Tailoring Global Capital Standards

Authors’ Note: In the May 2016 issue of International News, we provided an overview of the International Association of Insurance Supervisors (IAIS) and its activities related to the development of global capital standards for insurers. This article provides an update on the IAIS activities, with a focus on the further technical development of the Insurance Capital Standard (ICS).

Established in 1994, the International Association of Insurance Supervisors (IAIS) is a standard-setting body comprised of member insurance regulators and supervisors from around the world. There are more than 200 jurisdictions from nearly 140 countries represented in the IAIS. The IAIS’ stated objectives are to promote effective and globally consistent supervision of the insurance sector and to contribute to global financial stability. As a global standard-setting body, the IAIS does not have authority within any jurisdiction to enact or enforce the policy measures it develops, or supervisory authority over insurers. Rather, the IAIS seeks to create principles, standards and other supporting materials for the supervision of the insurance sector and assist with their implementation should jurisdictional insurance authorities and governments choose to adopt them.

The Insurance Capital Standard

The Insurance Capital Standard (ICS) is contemplated as a common, global and consolidated capital standard for internationally active insurance groups (IAIGs).¹ The IAIS envisions the ICS serving as a minimum capital requirement for IAIGs and acting as a complement to other supervisory tools within the Common Framework for the Supervision of Internationally Active Insurance Groups (ComFrame),² of which the ICS is a component.

The ICS is being developed through a multiyear process of field-testing and public consultation and is guided by 10 principles published by the IAIS (see the “Insurance Capital Standard Principles” sidebar). Annual quantitative field-testing exercises have occurred since 2014 and are scheduled through 2019. Public consultations were held in 2014 and 2016, and a third consultation is scheduled for 2018. The IAIS is scheduled to adopt a version of the ICS that is “fit for implementation” in late 2019, along with ComFrame implementation. The IAIS has noted that ongoing monitoring and evolution of the ICS is to be expected following its adoption due to the complexity of the supervisory tool and the importance of ensuring it is fit for purpose.

While the IAIS continues to evaluate and field-test several options for key technical design elements of the ICS, it will release “ICS Version 1.0” this year. ICS Version 1.0 is not intended to serve as a version that is fit for adoption by jurisdictions, but rather it represents the first developmental milestone in the multiyear ICS development process.

There are three major components of the ICS: valuation, qualifying capital resources and capital requirements. Each component is discussed in detail within this article, along with some of the key considerations in the current state of ICS development.

Valuation

The ICS introduces a new valuation basis for valuing the consolidated insurance balance sheet, distinct from the existing generally accepted accounting principles (GAAP), International Financial Reporting Standards (IFRS) or statutory rules currently applicable in insurance accounting and regulation. Currently, two valuation bases are being developed and field-tested: a market-adjusted valuation (MAV) basis and a GAAP with adjustments (GAAP Plus) valuation basis. Within both approaches and central to the ICS balance sheet is the concept of “current estimate” liabilities. For global comparability and transparency on an “economic” basis, liabilities are valued using best-estimate actuarial assumptions without additional conservatism and reflect all relevant cash flows. The approach to asset valuation also varies between the two bases.

The approach to valuation is a matter of significant discussion and debate among the IAIS and stakeholder community, given the significant impact it can have on an IAIG’s overall ICS solvency ratio. Throughout the development of the ICS, stakeholders have called for the IAIS to employ methods that align the valuation of assets and insurance liabilities to properly reflect the economics of long-term life insurance products and related asset-liability management (ALM). Symmetry between assets and liabilities is created through the linkage of the liability discount rate with the supporting assets on the balance sheet and the insurer’s ALM practice. Valuation asymmetry can result in mismeasurement of capital resources and requirements, as well as artificial volatility and procyclicality of the capital adequacy measurement.

Market-Adjusted Valuation

The MAV approach is based on the market value of assets, and current estimate liabilities are valued using a discount curve that reflects the risk-free curve plus a prescribed spread adjustment. The IAIS continues to explore various MAV discounting options through the field-testing exercises. The primary focus of the discount rate analysis relates to the spread adjustment, in particular whether the spread adjustment should be based on a single, consistently applied prescribed reference rate, a currency- and sector-specific representative portfolio, or the IAIG’s own asset portfolio. Another key question is whether the discount rate should reflect the full spread derived from such bases or a conservative, limited portion of the spread. A third key question is whether and how much of a spread should be reflected beyond the investable horizon, or the last observable point on the yield curve—an important consideration for liabilities cash flows that extend for decades beyond the investable horizon.

Appropriate outcomes on all three points are necessary to derive an appropriate current estimate liability and measurement of available and required capital. This is especially true for insurers with predominantly long-term liabilities, such as those in the life and retirement sectors, as long-term insurance liabilities are very sensitive to the discount rate. Some view the answers to these questions through a conservative lens, where the discount rate would reflect a reference rate rather than the invested assets supporting liabilities and the spread would be subject to conservative haircuts and limits based on the view that the valuation basis should serve as a means to deter insurers from improper investment behavior and reflect liability liquidity risk. Considering the fact that symmetry between assets and liabilities hinges on reflecting the insurer’s assets and ALM practice in the liability discount rate, the closer the spread adjustment is to the insurer’s own asset portfolio, the better the balance sheet symmetry will be.

GAAP With Adjustments (GAAP Plus)

The GAAP Plus valuation basis utilizes existing balances and defined adjustments anchored to local GAAP/IFRS accounting rules in order to arrive at current estimate insurance liabilities. For instance, the U.S. GAAP Plus approach leverages the best estimate gross premium valuation within loss recognition testing rules to determine the current estimate liability. Assets are valued consistent with reported GAAP balances. Additional adjustments may be made to create symmetry between the valuation of assets and liabilities.

Since the GAAP Plus approach applies existing GAAP rules for determining best estimate liabilities (which typically are based on supporting asset portfolios), there has been less of a focus on potential alternative approaches for developing yield curves for discounting liability cash flows. However, the GAAP Plus approach is expected to evolve as changes to the underlying accounting frameworks—such as those proposed by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB)—are made. Such changes may give rise to debate on the GAAP Plus discounting approach and potential approaches to explore in future ICS field-testing exercises.

Qualifying Capital Resources

The ICS has two tiers for qualifying capital resources, based on specific criteria for loss absorption and policyholder protection. Within each tier, certain capital resources are subject to limits. All potential capital resources are assessed against the ICS criteria to determine:

1. If they qualify as available capital resources for purposes of the ICS
2. If they are subject to any limits within each tier (for resources that qualify only)

Ensuring consistent treatment of comparable capital resources across jurisdictions, such as the treatment of the various and substantially similar forms of surplus notes and debt around the world, is a key topic of discussion in the current discourse.

A margin over current estimates (MOCE) is deducted from capital resources. The MOCE represents a provision for the inherent uncertainty in the current estimate liabilities and is applied in addition to the capital requirements described in the next section. Currently, two MOCE approaches are being considered: a Cost of Capital MOCE (CoC-MOCE), which is based on an assumed cost of holding ICS required capital; and a Prudence MOCE (P-MOCE), which determines a conservative buffer at the 75^th percentile of an assumed loss distribution, assuming a normal distribution of losses between current estimate liabilities (50^th percentile) and capital requirements (99.5^th percentile). The potential redundancy of the MOCE with the required capital has been a key topic of discussion, given that both establish provisions related to risk in the liabilities (MOCE relates to risks associated with insurance liabilities only, while capital requirements relate to risk on the entire balance sheet).

Capital Requirements

The ICS capital requirement, calculated using a risk-based method, is the amount of capital resources needed to cover losses for the insurance, investment, market and operational risks to which the IAIG is exposed. The ICS capital requirement is intended to represent a one-year 99.5 percent Value-at-Risk (VaR) level of stress.

The design and calibration of stresses that determine the capital requirement are key areas of debate among the IAIS and stakeholders. Stakeholders have questioned the appropriateness of the current design and calibration relative to the target time horizon and severity level, and the inclusion of the MOCE provision described previously. For instance, many of the stresses for long-term insurance liabilities reflect a very severe stress over the life of the liability rather than a one-year period.

The IAIS is currently focused on developing a standard method for calculating required capital, but it may explore the use of internal model approaches (similar to Solvency II) in the future. Some stakeholders have expressed the view that the ICS should permit the use of internal models, and that doing so would enable IAIGs to reflect their risk profiles more accurately. Other stakeholders have stressed the need for the IAIS to design a sound standard method before considering the use of internal models.

Figure 1 summarizes the key elements and considerations of the ICS.

Key Observations

As the elements of the ICS are further developed and field-tested, discussions increasingly have focused on the implications of specific design and calibration decisions on the business models of insurers and the markets in which they operate. Some of these decisions may seem at the surface to be minor technical details, such as an aspect of the discount rate or a required capital stress. But the impact of “small” technical details on certain products and markets can be profound.

The robust dialogue facilitated by the IAIS on the technical design of the ICS has helped shed light on the underlying objectives of supervisors, such as incentivizing appropriate risk management by insurers, as well as concerns held by industry and other stakeholders, such as artificial volatility in capital measures or prohibitively conservative capital requirements that penalize certain types of insurance products. Both the supervisor and industry views and objectives are valid and must be taken into consideration, and the choices about if and how the ICS addresses these concerns are very important.

Two key ideas could help guide the technical design of the ICS in light of the various stakeholder concerns and objectives:

1. First, the ICS must not violate the fundamental economics of the insurance business model. The economics of the insurance business model entails the way risks manifest themselves through time, the effects of risk pooling and risk mitigation, and the role of ALM in determining the value of long-term insurance liabilities and the sensitivity of the balance sheet to risk over time.
2. Second, stakeholders should ensure that the ICS is viewed in conjunction with the broader ComFrame framework and not as a standalone “silver bullet” to address all supervisory objectives. Where certain ICS technical features introduced for prudential objectives would misrepresent the fundamental economics of the business model, designers should look to other aspects of ComFrame to address such objectives, so as not to create noneconomic outcomes in the ICS and potential further unintended consequences. ComFrame offers appropriate and targeted means to address prudential objectives, such as those pertaining to insurer risk management, ALM and investment behavior, and liquidity risk.

By integrating these key ideas into the design and field-testing of the ICS, the IAIS can ensure that the ICS becomes a meaningful and viable supervisory tool.

Conclusion

The engagement of industry players, regulators and other key stakeholders in the ICS development process underscores the interest in and significance of the ICS for insurance markets around the globe. Although the ICS remains a work in progress, it has become clear that it has the potential to meaningfully influence the way the world looks at risks and capital for the insurance sector. For instance, some markets have started to explore what an ICS framework would mean for their jurisdictions through local field-test exercises and quantitative impact studies.

Given the potential impact to insurers and the markets in which they operate, it is imperative that the IAIS take the time necessary to ensure that the ICS provides a meaningful and appropriate measure of risks and loss absorption capacity, promotes appropriate outcomes and behavior, and avoids creating false positives/negatives of insurer solvency or other unintended consequences. A flawed ICS would be a disservice to consumers and financial markets throughout the world, as it could inhibit insurers from offering sound, economically viable insurance products and from providing the associated capital investment to support their liabilities. Constructive stakeholder engagement—through open dialogue with supervisors and participation in quantitative field tests—is critical for informing the design of the ICS and ensuring the final version of the framework is appropriate, an outcome that is in the interest of supervisors, industry players and other stakeholders alike.

Copyright © 2017 by the Society of Actuaries, Chicago, Illinois.