Prudential Standard FSI 2.3 (Determination of Eligible Own Funds)

Question 1

The Financial Soundness Standards for insurers are designed to ensure that …

Answer 1

insurers can meet policyholder obligations by
… holding Own Funds of sufficient quantity and quality
… to absorb significant unforeseen losses
… arising from the risks associated with an insurer’s activities.

Question 2

The Standard set out…

Answer 2

the characteristics that an instrument must have to qualify for inclusion as Eligible Own Funds,

including the various regulatory adjustments that apply to meet the financial soundness requirements.

Question 3

4 Key principles and requirements of this standard

Answer 3

• Include in the appropriate category of Own Funds, only those items that meet the detailed criteria specified for that category.
• Ensure all items recognised as Eligible Own Funds are capable of absorbing losses.
• Make certain regulatory adjustments to Own Funds in order to determine Eligible Own Funds.
• Comply with the minimum requirements regarding the size and composition of Eligible Own Funds used to meet the SCR and MCR.

Question 4

Eligible Own Funds

Answer 4

Those capital resources that are deemed eligible to cover the capital requirements under the SCR and MCR.

Question 5

Own Funds

Answer 5

The sum of:

• Basic Own Funds
• Ancillary Own Funds

Question 6

Basic Own Funds consist of the following items: (3)

Answer 6

The excess of assets over liabilities
PLUS subordinated liabilities
LESS any regulatory adjustments

Question 7

Ancillary Own Funds

Answer 7

May include the following items to the extent that they are not Basic Own Funds:

a) Unpaid share capital or initial fund that has not been called-up;
b) Unpaid and uncalled initial funds, members’ contributions callable on demand.
c) Unpaid and uncalled preference shares callable on demand.
b) Letters of credit and guarantees; and
c) Other legally binding commitments received by an insurer.

An insurer must seek prior approval from the Prudential Authority for an item to be deemed appropriate for inclusion as Ancillary Own Funds.

Question 8

Own funds are allocated into tiers based on an assessment against 6 criteria:

Answer 8

• Loss absorbency
• Subordination
• Sufficient duration
• Free from requirements and incentives to redeem
• Free from mandatory costs
• Free from encumbrances

Question 9

Tier 1 Funds classification

Answer 9

BASIC Own Funds possessing:
- loss absorbency, and
- subordination
characteristics;

with consideration of:

• sufficient duration
• free from requirements and incentives to redeem
• free from mandatory costs
• free from encumbrances

Ancillary own funds CANNOT be Tier 1.

Question 10

Tier 2 Funds classification

Answer 10

Basic Own Funds and Ancillary Own funds, possessing loss absorbency characteristics;

taking into consideration:

• sufficient duration
• free from requirements and incentives to redeem
• free from mandatory costs
• free from encumbrances

Question 11

Tier 3 funds classification

Answer 11

Funds that are not Tier 1 or Tier 2.

Question 12

Tier 1 Basic Own Funds description

Answer 12

Highest quality Own Funds that are available to fully absorb losses and enable an insurer to continue as a going concern.

Question 13

6 Types of Basic Own Funds classified as Tier 1

Answer 13

• Paid-up common equity, less own shares held by an insurer where the investment risk attached to these shares is not carried by the policyholder)
• Share premium account
• Retained earnings
• Other reserves
• Surrender Value Gap (SVG)
• Other paid-in capital instruments, including:
• – preference shares
• – subordinated liabilities
• – subordinated mutual member accounts

Question 14

4 Types of Basic Own funds that may be classified as Tier 2 funds

Answer 14

• Called-up (but not paid-in) ordinary share capital
• Other called-up capital instruments that absorb losses first or rank pari passu, in going concern, with capital instruments that absorb losses first
• Other paid-in capital instruments including preference shares, subordinated mutual members accounts and subordinated liabilities that do not have the features required for Tier 1.
• Own Funds in excess of amounts being used to cover related risks in the case of “restricted reserves”.

Question 15

pari passu

Answer 15

Pari-passu is a Latin phrase meaning “equal footing” that describes situations where two or more assets, securities, creditors or obligations are equally managed without any display of preference.

Question 16

2 Types of Basic Own Funds that should be classified as Tier 3

Answer 16

• Deferred tax assets net of deferred tax liabilities (subject to a floor of zero)
• Other capital instruments including preference shares, subordinated mutual members’ accounts and subordinated liabilities that do not have the features required for Tier 1 or Tier 2.

Question 17

2 Ancillary Own Funds items that may be classified as Tier 2

Answer 17

Subject to the approval of the Prudential Authority:

• Letters of credit and guarantees which are held in trust for the benefit of insurance creditors by an independent trustee and provided by credit institutions; and
• Any future claims with variable contribution which mutual or mutual-type associations may have against their members by way of a call for supplementary contributions within the following 12 months.

Question 18

Determining Eligible Own Funds:

Intangible assets

Answer 18

Only 20% of the value of any intangible assets recognised under FSI 2.1 must be recognised in Eligible
Own Funds.

They must be classified as Tier 3.

Question 19

Determining Eligible Own Funds:

Investments in an insurer’s own holding company

Answer 19

• Unlisted ordinary shares held by an insurer in it’s own holding company must be FULLY DEDUCTED from the insurer’s Basic Own Funds.
• Listed ordinary shares held by an insurer in it’s own holding company IN EXCESS OF 5% of the non-linked assets of the insurer must be DEDUCTED from the insurer’s Basic Own Funds.
• An insurer may not include bonds / other capital instruments in any holding company.
• An insurer may - however - hold and take into account for the SCR, investments in companies that, in turn, hold shares in the insurer.

Question 20

Determining Eligible Own Funds:

Cash and deposits at a bank within the same financial conglomerate

Answer 20

Any cash balances and short-term deposits in excess of 15% of the non-linked assets of an insurer, which are held at a bank that is part of the same financial conglomerate of the insurer, must be fully deducted from Basic Own Funds.

Question 21

Determining Eligible Own Funds:

Participation in financial and credit institutions

Answer 21

Participations in financial institutions and credit institutions (excluding insurance-related business)

in excess of 15% of Tier 1 Basic Own Funds

must be fully deducted from Basic Own Funds.

Question 22

Determining Eligible Own Funds:

Net deferred taxes

Answer 22

Any net deferred tax assets recognised in Tier 1 Basic Own Funds must be fully deducted from Tier 1, and recognised as Tier 3 Basic Own Funds.

Question 23

Own Funds to cover the SCR and MCR

Answer 23

Eligible Own Funds are Own Funds that count toward covering the SCR and the MCR, subject to the conditions:

• Tier 3 Basic Own Funds are eligible to cover the SCR, but are not eligible to cover the MCR.
• Ancillary Own funds are eligible to cover the SCR, but are not eligible to cover the MCR.

Question 24

Limits that apply in relation to the composition of Eligible Own Funds to meet the SCR

Answer 24

• At least 50% of the SCR must be met by Tier 1 Eligible Own Funds
• No more than 15% of the SCR must be met by Tier 3 Eligible Own Funds
• The sum of the Tier 2 and Tier 3 Eligible Own Funds shall not exceed 50% of the SCR.

Question 25

Limits that apply in relation to the composition of Eligible Own Funds to meet the MCR

Answer 25

At least 80% of the MCR must be met by Tier 1 Eligible Own Funds.

Question 26

Criteria to be met for classifying an item as Basic Own Funds (Tier 3)

Answer 26

• Item must rank after the claims of all policyholders and beneficiaries and non-subordinated creditors.
• The item must not cause or accelerate the insolvency of the insurer.
• The item must be undated, or have a remaining duration before its maturity date of at least 3 years.
• Must provide for the suspension of its repayment or redemption if the insurer breaches its SCR. The Prudential Authority may waive the suspension of repayment or redemption of the item provided it is exchanged for, or converted into, another Basic Own Funds item of the same or higher quality and the MCR is not breached.
• Must provide for the deferral of payments of coupons or dividends if the insurer breaches the MCR.
• Must be free of encumbrances, and must not be connected with any other transaction which could undermine the characteristics and features of the item.

Question 27

Criteria to be met to classify an item as Tier 1 Basic Own Funds

Answer 27

In addition to Tier 2 Basic Own Funds Requirements…

• The item must be the most deeply subordinated in a wind-up situation.
• Item must be able to absorb losses at least when the insurer breaches SCR, and shouldn’t hinder re-capitalisation.
• The item must be undated, or have a remaining duration before its maturity date of at least 10 years.

Question 28

Criteria to be met for classifying an item as a Tier 2 Basic Own Fund item

Answer 28

In addition to Basic Own Funds Requirements…

• The holder of the instrument must not be in a position to petition for the insolvency of the inurer.
• The instrument must not be taken into account for the purposes of determining whether the insurer is insolvent.
• The insurer must be able to defer or cancel coupons or dividend payments at any point in time (without triggering legal insolvency).
• The item must be undated or have an original maturity of at least 5 years.
• In the case of a capital instrument called-up but not paid-in, the instrument must meet the criteria for Tier 1, other than the item being fully paid-in and immediately available to absorb losses.

Question 29

Surrender Value Gap (SVG)

Answer 29

Expected profits included in future cash-flows result from the recognition of profits yet to be earned.

These profits emanate from the cash-flows from existing (in-force) business that are expected in the future.

The expected profits included in future cash-flows are also known as the SVG.

Question 30

How is the SVG broadly calculated?

Answer 30

As the change in the Basic Own Funds following a selective mass lapse event, which is the lapse of all existing (in-force) business where there is a positive surrender strain.