest
quality capital elements
Tier 2 ("supplementary capital") elements fall
short in meeting either of the first two capital
properties listed above (permanence and free of
fixed charges), but contribute to the overall
strength of a company as a going concern
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Available Assets
Tier 1 capital elements are restricted to the following:

Common shareholders' equity, defined to include common shares,

contributed surplus, and retained earnings
Qualifying non-cumulative perpetual preferred shares
Qualifying innovative tier 1 instruments
Participating account
Non-participating account (for mutual companies)
Accumulated net after-tax foreign currency translation adjustment
Net deferred gains/losses on real estate that have not been taken into
account in the valuation of policy liabilities less 45% on the portion of
gains/losses on which no income taxes payable has been accounted for, or
the future income tax amount
Qualifying non-controlling interests in subsidiaries arising on consolidation
from tier 1 capital instruments

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Available Assets
Tier 1 capital instruments are intended to be permanent
Where tier 1 preferred shares provide for redemption by
the issuer after five years, with supervisory approval, the
Office would not normally prevent such redemptions by
healthy and viable companies when the instrument is or
has been replaced by equal or higher quality capital
including an increase in retained earnings, or if the
company is downsizing. The redemption or purchase for
cancellation of tier 1 instruments requires the prior
approval of the Superintendent
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Available Assets
Tier 2 is divided in three sub-tiers
Tier 2A: Hybrid (debt/equity) capital instruments
Hybrid capital includes instruments that are essentially
permanent in nature and that have certain characteristics of both
equity and debt

Tier 2B: Limited life instruments

Limited life instruments are not permanent and include
subordinated term debt and term preferred shares

Tier 2C: Other capital items

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Available Assets
Common shareholders equity (i.e., common shares and retained earnings) and
policyholders equity (mutual companies) should be the predominant form of a
companys tier 1 capital
The following limitations apply to capital elements after the specified deductions
and adjustments:

a strongly capitalized company should not have innovative instruments and

non-cumulative perpetual preferred shares that, in aggregate, exceed 40% of
net tier 1 capital

innovative instruments shall not, at the time of issuance, comprise more than
15% of net tier 1 capital

the amount of capital elements, net of amortization, included in tier 2 shall not
exceed 100% of net tier 1 capital

limited life instruments, net of amortization, included in tier 2B shall not exceed
a maximum of 50% of net tier 1 capital

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Capital Ratios
It is common to measure a firms capital ratio as
(available assets) / (required capital)
Certain capital targets are often expressed as
minimum ratios
the Canadian minimum is 120%
the Canadian supervisory target is 150%
companies are encouraged to establish their own
target ranges
a common choice is 175% - 200%

the Canadian industry average is in excess of 220%

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Capital Ratios
Asset quality requirements can also be
expressed in terms of capital ratios
Canada has a minimum tier 1 ratio of 60%
The minimum supervisory tier 1 ratio is
105% represents 70% of the 150% total
supervisory target ratio
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Capital Ratios
In banking, the Basel Accord was initially
focused on assets and credit risk in
particular
Subsequent revisions to the Basel Accord
extended coverage to market risk
associated with the portfolio of assets a
bank holds for trading and to operational
risk
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Capital Ratios
Required capital is expressed in terms of a fixed
percent of assets
The same factor, 8%, is applied to all assets
To account for differing asset quality, assets are riskweighted
Required capital for other risks is multiplied by 12.5
(the reciprocal of 8%), the result is included in riskweighted assets, to which the 8% factor is applied to
the determine total required capital
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Capital Ratios
Under the Basel Accord, a banks minimum capital ratio is
required capital expressed as a percent of risk weighted
assets
The minimum ratio is 8%
The minimum Tier 1 ratio is 4%
OSFI requires Canadian banks to hold a minimum Tier 1
ratio of 7% and a minimum total ratio of 10%
That this is a sound policy has been demonstrated by the strength
of the Canadian banking system during the current world financial
crisis
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Questions and Discussion