INSPRU overview. Paul Edmondson T: E: November 2013

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1 INSPRU overview Paul Edmondson T: E: November 2013

2 Three rules Insurers must maintain assets to meet liabilities maintain capital only carry on insurance business 2

3 But first some context An insurance company s product is a promise. Very simply, an insurer s core business is to make financial promises to others in the form of policies under which it will: receive premiums assume obligations (ie actual/contingent liabilities to pay claims to policyholders) Insurers use premiums to: pay expenses; and invest in assets which they use to: pay claims; mitigate / manage risks (ie buy risk mitigation); and ideally, make investment profits (in addition to underwriting profits) 3

4 Assets Key strategic / management questions for any insurer include: What types of assets should it hold? How and by whom should these be managed? How well matched are its assets to its liabilities including in terms of duration (think liquidity)? When will assets be recognised as belonging to the insurer, and when will they not? Questions from a regulatory perspective: What is an asset? Should rules prescribe which assets insurers can hold? What risks is an insurer exposed to on the asset side? How should these risks be managed? Should insurers capital requirements reflect those risks? How should insurers value their assets? 4

5 Liabilities What about liabilities? What are they? Insurance liabilities Other liabilities (employees, office, loans etc.) Which insurance liabilities should be recognised? How should insurance liabilities be valued? What risks might affect the value of an insurer s liabilities? What about other liabilities? When should these be recognised for regulatory purposes? Should prudential regulation address these questions? If so, how? 5

6 Capital Requirements What are capital requirements? Very broadly, a regulatory capital requirement is the amount of excess assets that an insurer must hold above its liabilities, calculated in accordance with relevant rules, It is a required minimum buffer against the risk of actual insolvency It is not a guarantee against insolvency - the regulatory aim is not zero failures If capital requirements are set too high, there will be no commercial incentive to do business - the cost of capital will be too high Further, if capital requirements are not tailored to the specific risks inherent in the specific business, then: The risk buffer won t reflect the risks! The sufficiency of the buffer in stress scenarios will vary by company; and The costs of capital for: low risk businesses may be unduly high high risk businesses may be unduly low 6

7 Crude balance sheet of an insurer (assets and liabilities) Regulatory Capital Headroom /excess e.g. for credit rating Capital Non-insurance liabilities Insurance liabilities/ Technical Provisions Assets Liabilities 7

8 Summary of UK regulatory capital requirements calculation of requirements mapped against total asset stack First regulatory intervention point Final regulatory intervention point 3 Free Assets 2 Assets representing regulatory capital requirements 1 Assets covering technical provisions and other liabilities Headroom additional net assets/capital above regulatory capital requirements additional loss absorption/capital, which may improve credit rating Adjusted ICA/ICG ICA ECR MCR Capital Resource Requirement (CRR) (capital resources (CR) must exceed this requirement) Net assets (above line) MCR = Minimum Capital Requirement: EU Minimum Requirement under Solvency I 8

9 UK regulatory capital requirements MCR Minimum Capital Requirement under Solvency I ECR Enhanced Capital Requirement (general insurance) = soft calculation of requirement Used by PRA in ICA review but not published ICA Individual capital assessment by firm ICG PRA guidance following the PRA s review of the insurer s ICA 9

10 Some key concepts (1) Must hold admissible assets at least equal to technical provisions ie. insurance liabilities GENPRU 2, Annex 7 ECR for life assurers requires additional capital by reference to: amount payable on death premiums claims expenses market risk plus more for with profits business ECR for general insurers requires additional capital by reference to: net written premiums technical provisions type of assets held 10

11 Some key concepts (2) Forms of eligible capital set out in GENPRU 2, Annex 1 Need to make certain deductions from gross capital amount eg in respect of: intangible assets inadmissible assets assets in excess of market risk and counterparty limits 11

12 Contagion Risk (INSPRU 1.5) A firm must not carry out any commercial business other than insurance business and activities directly arising from that business A firm must limit, manage and control its non-insurance activities so that there is no significant risk arising from those activities that it may be unable to meet its liabilities as they fall due 12

13 Solvency II Regulating capital requirements calculation of requirements mapped against total assets 3 Initial regulatory intervention point (*will be made public) Final regulatory intervention point 2 Adjusted SCR SCR* MCR** 1b 1a *Solvency Capital Requirements **Minimum Capital Requirements 13

14 Solvency II key to diagram 1a: best estimate of liabilities (hedgeable risks subject to market-consistent valuation) 1b: risk margin within technical provisions 2: regulatory capital requirements 3: capital held in excess of regulatory capital requirements MCR: Minimum Capital Requirement the minimum level of regulatory capital. Incorporates absolute minimum = to MGF. MGF calculation still to be agreed must be within 20%/50% of SCR SCR: Solvency Capital Requirement the risk based level of regulatory capital, calculated according to = (i) standard formula; or = (ii) internal model (partial or full) approved by regulator according to specified requirements Adjusted SCR SCR level which includes any supplementary capital requirement determined through the Pillar 2 supervisory review 14

15 Solvency II technical provisions and calculation of regulatory capital requirements under Pillar 1 mapped against total assets Assets available for SCR/MCR Initial regulatory intervention point (will be made public) Final regulatory intervention point Solvency Capital Requirement (SCR) Minimum Capital Requirement (MCR) Assets covering technical provisions Assets at market value Risk margin. For nonhedgeable risks Technical provisions Best estimate Market-consistent valuation for hedgeable risks 15

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