Chapter 3: Solvency Assessment and Management (SAM)

Question 1

SAM is based on 3 principles

Answer 1

• principles-based regulatory framework
• based on an economic balance sheet view
• structured on 3 pillars:
• — capital adequacy
• — systems of governance
• — reporting requirements

Question 2

Objectives of the SAM regime

Answer 2

Primarily: POLICYHOLDER PROTECTION

• to align capital requirements with the underlying risks.
• a PROPORTIONATE, RISK-BASED SUPERVISION with appropriate treatment for all insurers.
• incentivize use of more SOPHISTICATED TOOLS for risk monitoring and risk management - e.g. internal capital models, risk mitigation and risk transfer tools.
• to maintain FINANCIAL STABILITY.

Question 3

SAM Requirements:

Pillar I

Answer 3

QUANTITATIVE REQUIREMENTS to demonstrate that insurers have adequate financial resources.

The ECONOMIC BALANCE SHEET approach allows for a consistent treatment of all assets and liabilities, calculated at MARKET CONSISTENT values.

MCR
the minimum amount of capital below which no insurer will be allowed to operate.

SCR
a much higher amount and indicates the first “trigger” point at which the regulator would start to intervene in the affairs of an insurer.

Long-term insurers are also required to calculate the Liquidity Shortfall Indicator.
This is a high level assessment of the magnitude of liquidity risk that an insurer may be exposed to following an SCR event.

Question 4

Valuation of Assets under SAM Pillar I

Answer 4

follows International Financial Reporting Standards (IFRS):

• market consistency
• economic (fair value) valuation approach

Minor deviations from IFRS (intention being to be closer to an economic valuation):

• Goodwill valued at zero.
• Other intangible assets should only be included such that a fair value can be placed on them.
• Property valued at fair value.

Participations in subsidiaries, associates and joint ventures are valued using a market value approach, being a quoted market value or, if this is not available, a market consistent valuation.

Reinsurance assets

• shown as an asset on the balance sheet
• should allow for expected losses due to default of the reinsurer.

Question 5

SAM:

Valuation method of the technical provisions

Answer 5

Technical provisions are calculated using market consistent principles.

They consist of:
= best-estimate liabilities
+ a risk margin.

Best-estimate liability
= probability-weighted average of future cash flows,
(taking account of the time value of money by discounting using a risk free yield curve)

Risk margin
represents the premium over and above the best-estimate liabilities that a third party would be willing to pay to assume obligation to the policyholders.

Best-estimate liabilities should be calculated GROSS OF REINSURANCE, with reinsurance recoverables reflected explicitly as an asset in the balance sheet.

Question 6

SAM: Best estimate liabilities

Answer 6

Determined as the discounted value of projected cash flows under each policy up to the “contract boundary”, calculated on a policy-by-policy basis.

The assumptions should be best-estimate with no additional margins for prudence.

Question 7

SAM:

Risk-free discount rate

Answer 7

The risk-free discount rate used in the calculation of the technical provisions shall in general be the government bonds curve.

Question 8

SAM

Risk margin

Answer 8

The risk margin represents the premium over and above the best-estimate liabilities that one insurer would require to take on the obligations of another insurer.

It represents the theoretical compensation for the risk of future experience being worse than assumed in the calculation of the best-estimate liabilities.

Question 9

SAM

Basic own funds

Answer 9

Basic own funds are defined in the market consistent value balance sheet as
… the excess of assets over liabilities,
… plus subordinated liabilities,
… less any regulatory adjustments.

Regulatory adjustments are made for:

• certain ineligible assets,
• holdings in own holding company shares,
• cash and deposits at a bank in the same financial conglomerate,
• restricted reserves,
• participations in financial and credit institutions, and
• for any ring-fenced funds.

Question 10

SAM

Ancillary own funds

Answer 10

Off-balance sheet capital resources that can be called upon to absorb losses.

Such contingent capital items would include instruments such as letters of credit and guarantees.

Question 11

SAM

Available own funds

Answer 11

basic own funds

+ ancillary own funds

Question 12

Tiers of available own funds

Answer 12

3 tiers.

Tiering according to a strict range of criteria, e.g. whether the instrument is immediately available to absorb losses at its full value.

Limits apply as to the proportion of Tier 1, Tier 2 and Tier 3 own funds that can be used to cover the SCR and the MCR.

These limits may result in some of the own funds being regarded as ineligible for the purposes of determining solvency.

Question 13

The SAM non-life underwriting risk module consists of 4 sub-modules

Answer 13

a) the non-life PREMIUM AND RESERVE RISK sub-module
b) the non-life LAPSE RISK sub-module
c) the non-life CATASTROPHE RISK sub-module and
d) an optional adjustment to the basic non-life underwriting risk capital to allow for the loss-absorbing or amplification capacity of features of (re)insurance contracts that involve an element of risk sharing between one or more of the parties to the agreement.

Question 14

SAM:

Non-life lapse risk

Answer 14

Non-life lapse risk should be quantified where insurance contracts include policyholder options which significantly influence the obligations arising from them.

(e.g. an option to terminate a contract before the end of a previously agreed insurance period or an option to renew a contract according to previously agreed conditions)

Question 15

SAM:

2 Scenarios considered for the purpose of calculating non-life lapse risk

Answer 15

lapseshock1:
Lapsing of 40% of the insurance policies for which lapsing would result in an increase of technical provisions without the risk margin.

lapseshock2:
Decrease of 40% of the number of future insurance or reinsurance contracts used in the calculation of technical provisions associated to insurance or reinsurance contracts to be written in the future.

Question 16

SAM:

Non-life catastrophe risk (4 sub-modules)

Answer 16

The non-life catastrophe risk is determined using a complex series of formulae defined in various sub-modules of the calculation, and comprises:

• NATURAL CATASTROPHE risk sub-modules, sub-divided: earthquake/hail

- a sub-module for catastrophe risk of NON-
PROPORTIONAL PROPERTY REINSURANCE

- a MAN-MADE CATASTROPHE risk sub-module, sub-divided between 
—-- motor vehicle, 
—— liability, 
—— fire, marine, 
—— aviation,
—— liability,
—— terrorism,
—— accident and health; 
—— trade credit and consumer credit.

• a sub-module for OTHER NON-LIFE CATASTROPHE risk not considered previously by zone or peril.

Question 17

SAM:

Calculation of Final SCR Requirement

Answer 17

Individual capital requirements are combined using pre-specified correlation matrices, in order to allow for diversification between different risks.

Separate correlation matrices are used to aggregate capital requirements,
- first WITHIN SPECIFIC RISK MODULES
(e.g. combining the capital requirements for global, SA and other equities to get the diversified equity price risk capital requirement), and
- then ACROSS RISK MODULES within the broad risk categories
(e.g. combining the capital requirements for all risk modules within market risk to give the diversified market risk capital requirements), and
- then finally across market risk, life underwriting risk and non-life underwriting risk
to give the BASIC SCR (BSCR).

The OVERALL SCR is obtained by adding the capital requirements for insurance participants within the same sector (i.e. any life insurance participants) and operational risk, and adjusting for the loss absorbing capacity of deferred taxes.

The loss absorbing capacity of deferred taxes arises as a result of companies being able to reduce any existing deferred tax liabilities or establishing a deferred tax asset following a loss as a result of the SCR event.

The capital requirements for other participants (insurance participants in a different sector and non-insurance participants) are included under equity risk.

Question 18

SAM:

5 Requirements of an INTERNAL MODEL

Answer 18

The use of a partial or full internal model is subject to regulatory approval, and would be required to satisfy the following key requirements:

• Insurers must have an EFFECTIVE SYSTEM OF GOVERNANCE for the internal model.
• Insurers must demonstrate via the Use Test that the MODEL IS WIDELY-USED in risk management and decision-making, and plays an important role in their system of governance.
• Insurers must meet requirements relating to:
• — statistical quality,
• — data quality,
• — model calibration
• — and validation.
• Insurers must ADEQUATELY DOCUMENT the design and operational details of their internal model.
• Partial models may be approved provided they are sufficiently justified and integrated into the remaining standardised formula.

Question 19

SAM:

‘The Use Test’ for internal models

Answer 19

The Use Test includes the use of the model in

• decision-making processes,
• business planning,
• risk management,
• capital assessment
• and allocation processes,
• and the Own Risk and Solvency Assessment (ORSA).

Question 20

SAM:

The SCR attempts to address 4 important shortcomings of the CAR methodology.

Answer 20

• The CAR does not consider the risks arising from assets held in excess of liabilities and the CAR, and therefore does not provide the regulator with the full scope of risks that could impact the insurer’s solvency position.
• The CAR uses a fairly simplistic approach to correlating risks.
• The CAR excludes certain risks which are now covered in the SCR, such as lapse risk, catastrophe risk and non-proportional reinsurance risk mitigation.
• The capital requirements for short-term insurers and long-term insurers were not calculated on a consistent basis, potentially resulting in regulatory arbitrage.

Question 21

SAM:

6 Shortcomings of the standardised formula which need to be adressed in an internal model.

Answer 21

• The use of multiple correlation matrices is theoretically invalid and can result in inaccuracies in the correlations between risks.
• It may not be appropriate for fast growing or closed books
• Operational risk is modelled at a very high level with no link to the insurers’ actual risk management framework.
• It does not allow for non-linearity between risks. This refers to situations where the capital required for two risks occurring simultaneously is greater than the sum of the capital required for each risk individually.
• Complex risk management techniques such as dynamic hedging and certain reinsurance structures cannot be allowed for in the standardised formula.
• The allowance for the risk sharing inherent in cell captive business between third party cells and the promotor cell is allowed for on an approximate basis, which may overstate the SCR for this business.

Question 22

SAM:

MCR

Answer 22

Establishes a lower bound for the required solvency capital, below which policyholders and beneficiaries would be exposed to an unacceptable level of risk if the insurer were allowed to continue its operations.

The MCR is the minimum amount of capital below which no insurer will be allowed to operate.

It is calibrated (at a high level) at the Value-at-Risk of the basic own funds of an insurer or reinsurer, subject to a confidence level of 85% over a one-year period.

Question 23

2 Main elements contained in Pillar 2 of Solvency II

Answer 23

• the Own Risk and Solvency Assessment (ORSA)

- the Supervisory Review Process (SRP)

Question 24

Define the ORSA

Answer 24

Processes and procedures to:
- identify,
- assess,
- monitor,
- manage,
- and report
long- and short term risks an insurer faces / may face 

To determine the OWN FUNDS NECESSARY to ensure overall solvency needs are met at all times.

Under ORSA, insurers conduct at least annually, and at any instance of a material change in the risk profile of the business, a SELF-ASSESSMENT of their risks and the level of solvency needed to cushion those risks.

Question 25

SAM:

Supervisory Review Process (SRP)

Answer 25

The FSB will use the SRP to assess the ability of an insurer’s system of governance to identify, assess, monitor and manage the risks and potential risks it faces.

The SRP considers an insurer’s:

• systems of governance and risk assessment
• technical provisions
• capital requirements
• investment rules
• quality and quantity of own funds
• use of a full or partial internal models

Question 26

SAM: Pillar III

Answer 26

Pillar III specifies the public and confidential disclosures under SAM. It seeks to create transparency with the aim of harnessing market discipline in support of regulatory objectives.

Pillar III reporting will require insurers to describe how risks are managed.

The new disclosure documents required as part of Pillar III of Solvency II are:

• the confidential Report to Supervisor (RTS), and
• the public Solvency and Financial Condition Report (SFCR).

Both reports are each regulated solo insurer, as well as at an insurance group level.

The requirements for SAM are expected to achieve similar objectives but are likely to differ in structure.

The reporting requirements will, however, exceed current reporting requirements.

Question 27

SAM Pillar III disclosure requirements

Answer 27

Insurers may be required to disclose capital management details annually in the SFCR, including any material breaches of the MCR and SCR.

• The basis of and valuation methods for assets and technical provisions, including any significant differences between those presented in the financial statements;
• A description of the risk exposure, concentration, and mitigation for each risk category;
• Financial performance
• Governance; and
• Certification of compliance with investment requirements.

Question 28

SAM Pillar III

disclosure of sensitive information

Answer 28

Sensitive information, disclosure of which would result in significant undue competitive disadvantage, or which is subject to policyholder or other counterparty confidentiality obligations,

may be reported confidentially to the FSB in the equivalent of the RTS.

Question 29

SAM Pillar III

7 Key areas of change from the current statutory returns

Answer 29

• Significantly greater disclosure on non-linked assets, including instrument level disclosure.
• Greater detail on the calculation of the capital requirements.
• Additional analyses of change in excess assets and reconciliations to IFRS results.
• The results of the Liquidity Shortfall Indicator calculation.
• Detail on operational risk events.
• Additional detail on reinsurance arrangements.
• Additional reporting requirements for cell captives.

Question 30

SAM:

The role of the Head of Actuarial Control (HAC)

Answer 30

The HAC is required to attest to

• the accuracy of the calculations and
• the appropriateness of the assumptions

with regards to

• technical provisions,
• SCR calculations, and
• technical provisions
• capital requirements

forming part of the ORSA projections.

Question 31

SAM:

Impact on business culture and strategy (7)

Answer 31

• Engagement with SAM is important throughout the business, including at senior management and Board level. This is the case for all insurance companies and not just those opting to use an internal model - although being able to demonstrate full integration of SAM into the business is a key part of the internal model approval process.
• SAM is not just a reporting framework, but a risk management framework with implications for capital allocation, risk mitigation activities and performance management.
• The regime may also have an impact on the optimal product mix for the company, and on product design.
• It is also likely to impact the optimal asset mix for the company, since some asset classes will become relatively more attractive as a result of their lower capital requirements.
• The availability, or otherwise, of risk diversification benefits may also affect corporate structures and generate merger and acquisition activity.
• Management information is likely to align SAM metrics with the business and strategic decision-making process.
• The impact on the market of the external disclosures also needs to be considered.

Question 32

Proposed Twin Peaks model of financial regulation

Answer 32

• one regulator is tasked with prudential (financial soundness) regulation of the sector,
• another regulator is tasked with market conduct regulation.

The South African Reserve Bank is seen as best placed to play the role of macro prudential regulator, while the FSB will focus on market conduct regulation, with its mandate extended to include market conduct regulation of retail banking.

Question 33

SAM will be implemented through the Insurance Act with supporting subordinate legislation in the form of Insurance Prudential Standards cover 6 areas

Answer 33

• General Standards (GS)
• Fit and Proper Standards (FP)
• Governance Standards (GR)
• Financial Soundness Standards (FS)
• Auditing Standards (AU)
• Reporting and Disclosure Standards (RD)

Question 34

SAM: Pillar II

Answer 34

A shortcoming in regulatory frameworks highlighted by the global financial crisis has been the lack of sufficient mechanisms to provide supervisors with an early warning of a potential solvency concern, or sufficient powers to intervene.

Pillar 2 addresses this issue by assessing the effectiveness of corporate governance and risk management.

Pillar 2 serves as a major link between Pillar 1 and Pillar 3 of SAM by considering the extent to which the corporate governance structure is embedded in the day-to-day running of the business.

Question 35

The systems of governance that insurers are required to maintain as proposed in Solvency II address 8 areas

Answer 35

• General governance
• Fit and proper requirements
• Risk management system
• Internal control
• Internal audit
• Actuarial function
• Outsourcing
• Compliance

Question 36

SAM Pillar I:

How should the Risk Margin be calculated

Answer 36

By determining the cost of providing an amount of eligible own funds equal to the SCR necessary to support the insurance obligations over the lifetime thereof, assuming that the business is transferred to a third party.

The risk margin is therefore calculated as 6% of the projected SCR at each future year-end, discounted using risk-free rates of return.

When projecting the SCR, approximate methods can be used, subject to proportionality and materiality.

Question 37

SAM Pillar I:

Calculation of the SCR

Answer 37

The SCR should correspond to the Value-at-Risk of the basic own funds of an insurer or reinsurer subject to a confidence level of 99.5% over a one-year period.

Question 38

SAM Pillar I:

MCR overall minimum

Answer 38

The MCR is subject to a minimum overall value of R15 million (R30 million for composite reinsurers) or 25% of gross annualised operational expenses.