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Unpacking the SAM standard formula for calculating the capital requirement and the capital resources

12 November 2014 Patrick Ndururi, Centriq Insurance
Patrick Ndururi, Executive Head: Actuarial, Centriq Insurance.

Patrick Ndururi, Executive Head: Actuarial, Centriq Insurance.

Under Solvency Assessment and Management (SAM), the capital required to support the business written will be determined on a risk-based approach, whereby different lines of business will attract a capital charge based on the nature of the risks presented.

Three Quantitative Impact Studies (QIS) have been done to date to test the appropriateness of the standard formula that will apply. But how will it work?

The standard formula requires three steps to be followed:

• To construct an economic or market value balance sheet
• To calculate the Solvency Capital Requirement (SCR)
• To ensure that capital resources comply with eligibility and tiering requirements

Step 1: Constructing an economic or market value balance sheet

This entails restating the assets and liabilities in the balance sheet.

Assets are re-valued using a market consistent basis, i.e. each asset is restated to reflect the value that it could realise in the open market, whilst liabilities relating to claims and premium provisions are calculated as probability weighted average of all future cash-flows, taking account of the time value of money (i.e. discounting).

A risk margin is calculated representing the cost of capital that another insurer would incur if all the liabilities were transferred to it.

All calculations are done for each line of business (LOB), and LOBs are far more granular compared to the current LOBs, e.g. for short term insurers the segmentation proposes 16 LOBs, compared to the current 8 LOBs. The value for other liabilities are determined according to set guidelines.

The difference between the Assets and the Liabilities give the insurer its Own Funds available. These Own Funds, however, are subjected to some eligibility criteria as explained in step 3 below to establish the portion of the funds available to meet the solvency capital requirement (SCR).

Step 2: Calculating the Solvency Capital Requirement (SCR)

Three main modules, namely underwriting risk, market risk and operational risk are used to calculate the SCR. These risks are defined as follow:

Underwriting risk capital: This risk is assessed and the capital required is calculated to ensure a 99.5% confidence that the insurer will endure all the underwriting risks it faces. In other words, the calculated capital should be equal to the worst result expected to occur in a single year over the next 200 years. The main considerations here are the premiums and claims reserves volumes as well as the risk of catastrophes. For life insurers, consideration is given to future mortality (death rates), morbidity (disability rates), retrenchments and lapses as well.

Calculations are carried out using gross numbers. Reinsurance is applied where applicable and adjustments for possible reinsurer default are made.

Market risk capital: This is to cover the risk of a fall in asset values, i.e. the assets backing the capital and reserves. Considerations here include the shocks applied to interest rates, equities, property, currency, asset counterparty default and asset concentration. The effect of the shock on both the assets and the liabilities are noted.

Operational risk capital: This covers the risk of loss arising from inadequate or failed internal processes; risks that arise from personnel and systems or from external events. Calculation of the capital charge in respect of this risk is largely based on either gross written premium or gross technical provisions. Broadly speaking, this works out to about 4% and 3% of Gross Written Premium for long term - and short term insurers respectively.

Some correlations are applied between underwriting and market risks, and then the operational risk is added to arrive at the total SCR. Unlike the current framework where capital is broadly calculated retrospectively, the SCR under SAM will be forward-looking, i.e. largely driven by the type of risks expected to be written by the insurer over the next year.

Step 3: Eligibility and Tiering requirements of Capital Resources (Own Funds)

Capital resources are classified under two categories:

• Basic Own Funds: Essentially the excess of assets over liabilities as determined in Step 1

• Ancillary Own Funds: Off-balance sheet items that are able to absorb losses

Basic Own Funds are further classified into tiers 1, 2 and 3 based on their characteristics. Ancillary Own Funds are classified into tiers 2 and 3. Eligibility of the funds to support SCR is then applied, with a requirement that at least 50% of SCR must be supported by tier 1 funds, and not more than 15% of SCR can be supported by tier 3 funds.

This process determines the so-called Eligible Own Funds. The requirement is that these eligible own funds must exceed the SCR. The insurer’s solvency ratio is derived by dividing the amount of the eligible own funds by the SCR.

Minimum Capital Requirement (MCR)

Although the aim of the insurer should be to have the value of eligible own funds exceeding the SCR, a minimum capital requirement is determined for the insurer. The calculation of the MCR combines a linear formula with a floor of 25% and a cap of 45% of the SCR. The MCR is subject to an absolute floor of the higher of R15m and 25% of the annualised operating expenses of the preceding 12 months.

For large insurers, the SCR will typically be higher than the MCR. For small insurers, it is possible to have an SCR lower than the MCR, in which case the absolute floor as defined above would apply.

Regulatory intervention would be applied where the amount of eligible own funds is lower than the SCR.

 

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