ICP 17 Capital Adequacy
The supervisor establishes capital adequacy requirements for solvency purposes so that insurers can absorb significant unforeseen losses and to provide for degrees of supervisory intervention.
Capital adequacy in the context of a total balance sheet approach
17.1 |
The supervisor requires that a total balance sheet approach is used in the assessment of solvency to recognise the interdependence between assets, liabilities, regulatory capital requirements and capital resources and to require that risks are appropriately recognised.
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Establishing regulatory capital requirements
17.2 |
The supervisor establishes regulatory capital requirements at a sufficient level so that, in adversity, an insurer’s obligations to policyholders will continue to be met as they fall due and requires that insurers maintain capital resources to meet the regulatory capital requirements.
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Structure of regulatory capital requirements - solvency control levels
17.3 |
The regulatory capital requirements include solvency control levels which trigger different degrees of intervention by the supervisor with an appropriate degree of urgency and requires coherence between the solvency control levels established and the associated corrective action that may be at the disposal of the insurer and/or the supervisor.
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Structure of regulatory capital requirements - triggers for supervisory intervention in the context of legal entity capital adequacy assessment
17.4 |
In the context of insurance legal entity capital adequacy assessment, the regulatory capital requirements establish:
- a solvency control level above which the supervisor does not intervene on capital adequacy grounds. This is referred to as the Prescribed Capital Requirement (PCR). The PCR is defined such that assets will exceed technical provisions and other liabilities with a specified level of safety over a defined time horizon.
- a solvency control level at which, if breached, the supervisor would invoke its strongest actions, in the absence of appropriate corrective action by the insurance legal entity. This is referred to as the Minimum Capital Requirement (MCR). The MCR is subject to a minimum bound below which no insurer is regarded to be viable to operate effectively.
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17.4.1 |
A range of different intervention actions should be taken by a supervisor depending on the event or concern that triggers the intervention. Some of these triggers will be linked to the level of an insurer’s capital resources relative to the level at which regulatory capital requirements are set.
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17.4.2 |
In broad terms, the highest regulatory capital requirement, the Prescribed Capital Requirement (PCR), will be set at the level at which the supervisor would not require action to increase the capital resources held or reduce the risks undertaken by the insurer[12]. However if the insurer’s capital resources were to fall below the level at which the PCR is set, the supervisor would require some action by the insurer to either restore capital resources to at least the PCR level or reduce the level of risk undertaken (and hence the required capital level).
[12] Note that this does not preclude the supervisor from intervention or requiring action by the insurer for other reasons, such as weaknesses in the risk management or governance of the insurer. Nor does it preclude the supervisor from intervention when the insurer’s capital resources are currently above the PCR but are expected to fall below that level in the short term. To illustrate, the supervisor may establish a trend test (a time series analysis). A sufficiently adverse trend would require some supervisory action. The trend test would support the objective of early regulatory intervention by considering the speed at which capital deterioration is developing.
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17.4.3 |
The regulatory objective to require that, in adversity, an insurer’s obligations to policyholders will continue to be met as they fall due will be achieved without intervention if technical provisions and other liabilities[13] are expected to remain covered by assets over a defined period, to a specified level of safety. As such, the PCR should be determined at a level such that the insurer is able to absorb the losses from adverse events that may occur over that defined period and the technical provisions remain covered at the end of the period.
[13] To the extent these liabilities are not treated as capital resources.
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17.4.4 |
The Minimum Capital Requirement (MCR) represents the supervisory intervention point at which the supervisor would invoke its strongest actions, if further capital is not made available[14]. Therefore, the main aim of the MCR is to provide the ultimate safety net for the protection of the interests of policyholders.
[14] Note that this does not preclude such actions being taken by the supervisor for other reasons, and even if the MCR is met or exceeded.
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17.4.5 |
These actions could include stopping the activities of the insurer, withdrawal of the insurer’s licence, requiring the insurer to close to new business and run-off the portfolio, transfer its portfolio to another insurer, arrange additional reinsurance, or other specified actions. This position is different from the accounting concept of insolvency as the MCR would be set at a level in excess of that at which the assets of the insurer were still expected to be sufficient to meet the insurer’s obligations to existing policyholders as they fall due. The PCR cannot be less than the MCR, and therefore the MCR may also provide the basis of a lower bound for the PCR, which may be especially appropriate in cases where the PCR is determined on the basis of an insurer’s internal model[15] approved for use in determining regulatory capital requirements by the supervisor.
[15] The term “internal model” refers to “a risk measurement system developed by an insurer to analyse its overall risk position, to quantify risks and to determine the economic capital required to meet those risks”. Internal models may also include partial models which capture a subset of the risks borne by the insurer using an internally developed measurement system which is used in determining the insurer's economic capital. The IAIS is aware that insurers use a variety of terms to describe their risk and capital assessment processes, such as “economic capital model”, “risk-based capital model”, or “business model”. The IAIS considers that such terms could be used interchangeably to describe the processes adopted by insurers in the management of risk and capital within their business on an economic basis. For the purposes of consistency, the term “internal model” is used throughout.
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17.4.6 |
In establishing a minimum bound on the MCR below which no insurer is regarded to be viable to operate effectively, the supervisor may, for example, apply a market-wide nominal floor[16] to the regulatory capital requirements, based on the need for an insurer to operate with a certain minimal critical mass and consideration of what may be required to meet minimum standards of governance and risk management. Such a nominal floor might vary between lines of business or type of insurer and is particularly relevant in the context of a new insurer or line of business.
[16] In this context, a market-wide nominal floor may, for example, be an absolute monetary minimum amount of capital required to be held by an insurer in a jurisdiction.
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17.4.7 |
Regulatory capital requirements may include additional solvency control levels between the level at which the supervisor takes no intervention action from a capital perspective and the strongest intervention point (that is, between the PCR and MCR levels). These control levels may be set at levels that correspond to a range of different intervention actions that may be taken by the supervisor itself or actions which the supervisor would require of the insurer according to the severity or level of concern regarding adequacy of the capital held by the insurer. These additional control levels may be formally established by the supervisor with explicit intervention actions linked to particular control levels. Alternatively, these additional control levels may be structured less formally, with a range of possible intervention actions available to the supervisor depending on the particular circumstances. In either case the possible triggers and range of intervention actions should be appropriately disclosed by the supervisor.
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17.4.8 |
Possible intervention actions include:
- measures that are intended to enable the supervisor to better assess and/or control the situation, either formally or informally, such as increased supervision activity or reporting, or requiring auditors or actuaries to undertake an independent review or extend the scope of their examinations;
- measures to address capital levels such as requesting capital and business plans for restoration of capital resources to required levels, limitations on redemption or repurchase of equity or other instruments and/or dividend payments;
- measures intended to protect policyholders pending strengthening of the insurer’s capital position, such as restrictions on licences, premium volumes, investments, types of business, acquisitions, reinsurance arrangements;
- measures that strengthen or replace the insurer’s management and/or risk management framework and overall governance processes;
- measures that reduce or mitigate risks (and hence required capital) such as requesting reinsurance, hedging and other mechanisms; and/or
- refusing, or imposing conditions on, applications submitted for regulatory approval such as acquisitions or growth in business.
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17.4.9 |
In establishing the respective control levels, consideration should be had for these possibilities and the scope for an insurer with capital at this level to be able to increase its capital resources or to be able to access appropriate risk mitigation tools from the market.
Figure 17.2 below illustrates the concept of solvency control levels in the context of establishing regulatory capital requirements:
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Structure of regulatory capital requirements - Triggers for supervisory intervention in the context of group-wide capital adequacy assessment
17.5 |
In the context of group-wide capital adequacy assessment, the regulatory capital requirements establish solvency control levels that are appropriate in the context of the approach to group-wide capital adequacy that is applied.
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Structure of regulatory capital requirements - approaches to determining regulatory capital requirements
17.6 |
The regulatory capital requirements are established in an open and transparent process, and the objectives of the regulatory capital requirements and the bases on which they are determined are explicit. In determining regulatory capital requirements, the supervisor allows a set of standardised and, if appropriate, other approved more tailored approaches such as the use of (partial or full) internal models.
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17.7 |
The supervisor addresses all relevant and material categories of risk in insurers and is explicit as to where risks are addressed, whether solely in technical provisions, solely in regulatory capital requirements or if addressed in both, as to the extent to which the risks are addressed in each. The supervisor is also explicit as to how risks and their aggregation are reflected in regulatory capital requirements.
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17.8 |
The supervisor sets appropriate target criteria for the calculation of regulatory capital requirements, which underlie the calibration of a standardised approach. Where the supervisor allows the use of approved more tailored approaches such as internal models for the purpose of determining regulatory capital requirements, the target criteria underlying the calibration of the standardised approach are also used by those approaches for that purpose to require broad consistency among all insurers within the jurisdiction.
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Variation of regulatory capital requirements
17.9 |
Any variations to the regulatory capital requirement imposed by the supervisor are made within a transparent framework, are appropriate to the nature, scale and complexity according to the target criteria and are only expected to be required in limited circumstances.
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Identification of capital resources potentially available for solvency purposes
17.10 |
The supervisor defines the approach to determining the capital resources eligible to meet regulatory capital requirements and their value, consistent with a total balance sheet approach for solvency assessment and having regard to the quality and suitability of capital elements.
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Criteria for the assessment of the quality and suitability of capital resources
17.11 |
The supervisor establishes criteria for assessing the quality and suitability of capital resources, having regard to their ability to absorb losses on both a going concern and wind-up basis.
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General provisions on the use of an internal model to determine regulatory capital requirements
17.12 |
Where a supervisor allows the use of internal models to determine regulatory capital requirements, the supervisor:
- establishes appropriate modelling criteria to be used for the determination of regulatory capital requirements, which require broad consistency among all insurers within the jurisdiction; and
- identifies the different levels of regulatory capital requirements for which the use of internal models is allowed.
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Initial validation and supervisory approval of internal models
17.13 |
Where a supervisor allows the use of internal models to determine regulatory capital requirements, the supervisor requires:
- prior supervisory approval for the insurer’s use of an internal model for the purpose of calculating regulatory capital requirements;
- the insurer to adopt risk modelling techniques and approaches appropriate to the nature, scale and complexity of its current risks and those incorporated within its risk strategy and business objectives in constructing its internal model for regulatory capital purposes;
- the insurer to validate an internal model to be used for regulatory capital purposes by subjecting it, at least, to three tests: “statistical quality test”, “calibration test” and “use test”; and
- the insurer to demonstrate that the model is appropriate for regulatory capital purposes and to demonstrate the results of each of the three tests.
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Statistical quality test for internal models
17.14 |
Where a supervisor allows the use of internal models to determine regulatory capital requirements, the supervisor requires:
- the insurer to conduct a “statistical quality test” which assesses the base quantitative methodology of the internal model, to demonstrate the appropriateness of this methodology, including the choice of model inputs and parameters, and to justify the assumptions underlying the model; and
- that the determination of the regulatory capital requirement using an internal model addresses the overall risk position of the insurer and that the underlying data used in the model is accurate and complete.
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Calibration test for internal models
17.15 |
Where a supervisor allows the use of internal models to determine regulatory capital requirements, the supervisor requires the insurer to conduct a “calibration test” to demonstrate that the regulatory capital requirement determined by the internal model satisfies the specified modelling criteria.
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Use test and governance for internal models
17.16 |
Where a supervisor allows the use of internal models to determine regulatory capital requirements, the supervisor requires:
- the insurer to fully embed the internal model, its methodologies and results, into the insurer’s risk strategy and operational processes (the “use test”);
- the insurer's Board and Senior Management to have overall control of and responsibility for the construction and use of the internal model for risk management purposes, and ensure sufficient understanding of the model's construction at appropriate levels within the insurer's organisational structure. In particular, the supervisor requires the insurer’s Board and Senior Management to understand the consequences of the internal model's outputs and limitations for risk and capital management decisions; and
- the insurer to have adequate governance and internal controls in place with respect to the internal model.
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Documentation for internal models
17.17 |
Where a supervisor allows the use of internal models to determine regulatory capital requirements, the supervisor requires the insurer to document the design, construction and governance of the internal model, including an outline of the rationale and assumptions underlying its methodology. The supervisor requires the documentation to be sufficient to demonstrate compliance with the regulatory validation requirements for internal models, including the statistical quality test, calibration test and use test outlined above.
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Ongoing validation and supervisory approval of the internal model
17.18 |
Where a supervisor allows the use of internal models to determine regulatory capital requirements, the supervisor requires:
- the insurer to monitor the performance of its internal model and regularly review and validate the ongoing appropriateness of the model’s specifications. The supervisor requires the insurer to demonstrate that the model remains fit for regulatory capital purposes in changing circumstances against the criteria of the statistical quality test, calibration test and use test;
- the insurer to notify the supervisor of material changes to the internal model made by it for review and continued approval of the use of the model for regulatory capital purposes;
- the insurer to properly document internal model changes; and
- the insurer to report information necessary for supervisory review and ongoing approval of the internal model on a regular basis, as determined appropriate by the supervisor. The information includes details of how the model is embedded within the insurer’s governance and operational processes and risk management strategy, as well as information on the risks assessed by the model and the capital assessment derived from its operation.
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