Prudential Standard FSI 4 (Calculation of the SCR Using the Standard Formula)

Question 1

The SCR is designed to ensure…

Answer 1

that a sufficient minimum level of Eligible Own Funds is held against the key risks to which an insurer is exposed.

Question 2

The risk measure which the SRC is calibrated to correspond to…

Answer 2

VALUE-AT-RISK
of an insurer’s
BASIC OWN FUNDS

at a confidence level of:
99.5% over a ONE YEAR PERIOD

Question 3

4 Main Features of the Standardised Formula

Answer 3

• It’s a forward-looking, risk-based measure that addresses the key risks faced by insurers.
• It measures risks primarily through the application of stress scenarios to an insurer’s assets and liabilities.
• It is proportionate in that it allows for the use of simplified calculations under certain conditions.
• It makes allowance for the risk-reducing impact of DIVERSIFICATION benefits between risks, and also for risk mitigation instruments, changes to policyholder behaviour and future management actions.

Question 4

Outline the Standardised Formula calculations

Answer 4

Requires the calculation of capital requirements for each key risk category, namely:

• market risk
• underwriting risk
• operational risk

The capital requirements for each risk category are aggregated using a correlation matrix prescribed in this Standard, which allows for diversification benefits between some categories in calculating the SCR.

Question 5

To whom does Prudential Standard FSI 4 apply?

Answer 5

All insurers licensed under the Insurance Act (2016), other than:

• microinsurers,
• Lloyd’s, and
• branches of foreign reinsurers.

Question 6

To what does the term “insurer” refer to in this standard?

Answer 6

• life insurers
• non-life insurers
• reinsurers

Question 7

Responsibilities of an insurer’s Head of Actuarial Control

Answer 7

Responsible for
… providing assurance to the board of directors
… regarding the accuracy of the calculations
… to derive the SCR,
… including the appropriateness of the assumptions underlying the calculations.

Question 8

4 Key risk categories of the SCR

Answer 8

• Market risk
• Underwriting risk
• Operational risk
• Participation risk

Question 9

Market risk

Answer 9

The risk of loss arising from:

• the impact of movements in market prices on the value of an insurer’s assets and liabilities, or
• the default of the insurer’s counterparties.

Question 10

7 Market risk components accounted for in the Standardised Formula

Answer 10

• Interest rate risk
• Equity risk
• Property risk
• Currency risk
• Spread and default risk
• Concentration risk
• Illiqudity premium risk

Question 11

Underwriting risk

Answer 11

The risk of loss arising from insurance obligations, such as:

• poor claims experience,
• expense over-runs and
• policy lapses.

Question 12

3 Underwriting risk components accounted for in the Standardised Formula

Answer 12

• Premium and reserve risk;
• Lapse risk
• Catastrophe risk

Question 13

Operational risk

Answer 13

The risk of loss arising from inadequate or failed internal processes, people and systems, or from external events.

Question 14

Participation risk

Answer 14

Risk arising from losses associated with investments by an insurer in participations.

Question 15

Allowance for future management actions in the SCR

Answer 15

Future management actions may be taken into account in calculating the capital requirement for individual risk components, subject to the following conditions:

• If a stress scenario is instantaneous, no management actions may be assumed to be taken,
• Any assumptions regarding future management actions for the assessment of the SCR should be objective, realistic and verifiable.

Question 16

Allowance for changes to policyholder behaviour in the SCR

Answer 16

Insurers should consider changes to policyholder behaviour under each stress scenario.

Examples include:

a) Decreases in policy lapse as investment guarantees become more valuable;
b) Increases in the exercise of guaranteed annuity options due to a permanent decrease in mortality rates; and
c) Increases in policyholders exercising their options to extend the term of existing guaranteed policies where there are changes in market conditions that lead to an increase in mortality and term assurance rates.

Question 17

Risk mitigation through risk transfer by insurers usually takes one of two main forms:

Answer 17

• Reinsurance
  whereby the insurer cedes part of its underwriting risk to another insurer/reinsurer.
• Financial risk mitication
  whereby the insurer purchases financial instruments to transfer risk to participants in the financial markets.

Question 18

Allowance for risk mitigation in the SCR

Answer 18

Subject to conditions, the effect of a risk mitigation instrument may be included,
provided that the related COUNTERPARTY DEFAULT RISK is properly captured.

Inclusion is limited to computation for market risk and underwriting risk (no risk mitigation for operational risk).

Question 19

Calculation of the SCR when an insurer has ring-fenced funds

Answer 19

Involves calculating a notional SCR for :

• each ring-fenced fund,
• and for the insurer as a whole (including the ring-fenced funds and the business written outside the ring-fenced arrangements).

Question 20

Principle of proportionality

Answer 20

Resources devoted to complying with a particular regulatory requirement, such as calculating SCR, should be consistent with the nature and complexity of the risks involved.

Question 21

General QUALITATIVE provisions for a risk mitigation instrument to be eligible to be taken into account in calculating the SCR (11)

Answer 21

1. The contractual arrangements and transfers of risk must be LEGALLY EFFECTIVE and ENFORCEABLE.
   (taking into account any CONDITIONS or CONNECTED TRANSACTIONS which could undermine the effective transfer of risk)
2. Cover provided is clearly DEFINED and INCONTROVERTIBLE
3. Insurer appropriately addresses the EFFECTIVENESS and RELATED RISKS on an ongoing basis.
4. Transaction documents set out a DIRECT CLAIM on the counterparty in the event that the counterparty suffers a credit event.
5. Arrangements must not result in the creation of new risks, unless these are properly captured in the SCR.
6. There is no double-counting of risk mitigation effects.
7. Instruments must be in-force at the date of reference and for at least the next 12 months thereafter, to be fully taken into account.
8. Instruments in-force at the date of reference for a period of time less than 12 months thereafter may be taken into account on a pro-rata basis.
9. Shared risk mitigation techniques where activation of protection to one party means the loss of protection (partially / totally) for the rest, should not be treated as a risk mitigation instrument.
10. The instrument must meet the requirements of the insurer’s risk management policies.
11. The instrument must be able to be valued reliably.

Question 22

A credit event includes: (3)

Answer 22

• default
• insolvency
• bankruptcy
  of the counterparty

Question 23

The counterparties to reinsurance contracts must either be: (2)

Answer 23

• An insurer or reinsurer regulated by the Prudential Authority, or
• An insurer not regulated by the Prudential Authority, but where the Prudential Authority has given equivalence status to the jurisdiction where the insurer or reinsurer is regulated.

Question 24

Condition to allowing an approved Special Purpose Vehicle (SPV) insurance risk mitigation instrument

Answer 24

The funding level of the SPV is fully allowed for in the calculation of counterparty default risk.

Question 25

Condition to allowing risk mitigation by securitisation using a legal entity other than a SPV

Answer 25

The insurer has to demonstrate (to the satisfaction of the Prudential Authority) that requirements equivalent to those set out for an SPV are fully met by the legal entity to which risk is transferred.

Question 26

Conditions to allowing risk mitigation instruments that are credit derivatives (2)

Answer 26

The insurer has in place generally applied procedures for the mitigation of credit exposures by using credit derivatives.

The credit events specified cover at least:

• Failure to pay the amounts due under the terms of the underlying obligation that are in effect at the time of such failure.
• Bankruptcy, insolvency, or inability of the obligor to pay its debts,
• Restructuring of the underlying obligation, involving forgiveness or postponement of principal, interest or fees that results in a credit loss event.

Question 27

An insurer with participations in insurance-related business that are in the same sector must classify the participations in to 1 of 3 categories:

Answer 27

• “Global”
• “SA”
• “Other”
  participations

Question 28

“Global” participations

Answer 28

Participations in companies listed in regulated markets in countries which are members of either:

• the European Economic Area (EEA), or
• the Organisation for Economic Co-operation and Development (OECD)

Question 29

“SA” participations

Answer 29

Participations in companies listed on the Johannesburg Stock Exchange (JSE).

Question 30

“Other” participations

Answer 30

Includes all other participations not already included in the Global and SA categories.

Question 31

How is the notional SCR for a ring-fenced fund calculated?

Answer 31

By aggregating the SCR under the worst-case scenario for each risk category and risk component using the usual procedure for aggregation under the Standard Formula.

This procedure allows for recognition of diversification benefits between risks within a ring-fenced fund.

Question 32

The capital requirement for

each risk category where individual risk components must be aggregated (ie market risk, non-life underwriting risk),

must be calculated as:

Answer 32

√[ Σᵢ,ⱼ CorrComponentᵢ,ⱼ x SCRᵢ x SCRⱼ ]

CorrComponentᵢ,ⱼ
is the correlation between risk components i and j (specified in correlation matrices within the detailed standards for each risk category)

SCRᵢ, SCRⱼ
Capital requirement for the risk component i and j, where i and j are both components of the same risk category

Question 33

The Basic Solvency Capital Requirement (BSCR) must be calculated as:

Answer 33

√[ Σᵢ,ⱼ CorrBSCRᵢ,ⱼ x SCRᵢ x SCRⱼ ]

CorrBSCRᵢ,ⱼ
The correlation between risk CATEGORIES i and j, specified in the CorrBSCR correlation matrix.

SCRᵢ, SCRⱼ
Capital requirement for the risk CATEGORIES i and j,

Question 34

Total SCR (SCR) must be calculated as:

Answer 34

SCR = 
BSCR 
\+ SCR_op 
\+ SCR_part
\+ AdjDT

Where:

SCR_op
is the capital requirement for operational risk

SCR_part
is the capital requirement for insurance-related participations in the same sector as the insurer.

AdjDT
is the adjustment factor for the loss-absorbing capacity of deferred taxes.

Question 35

3 Requirements to be met by the counterparties to a risk mitigation instrument (financial or insurance) for the arrangement to be incorporated in the SCR

Answer 35

1. The risk mitigation instrument issuer has deposited collateral with the insurer or the insurer’s nominee in SA equal to the insurance obligations assumed by the issuer and on which the insurer has a prior charge and lien.
2. Where a collateral arrangement exists and the value of the collateral is less than the total risk exposure, the collateral arrangement must only be taken into account to the extent that the collateral covers the risk exposure.
3. Where the risk mitigation instrument is accompanied by another risk mitigation arrangement, the other arrangement, whether viewed separately or in combination, meets the relevant requirements in this standard.

Question 36

How is counterparty default risk on risk mitigation instruments provided for?

Answer 36

Insurers are required to apply an adjustment for risk mitigation instruments assumed in the calculation of the SCR.

This adjustment is to account for the risk of impairment on recoverables from risk mitigation instruments, where the effects of risk mitigation have been recognised in a specified module of the SCR calculation.

The adjustment must be calculated by deducting an impairment factor (IMP) from the best estimate of the recoverables recognised in the module where risk mitigation has been assumed.

Question 37

The impairment factor (IMP) on risk mitigation instruments, must take into account…

Answer 37

the overall risk exposure of the insurer to its counterparties based on the stresses under the relevant module, irrespective of the legal form of their contractual obligations to that insurer.

Question 38

The impairment factor (IMP) must be calculated as:

Answer 38

IMP =
- MKT_def,type1
+ IMP_stress

Where

MKT_def,type1
is the capital requirement for default risk for type 1 exposures as calculated in FSI 4.1 (Market Risk Capital Requirement)

IMP_stress
is the potential loss across all counterparties in the spread and default module, after the application of the stresses in the relevant module where risk mitigation has been assumed.

Question 39

IMP_stress must be calculated as

Answer 39

IMP_stress =
min( Σᵢ LGDᵢ , 3 x √V )

Where
LGDᵢ
is the loss-given-default to each independent counterparty/issuer i included in the spread and default module of FSI 4.1, after the application of the stresses in the relevant module where risk mitigation has been assumed.

V
is the variance of the loss distribution for type 1 exposures, as calculated in FSI 4.1 (Market Risk Capital Requirement).

Question 40

The capital requirement for participations in same-sector, insurance-related businesses for EACH CATEGORY (Global / SA / Other) must be calculated as:

Answer 40

SCR_Part_i
= max( ∆BOF | participationshockᵢ , 0)

∆BOF
is the change in the value of Basic Own Funds

participationshockᵢ
is the prescribed fall in the value of same-sector insurance-related participations in category i, where the prescribed fall is calculated based on the equity price shocks set out in FSI 4.1 (Market Risk Capital Requirement).

Question 41

The OVERALL capital requirement for participations in same-sector, insurance-related businesses (SCR_part) must be calculated as:

Answer 41

The simple sum of the capital requirements for each category of participants. I.e.

SCR_part = Σᵢ SCR_part_i

Question 42

Adjustment required to Eligible Own Funds due to the existence of ring-fenced funds

Answer 42

The Eligible Own Funds of the insurer should be decreased to the extent that the surplus Eligible Own Funds in a ring-fenced fund are not available to meet losses outside of that ring-fenced fund.

Question 43

In determining Eligible Own Funds for ring-fenced funds and the insurer as a whole, an insurer should: (4)

Answer 43

• Determine the amount of Eligible Own Funds that reside outside of the ring-fenced funds
• Determine the amount of Eligible Own Funds that reside within each of the ring-fenced funds.
• Exclude amounts representing future shareholder transfers from Eligible Own Funds where the transfer has been declared or approved by a board of directors.
• For the insurer as a whole, recognise as Eligible Own Funds in increasing levels of tiering, the amount up to the minimum of the notional SCR and Eligible Own Funds of each ring-fenced fund, plus the Eligible Own Funds of the insurer outside of the ring-fenced funds.

Question 44

The total SCR for the insurer as a whole where a CELL STRUCTURE IS INVOLVED must be calculated as:

Answer 44

SCR_Total
= SCR_promoter
+ SCR_cells
+ SCR_diversifiedshortfall

Where:

SCR_promoter
refers to the Promoter’s contribution to the overall diversified SCR excluding business in the cells.

SCR_cells
is the adjusted SCR across cells, represents the amount of capital that can be covered by all cells after taking into account any capital charge for counterparty default risk for cells with negative Eligible Own Funds.

SCR_diversified_shortfall
represents a diversified SCR calculated from the shortfall within cells.

Question 45

SCR_promoter is calculated as:

Answer 45

SCR_promoter = 
max( 
SCR_diversified_incl_promoter - SCR_diversified_excl_promoter 
,
0)

Where

SCR_diversified_incl_promoter
is the diversified SCR including the promoter business, which must be calculated by pooling all business together as if it had been written under the same insurance licence.

SCR_diversified_excl_promoter
The diversified SCR excluding the Promoter business, calculated in the Same way as SCR_diversified_incl_promoter, but with assets and liabilities outside the ring-fenced arrangements excluded from the calculation.

Question 46

SCR_cells is calculated as

Answer 46

∑ SCR_cell_i

Where

SCR_cell_i
is the SCR covered by cell i, representing the amount of capital that can be covered by cell i. The amount that can be covered is the lesser of the SCR or the Eligible Own Funds of the cell, with a floor of zero.

I.e.
SCR_cell_i = max( min(SCR_i, EOF_i), 0 )

SCR_i
The SCR for cell i subject to a minimum of R1 million

EOF_i
Eligible Own Funds for cell i

Question 47

The calculation of the diversified SCR shortfall across cells (SCR_diversified_shortfall) involves 3 steps:

Answer 47

• Determining the shortfall per cell (SCR_shortfall_i)
• Calculating a correlation factor (β)
• Calculating the diversified SCR covered by the Promoter (SCR_diversified_shortfall)

Question 48

How is the shortfall for each cell (SCR_shortfall_i) calculated?

Answer 48

As the difference between the cell’s SCR and Eligible Own Funds, in those cases where Eligible Own Funds are not sufficient to cover the SCR in a particular cell.

Negative Eligible Own Funds should not be included in the calculation.

Question 49

Why do deferred taxes possess a “Loss-Absorbing Capacity”

Answer 49

The Financial Soundness Standards for Insurers require a valuation basis of technical provisions that is likely to be different from the basis on which insurers’ profits are taxed.

This difference means that deferred tax assets and liabilities are created on an insurer’s balance sheet, which may be able to absorb losses for the stresses considered under calculation of the SCR.

Question 50

The Adjustment Factor for the Loss-Absorbing Capacity of Deferred Taxes (AdjDT)

Answer 50

A factor designed to allow for the loss-absorbing capacity of deferred taxes that may arise under the stresses involved in the calculation of the SCR.

Question 51

Calculation of AdjDT

Answer 51

Insurers set AdjDT equal to the change in the value of the insurer’s deferred taxes that would result from an instantaneous loss of an amount that is equal to:

SCR_shock = BSCR + SCR_op + SCR_part

Where

BSCR
is the Basic Solvency Capital Requirement

SCR_op
The capital requirement for operational risk

SCR_part
The capital requirement for risks in relation to same-sector insurance-related participations.