Insurance solvency standards: the quality of capital and regulatory treatment of financial reinsurance

Consultation Paper:
Insurance solvency standards: the quality of capital and regulatory treatment of financial reinsurance The Reserve Bank invites submissions on this Consultation Paper by 28 February 2013. Submissions and enquiries about this consultation should be addressed to:
Ian Woolford
Manager, Financial Policy
Prudential Supervision Department
Reserve Bank of New Zealand
PO Box 2498
Wellington 6140
Email: Ian.woolford@rbnz.govt.nz

Please note that 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, you should indicate this clearly. 7 December 2012

Insurance Solvency Standards:
The Quality of Capital and Regulatory Treatment of Financial Reinsurance Introduction

1. The Reserve Bank is the regulator and supervisor of all insurers carrying on insurance
   business in New Zealand under the Insurance (Prudential Supervision) Act 2010 (the “Act”) legislation. The Reserve Bank regulates and supervises for the purposes of:
   a. promoting the maintenance of a sound and efficient insurance sector; and b. promoting public confidence in the insurance sector.
2. As such, the Reserve Bank will review and refine its regulatory requirements to assist in
   meeting these purposes as required. This consultation paper comprises three parts and seeks submissions on the various proposals. Part One of the paper outlines the attributes the Reserve Bank expects to see in regulatory capital instruments, such as permanence and the ability to absorb losses, and proposes consequential clarifications to the solvency standards to reflect these expectations.
3. Part Two of the paper focuses on the area of financial reinsurance and the impact it can
   have on an insurer’s solvency position. This consultation paper is designed to outline the Reserve Bank’s preliminary thinking about financial reinsurance, to seek industry and other stakeholder input on our initial views and policy options and to determine the extent to which financial reinsurance is used by industry.
4. Part Three outlines a number of technical refinements that bring consistency to the
   solvency standards, correct minor drafting errors or otherwise clarify requirements. Submissions are also welcome on these points.
5. Submissions are sought by the end of February, 2013. Following this consultation
   process, the Reserve Bank expects to issue revised solvency standards during the first half of 2013.

PART ONE: The quality of capital
6. If a licensed insurer incurs significant unexpected losses, in an extreme situation this can
lead to financial distress or even the failure of that insurer. The purpose of capital is to support the ongoing activities of an insurer and importantly to act as a buffer to absorb large but plausible unexpected losses. Accordingly, it is important that the quality and quantity of regulatory capital is sufficient to meet this objective.
7. In terms of the ‘quality’ of capital, both the type of instrument and the attributes of the
instrument have a bearing on its ‘quality’. For example, ordinary shares and retained earnings and other reserves (“Shareholders' Funds”) represent capital of the highest quality because these forms of capital have the ability to absorb losses incurred by an insurer in all situations.
8. This wide-ranging capability to absorb losses means that Shareholders' Funds must be
permanently available to protect the insurer’s financial strength in all but the most extreme circumstances. Any element of funding that is not of a permanent nature cannot be considered Shareholders' Funds for regulatory solvency purposes. Similarly, financial reinsurance arrangements incorporate funding aspects and where such funding is not of a permanent nature, it cannot be considered part of Shareholders’ Funds for solvency purposes.
9. Credit Union Securities are a form of high quality capital for credit unions that are being
introduced as a form of capital for solvency purposes following the recent enactment of the Financial Reform Bill.
10. It is recognised that policyholders may bear some or all of the cost of capital and that such
costs are typically proportional to the quality of capital. The highest quality capital best protects the insurer and helps to minimise the potential risk that policyholder obligations will not be met in a range of unexpected situations. Lower quality capital instruments typically only have the ability to absorb losses in certain situations.
11. Nevertheless the Reserve Bank recognises that capital instruments, other than
Shareholders' Funds, can make an important contribution to an insurer’s capital. However, the qualifying amount of lower quality capital instruments within a licensed insurer’s solvency calculation will be limited to recognise that such capital has less ability to absorb losses, compared to the highest quality capital. Structure of this section
12. The remainder of this section provides a definition of capital for solvency purposes,
outlines the overall characteristics of high quality capital and describes some general requirements for capital instruments that must be met. Then the proposed qualifying

criteria for the major elements of capital that can be used within licensed insurers’ solvency calculations are described.
13. It is proposed that the additional explanation below will be included within the Reserve
Bank’s solvency standards. This would represent an elaboration of material included within the current solvency standards. Definition of capital for solvency purposes
14. The capital of a licensed insurer may include ordinary shares, retained earnings and
revenue and other reserves (“Reserves” as defined below), perpetual non-cumulative preference shares, credit union securities, non-controlling interests and any other capital instrument that satisfies all of the appropriate requirements set out within this section of the consultation paper (“capital instruments”).
15. Reserves comprise accumulated Reserves and any current or prior year additions to
Reserves. Additions to Reserves can be made through profit and loss or directly. Reserves are retained earnings and revenue and other reserves, including the following:
i. capital redemption reserves;
ii. reserves that are created or increased by appropriations of retained earnings net
of tax and dividends payable;
iii. any share premium reserves arising from the issue of ordinary shares;
iv. each of the following types of reserves that are reflected in the statement of
financial position:
a. reserves arising from a revaluation of tangible fixed assets, including owner-occupied property; b. foreign currency translation reserves; and
c. reserves arising from the revaluation of investments.
16. Reserves do not include (a) reserves that are held aside or otherwise committed on
account of any assessed likelihood of loss; (b) any part of Reserves which does not have an unequivocal ability to absorb losses in all circumstances; (c) any part of Reserves that relates to financing or any other similar arrangement that is not of a permanent nature; and (d) any part of Reserves which could potentially be reduced by a contractual or any other arrangement (wherever set out).
17. Perpetual non-cumulative preference shares without full voting rights may not constitute
more than 50% of capital for a licensed insurer that is a mutual insurer and 25% for all other licensed insurers.
18. There is no proposed change to deductions from capital apart from item 3 set out within
Part Three of this consultation document.

Overall characteristics of high quality capital
19. To provide greater clarity about which capital instruments are acceptable for solvency
purposes, it is considered appropriate to establish the overall characteristics of high quality capital and more detailed qualifying criteria which the major elements of capital must meet. The intention is that this framework will be helpful to insurers’ boards in managing their required capital for solvency and business purposes.
20. The following overall characteristics of capital are relevant to ensure that insurers’ capital
is of a sufficiently high quality. All1 elements of an insurer’s capital, held for solvency purposes, must:
a) provide a permanent and unrestricted commitment of funds (“Permanence”); b) be freely available to absorb losses (“Loss absorption”); c) not impose any unavoidable servicing charge against earnings (“Servicing charge”); and d) rank behind the claims of policyholders and other creditors in the event of a winding￾up of the licensed insurer (“Ranking on winding-up”); and e) have other features or treatments appropriate to the capital instrument (“Other appropriate features”).
21. The overall characteristics of high quality capital are further articulated below into
qualifying criteria for each type of capital instrument.
General requirements for capital instruments
22. Each capital instrument must meet the following general requirements:
a) The capital instrument in its entirety must meet the qualifying criteria for the appropriate constituent of capital as defined for solvency purposes. Any capital instrument that is part of another capital instrument or other arrangement will not qualify as capital for solvency purposes. b) The capital instrument must satisfy the substance as well as the legal form of the overall characteristics of high quality capital and the qualifying criteria for the appropriate constituent of capital. c) If a capital instrument does not meet any of the qualifying criteria for the appropriate constituent of capital, then it cannot be included within capital for solvency purposes by the licensed insurer. In this situation the appointed actuary must give advice to this effect to the licensed insurer and subsequently also in the Financial Condition Report. If the appointed actuary recommends that a licensed insurer’s capital

1 Note that non-controlling interests may not meet all of these requirements.

instrument should be excluded from capital, then the licensed insurer must follow that advice. d) For capital instruments apart from ordinary shares, retained earnings and revenue and other reserves, perpetual non-cumulative preference shares and credit union securities to be included within a licensed insurer’s capital, the capital instrument must meet appropriate qualifying criteria. e) The capital instrument must not contain any terms, covenants or restrictions that could:
(i) hinder recapitalisation of the licensed insurer or any related party of the licensed insurer; or (ii) inhibit the licensed insurer’s ability to be managed in a sound and prudent manner, particularly in times of financial difficulty; or (iii) restrict the Reserve Bank’s ability to use its powers under the Act to assist in resolving any actual or potential issues relating to the solvency or any other matter experienced by the licensed insurer. Qualifying criteria for capital instruments
23. The qualifying criteria for each type of capital instrument that can be included within a
licensed insurer’s solvency calculations are set out below. To be included within an insurer’s solvency calculation, each capital instrument must meet the qualifying criteria for the appropriate capital instrument, in a manner satisfactory to the Reserve Bank. Ordinary shares: qualifying criteria Permanence
24. The principal amount of the ordinary shares must be perpetual (i.e., there is no maturity
date) and cannot be repaid outside of liquidation (i.e., the ordinary shares are not redeemable as defined in section 68 of the Companies Act 1993) setting aside discretionary acquisitions permitted by section 58 of the Companies Act 1993.
25. Neither the licensed insurer nor any related party of the licensed insurer may do anything
to create an expectation at issuance or thereafter that the ordinary shares will be repaid or cancelled, and the contractual terms of the ordinary shares (wherever set out) must not contain any feature which may give rise to such an expectation.
26. The ordinary shares can only be included within capital to the extent the ordinary shares
are paid and the paid-up amount must be irrevocably received by the licensed insurer.

Loss absorption
27. After Reserves,
the issued ordinary shares must be available to absorb the first and proportionately greatest share of any losses as they occur in all circumstances, including on a going concern basis and upon wind-up of the insurer. Servicing charge
28. Distributions must meet the following requirements:
a) distributions must only be paid out of distributable items (retained earnings included) of the licensed insurer. The level of distributions may not be linked in any way to the amount paid at issuance and may not be subject to a contractual cap; b) there must be no circumstances under which the distributions are obligatory and in all circumstances the licensed insurer must be able to waive any distribution; c) any waived distributions must be non-cumulative (i.e., they are not required to be made up by the licensed insurer at a later date); d) non-payment of distributions must not be an event constituting default of the licensed insurer or any related party of the licensed insurer; e) distributions may only be paid by the licensed insurer after all other legal and contractual obligations in respect of the ordinary shares have been met and payments on more senior capital instruments or debt have been made. This means that the ordinary shares must not have any preferential or predetermined rights to distributions of capital or income; and f) distributions must not cause the licensed insurer to breach any solvency requirements of the Act, solvency standards issued by the Reserve Bank or condition(s) of licence of the licensed insurer. Ranking on winding-up
29. The ordinary shares must represent the most subordinated claim in the event of liquidation
of the licensed insurer.

2 For the definition of Reserves, refer to the section entitled “Definition of capital for solvency purposes”.

30. Ordinary shareholders are entitled to a claim on the residual assets of the insurer that is
    proportional with their share of issued capital, after all senior claims have been repaid in liquidation i.e., the claim is variable and unlimited and not fixed or capped.
31. The paid in amount must be recognized as equity capital for determining balance sheet
    solvency of the licensed insurer under legislation applicable to the licensed insurer.
32. The paid in amount, or any future payments related to the ordinary shares, must not be
    secured nor covered by a guarantee of the licensed insurer or any related party of the licensed insurer or subject to any other arrangement that legally or economically enhances the seniority of the holder’s claim. The ordinary shares must not be subject to netting or offset claims on behalf of the holder of the ordinary shares. Other appropriate features
33. The ordinary shares must be directly issued by the licensed insurer and neither the
    licensed insurer nor any related party of the licensed insurer over which the licensed insurer exercises control may have purchased the ordinary shares nor directly or indirectly funded their purchase.
34. Holders of the ordinary shares must have full voting rights arising from the ownership of
    the shares.
35. The ordinary shares must be classified as equity under NZGAAP and clearly and
    separately disclosed on the licensed insurer’s balance sheet.
    Reserves: qualifying criteria
    Permanence
36. All Reserves3
    must be perpetual and irrevocable in nature. Any part of Reserves that relates to financing or any other similar arrangement that is not of a permanent nature will not be considered Reserves for solvency purposes. Any part of Reserves that could potentially be reduced by a contractual or any other arrangement (wherever set out), will not be considered Reserves for solvency purposes.
37. Neither the licensed insurer, nor any related party of the licensed insurer, may do anything
    to create an outcome or expectation that Reserves can be reduced by a contractual or any other arrangement (wherever set out) that relates to financing or any other similar arrangement that is not of a permanent nature.

3 For the definition of Reserves, refer to the section entitled “Definition of capital for solvency purposes”.

Loss absorption
38. Reserves must incur the first and proportionately greatest share of any losses as they occur
in all circumstances, including on a going concern basis and upon wind-up of the insurer. Any part of Reserves which does not have an unequivocal ability to absorb losses in all circumstances will not be considered part of Reserves for solvency purposes. Servicing charge
39. Servicing charges for Reserves must meet the following requirements:
i. non-payment of a servicing charge must not be an event of default of the licensed
insurer or any related party of the licensed insurer; and
ii. payment of or the provisioning for a servicing charge must not cause the licensed
insurer to breach any solvency requirements of the Act, solvency standards issued by the Reserve Bank or condition(s) of licence of the licensed insurer. Other appropriate features
40. The Reserves must be directly earned or acquired by the licensed insurer as an outcome of
its normal business activities and neither the licensed insurer nor any related party of the licensed insurer over which the licensed insurer exercises control, may have directly or indirectly funded their purchase.
41. The Reserves must be classified as equity under NZGAAP and clearly and separately
disclosed on the licensed insurer’s balance sheet.
Perpetual non-cumulative preference shares: qualifying criteria Permanence
42. The principal amount of the perpetual non-cumulative preference shares (“Perpetuals”)
must be perpetual (i.e., there is no maturity date).
43. Neither the licensed insurer nor any related party of the licensed insurer may do anything
to create an expectation at issuance or thereafter that the Perpetuals will be repaid or cancelled, and the contractual terms of the Perpetuals (wherever set out) must not contain any feature which may give rise to such an expectation.
44. The Perpetuals can only be included within capital to the extent the Perpetuals are paid
and the paid-up amount must be irrevocably received by the licensed insurer.

45. The Perpetuals may only be callable or redeemable (as defined in section 68 of the
    Companies Act 1993) at the initiative of the licensed insurer and only after a minimum of five years from the date on which the licensed insurer irrevocably receives the proceeds of payment for the Perpetuals, except for the following:
    (i) a Perpetuals instrument may provide for a call within the first five years of issuance as a result of a tax or regulatory event. The Reserve Bank will not permit such a call if it forms the view that the licensed insurer was in a position to anticipate the tax or regulatory event when the Perpetuals instrument was issued, or if it forms the view that the tax or regulatory event is minor or not applicable.
46. The licensed insurer is required to receive the prior written approval of the Reserve Bank
    to make any repayment of principal (including through redemption, acquisition or as the result of a call, whether as a result of a tax or regulatory event or otherwise). Prior to or concurrent with the repayment, the Perpetuals must be replaced with a paid-up capital instrument (as defined in this solvency standard) of the same or better quality and of the same or higher amount, or the licensed insurer must demonstrate to the Reserve Bank’s satisfaction that the licensed insurer’s (and group’s) solvency margin is sufficiently above the required solvency margin after the repayment. The licensed insurer should make an application for approval of repayment of the Perpetuals to the relevant insurance supervisor.
47. The Perpetuals must not contain any step-ups or incentives to redeem. This means that the
    terms of the Perpetuals must provide for the interest or dividend rate to be fixed for the entire term of the instrument and must not provide for the rate to be altered or reviewed except for the following:
    (i) where the interest payment or dividend is cancelled; and (ii) where there is a variable rate and where the formula for setting the rate is fixed (for the term of the debt) at the outset. For example, it would be acceptable to specify the interest rate as a fixed margin above a recognized market benchmark such as the bank bill rate. Conversion from a fixed rate to a floating rate (or vice versa) in combination with a call option without any increase in credit spread will not in itself be viewed as an incentive to redeem. However the licensed insurer or any related party of the licensed insurer must not do anything that creates an expectation that the call will be exercised. A change in the margin will be considered to be an incentive to redeem.

4 Conversion from a fixed rate to a floating rate that is calculated as a benchmark rate plus a margin, will be considered an incentive to redeem if there is an increase in the margin relative to that implied for the fixed rate.

Loss absorption
48. The Perpetuals must have the potential to absorb losses upon wind-up of the insurer.
Servicing charge
49. Distributions must meet the following requirements:
(i) the licensed insurer must have full discretion at all times to cancel distributions on the Perpetuals. Any waived distributions must be non-cumulative (i.e., waived distributions cannot be required to be made up by the licensed insurer at a later date and bonus payments to compensate for unpaid distributions are prohibited); (ii) cancellation of distributions must not be an event constituting default of the licensed insurer or any related party of the licensed insurer. Holders of the Perpetuals must have no right to apply for the liquidation or voluntary administration of the licensed insurer or any related party of the licensed insurer or appoint a receiver of the property of the licensed insurer or any related party of the licensed insurer on the grounds that the licensed insurer fails to make, or may become unable to make, a distribution on the Perpetuals; (iii) cancellation of distributions must not impose restrictions on the licensed insurer, or any related party of the licensed insurer, except in relation to:
(A) the acquisition, repurchase or redemption of the Perpetuals; or (B) dividend stopper arrangements that stop distributions on ordinary shares, other Perpetuals or other capital instruments; (iv) the licensed insurer must have full access to cancelled distributions to meet obligations as they fall due; (v) distributions on the Perpetuals can only be paid out of distributable items (retained earnings included) of the licensed insurer; (vi) the Perpetuals must not have a credit sensitive distribution feature5 , such as a distribution that is reset periodically based in whole or in part on the credit standing of the licensed insurer or any related party of the licensed insurer; and

5 Perpetuals may utilise a broad index as a reference rate for the calculation of distributions, provided that the index does not exhibit any significant correlation with the licensed insurer’s credit rating.

(vii) distributions must not cause the licensed insurer to breach any solvency requirements of the Act, solvency standards issued by the Reserve Bank or condition(s) of licence of the licensed insurer. Ranking on winding-up
50. The Perpetuals must represent the most subordinated claim after ordinary shares in the event
of liquidation of the licensed insurer.
51. The paid-up amount of the Perpetuals, or any future payments related to the Perpetuals, must
not be either secured nor covered by a guarantee of the licensed insurer or any related party of the licensed insurer or subject to any other arrangement that legally or economically enhances the seniority of the holder’s claim. The Perpetuals must not be subject to netting or offset claims on behalf of the holder of the Perpetuals. Other appropriate features
52. The Perpetuals must be directly issued by the licensed insurer and neither the licensed
insurer nor any related party of the licensed insurer over which the licensed insurer exercises control may have purchased the Perpetuals nor directly or indirectly funded their purchase. Credit Union Securities: qualifying criteria
53. Credit Union Securities (“Securities”) are a capital instrument that may only be issued by
credit unions under the Friendly Societies and Credit Union Act 1982. Permanence
54. The principal amount of the Securities must be perpetual (i.e., there is no maturity date) and
must never be repaid outside of liquidation.
55. Neither the licensed insurer nor any related party of the licensed insurer may do anything to
create an expectation at issuance or thereafter that the Securities will be repaid or cancelled, and the contractual terms of the Securities (wherever set out) must not contain any feature which may give rise to such an expectation.
56. The Securities can only be included within capital to the extent the Securities are paid and the
paid-up amount must be irrevocably received by the licensed insurer.
Loss absorption

57. After Reserves6
    , the Securities must incur the first and proportionately greatest share of any losses as they occur in all circumstances, including on a going concern basis and upon wind￾up of the insurer. The Securities must be issued in accordance with the requirements and provisions of the Friendly Societies and Credit Unions Act 1982. Servicing charge
58. Distributions must meet the following requirements:
    a. distributions must only be paid out of distributable items (retained earnings included) of the licensed insurer. The level of distributions may not be linked in any way to the amount paid at issuance and may not be subject to a contractual cap; b. there must be no circumstances under which the distributions are obligatory and in all circumstances the licensed insurer must be able to waive any distribution;
    c. any waived distributions must be non-cumulative (i.e., waived distributions
    cannot be required to be made up by the licensed insurer at a later date and bonus payments to compensate for unpaid distributions are prohibited); d. non-payment of distributions must not be an event constituting default of the licensed insurer or any related party of the licensed insurer; e. distributions may only be paid by the licensed insurer after all other legal and contractual obligations in respect of the Securities have been met and payments on more senior capital instruments or debt have been made. This means that the Securities must not have any preferential or predetermined rights to distributions of capital or income; and f. distributions must not cause the licensed insurer to breach any solvency requirements of the Act, solvency standards issued by the Reserve Bank or condition(s) of licence of the licensed insurer. Ranking on winding-up
59. The Securities must represent the most subordinated claim in the event of liquidation of
    the credit union licensed insurer.

6 For the definition of Reserves, refer to section entitled “Definition of capital for solvency purposes”.

60. The paid in amount, or any future payments related to the Securities, must not be either
    secured nor covered by a guarantee of the licensed insurer or any related party of the licensed insurer or be subject to any other arrangement that legally or economically enhances the seniority of the holder’s claim. The Securities may not be subject to netting or offset claims on behalf of the holder of the Securities. Other appropriate features
61. The Securities must be directly issued by the licensed insurer and neither the licensed
    insurer nor any related party of the licensed insurer over which the licensed insurer exercises control may have purchased the Securities nor directly or indirectly funded their purchase.
62. The paid in amount must be recognized as equity capital for determining balance sheet
    insolvency under the Friendly Societies and Credit Unions Act 1982 and the Companies Act 1993.
63. The Securities must be classified as equity under NZGAAP and clearly and separately
    disclosed on the licensed insurer’s balance sheet.
    Questions:
    Consultation responses are sought on the following questions:
64. Do you agree/disagree with the definition of capital for solvency purposes?
65. Do you agree/disagree with the overall characteristics of high quality capital?
66. Do you agree/disagree with the general requirements for capital instruments?
67. Do you agree/disagree with the qualifying criteria for capital instruments, for:
    a) Ordinary shares b) Reserves c) Perpetual non-cumulative preference shares d) Credit Union Securities
68. Are the proposed qualifying criteria for capital instruments appropriate for licensed
    insurers to manage their current and future capital requirements?

PART TWO: Regulatory treatment of financial reinsurance
64. This part of the consultation document is organised as follows: it first outlines the Reserve
Bank’s preliminary assessment of the policy questions relating to financial reinsurance in the context of its approach to the quality of capital and then sets out policy options for clarifying the solvency standards. Lastly stakeholders are invited to make a written submission to this consultation either by responding to the specific questions or by providing more general feedback.
65. Reinsurance is an important element in many insurers’ risk management plans and allows
risks to be spread (or pooled) across insurers and regions, with associated efficiency and stability benefits for individual insurers and the sector itself. Under the Reserve Bank solvency standards, insurers are able to take account of reinsurance, the intention being that to the extent that it effectively transfers risk it should also reduce required capital.
66. Some forms of reinsurance, generally known as financial reinsurance, or sometimes finite
insurance or limited-risk transfer reinsurance, may include funding that has debt-like characteristics. These are not precluded from being counted as capital under the current solvency standards. However, there is the potential for the risk transfer component of a financial reinsurance treaty to be unclear or difficult to establish, leading to an overestimation of the risks that have been transferred. Both of these features produce capital benefits that give rise to some concerns, and therefore raise questions about whether our solvency standards should treat financial reinsurance differently for regulatory capital purposes. The Reserve Bank has begun to assess the potential impact of the use of financial (or finite) reinsurance agreements on the solvency position of New Zealand insurers and the integrity of its solvency standards.
67. There is no universal definition of financial reinsurance and the Reserve Bank is
conscious of the importance of (economic) substance over (legal or accounting) form when attempting to define the types of arrangements that may constitute financial reinsurance. In practice, whether something is financial reinsurance (or a limited risk transfer agreement) that gives rise to concern may have to be decided on a case by case basis. Certain characteristics or attributes may help in forming that decision. One characterisation of financial reinsurance may be a risk transfer or other agreement that involves a financial or other benefit for the insurer that is over and above that commonly seen under conventional reinsurance. With that in mind and for the purpose of this consultation, the Reserve Bank is concerned with risk transfer or other agreements where the insurance risk (in substance) transferred under the agreement is insufficient to justify the capital relief resulting from the agreement being treated as reinsurance for solvency purposes. Also, if a significant part of the agreement behaves like debt in some or all circumstances, its impact on the licensed insurer’s solvency position ought to reflect that.

68. Some examples of further possible indicators of financial reinsurance are the intention on
    the part of the insurer to fund business activity disproportionately from advances or commissions resulting from the agreement; the existence of a bonus, or deficit or experience account; limited or opaque risk transfer; side letters or verbal agreements significantly altering key attributes of the original contract; having the effect of misrepresenting profit and loss recognition; and any other debt-like attributes. It is important to recognise that this is not an exhaustive list. At the same time, if one (or more) of these indicators are met, it does not necessarily mean that the agreement constitutes financial reinsurance or is something the Reserve Bank would be concerned about. For example, the Reserve Bank is aware that all reinsurance contracts may contain an element of funding or lead to some form of profit smoothing. The precise arrangements may vary from reinsurance treaty to treaty; however, as noted above, the Reserve Bank is interested in the underlying economic substance of the arrangement.
69. There are currently no provisions for, or limits on, the use of financial reinsurance in the
    Reserve Bank’s solvency standards, and insurers have been at liberty to enter into such contracts and avail themselves of any associated solvency benefits, provided they comply with the relevant accounting and solvency standards.
70. It is worthwhile making three points clear. First, the analysis and proposed policy options
    discussed in this part of the document relate to financial reinsurance, not conventional reinsurance whose primary purpose is the transfer of risk. Second, there is nothing currently prohibiting the use of financial reinsurance in our solvency standards. And third, the question being addressed here is how to treat financial reinsurance for regulatory capital purposes. That is, the Reserve Bank does not have potential concerns about financial reinsurance per se – insurers may choose to enter into such arrangements for a variety of legitimate purposes, as distinct from what, if any, proportion should be allowed to contribute to meeting solvency requirements. Policy questions
71. The primary question is whether components of financial reinsurance arrangements can be
    considered as essentially debt-like arrangements. A complicating factor is that financial reinsurance arrangements tend to be bespoke and complicated, making determination of the substance of any arrangement complex.
72. Arrangements that are to a large extent effectively debt-like raise policy questions about
    their potential effects on an insurer’s solvency position (and the reporting of profits and liabilities). Specifically, the Reserve Bank is concerned that they may not provide insurers with capital that is of similar quality to conventional capital. Indeed, they may lead to a

leveraging up of conventional capital by allowing more business to be written with a limited amount of conventional capital. There is also the risk of an insurer’s underlying profits and liabilities being difficult to interpret, thereby potentially leading to erroneous conclusions being drawn.
73. A further concern with some financial reinsurance agreements is that the amount of risk
transfer may be difficult to establish, leading to an amount of capital benefit being granted for reinsurance when there may be insufficient risk transfer to justify this amount. In this context, risks that are transferred under financial reinsurance agreements include persistency risk and any other risks applicable to the underlying contracts issued by the insurer.
74. The Reserve Bank acknowledges that there are a variety of forms that a financial
reinsurance arrangement can take. One simplified description of a financial reinsurance agreement is one that generally involves the transfer of a portion of the insurance risk to a reinsurer, who pays the direct insurer an advance (often referred to as a commission), which is then used to fund new business growth. In theory, the insurer pays the reinsurer a premium for the share of the risk the reinsurer takes on. The reinsurer in return accepts the risk for a share of any claims. The rationale for the payment of the advance by the reinsurer to the insurer is usually to fund the upfront costs the insurer has when originating business. Those costs include commission payments to brokers and agents, which in New Zealand are comparatively high. It seems that it is not uncommon for the advance to be significantly in excess of first year premiums, hence their usefulness as a funding mechanism for writing new business. Reinsurance arrangements of this kind therefore have two key components: a risk transfer component and a financing component.
75. Under the Reserve Bank’s current standards, both of these components may produce a
solvency benefit from the point of view of the insurer. Transferring risks (or a proportion of the risks) via a reinsurance treaty has the effect of reducing elements of the capital charge. For example, according to the Reserve Bank’s Solvency Standard for Life Insurance Business, both the insurance risk capital charge and the catastrophe risk capital charge are calculated net of reinsurance. The remaining counterparty risk, i.e., the risk that the reinsurer is not able to pay out when called upon, is reflected in the reinsurance risk capital charge (paragraphs 100-105 of the life solvency standard).
76. The capital benefit granted for transferred risks is justified because by definition the direct
insurer does not bear that portion of the risk. Any claims that become due can be recouped from the reinsurer in accordance with the share of the risk that has been transferred. A concern with some financial reinsurance arrangements is that their intention often is not primarily to transfer risk but to provide funding for business activity, and that in substance

the contracts may behave more like debt financing than like equity, particularly in stress scenarios.
77. Early financial reinsurance treaties involved minimal insurance risk transfer. According to
the European Commission, by 2002 these types of arrangements had “ceased to be effective in most major jurisdictions due to accounting and regulatory constraints”7 . Some jurisdictions, for instance, require the reinsurer to assume significant insurance risk and this may include a reasonable possibility of the reinsurer realising a loss. For long￾duration treaties (e.g., life and health insurance), it may mean that there has to be a significant amount of mortality and morbidity risk transfer. Although the term ‘significant’ is difficult to define, one rule of thumb that is sometimes referred to is the 10/10 rule: the reinsurance contract has a 10 percent chance of resulting in a 10 percent loss8 .
78. But even when a financial reinsurance treaty satisfies the accounting test of including
significant insurance risk transfer to qualify as a reinsurance contract, it may be difficult to establish the amount of actual risk transfer that takes place. The treaty may contain clauses limiting the risk exposure to the reinsurer or amendments are made, for example by side letters or verbal agreement, which have the same effect. A more sophisticated way of limiting the risk for the reinsurer is through the structure of money flows between the reinsurer and the insurer. If these are structured in such a way that there is a very low probability of the reinsurer incurring a loss even when paying out claims to the insurer, there may be insufficient risk transfer for this component to be treated as reinsurance for the purposes of calculating solvency. An example of this may be where a treaty includes a bonus or deficit account structured in such a way to have this effect. In such instances, the capital benefit claimed by the insurer for the reinsurance taken out may not reflect economic reality.
79. The second solvency improvement for the insurer arises from the accounting treatment of
the financial benefit the insurer receives from the reinsurer. For the purposes of this

7 European Commission report prepared by KPMG: “Study into the methodologies for prudential supervision of reinsurance with a view to the possible establishment of an EU framework”, 31 January 2002 8 See for example http://www.fasb.org/st/summary/stsum113.shtml The Reserve Bank is concerned that the nature of financial reinsurance arrangements can be such that it is difficult to establish their risk transfer content, and that there is a risk of insurers receiving a solvency benefit that is not commensurate with the actual risk transfer. This could lead to insurers being undercapitalised.

consultation paper we treat this financial benefit as a financial advance and refer to it as a commission but it should be noted that the financial benefit may take a different form and be given a different name depending on the specific financial reinsurance treaty. However, as noted before, it is the economic substance and its intended use (e.g., funding as opposed to risk transfer) that are of importance. This includes whether it primarily serves as funding for existing or new business activity and/or to enhance an insurer’s solvency position.
80. The accounting treatment of the commission is such that it can be booked as income when
received. Depending on how the reinsurance arrangement is reflected elsewhere in the accounts of the insurer (for example, through the policy liability), this income may not be fully offset in the year in which it is received, leading to an increase in retained earnings. If in substance the commission is debt-like in nature, this accounting treatment would not reflect the economic substance of the transaction.
81. The solvency standards for life (and non-life) insurers define what constitutes regulatory
capital: ordinary shares, certain perpetual non-cumulative preference shares9 , revenue and other reserves, retained earnings and non-controlling interests. Thus, to the extent it increases retained earnings, the commission payment may count as capital under the current standard.
82. Part 1 of this consultation paper sets out the Reserve Bank’s approach to the quality of
capital and the criteria that determine an instrument’s suitability to count as regulatory capital. Two of the criteria applied by the Reserve Bank are loss absorbency and permanency. Capital has to be able to absorb losses and be readily available in such an eventuality. However, financial reinsurance treaties may contain rollover clauses or triggers that require the commission advance to be repaid immediately. Such clauses, or economically-equivalent mechanisms, will not meet the permanency and loss absorbency criteria.
83. For instance, a clause that enables the reinsurer to cancel the agreement on an annual basis
and obliges the insurer to repay the outstanding commission balance immediately or within a short period of time exposes the insurer to rollover risk and does not meet the permanency or loss absorbency criteria. Clauses that require the commission balance to be repaid immediately if the insurer’s financial position deteriorates below a specified level do not meet the loss absorbency and permanency criteria. Similarly, in a situation of financial deterioration or insolvency/liquidation of the insurer where a commission

9 Perpetual non-cumulative preference shares without full voting rights may not constitute more than 50 percent of capital for a mutual insurer and not more than 25 percent of capital for other insurers.

converts into a liability, or takes seniority over other claims, then the Reserve Bank’s qualifying capital criteria will not be met.
84. In addition, at this stage the Reserve Bank questions whether booking a financial benefit
that is intended as funding as income earned when there is clearly an obligation of repayment is an accurate reflection of the economic substance, even if accounting rules are met. Its effect on the income statement may be such that it improves income in the years when the commission (funding) is received, although the ‘income earned’ has to be repaid in later years subject to profits being earned. Unless there is a full offset when received, this does not seem to reflect the economic substance, nor the intent of the financial benefit (e.g., commission), which often seems to be to fund business growth and to relieve any regulatory solvency constraint thereon.
85. One argument in support of financial reinsurance that is made is that the commission
advance is an equity-like investment and that the repayments resemble dividend-like payments. This is based on the notion that since the commission (plus interest) is repaid out of the profits of the underlying policies, it has equity-like features and does not constitute a loan.
86. The Reserve Bank is not convinced by this argument at the present time. Firstly, in
instances where an unbundling of the funding component from the risk transfer component would lead to the former being treated as a deposit or a loan rather than as capital, it seems doubtful as to whether it represents a genuine capital investment. If the accounting treatment of the funding component as capital is intrinsically linked to it being
part of an insurance contract, but its motivation is to fund business growth, it becomes
questionable whether counting it towards capital reflects economic reality. At this stage, the Reserve Bank is unconvinced of the rationale as to why something when part of an insurance contract is one thing (i.e., capital), whereas when not part of an insurance contract it becomes something else (i.e., a debt).
87. Second, the contention that repayment of the financial funding (e.g., the commission)
poses a genuine risk for the reinsurer similar to an equity investment may not always hold. While at a general level repayments may depend on profits being made, the reality can be such that repayments are structured in a way that results in only a very small probability of the reinsurer not being repaid the financing component.
88. Where a financial reinsurance treaty includes a bonus or deficit account, it is common
practice for the commission plus any agreed interest on it to be debited to this account. It is then paid back over a period of time out of the policies’ profits, which get credited to the account.

Policy options
89. The potential concerns outlined above arise because the current solvency standards do not
address financial reinsurance. The absence of a policy on the eligibility of financial reinsurance arrangements for solvency purposes is unusual amongst regulatory authorities around the world. As already alluded to above, regulatory authorities around the world tend to have put constraints around the use of financial reinsurance arrangements for solvency purposes. Disclosure requirements are often part of a regulator’s requirements as well as the requirement for financial reinsurance treaties to include a substantial amount of insurance risk transfer. There have also been proposals to unbundle the finance from the reinsurance component, generally after insurer failures or the discovery of deceitful or fraudulent activity involving financial reinsurance. In Australia, a number of high profile cases involving financial reinsurance led APRA to introduce tighter regulation and disclosure and these types of arrangements now require regulatory approval.10 11
90. The Reserve Bank is seeking views from stakeholders on the potential concerns expressed
in the previous section. Our preliminary view is that the solvency standards should explicitly address financial reinsurance in some way, and therefore leaving the current standards unchanged is not seen as a viable option.

10 For a summary of insurance cases involving financial reinsurance in Australia see http://www.apra.gov.au/GI/Documents/Final-GRA-report-Part-1-for-public-release.pdf 11 The following is a link to APRA’s current regulatory standards regarding the treatment of financial reinsurance in the general and life insurance business http://www.apra.gov.au/GI/PrudentialFramework/Documents/Final-GPS￾230-July-2008.pdf and http://apra.gov.au/lifs/PrudentialFramework/Documents/LPS-230- Reinsurance_Nov2007.pdf The Reserve Bank notes that the accounting treatment of financial benefits that are
part of financial reinsurance arrangements may not always reflect economic
reality, especially where the outcome is business funding which is repayable. The policy question is: to the extent that financial reinsurance arrangements do not have similar economic characteristics to other forms of regulatory capital, how should these arrangements be treated under the Reserve Bank’s solvency standards?

91. The Reserve Bank has assessed enhanced disclosure requirements for financial
    reinsurance arrangements but does not consider a policy option purely based on enhanced disclosure as sufficiently effective in addressing the concerns raised above. Similarly, specifying minimum standards for the amount of risk transfer that needs to occur does not sufficiently address all the issues. While it may help to better ensure that there is genuine risk transfer, monitoring could be difficult given the scope for treaty amendments by side letters and repayment structures which could reduce the reinsurer’s probability of incurring a loss on any financing component to a minimum. Moreover, such an option would leave the Reserve Bank’s concerns regarding the solvency aspects of using refundable advances as capital unaddressed.

92. The policy options contemplated by the Reserve Bank are to disallow any solvency
    benefit arising from financial reinsurance arrangements or to limit the solvency benefit that can be obtained. Option 1: no solvency benefit from financial reinsurance

93. Under this option, a financial reinsurance agreement could no longer enhance an insurer’s
    solvency position. Any financing benefits received by the insurer would not be counted as capital for solvency purposes. Where the agreement includes insurance risk transfer, the reinsurance component would have to be unbundled from the financing element if the insurer wishes to make use of the capital benefit. Such unbundling will allow the insurer’s balance sheet and solvency position to be re-stated and would be required for regulatory capital purposes, even if unbundling is not required for accounting purposes.

94. The aim of this option is to ensure that insurers operating in New Zealand are backed by
    conventional capital which meets the Reserve Bank’s loss absorbency, permanency and other criteria and not by, for instance, refundable commission payments or other forms of financial benefits with debt-like characteristics.

95. The Reserve Bank realises that this option – at least in theory – may be more restrictive
    than the regulatory constraints that exist in a number of other jurisdictions. However, it is important to note that conventional reinsurance agreements, even where they involve a reasonable financial offset for the upfront costs an insurer incurs when originating business (e.g., the broker’s commissions) will not be captured by this option.

96. It appears to be industry practice to include an offset for costs incurred by the insurer in
    conventional reinsurance transactions. The Reserve Bank has no intention of disqualifying such contracts from any capital benefit. The test is whether the reinsurance treaty’s motivation is the transfer of risk. If that is the case and the commission payment is a

reasonable reimbursement of incurred costs and does not distort the insurer’s solvency position or income statement, the Reserve Bank will continue to classify it as conventional reinsurance and not as financial reinsurance.
97. This option no longer permits a financial reinsurance agreement to be used as funding to
meet solvency positions. The insurer would still be at liberty to continue to enter into financial reinsurance agreements but any financial benefit, e.g., a refundable advance, would have to be unbundled and recognised as an obligation for solvency purposes. The reinsurance component of the agreement would also not qualify for capital relief unless it is unbundled from the funding component and the amount of genuine risk transfer can be clearly established.
98. This option comprises insurers confirming that their reported solvency positions do not
include any benefit as a result of financial reinsurance arrangements. The insurer’s CEO and CRO and appointed actuary would have to attest to the accuracy of this information. Any false or misleading reporting of information would have serious consequences for the people attesting to its accuracy. Enforcement action could be taken against individuals, for example via fit and proper certification and other appropriate penalties.
99. It should be clear to the insurer why a reinsurance treaty has been entered into, e.g.,
whether a main aim is to fund business growth with funding that has debt-like features or to improve the solvency position, or whether it is to transfer risk. While in many instances it may be relatively easy to establish whether a reinsurance arrangement is conventional reinsurance or financial reinsurance, there are likely to be contracts where this is not so easily established. Arrangements that contain no or only a small financial benefit for the insurer and where that benefit does not significantly distort the income statement or solvency position are likely to be seen as unproblematic by the Reserve Bank. On the other hand, if an arrangement provides a significant source of debt-like funding it is likely to constitute financial reinsurance regardless of the name it is given. In-between these relatively clear cases, there are likely to be many instances where it is more difficult to establish the nature of an arrangement. 100.This option includes the development and issuance of guidance by the Reserve Bank on the kinds of treaties that are likely to constitute financial reinsurance. This guidance is yet to be developed but it is likely to be based around indicators and other features that appointed actuaries, accountants and senior managers can use in deciding whether a specific arrangement is financial reinsurance and must therefore be excluded from the solvency calculation. However, there are likely to be instances where even with this guidance it may be difficult to establish this. The Reserve Bank may also want to verify the nature of arrangements itself. In order to do this, insurers will have to submit key

information on their (financial) reinsurance arrangements to the Reserve Bank. The information requirements have not yet being fully developed but they are likely to include the following:

• Name, address, registered office of the reinsurer.
• Why the contract is being entered into.
• How it fits with the insurer’s overall risk management plan.
• The amount of risk transfer and the risks being transferred.
• Any financial benefits the insurer obtains.
• Whether the financial benefits are refundable and how repayments and interest
  rates are determined.
• The interest payable by the insurer on the commissions or other funding received
  from the reinsurer.
• (Actuarial) analysis of the projected cash flows.
• Accounting treatment of the cash flows and certification by auditors.
• Where there is a bonus, deficit or experience account, how it operates,
  amortisation schedule and any risk sharing arrangements upon amortisation.
• Duration of the contract.
• Whether there are any termination events or conversion clauses.
• The effect the arrangement will have on the insurer’s balance sheet and on the
  resulting solvency margin.
  101.At this stage, it appears to the Reserve Bank that the reliance on financial reinsurance agreements for meeting solvency requirements is not overly widespread in the New Zealand market. But these arrangements have thus far been permissible under existing solvency standards and as such, they may have represented an attractive form of funding and a means of meeting solvency positions for some insurers. Where that is the case, those insurers would have to seek other more conventional sources of capital if this option was implemented. Those other sources of capital are likely to be more costly and this may impact on some insurers’ growth projections and business plans. However, the Reserve Bank does not expect this impact to translate into any efficiency costs for the sector as a whole. 102.However, insurers that use financial reinsurance arrangements to meet the Reserve Bank’s solvency requirements have acted within the limits of existing requirements and may find it difficult to obtain capital from other sources in the short term. In order to give those insurers sufficient time to meet the new requirements, this option envisages a two year transition period. This transition arrangement may be coupled with other requirements that the Reserve Bank considers appropriate. Affected insurers would not be allowed to increase their reliance on financial reinsurance agreements to meet their

solvency requirements but they could use this time to gradually reduce their reliance on them and build up their stock of other, conventional sources of capital. Option 2: restricting the solvency benefit from financial reinsurance 103.A second option is to allow financial reinsurance funding to continue to count towards capital in principle but to limit it for the purpose of meeting the Reserve Bank’s solvency standards. The Reserve Bank would determine the eligibility of a financial reinsurance treaty for capital relief. This option would also include minimum risk transfer requirements and disallow any termination or conversion clauses or subsequent amendments via side letters or verbal agreements to a financial reinsurance treaty if it is to be eligible to qualify for capital benefits. In addition, adherence would be ensured by enhanced regulatory scrutiny, including the reporting of key information to the Reserve Bank. The insurer’s CEO, CRO and appointed actuary would have to attest to the accuracy of the reported information. 104.The current solvency standards already include a cap on perpetual non-cumulative preference shares that do not have full voting rights. These shares may not constitute more than 50 percent of capital for a mutual insurer and not more than 25 percent for all other insurers. The Reserve Bank considers a cap on financial reinsurance funding of no more than 15 percent of total capital would be appropriate under this option. This would allow insurers to continue to receive a capital benefit from financial reinsurance funding such as refundable advances but also (at least partly) address the concerns that Reserve Bank has regarding this form of capital. Under this option unbundling of the funding within the financial reinsurance arrangement will be required in order to measure the proposed 15 percent allowance. 105.For a financial reinsurance agreement to be eligible to produce a capital benefit, the funding received as part of that treaty would have to be available for as long as the policies are in place. Specifically, the treaty must not contain any clauses that allow the reinsurer to cancel the treaty and trigger immediate or faster repayment of any funding provided. The treaty must also not contain any clauses which trigger the immediate repayment of the funding or its conversion into a liability under any circumstances. 106.The current accounting definition of an insurance contract already requires the transfer of significant insurance risk. This option envisages requiring insurers to establish and report to the market and the Reserve Bank the amount of risk transfer net of any risk limitations the treaty may contain. That is, the effects of any risk ceiling and any excess amounts or risk collars need to be assessed and fully taken into account. Amendments to a treaty by side letter or verbal agreement would no longer by permitted. The insurer would also have

to demonstrate that there is a real risk to the reinsurer of incurring a loss (e.g., of not having the advance commission and any interest repaid). Where a bonus or deficit accounts exist, the amortisation schedule of such accounts will need to be presented together with other relevant actuarial projections. These would need to be signed off by the appointed actuary and the insurer’s senior management. 107.This option also requires insurers seeking approval for financial reinsurance transactions to submit relevant information concerning their reinsurance treaty. The Reserve Bank would produce guideline as to the information that would be required, but at a minimum this would mean that insurers provide the Reserve Bank with information similar to that envisaged under option 1, namely:

• Name, address, registered office of the reinsurer.
• Why the contract is being entered into.
• How it fits with the insurer’s overall risk management plan.
• The amount of risk transfer and the risks being transferred.
• Any financial benefits the insurer obtains.
• Whether the financial benefits are refundable and how repayments and interest
  rates are determined.
• The interest payable by the insurer on the commissions or other funding received
  from the reinsurer.
• (Actuarial) analysis of the projected cash flows.
• Accounting treatment of the cash flows and certification by auditors.
• Where there is a bonus, deficit or experience account, how it operates,
  amortisation schedule and any risk sharing arrangements upon amortisation.
• Duration of the contract.
• Whether there are any termination events or conversion clauses.
• The effect the arrangement will have on the insurer’s balance sheet and on the
  resulting solvency margin.
  108.Apart from disclosing key information to the regulator, this option would also include requirements for the disclosure of any major financial reinsurance arrangements and their content to the market. This could be achieved with a standardised format requiring insurers to disclose the financial reinsurance arrangements that are in place, why they have been entered into, the risks being transferred, the duration of the arrangements, how any advances impact the balance sheet and solvency position, and therefore how much of the regulatory capital is financial reinsurance capital.

109.Any false or misleading reporting of information would have serious consequences for the people attesting to its accuracy. Enforcement action could be taken against individuals, for example through fit and proper certification and other appropriate penalties. 110.The Reserve Bank currently favours option 1 as it would better address its concerns expressed above, particularly as regards the solvency treatment of refundable advances and any other attributes of the contract that, in substance, amount to funding which does not meet the Reserve Bank’s capital criteria. Option 2 is an alternative which addresses a number of the issues and reduces the risks to the stability and efficiency of the insurance sector arising from these arrangements. Questions:
Consultation responses are sought on the following questions:

1. Do you agree/disagree with the Reserve Bank’s concerns regarding the current lack of
   constraints on the solvency benefits arising from financial reinsurance arrangements?
2. Do you agree/disagree that these concerns should be addressed?
3. Are the two policy options presented in this paper appropriate ways of dealing with the
   issues?
4. What are the advantages and disadvantages of the two options?
5. Are there any other options that the Reserve Bank should consider?
6. For insurers: How would your company be affected by the two options presented here?
7. What is your current use of financial reinsurance arrangements and what were the reasons
   for entering into those arrangements?
8. Are there any technical or implementation issues? If so, what are they and how could
   they be addressed?
9. Are there any other possible indicators of financial reinsurance, apart from those outlined
   within the introduction to this part of the consultation paper?

PART THREE: Other revisions to solvency standards
111.This section of the consultation paper outlines some proposed other revisions to the Reserve Bank’s solvency standards. These revisions are mainly in response to questions of interpretation raised by insurers as they have applied the solvency standards. 112.The proposed revisions to the Reserve Bank’s solvency standards are set out within the
table below, which includes the existing wording within the solvency standard(s) together
with the proposed revised wording to the solvency standard(s).
113.The proposal to allow partly paid perpetual non-cumulative preference shares to be included within capital is consistent with the existing approach for ordinary shares. The revision to the definition of Fixed Capital within the life solvency standard is proposed in order to align the treatment with the non-life solvency standard. The other items are largely refinements to the wording of the solvency standards.

Other revisions to solvency standards:
change standard(s)
Proposed revised wording within solvency standard(s) Solvency standard(s) affected12 1 It is proposed that partly paid perpetual non-cumulative preference shares can be included within capital. Fully paid-up perpetual non-cumulative preference shares may be included in capital if they meet the following
requirements:......
Perpetual non-cumulative preference shares: qualifying criteria (refer to The quality of capital section of this consultation paper)
3. The perpetual non-cumulative
preference shares can only be included within capital to the extent the Perpetuals are paid and the paid-up amount must be irrevocably received by the licensed insurer. Life, Non- life, Non-life Captives, Non￾life Run-off

12 Solvency standards affected by proposed change, refer to definitions on last page of this document

change standard(s)
Proposed revised wording within solvency standard(s) Solvency standard(s) affected 2 Revised definition of Fixed Capital.
6. Where a licensed insurer is subject to
more than one solvency standard the
Fixed Capital described in paragraph
18 of this solvency standard applicable to the licensed insurer will be the higher, or highest, of the Fixed Capital (or in the case of a non-life insurer, the Minimum Capital Requirement) amounts within the applicable solvency standards. The requirements shall not be additive.
18. Fixed Capital is the amount referred
to in Sections 19(1)(f), 21(2)(b) and
56(a)(1) of the Act, and means the minimum amount of Actual Solvency Capital that the licensed insurer is required to hold at all times in order to meet the Solvency Margin requirements of this solvency standard. This requirement applies at the entity level and the capital may be held within or outside the statutory fund(s) of the life insurer provided at all times that, for each statutory fund of the licensed insurer, sufficient Actual Solvency Capital to meet the requirements of the solvency standard is held within the statutory fund(s). If the Actual Solvency Capital falls below the Fixed Capital at any time then the licensed insurer must increase its Actual
6. Where a licensed insurer is subject to
more than one solvency standard the Fixed
Capital described in paragraph 18 of this solvency standard applicable to the licensed insurer will be the higher, or highest, of the Fixed Capital (or in the case of a non-life insurer, the Minimum Capital Requirement) amounts within the applicable solvency standards. The requirements shall not be additive.
18. Fixed Capital is the amount referred to
in Sections 19(1)(f), 21(2)(b) and 56(a)(1) of the Act, and means the minimum amount of Minimum Solvency Capital that the licensed insurer is required to hold at all times in order to meet the Solvency Margin requirements of this solvency standard. At an entity level, the Minimum Solvency Capital of the licensed insurer is subject to a minimum required amount of $5 million. Actual Solvency Capital to cover this amount may be held within or outside the statutory fund(s) of the life insurer provided at all times that, for each Life Fund of the licensed insurer, sufficient Actual Solvency Capital to meet the requirements of the solvency standard is held within that Life Fund. If the Minimum Solvency Capital calculated at an entity level is less than $5 million then Life

Solvency Capital to this amount. If the
Actual Solvency Capital of the life insurer, calculated in accordance with paragraphs 43 - 45 of this solvency standard, is less than $5 million then the life insurer will be required to increase its Actual Solvency Capital to $5 million.
138. A licensed insurer must disclose in
its annual financial statements
(required under the Financial Reporting
Act 1993) and on its website (if any) the licensed insurer’s current Solvency Margin for each Life Fund, from its most recent annual solvency return. In addition an aggregate Solvency Margin must be disclosed for all Life Funds of the licensed insurer. Website disclosure must reflect the solvency position in the latest financial statements provided to the Bank in accordance with Section 81 of the Act. the licensed insurer must increase its Minimum Solvency Capital to this amount for the purpose of calculating its entity level solvency margin.
138. A licensed insurer must disclose in its
annual financial statements (required under the Financial Reporting Act 1993) and on its website (if any) the licensed insurer’s current Solvency Margin for each Life Fund, from its most recent annual solvency return. In addition an entity level Solvency Margin must be disclosed for the licensed insurer, allowing for the Fixed Capital requirement described in paragraph 18 of this solvency standard. Website disclosure must reflect the solvency position in the latest financial statements provided to the Bank in accordance with Section 81 of the Act.

change standard(s)
Proposed revised wording within solvency standard(s) Solvency standard(s) affected 3 Solvency treatment of licensed insurers’ overseas branches. Deduction from capital, paragraph 38(k): any net assets of an overseas branch not freely available in all circumstances (refer paragraph 44 below).
44. Where a licensed insurer has one or
more overseas branches in a country or countries in which all or a portion of the net assets of any such branch are not freely available outside the branch, then the portion of net assets which are not freely available outside the branch in all circumstances must be treated as a Deduction from Capital (refer to paragraph 38(k)). The above treatment is currently included within Non-life only. Deduction from capital, paragraph 38 (k):
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 branch(es). Refer paragraph 44 below for how this is to be determined.
44. Where a licensed insurer has one or
more overseas branches, it must calculate, excluding this paragraph and clause (k) of paragraph 38, a preliminary Solvency Margin for the entity as a whole, incorporating any branch assets and liabilities into the calculation. If any portion of this preliminary Solvency Margin is not freely available to meet losses of the licensed insurer outside its branch(es), then this amount must be treated as a Deduction from Capital (refer to paragraph 38(k)). Such an amount may arise due to restrictions on the use of branch assets in the jurisdiction in which the branch operates, or because of local capital requirements relating to the branch, or for some other reason. The proposed treatment will be included within all solvency standards. Life, Non- life, Non-life Captives, Non￾life Run-off

change standard(s)
Proposed revised wording within solvency standard(s) Solvency standard(s) affected 4 Clarification of taxation treatment of numerical capital factors. The treatment of this issue was not explicitly included within the solvency standards previously. Within this solvency standard, all numeric capital factors to be used within the capital charge calculations are stated gross of taxation i.e., before any allowance for taxation. Life, Non- life, Non-life Captives, Non￾life Run-off 5 Clarification of the prescribed solvency assumption margin for disability income IBNR claims. The treatment of this issue was not explicitly included within the solvency standards previously. Prescribed Solvency Assumptions
Appendix A:
Disability income (Individual and
Group):
Active Lives
Claims in Payment (Projection
Method)
Claims in Payment (Case Estimate)
Prescribed Solvency Assumptions
Appendix A:
Disability income (Individual and Group):
Active Lives
Claims in Payment (Projection Method)
Claims in Payment (Case Estimate)
IBNR is to be treated consistently with
Claims in Payment.
Life
6 Clarification of catastrophe risk capital charge within Life.
The treatment of this issue was not explicitly included within the Life solvency standard previously. The catastrophe risk capital charge is subject to a minimum of zero. Life

change standard(s)
Proposed revised wording within solvency standard(s) Solvency standard(s) affected 7 Clarification of the application of the asset risk capital factors table within Non-life Captives. Row 5 of table 2 will be deleted and the reference to unpaid premiums in row 9 of
table 2 will be
removed because these items are covered by row 10 of
table 2.
Row 5 of table 2:
Unpaid premiums that are not yet due or are less than six months past the contractual due date for payment to the licensed insurer Row 9 of table 2:
Any debt obligation with counterparty rating of Grade 5 or unrated Cash management trusts with counterparty rating of Grade 5 or unrated Subordinated debt of a counterparty with rating of Grade 1 or 2 or 3 Unpaid premiums that are more than six months but less than twelve months past the contractual due date for payment to the licensed insurer Row 5 of table 2 will be deleted. Row 9 of table 2:
Any debt obligation with counterparty rating of Grade 5 or unrated Cash management trusts with counterparty rating of Grade 5 or unrated Subordinated debt of a counterparty with rating of Grade 1 or 2 or 3 Non-life Captives

change standard(s)
Proposed revised wording within solvency standard(s) Solvency standard(s) affected 8 Amendment of interest rate risk charge within Non￾life Run-off. Insurance liabilities are premium liabilities (as defined in this solvency standard) and the net outstanding claims liability at a minimum 75% POS, as advised by the appointed actuary. Insurance liabilities are premium liabilities (as defined in this solvency standard) and the net outstanding claims liability at a minimum 90% POS, as advised by the appointed actuary. Non-life Run-off 9 Update all solvency standards to refer to any previous versions of the solvency standards that have been issued. There is a section in each solvency standard for previous versions and it has not been completed for Non-life. All solvency standards will refer to any previous versions of solvency standards that have been issued. Life, Non- life, Non-life Captives, Non￾life Run-off

change standard(s)
Proposed revised wording within solvency standard(s) Solvency standard(s) affected 10 Only Life currently includes the requirement to provide section 78 reports with the solvency return. It is proposed that all solvency standards will include this requirement. Frequency of solvency returns to the Bank The licensed insurer must provide an annual solvency return to the Bank within five months and twenty days after the end of the licensed insurer’s financial year. The annual solvency return must be in the form specified by the Bank and be accompanied by:
(a) an attestation by two directors of the licensed insurer (or in the case of an overseas insurer, its New Zealand Chief Executive Officer) in the form specified by the Bank; and (b) a copy of the audited financial statements of the licensed insurer; and (c) a report by the auditor of the licensed insurer on the audit of the solvency return; and (d) a financial condition report prepared by the appointed actuary of the licensed insurer. Frequency of solvency returns to the Bank The licensed insurer must provide an annual solvency return to the Bank within five months and twenty days after the end of the licensed insurer’s financial year. The annual solvency return must be in the form specified by the Bank and be accompanied by:
(a) an attestation by two directors of the licensed insurer (or in the case of an overseas insurer, its New Zealand Chief Executive Officer) in the form specified by the Bank; and (b) a copy of the audited financial statements of the licensed insurer; and (c) a report by the auditor of the licensed insurer on the audit of the solvency return; (d) a financial condition report prepared by the appointed actuary of the licensed insurer: and (e) a report from the appointed actuary that meets the requirements of section 78 of the Act. Non- life, Non￾life Captives, Non-life Run-off

Solvency standards definitions
Life = Solvency Standard for Life Insurance Business Non- life = Solvency Standard for Non- life Insurance Business Non-life Captives = Solvency Standard for Captive Insurers Transacting Non- life Insurance Business Non-life Run-off = Solvency Standard for Non- life Insurance Business in Run-off Questions:
Consultation responses are sought on the following questions:

1. Do you agree/disagree with the proposed other revisions to the Reserve Bank’s solvency
   standards set out above?
2. Are there any technical or implementation issues? If so, what are they and how could
   they be addressed?