Response to submissions on the quality of capital and other revisions to solvency standards

Response to submissions received on the consultation on the quality of capital and other revisions to the solvency standards Introduction 1 In October 2012 the Reserve Bank of New Zealand (“Reserve Bank”) released the consultation document: the quality of capital and regulatory treatment of financial reinsurance. This note provides a summary of the main substantive issues raised by respondents in respect of proposals to improve the regulatory treatment of the quality of capital used for solvency purposes and other revisions to the Reserve Bank’s solvency standards that were consulted on at the same time, together with the Reserve Bank’s response. This note does not address financial reinsurance which has been subject to a separate consultation process. 2 The Reserve Bank received feedback on the consultation document from fifteen respondents. 3 This note is divided into two sections. The first section discusses the quality of capital and the second section discusses the other revisions to the Reserve Bank’s solvency standards. Section 1: The quality of capital 4 The first section of the consultation document sought feedback on a revised definition of capital proposed to be included within the Reserve Bank’s solvency standards. The proposed definition of capital includes the following: a) five overall characteristics of high quality capital, which are developed into more detailed qualifying criteria specific to each type of capital instrument and five general requirements that apply to any capital instrument included within solvency capital. These principles are an integral part of the proposed definition of capital; b) inclusion of Credit Union securities and partly paid perpetual non￾cumulative preference shares as qualifying capital instruments; and Ref #5860395

2 c) some changes to the drafting of the existing definition of capital. Summary of responses 5 Overall, respondents were supportive of the proposals to extend and improve the definition of capital used within the Reserve Bank’s solvency standards. The main issues raised by respondents in respect of the proposals are set out below. In addition to these issues many other helpful comments and suggestions were received from respondents. Where appropriate, amendments arising from these comments and suggestions have been incorporated within the 2014 exposure draft of the solvency standards, which is intended to commence in January 2015. 6 Tiers of Capital. The Reserve Bank uses a tiered approach to qualifying regulatory capital for its regulation of the New Zealand banking sector (although it does not take this approach in the non-bank deposit taker sector), with associated minimum capital requirements. Some insurers requested the Reserve Bank to allow debt instruments that meet the qualifying criteria to be included within solvency capital and/or that the Reserve Bank should fully adopt the tiered approach to qualifying regulatory capital for use in the insurance sector. 7 Perpetual non-cumulative preference shares (“Perpetuals”). The current and proposed definition of capital limits the amount of qualifying Perpetuals to 50% of capital for mutual insurers and 25% for non-mutual insurers. A few submitters argued that there should be no limit on the amount of any capital instrument that may be included within an insurer’s solvency capital. There was also limited objection to some of the detailed requirements for Perpetuals, such as if the Perpetuals are redeemed they must be replaced with a paid-up capital instrument of the same or better quality and of the same or higher amount. 8 Issuance through SPV. One submission suggested that to align the definitions of capital used in the insurance and banking sectors, insurers should be permitted to issue going concern capital through a special purpose vehicle. 9 Alternative approaches to permitted capital instruments. One submission recommended that the Reserve Bank should have discretionary power to examine and approve any capital instrument that meets the proposed general requirements. Another submission recommended a more principles based approach and questioned the need for the Reserve Bank to be overly prescriptive or restrictive with respect to the type or amount of capital instruments permitted. It was also suggested that the Reserve Bank should consider adopting minimum coverage levels of regulatory capital requirements as a primary way of ensuring adequacy and quality of capital. 10 General requirements - Reserve Bank’s powers. The proposed general requirements within the definition of capital provide that the terms and conditions of the capital instrument must not restrict the Reserve Bank’s

3 ability to use its powers under the Insurance (Prudential Supervision) Act 2010 in respect of solvency or other issues. One submission requested example situations and commented that the provision would provide little certainty to insurers. 11 Qualifying criteria for capital instruments. Some submissions contained questions or suggestions about aspects of the detailed qualifying criteria for the proposed capital instruments. 12 Definition of reserves. The consultation paper proposed qualifying criteria for reserves to be included within capital for solvency purposes. Some submissions considered that the drafting of these qualifying criteria was too broad and could capture unintended items. 13 Voting rights. The consultation process raised some questions about the requirement for voting rights within the proposed definition of capital. For example, there were different voting rights requirements for ordinary and preference shares and it was pointed out that instances can exist where the voting rights included within a capital instrument may not necessarily align with ownership of a capital instrument. 14 Credit Union Securities. One submission objected to the requirement that Credit Union Securities are required to be written down if losses are incurred by the credit union that exceed its retained earnings and reserves. The same submission also objected to one of the permanence requirements proposed by the Reserve Bank: that Credit Union Securities must never be repaid outside of liquidation. 15 Financial reinsurance. In the context of what should be included within the definition of capital a few submissions discussed financial reinsurance which is provided by reinsurers. One submission in this area disagreed with the Reserve Bank’s proposed definition of capital for solvency purposes and some other aspects of the Reserve Bank’s proposals. 16 Disclosure. One submission requested that disclosure of the components of capital should be made within each insurer’s financial statements. Reserve Bank response to issues raised 17 In light of the above responses, for some of the issues raised the Reserve Bank intends to make appropriate wording amendments to the proposed definition of capital which was included within the consultation paper. Further details are provided below. 18 Tiers of Capital. A tiered approach to qualifying regulatory capital is worth future consideration at some stage. However, the Reserve Bank does not consider that this methodology should be implemented for the regulation of the New Zealand insurance sector at the present time, for the following three reasons:

4 • The calibration of the solvency calculation methodology within the Reserve Bank’s solvency standards is currently predicated on regulatory capital being comprised only of the highest quality capital instruments. The licensing of New Zealand insurers has been completed using this level of calibration. Permitting lower quality capital instruments within the definition of capital is likely to require re-calibration of the solvency calculation methodology. This would require a fundamental review, which the Reserve Bank does not consider is appropriate at this time; • The Reserve Bank’s definition of capital for New Zealand banks does include certain lower quality capital instruments. However, the complexity of lower quality capital instruments (if they were permitted for solvency purposes) that would meet the Reserve Bank’s requirements may make such capital instruments undesirable for many insurers; and • Lower quality capital instruments are currently uncommon within the New Zealand insurance sector. This policy position may be reconsidered by the Reserve Bank in the future. 19 Perpetuals. The Reserve Bank’s rationale for the limit on the amount of Perpetuals is that Perpetuals are a lower quality capital instrument than ordinary shares and accordingly it is appropriate that licensed insurers can only hold a proportion of their capital in this form. The limits placed on Perpetuals is consistent with that used within the definition of capital that the Reserve Bank uses to regulate non-bank deposit takers. The favourable treatment for mutual insurers reflects the fact mutual insurers cannot issue ordinary shares and must rely upon other forms of capital such as retained earnings. The detailed requirements for Perpetuals are broadly consistent with the Reserve Bank’s banking capital regulations and it is considered that these requirements are appropriate. 20 Issuance through SPV. It is intended to include appropriate provisions within the revised definition of capital that perpetual non-cumulative preference shares that will qualify as capital for solvency purposes can be issued using an SPV structure, provided that certain conditions are met. For example, that at the same time the perpetual non-cumulative preference shares are issued to third party investors, a matching capital instrument is issued by the licensed insurer to the SPV. 21 Alternative approaches to permitted capital instruments. These alternative approaches have not been adopted because of potential disadvantages, including a possible lack of consistency between capital instruments that are included within licensed insurers’ solvency calculations. It is also considered important that licensed insurers ensure that all of the qualifying criteria for a capital instrument are met before the capital instrument is included within an insurer’s solvency capital.

5 22 General requirements - Reserve Bank’s powers. It would be impracticable to specify all the necessary examples that could restrict the Reserve Bank’s ability to use its powers under the Insurance (Prudential Supervision) Act 2010 in respect of solvency or other issues. The Reserve Bank considers that the flexibility inherent within this general requirement is necessary and important. 23 Qualifying criteria for capital instruments. The Reserve Bank has considered the questions and suggestions about aspects of the detailed qualifying criteria for capital instruments raised within some submissions. It is intended to make revisions to the qualifying criteria for capital instruments where this is considered appropriate. 24 Definition of reserves. The issue raised by the consultation process is accepted and it is now not intended to have qualifying criteria for reserves to be included within capital for solvency purposes. 25 Voting rights. It is intended that the proposed definition of capital will include a requirement that ordinary shares carry full voting rights, with no requirements in relation to voting rights for other capital instruments. This is consistent with the Reserve Bank’s requirements contained within the capital adequacy regulations used to regulate the New Zealand banking sector. 26 Credit Union Securities. The requirement to write down Credit Union Securities arises under the Friendly Societies and Credit Union Act 1982 and not the Reserve Bank’s solvency standards. The Reserve Bank considers that permanence is an important characteristic of Credit Union Securities and it is proposed that the permanence criteria for Credit Union Securities will be as consistent as possible with the permanence criterion proposed for ordinary shares. 27 Financial reinsurance. The Reserve Bank has separately consulted on the solvency treatment of financial reinsurance. 28 Disclosure. The Reserve Bank will separately consider insurers’ disclosure requirements on an ongoing basis. Section 2: Other revisions to the Reserve Bank’s solvency standards 29 Section 3 of the consultation document proposed several other amendments to the Reserve Bank’s solvency standards, including a revision to the definition of Fixed Capital within the life solvency standard. Summary of responses 30 Overall, respondents were very supportive of the proposals in respect of the other revisions to the Reserve Bank’s solvency standards.

6 31 One respondent considered that the proposed solvency treatment of insurers’ overseas branches was onerous in the situation of a well-capitalised branch. 32 Some questions and suggestions about aspects of the other revisions to the Reserve Bank’s solvency standards were raised within the submissions received. Reserve Bank response to issues raised 33 The proposed solvency treatment of insurers’ overseas branches is intended to properly measure the solvency margin of the licensed insurer by deducting any portion of the licensed insurer’s preliminary Solvency Margin relating to an overseas branch, not freely available to meet losses of the licensed insurer outside its overseas branch(es). Where a branch operates in a jurisdiction that does not limit the availability of capital to the licensed insurer, then a deduction from capital need not be made. 34 The Reserve Bank intends to implement the other revisions to the Reserve Bank’s solvency standards that were proposed within the consultation document. These revisions have been included within the 2014 exposure draft of the solvency standards that are being consulted on. Where appropriate, the revisions have been adopted including amendment(s) arising from the questions and suggestions raised by the consultation process or other drafting changes. Reserve Bank of New Zealand September 2014