Consultation Paper - Insurance Solvency Standards: Guarantees

Consultation Paper Insurance Solvency Standards: Guarantees The Reserve Bank invites submissions on this Consultation Paper by 28 February 2014.

Submissions and enquiries about this consultation should be addressed to: Edwin Budding Adviser Prudential Supervision Department Reserve Bank of New Zealand PO Box 2498 Wellington 6140 Email: edwin.budding@rbnz.govt.nz A summary of submissions may be published. If you think any part of your submission should properly be withheld on the grounds of commercial sensitivity or for any other reason, please indicate this clearly. December 2013

2 Insurance Solvency Standards: Guarantees I. Introduction

1. This consultation paper seeks comments from licensed insurers and any other interested parties on the proposed reforms reflected in the draft extracts of the Reserve Bank’s solvency standards in Appendix A and B.1 These changes seek to ensure the level of credit risk mitigation received by licensed insurers from the use of guarantees is appropriate.

2. This is the second consultation paper on the solvency treatment of guarantees. This consultation paper reflects changes to the proposals that have been made after consideration of the responses to the first consultation paper, issued in June 2013.

3. The Reserve Bank welcomes submissions on the proposed wording of the solvency standards and other issues set out in this consultation paper. Comments should be submitted by 28 February 2014 to: edwin.budding@rbnz.govt.nz.2 II. Summary of the proposed reforms

4. This section provides some background to the consultation, a non-technical summary and an illustration of how the proposed guarantees treatment works. Further background information on the solvency treatment of guarantees, including the “substitution” or “look through” approach, is contained in the June 2013 consultation paper. 3 (a) Overview of the June 2013 proposals and responses

5. The June 2013 consultation paper proposed recognition of guarantees with a term of less than the underlying asset, subject to haircutting the value of the guarantee recognised. Essentially, the recognition is based on the relative term of the guarantee versus the underlying asset via a Limited Term Guarantee formula (the “LTG Formula”). The LTG Formula is set out in Appendix A.4

6. Under the LTG Formula, guarantees with a term of less than 1 year receive no recognition (except renewable guarantees) and guarantees of demand loans would be haircut based on the length of the guarantee and assumed maturity of the demand loan. The majority of respondents considered the LTG Formula approach to be reasonable. Some respondents described the calibration of the LTG Formula as conservatively weighted.

7. In addition to the LTG Formula, the Reserve Bank proposed an overall limit of 15% on the amount that the Asset Risk Capital Charge (“ARCC”) can be reduced by way of a guarantee. This was to reflect the Reserve Bank’s view that although guarantees

1 The proposed wording for guarantees is provided in Appendix A. The changes to the Asset Concentration, Foreign Currency and Interest Rate Risk Capital Charges are in Appendix B. 2 Comments may also be sent by post to Edwin Budding, Adviser, Prudential Supervision Department, Reserve Bank of New Zealand, Wellington 6140, New Zealand 3 Paragraphs 5 to 10, RBNZ Consultation paper “Insurance Solvency Standards: guarantees and off-balance sheet exposures”, June 2013, available at http://www.rbnz.govt.nz/regulation_and_supervision/insurers/5310220.pdflink 4 See also paragraphs 12 to 19 in the June 2013 consultation for a more detailed explanation of the LTG formula: http://www.rbnz.govt.nz/regulation_and_supervision/insurers/5310220.pdf

3 may be expected to be an effective form of credit risk mitigation, guarantee contracts can give rise to residual risk, or may not perform as expected in times of stress. The risk includes legal risk arising from improper contractual formation or the risk of a sudden change in Minimum Solvency Capital requirements as a result of non￾renewal. In essence, we do not see a guarantee as a perfect substitute for a direct investment in the guarantor. 8. The proposed 15% limit was not supported by a majority of respondents. On reflection, the Reserve Bank has come to the view that a limit is not the best approach because it is not risk sensitive. 9. The June 2013 consultation also proposed: a. detailed requirements for the legal certainty of guarantees and the treatment of guarantees and assets involving foreign currencies; b. explicit clarification on the application of the Asset Concentration Risk Charge and interest rate risk in relation to guarantees; c. a transition period for guarantees. In particular the Asset Capital Factor applicable to the guarantor may continue to be used in relation to guarantees in place before June 2013, notwithstanding new rules, until the earlier of the maturity of the guarantee or two years following the passage of a new Solvency Standard on guarantees. 10. Respondents did not raise concerns with the proposals in paragraph 10 above. As such, we intend to update the Solvency Standards to reflect these requirements. (b) Changes to the June 2013 proposal 11. The most important changes to the June 2013 proposals are intended to address comments received from industry stakeholders and are the following: LTG Formula 12. The Reserve Bank intends to adopt the LTG Formula as broadly proposed in the June consultation. That said, in light of the submissions, the Reserve Bank considers that the following amendments have merit: a. for assets payable on demand that have no contractual maturity date, the residual maturity shall be set at 3 years, rather than the original proposal of 5 years, for the purposes of the LTG Formula. The Reserve Bank considers that limited term guarantees of demand loans gives rise to some residual risk. However, a 3 year guarantee is sufficient mitigation for this asset category; and, b. the maturity date definition for the guarantee will be amended to exclude “any date on which the beneficiary of the guarantee may terminate the guarantee and has an incentive to do so, such as a step-up in the cost of the guarantee”. The Reserve Bank accepts that in most cases a guarantee may be terminated by the beneficiary at any time and that this right should not frustrate defining the nature of the guarantee maturity for the purposes of the LTG Formula. Further, such a contractual right is quite unlikely to be used by a beneficiary to produce an adverse change of their own solvency position.

4 Increased risk charge on assets subject to guarantee 13. The Reserve Bank intends to replace the 15% limit proposal with a higher risk charge for guaranteed assets due to the unintended consequences the limit produces. The capital charge that applies to a particular asset and guarantee arrangement can vary depending on the composition of the rest of the asset portfolio. If the asset risk charges on the rest of the portfolio are high, a higher proportion of the guarantee on a loan is recognised, reducing the capital charge on this asset, despite there being no change in the economic circumstances of the guarantee arrangement or the loan. Similarly, the limit operates such that the risks of a portfolio may be increased without any increase in capital required to be held or by reducing the increase that would otherwise apply. This reduces the risk based sensitivity of the solvency requirements. 14. The 15% limit was intended to address the residual risks associated with guarantee arrangements, as well as to limit the extent to which guarantees can mitigate capital requirements. In other words, this treatment reflects the Reserve Bank’s view that a guarantee from a given counterparty has a higher risk than an investment directly held with that counterparty. Accordingly, the use of a full ‘look through’ to the asset risk factor of the counterparty is inappropriate. Instead, the Reserve Bank intends to apply an increased risk charge to assets subject to guarantee such as: Risk Factor of Assets subject to Guarantee = Risk Factor for the guarantor + an Asset Risk Capital Factor III. Consultation on calibration 15. The Reserve Bank is considering the calibration of the additional Asset Risk Capital Factor for residual risk. 16. In doing this, the Reserve Bank recognises the importance of ensuring that regulatory capital is sufficient such that the financial strength of the insurer is adequate to withstand significant adverse conditions and will continue to meet its financial obligations. Indeed, it is precisely during such stress periods that capital is required to absorb losses and safeguard the stability of the financial system. 17. In addition, the Reserve Bank is seeking to ensure that solvency measurement is risk sensitive, such that the solvency requirement adequately reflects the risks undertaken by the insurer. If the framework is insufficiently risk sensitive, then individual insurers may have a higher risk of failure. Inadequate risk sensitivity can also encourage inappropriate risk taking, where insurers disproportionately take on risks that attract inadequate capital charges. This results in a weakening of insurers that may not be apparent from examining their solvency position. 18. The Reserve Bank recognises that the loading factor reflects the residual risk of a guarantee in a context where the maturity mismatch risk will be mitigated by the LTG Formula and the legal risk is mitigated to a certain extent by the requirement of ‘legally certain’ guarantees in the solvency standards. 19. The Reserve Banks considers the risk mitigated by the loading factor to be real and not hypothetical, but low. Accordingly, we propose the loading factor to receive a

5 fixed Asset Risk Capital Factor of 2% irrespective of the asset class. For example, if we assume an additional Asset Risk Capital Factor of 2%, an AA rated bank guarantee could be charged at 4% instead of the 2% asset risk capital factor received under the current Solvency Standards. The increased 2% risk factor is designed to explicitly account for the real residual risk. 20. As with many types of risk, the nature of the risks associated with guarantees is such that accurate quantification is not feasible. Indeed to try and do so, given the nature of the risks and assumptions that would need to be made, would lead to spurious accuracy. As a prudential regulator, the Reserve Bank is required to anticipate plausible risks that insurers may not themselves identify or allow for, recognising that not every risk of insurer failure is to be avoided, so as to ensure that a sound and efficient insurance sector is maintained, together with public confidence in that sector.

Do insurers or any other interested parties have any views on the suitable calibration for the additional Asset Risk Capital Factor proposed, or any other related issues?

6 Appendix A The following amendments (in red italics) are proposed to be made in relation to guarantees. Changes to the June 2013 proposals are high-lighted in bold and underlined. Paragraph 68 of the Life Standard is proposed to be amended to read: The Asset Risk Capital Charge is the sum of the Resilience Risk Capital Charge (refer paragraphs 69 - 71 and paragraphs 93 - 94), the Asset Concentration Risk Capital Charge (refer paragraphs 95 - 98) and Reinsurance Recovery Risk Capital Charge (refer paragraphs 100 - 105). The Asset Risk Capital Charge applying to any asset cannot be more than the value of the asset. Paragraph 83 of the Non-life Standard is proposed to be amended to read: The Asset Risk Capital Charge is the total of the asset values in each Asset Class (to the extent that the asset values have not been excluded from, or reduced in, the determination of Actual Solvency Capital in Section 2 of this solvency standard) multiplied by the relevant Asset Risk Capital Factor from Table 2 plus the Asset Concentration Risk Charge (if any). The Asset Risk Capital Charge applying to any asset cannot be more than the value of the asset.

Other equivalent provisions of other Standards will be amended in the same manner. Paragraph 82 of the Non-life Standard and paragraph 77 of the Life Standard (and equivalent provisions of the other Standards) are proposed to be amended to read: Assets that have been guaranteed shall be treated in accordance with paragraphs A-J I. Guarantees provided to the licensed insurer by its own parent entity or by any related party are not eligible for this treatment. The following new paragraphs in relation to guarantees are proposed to be added. A. The portion of an asset covered by a guarantee that meets the requirements of paragraph C may be assigned the Asset Risk Capital Factor that would be applicable to the guarantor plus an Asset Risk Capital Factor of 2% of the asset, subject to paragraphs D-I. The portion of an asset considered to be covered by a guarantee is that portion of the asset equal to the value of the guarantee calculated in accordance with paragraphs D-I. Any unguaranteed portion of the asset must be assigned the Asset Risk Capital Factor applicable to the principal counterparty. B. For the purposes of paragraphs A – J I the following definitions apply:  Beneficiary in respect of a guarantee means the insurer that benefits from the guarantee;  Maturity in respect of a guarantee includes: i. a maturity date; and ii. any date on which the guarantor has the capacity to terminate, otherwise end or increase the effective cost of the guarantee; iii. any date on which the beneficiary of the guarantee has the capacity to terminate the guarantee and has an incentive to do so, such as an effective increase in the cost of the guarantee;

7  Maturity in respect of the underlying asset means the longest possible remaining time that the asset may remain an asset of the insurer (irrespective of any potential rights to call); and  Principal counterparty means the counterparty to the transaction with the insurer that gave rise to the underlying asset;  Residual maturity means the time remaining until maturity. For a demand loan the residual maturity shall be 5 3 years. C. The guarantee must:  be provided by a guarantor with a counterparty rating (or for governments, the long-term foreign currency credit rating) in Grades 1,2, or 3 (refer Table 4); and  be legally enforceable, clearly documented in writing and, if exercised, represent a direct claim on the guarantor that may be pursued without legal action being taken against the principal counterparty; and  be explicitly referenced to a specific asset or pool of assets; and  cover all types of payments the principal counterparty is required to make under the documentation (including interest); and  be irrevocable prior to maturity (that is no party may have the right to unilaterally terminate the guarantee prior to any specified date on which the guarantee will mature or may otherwise terminate); and  be unconditional (there must be no conditions that need to be fulfilled prior to the guarantor being liable on default of the principal counterparty). D. Where an asset, or pool of assets, of an insurer is subject to more than one guarantee, but those guarantees are limited to the extent of common collateral, the guarantees may only be recognised up to the value of that collateral. E. For the purposes of paragraph A, the value of a maturity matched guarantee is the guaranteed amount. A maturity matched guarantee exists when the residual maturity of the guarantee is the same or greater than the residual maturity of the underlying asset. F. For the purposes of paragraph A, the value of a maturity mismatched guarantee must be calculated in accordance with paragraphs G - I. A maturity mismatched guarantee exists if the residual maturity of the guarantee is less than the residual maturity of the underlying asset. G. Except as provided in the next sentence, the value of a maturity mismatched guarantee where the residual maturity of the guarantee is equal to or less than 12 months is 0. Where a maturity mismatched guarantee of residual maturity equal to or less than 12 months provides that it will be renewed automatically unless a notice of termination is given, and the licensed insurer has no reason to believe that the guarantee will not be renewed, the guarantee may be recognised in the 12 months prior to renewal provided that the value of the guarantee is calculated in accordance with the formula in paragraph H and the residual maturity of the guarantee is considered to be 6 months for the entirety of that 12 months for the purposes of that formula. H. If a guarantee is maturity mismatched and the residual maturity of the guarantee exceeds 12 months, the value of the guarantee for the purposes of paragraph A must be adjusted in accordance with the following formula: Value of guarantee = guarantee amount *

8 Where maturity is measured in years or part thereof; and “T” is the lesser of 5 and the residual maturity of the asset expressed in years. I. Where there is a single guarantee, limited in sum, that applies to a pool of assets where the residual maturity of the assets in the pool differ the licensed insurer must assume that the guarantee applies to the asset with the longest residual maturity first for the purposes of paragraph H.

9 Appendix B The additional text in red italics is proposed for the Asset Concentration Risk Charge, Foreign Currency Risk and Interest Rate Risk Charge (the Non-Life wording is given as the example here). Asset Concentration Risk Charge In order to determine the Asset Concentration Risk Charge, the licensed insurer must first calculate the total value of its assets, including contingent liabilities referred to that meet the criteria in paragraph [95] and the gross balance sheet asset in respect of derivatives (“asset derivative positions”) derivative positions (the asset derivative position in regards to a particular entity may be netted where there is a legally binding netting agreement), that represent obligations of one entity (counterparty) or group of related entities, (to the extent that the asset values have not been excluded from, or reduced in, the determination of Actual Solvency Capital in Section 2). Where the Asset Risk Capital Factor applicable to a guarantor has been used in relation to a guaranteed asset, then, to the maximum value of the guarantee, the guaranteed asset shall be considered to represent an obligation of the guarantor, (and not the principal counterparty) for the purposes of the Asset Concentration Risk Charge. Any unguaranteed portion of the asset must be considered as an obligation of the principal counterparty for the purposes of the Asset Concentration Risk Charge. Where the licensed insurer has ‘looked through’ an a collective investment vehicle or subsidiary in accordance with paragraph 80, the same look through basis must be used in calculating the Asset Concentration Risk Charge. The Asset Concentration Risk Charge for each counterparty is a separate change in the Asset Risk Capital Charge calculated in accordance with paragraph 83, and applies only to the licensed insurer’s total asset exposure to each counterparty that exceeds the limits specified in Table 3. Foreign Currency and Interest Rate Risks 96. In applying the solvency standard a licensed insurer must consider the degree of mismatching between assets and liabilities in terms of foreign currency and interest rate risks. Foreign Currency Risk 97. In the case of a currency position, an additional Foreign Currency Risk Capital Charge of 22% must be applied to the net open foreign exchange position in each currency other than NZD, regardless of whether the position is long or short. The net open foreign exchange position is the absolute difference (ignoring any negative sign in the outcome) between any assets and liabilities (taking into account applicable derivative positions and including any contingent liabilities referred to that meet the criteria in paragraph [95]) that are denominated in the relevant currency. Where an asset of a licensed insurer is denominated in a foreign currency and has been guaranteed in either a foreign currency or NZD, the underlying asset is included in the calculation of the net open foreign exchange position and the guarantee is not. Where a NZD asset of a licensed insurer is subject to a guarantee but is limited to a particular foreign currency value, and that asset has been assigned the Asset Risk Capital Factor applicable to the guarantor, then the guaranteed amount, to the extent that it is recognised in paragraphs D-I, must be included in the calculation of the net open foreign exchange position. (Uunlimited guarantees denominated in a foreign currency do not need to be included in the net open foreign exchange position).

10 98.An Interest Rate Capital Charge is calculated by reference to fixed interest-bearing assets and fixed interest-bearing liabilities. For the purposes of determining the Interest Rate Capital Charge: (a) fixed interest-bearing assets are those assets and derivative position bearing a fixed interest rate for a period of time (re-set period) beyond the balance date at which the solvency calculation is performed. Fixed interest-bearing assets must be included regardless of the existence of any guarantee in relation to such assets. (b) fixed interest-bearing liabilities are insurance liabilities and derivative positions and any other liabilities, including fixed interest-bearing contingent liabilities, where the economic value depends upon discounting actual or expected cash flows; in other words those liabilities where the value depends implicitly or explicitly on interest rate assumptions.