Insurance Solvency Standards Reissue Regulatory Impact Statement

REGULATORY IMPACT STATEMENT INSURANCE SOLVENCY STANDARDS – REISSUE

2 Contents AGENCY DISCLOSURE STATEMENT................................................................................ 3 I. GUARANTEES.................................................................................................................4 II. REINSURANCE................................................................................................................8 III. DISCLOSURE ............................................................................................................... 13 IV. FINANCIAL REPORTING ACT MOTIVATED CHANGES............................................. 14 V. TECHNICAL CLARIFICATIONS AND MINOR POLICY CHANGES.............................. 15 VI. IMPLEMENTATION....................................................................................................... 22 VII. MONITORING, EVALUATION AND REVIEW.............................................................. 23 2

3 AGENCY DISCLOSURE STATEMENT

1. This Regulatory Impact Statement (‘RIS’) is prepared by the Reserve Bank of New Zealand (‘Reserve Bank’). It provides analyses of the key proposals which together give reason for the reissue of the Insurance Solvency Standards made under Section 55 of the Insurance (Prudential Supervision) Act 2010.
2. In the period between 2012 and 2014 the Reserve Bank issued five consultation papers on four key proposals in the reissue, namely: quality of capital, financial reinsurance, guarantees and off-balance sheet exposures. These proposals and some additional proposals (see paragraph 5) are being consulted on in September 2014.
3. In addition to the public consultation, where relevant, the Reserve Bank has considered: (a) overseas solvency standards for the purpose of ensuring that no solvency standard to be issued by the Reserve Bank applies, in respect of a particular insurer, in an unreasonable manner (as compared to other insurers) as a result of the insurer being incorporated in New Zealand or some other jurisdiction; and (b) literature on aspects of insurance solvency in developing the key proposals.
4. The Reserve Bank has also informed the Minister of Finance’s office and the New Zealand Treasury about the key proposals.
5. The material that has not been consulted on prior to September 2014 includes: (a) additional changes to the Asset Risk Capital Charge and other parts of the Standards to improve clarity; (b) changes due to the passage of the Financial Reporting Act 2013 (‘FR Act 2013’) and associated changes to legislation; and (c) additional disclosure requirements.
6. Where applicable, the proposed changes apply to the Solvency Standard for Life Insurance Business (‘Life Standard’) and Solvency Standard for Non-life Insurance Business (‘Non-life Standard’), except for the proposals relating to reinsurance, which only apply to the Life Standard.
7. It is intended that equivalent changes will also be made to the Solvency Standard for Non-life Insurance Business in Run-off, the Solvency Standard for Captive Insurers Transacting Non-life Business and the Solvency Standard for Civic Assurance.
8. Further, it is intended that the Solvency Standard for Non-life Insurance Business – AMI Insurance Limited and the Solvency Standard for Captive 3

4 Insurers Transacting Life Insurance Business be revoked as they no longer apply to any licensed insurers. 9. The first five parts of this RIS set out the problem definition, options analysis and recommendation for each key proposal of the reissue, namely: (a) Guarantees; (b) Financial reinsurance; (c) Disclosure; (d) FR Act 2013 motivated changes; and (e) Technical clarifications and minor policy changes (including, quality of capital) 10. As the key proposals are being implemented together a sixth part describes the overall implementation plan. The final part notes the review and evaluation process for the Solvency Standards as a whole. I. GUARANTEES (a) Status quo and problem definition 11. Under the current Solvency Standards an asset subject to a guarantee may be assigned the capital charge that would apply if the guarantor were the counterparty as opposed to the capital factor of the principal counterparty. Accordingly, where the guarantor’s credit rating is higher than that of the principal counterparty a guarantee can reduce an insurer’s minimum capital requirement. 12. The rationale for this policy is that guarantees of assets provide an effective form of risk mitigation. However, the extent to which a guarantee mitigates risk will depend upon the terms of the contract. There are a number of provisions that may be included in a contract of guarantee that may limit the risk mitigation effect of a particular guarantee. The amount of credit that is given to a guarantee in the Solvency Standards needs to reflect the actual level of risk mitigation and any residual risks associated with the guarantee. 13. Under the current Solvency Standards, only guarantees of a greater duration than the underlying asset receive recognition (and all guarantees of demand loans receive full recognition). However, the Reserve Bank considers that guarantees of a shorter term than the underlying asset still provide some benefit in terms of risk mitigation, and thus it is appropriate that they receive some recognition in the Solvency Standards. Allowing such recognition improves economic efficiency by recognising a wider range of guarantees that exist in commercial practice. However, the level of recognition they receive should take account of the duration of the guarantee relative to the underlying asset, as this better reflects the level of risk mitigation over the life of the underlying asset. 14. The Reserve Bank is aware that some insurers have used relatively short term guarantees to effect very large reductions in the Asset Risk Capital 4

5 Charge that would have applied if the insurer had the same underlying assets but no guarantee. As a matter of contract, on-demand loans have on-demand repayment provisions. However, in practice a lender’s certainty about its ability to receive repayment at any given time (were the lender to demand repayment) depends on who its counterparty is and how liquid they are. Accordingly, an on-demand loan to a large bank is a different credit risk to an on-demand loan to a less liquid related party – and this is reflected in the solvency charge that would apply before the guarantee. That said, at present demand loans are considered fully guaranteed with a very short term guarantee. Put simply, the Reserve Bank considers that the amount by which the minimum capital requirement can be reduced by short term guarantees can in some circumstances be disproportionate to the amount of actual risk mitigation. In addition, the Reserve Bank considers that all guarantees can give rise to residual risks, such as legal risk arising from improper contract formation or the risk of a sudden change in minimum solvency requirements as a result of non-renewal. A guarantee is therefore not a perfect substitute for an investment where the guarantor is the counterparty. (b) Objectives 15. New requirements for guarantees seek to: (a) allow for the recognition of guarantees of assets with a shorter duration than the guaranteed assets in order to recognise the risk mitigating properties of these guarantees; (b) ensure that guarantees that are recognised for solvency purposes are legally robust; (c) ensure that the residual risks of guarantees are appropriately recognised; and (d) ensure that the amount of capital mitigation that can arise from guarantees of demand loans reflects the true amount of risk mitigation. (c) Options analysis 16. Under the current Solvency Standards, the eligibility rules for guarantees are brief. In June 2013, more extensive eligibility criteria were proposed, including expectations as to the legal certainty in relation to a guarantee. 17. Separately, as discussed, under the current Solvency Standards only guarantees of greater duration than the underlying asset are recognised (this results in full recognition of a guarantee of any length of a demand loan). In a June 2013 consultation paper the Reserve Bank proposed recognition of guarantees of a term less than the underlying asset, subject to haircutting the value of the guarantee recognised, consistent with the approach used in the Banking Capital Adequacy Framework. Essentially recognition is based on the relative term of the guarantee versus the underlying asset (the “recognition formula”). Non-renewing guarantees (where there is a maturity mismatch) of less than 1 year would receive no recognition and guarantees of demand loans would be haircut based on the initial length of the guarantee and an assumed maturity for the demand loan, to reflect that not all demand loans can be immediately liquidated. This proposal is expected to have a 5

6 positive benefit by improving the risk sensitivity of the Standards in that it allows for recognition of a wider range of guarantees than is currently the case. It also clarifies the intended interpretation of the Standard for demand loans and would result in a reduction in the amount of capital mitigation available in respect of some guaranteed demand loans. 15% Limit proposal 18. Further, the Reserve Bank proposed in June 2013, in addition to the recognition formula and rules on the eligibility of guarantees, an overall limit of 15% on the amount that the Asset Risk Capital Charge can be reduced through the use of guarantees and asked submitters for their views on the proposed limit. 19. The majority of respondents to the June 2013 consultation paper disagreed with the proposed limit for at least one of the following reasons: (a) the Reserve Bank had already proposed in the Consultation Paper practical restrictions on the use of guarantees to address risks associated with the use of them. Respondents argued that the recognition formula and requirements as to the legal enforceability of guarantees are an efficient approach which drives insurer behaviour in a positive way and obviates the need for an overall limit; (b) if a limit is to be introduced in relation to the use of guarantees, respondents submitted that it is unclear why it has been set at 15%. The respondents argued that the effect of the limit would be unduly punitive in light of the existing position of full recognition. 20. In addition, the 15% limit could have led to unexpected outcomes in the degree of recognition allowable under economically similar circumstances. Illustrative example - risk of other assets impacts on amount guarantee is recognised An insurer has a related party loan asset of $50m, covered by a maturity-matched guarantee by a high-quality guarantor. In addition, the insurer has other assets of $100m. Scenario 1: Other assets are AA rated fixed interest. With no recognition of the guarantee, Asset Risk Capital Charge would be 100%$50m + 2%$100m = $52m Maximum reduction in capital charge allowed for guarantee under 15% cap proposal = 15% of $52m = $7.8m Scenario 2: Other assets are also related party debt. With no recognition of the guarantee, Asset Risk Capital Charge would be 100%$50m + 100%$100m = $150m 6

7 Maximum reduction in capital charge allowed for guarantee under 15% cap proposal = 15% of $150m = $22.5m So, the amount of the guarantee recognised in capital charges varies in response to the other assets of the insurer, even though there is no change in the economic risks associated with the loan and guarantee. 21. Taking into account submissions and the fact the 15% limit could have led to unexpected outcomes, the Reserve Bank decided to consider an alternative option to address the residual risks of guarantees. Alternative – Additional risk factor for guaranteed assets 22. In December 2013 the Reserve Bank consulted on the option to apply an increased risk charge to assets for which the risk charge is based on the guarantor rating such that: Risk Factor of Assets subject to Guarantee = Risk Factor based on issuer rating of the guarantor + a loading factor. 23. So an asset (of maturity more than 1 year) subject to a counterparty Grade 1 bank guarantee would be charged at a risk factor of 4% instead of 2% (assuming a 2% additional risk factor). The increased risk factor explicitly recognises the residual risks discussed above. 24. In December 2013, the Reserve Bank consulted upon the calibration of this risk factor. Some submitters suggested it should be lower, such as 25% of 2%. However, this would make the additional risk factor charge so low as to be arguably meaningless. Such a small change would not be effective support for the principle that a guarantee from a given counterparty has a higher risk than an investment directly held with that counterparty. 25. Even for very low risk assets such as notes and coin, the Solvency Standards levy a 0.5% capital factor. As a result, we decided an additional risk factor at 2% was appropriate. This results in a small additional risk charge for a guaranteed asset above the status quo which we consider appropriately recognises residual risks of guarantees and is substantially less penal than the 15% limit proposal. (d) Consultation 26. The Reserve Bank has consulted twice on the treatment of guarantees in the Solvency Standards (June 2013, December 2013). Final proposals on guarantees are being consulted on in September 2014. (e) Conclusions and recommendations 27. The capital factor applying to a guaranteed asset will be the capital factor based on the guarantor’s issuer rating plus an additional charge of 2%. Guarantees of shorter maturity than the guaranteed asset may be recognised subject to a hair cut based on the relative maturity of the asset and guarantee. Demand loans will be subject to an assumed maturity of 3 years, meaning 7

8 that any guarantee of 3 years or greater will receive full recognition and shorter term guarantees will be recognised subject to a hair cut. II. REINSURANCE (a) Status quo and problem definition 28. 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. 29. The Reserve Bank has identified three areas of concern in respect of the solvency treatment of reinsurance: (a) there are no requirements as to when the benefits of reinsurance may be recognised. To receive recognition in the Solvency Standards reinsurance agreements should provide a sufficient level of certainty that a benefit will in fact accrue in a range of circumstances; (b) the absence of reporting to the Reserve Bank on reinsurance hinders the Reserve Bank’s ability to monitor reinsurance arrangements; and (c) some forms of reinsurance, generally known as financial reinsurance, may include funding that has debt-like characteristics. In the view of the Reserve Bank these debt like aspects of reinsurance are not always appropriately accounted for in solvency calculations under the Life Solvency Standard. This arises in part because of the different way reinsurance is treated in the Life Solvency Standard as compared to under accounting practice; namely the debt like aspects of reinsurance may be recognised on the balance sheet for accounting purposes but may not be included in the solvency capital calculation. Debt like obligations in reinsurance agreements may also not be appropriately recognised when they are contingent in nature. The result is that the minimum solvency capital requirement can in some circumstances be inappropriately reduced in respect of reinsurance. (b) Objectives 30. The changes to the Life Standard in respect of reinsurance have three key purposes: (a) ensuring that where the benefit of a reinsurance arrangement is recognised in the calculation of an insurer’s solvency capital requirement that there is a sufficient level of certainty that the insurer will in fact receive that benefit; (b) enhancing reporting requirements in respect of reinsurance in order to improve Reserve Bank oversight of reinsurance arrangements; and (c) requiring capital to be held in relation to arrangements considered to be financing reinsurance arrangements - where the reinsurance arrangement gives rise to or may give rise to debt like obligations. 8

9 (c) Options analysis 31. Below we discuss the options proposed in relation to each of the objectives outlined in paragraph 30. Recognition of the benefits of reinsurance 32. In October 2013 and May 2014 the Reserve Bank consulted on new requirements proposed to be included in the Life Solvency Standard that limit when the benefits of a reinsurance agreement can be recognised for solvency purposes. This included a requirement that the reinsurance agreement is legally binding and that the reinsurer is not able to unilaterally terminate the agreement except in a limited range of circumstances. The intent of these requirements is to ensure that where the benefits of reinsurance reduce solvency capital requirements there is a sufficient level of certainty that the assumed benefit will in fact materialise. Reporting 33. In October 2013 and May 2014 the Reserve Bank consulted on new requirements as to reporting of reinsurance arrangements to the Reserve Bank. Insurers will be required to provide a reinsurance statement to the Reserve Bank detailing specific information in relation to their reinsurance arrangements. Financial reinsurance 34. The Reserve Bank has undertaken 3 public consultations on ‘financial reinsurance’; that is on the solvency treatment of reinsurance arrangements that contain debt like obligations. A number of policy options have been considered by the Reserve Bank; at a high level these are summarised as options 1 and 2 below. Option 1: requiring capital to be held in respect of debt like obligations 35. Under this option, an insurer is required to hold capital to the extent that a reinsurance agreement gives rise to debt like obligations. The Standard defines the circumstances under which an obligation would be considered to be debt like; these obligations are termed ‘repayable amounts’. The aim of this option is to address the current deficiencies in the Life Solvency Standard in respect of reinsurance discussed in paragraph 29 and hence ensure that all liabilities or potential liabilities are recognised for solvency capital purposes. This will ensure that there is a level playing field in respect of the capital requirements for life insurers. 36. A repayable amount is defined to exist if any one of the following three tests is met: (a) likelihood test –if there is insufficient risk transfer under the agreement as a whole a repayable amount will exist; 9

10 (b) specified event test – if the insurer may become subject to an obligation to pay an amount to a reinsurer otherwise than from profits from the reinsured portfolio on the occurrence of a specified event then such an amount will be a repayable amount; and (c) embedded obligations test – if under the agreement the insurer is subject to an obligation to pay amounts otherwise than out of the future profits (other than in a termination event) from the reinsured portfolio then a repayable amount will exist. 37. Under this option the insurer must hold capital against a repayable amount. In calculating the capital requirement the insurer may take into account any amount of capital already held in respect of the repayable amount. Option 2: restricting the solvency benefit from financial reinsurance 38. A second option considered was to limit the extent to which a financial reinsurance arrangement could be used to reduce solvency capital. Under this option the Solvency Standard would define financial reinsurance arrangements and limit the extent to which solvency capital could be reduced by use of the agreement. This option would also entail 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. (d) Consultation and response 39. The Reserve Bank will have undertaken four rounds of consultation on reinsurance (December 2012, October 2013, May 2014, September 2014). In this section we provide a discussion of some of the key points raised by submitters in the first three rounds; this summary only identifies high level arguments. 40. Overall submitters expressed a wide range of views on the proposals throughout the consultation process and these views were in many cases divergent. However, the majority of respondents agreed that it would be useful for the Reserve Bank to clarify the regulatory treatment of reinsurance in order to provide greater certainty to industry. 41. Several submitters expressed support for requirements relating to when the benefit of reinsurance can be recognised. In response to submissions on the October 2013 consultation document the Reserve Bank made a number of changes to the proposals, particularly in allowing a larger number of exceptions to the requirement that a reinsurer may not be able to unilaterally cancel the agreement. Following further consultation in May 2014 a small number of further changes have been made to the proposals in response to submissions. Additionally a 1 year transition period will apply to these requirements so affected parties have time to restructure their arrangements. 42. Several submissions were received on the proposed reporting requirements for reinsurance. As a result of consultation a number of amendments were 10

11 made to the proposed information requirements, in particular clarifying that the basis on which stress testing of reinsurance agreements is reported on is an inception basis (i.e. from the commencement of the agreement). 43. During consultation several respondents agreed with the Reserve Bank’s concerns in relation to financial reinsurance and supported the intent of the policy approach. For example, one respondent expressed a concern that certain financial reinsurance arrangements “might lower the level of capital available in the industry to support stress scenarios, either by not effectively absorbing losses or by hindering recapitalisation if arrangements strip a large share of the insurer’s cash flows”. Other respondents considered that some financial reinsurance arrangements are effectively structured like a debt instrument or may contain contingent liabilities that are not recognised on the balance sheet or in solvency calculations. 44. Several submitters considered that any debt obligations implicit in reinsurance arrangements should be properly accounted for as debts in the solvency calculations. In the October 2013 consultation paper the Reserve Bank proposed tests to identify a debt like elements of a reinsurance agreement, termed ‘a repayable amount’. Submissions received on this consultation indicated that there was uncertainty as to the interpretation of the proposed tests. In response to submissions the Reserve Bank redefined the tests and provided a greater amount of guidance to determine when a repayable amount would exist. The refined tests were consulted on in May 2014. Submissions received on the May 2014 consultation expressed that the refined tests provided significantly greater clarity as to when a repayable amount would be considered to exist. Some further refinements to the tests were made following the May 2014 consultation. 45. Some submitters did not support the approach of requiring capital to be held in respect of financial reinsurance. Some of the key points raised by these submitters were: (a) the proposals are not consistent with international regulatory or accounting practice and are more restrictive than a number of other jurisdictions; (b) financial reinsurance provides a permanent source of funds and hence should be considered to be a capital instrument; (c) removing capital relief for financial reinsurance may cause solvency problems for some insurers and it may take time for them to replace current reinsurance funding with acceptable alternatives; (d) the proposals are technically difficult to implement; (e) given New Zealand’s limited access to development capital, the proposed policy would make it harder to start up insurance companies in New Zealand. 46. In response to the key concerns raised above: (a) the Reserve Bank has reviewed regulatory approaches to reinsurance, and in particular financial reinsurance, in a number of other jurisdictions, including the approach of the Prudential Regulation Authority, the Monetary Authority of Singapore and the Australian 11

12 Prudential Regulation Authority. The approach the Reserve Bank is taking is tailored to address problems that arise specifically under the New Zealand regime; however the Reserve Bank does not consider that the approach is inconsistent with other regulatory approaches; (b) the Reserve Bank does not accept that financial reinsurance provides funding of sufficient permanence and loss absorption to be considered as a form of capital funding; (c) the Reserve Bank is cognisant that removing the current solvency benefit that accrues for financial reinsurance will impact on the solvency position of some insurers under the Standard. For this reason a transition period for the new requirements will be implemented. Under this transition insurance business written after January 2016 will be subject to the Standard from January 2016, insurance business written prior to January 2016 will be subject to the Standard from January 2019; (d) the Reserve Bank agrees that the proposals are technically complex. Some submitters considered that to address the complexity the Reserve Bank should implement an approvals regime for financial reinsurance similar to Australia. The Reserve Bank considered this approach but does not intend to implement a formal approvals regime at this stage. Where insurers require greater certainty as to the appropriate treatment of a particular arrangement they may submit the agreement to their Reserve Bank supervisor to receive a Reserve Bank view; and (e) the Reserve Bank has taken into account the argument that increasing the capital requirement for financial reinsurance will harm start-up businesses. However, the Reserve Bank notes that reinsurance agreements that genuinely pass insurance risk to the reinsurer and do not give rise to contingent debt obligations for the insurer will not give rise to an additional capital impost under the standards. The Reserve Bank considers that agreements that are not considered to be financial reinsurance are currently used in the market place. Where any insurer, including a start up, is subject to debt like obligations within a reinsurance agreement it is important that these obligations be recognised as such in the solvency calculations in order to ensure that the insurer has adequate financial resources to meet it payment obligations as they fall due, including to policy holders. This is important to support the soundness of the insurance sector. (e) Conclusions and recommendations 47. Taking into account submissions received, the Reserve Bank’s preferred approach is option 1: to require that an insurer must hold capital in respect of any debt like elements in a reinsurance agreement. The Reserve Bank considers that this solution is tailored to the problems that arise with the Reserve Bank’s Solvency Standards. The proposed solution supports the soundness of the insurance sector, improves transparency and allows for investors to make informed decisions by ensuring that debt like obligations of a licensed insurer are properly accounted for in solvency calculations. 12

13 48. The Reserve Bank does not consider that option 2 (restrict recognition) addresses the problems identified with the Life Solvency Standard (discussed in paragraph 29). Failure to address these problems would result in a failure to recognise all debt like obligations to which an insurer may be subject. This would not enhance the soundness of the insurance sector, would not improve transparency and would fail to create a level playing field in respect of life insurers’ capital requirements. 49. The proposed amendments contains three main parts: (a) restrictions on when reinsurance can be recognised for the purpose of the insurer calculating its solvency capital requirement; (b) a rule requiring that whenever a reinsurance agreement gives rise to a repayable amount, that amount must be recognised in the insurer’s Solvency Margin. The requirements for identification and valuation of the repayable amount are contained in an appendix to the Standard; and (c) requirements to report to the Reserve Bank. III. DISCLOSURE (a) Status quo and problem definition 50. There has been a degree of inconsistency observed in respect of the content and timing of the disclosure of solvency margin information within insurers’ annual financial statements and on insurers’ websites. The current minimum requirement of disclosure of a dollar solvency margin also provides limited information to enable the disclosed margin to be placed in context, such as in relation to the size of the insurer’s balance sheet or the prior year’s solvency margin. (b) Objectives 51. Changes to the minimum disclosure requirements are motivated by a desire to have more information available to the market to enhance market discipline, to improve the consistency of minimum disclosure across the industry and to provide an adequate timeframe for the updating of website information. (c) Options analysis 52. The proposed minimum disclosure requirements have been considered against the status quo and a requirement that involved the disclosure of each primary risk charge within the calculations conceptually similar to that required annually within the Australian regime. The Reserve Bank considers that the proposed approach strikes an appropriate balance between providing a minimum level of information that can place the disclosed solvency information in context (e.g. the size of the insurer’s balance sheet and 13

14 compared to prior periods) whilst encouraging a more consistent disclosure across the industry. Many insurers already disclose the proposed minimum requirements. (d) Consultation 53. The Reserve Bank will consult on this new material in September 2014. (e) Conclusions and recommendations 54. Enhanced disclosure requirements are proposed that require an insurer to disclosure its Actual Solvency Capital, Minimum Solvency Capital, Solvency Margin and Solvency Ratio in its financial statements and on its website in respect of each business line and in respect of the business as a whole. IV. FINANCIAL REPORTING ACT MOTIVATED CHANGES (a) Status quo and problem definition 55. The existing Solvency Standards do not address the replacement of the Financial Reporting Act 1993 (‘FR Act 1993’) with the FR Act 2013 and associated legislative changes. (b) Objectives 56. These changes are to ensure the Solvency Standards address the replacement of the FR Act 1993 with the FR Act 2013 and associated legislative changes. The changes to the Solvency Standards are to reporting dates and updating of references. (c) Options analysis 57. In so far as legislative references are concerned there are limited choices for this initiative. A number of changes are proposed to be made to the Standard to ensure that the terminology used is consistent with that of the new legislation. This includes the references to legislation, to definitions such as the definition of GAAP and ensuring that the Standards provide correct references to insurer specific or group financial statement requirements. 58. The enactment of the FR Act 2013 and associated legislative changes sets a requirement for financial statements, in respect of certain entities, to be registered under the relevant legislation within 4 months of an entity’s reporting date. The Reserve Bank considered two options in respect of timeframes for supplying financial information such as the Financial Condition Report, solvency returns and accompanying information, to the Reserve Bank. Option 1 was maintaining the current time frame of 5 months and 20 days. Option 2 was to continue to align the timeframe with the timeframe for the provision of information under the relevant legislation, which is now 4 months. 14

15 (d) Consultation 59. The Reserve Bank will consult on this new material in September 2014. (e) Conclusion and recommendations 60. The existing Solvency Standards are updated to align with the FR Act 2013 and associates legislative changes. 61. The Reserve Bank prefers to maintain alignment of the requirements for reporting to the Reserve Bank with the legislative requirements for the registration of financial information. This requires information to be submitted to the Reserve Bank 4 months after the reporting date. V. TECHNICAL CLARIFICATIONS AND MINOR POLICY CHANGES (a) Status quo and problem definition Clarification 62. The Reserve Bank has encountered instances of insurers having difficulty in interpreting the Standards and other areas where the wording of the Standards is unclear. One of the major areas of uncertainty was in respect of off-balance sheet exposures; this is discussed further below. There are also a number of other more minor areas that have been clarified that are not discussed in this RIS. Clarity is important so insurers can be sure about what their obligations are and to reduce compliance and administration costs. Definition of Capital 63. The section within the existing Solvency Standards’ requirements regarding the quality of capital instruments included within the definition of capital is brief. Uncertainty as to the characteristics of capital instruments that qualify for solvency purposes is considered inappropriate. Summation of charges 64. Under the current Standards some components of the Asset Risk Capital Charge and Asset Concentration Risk Charge (‘ACRC’) applied to a given asset may sum to greater than the value of the asset. Asset concentration risk 65. Under the current Solvency Standards there is an inconsistency in how contingent liabilities are treated in the ACRC in the Life and Non-life Standards. Due to the different structure of the Standards contingent liabilities are not included in the ACRC under the Life Standard as they are under the Non-life Standard. This results in an unequal treatment and not all risks being captured. Additionally it is currently unclear how the ACRC should be applied in a number of places. 15

16 Off-balance sheet exposures 66. The current Standards require that all known contingent liabilities are included, whether “disclosed in financial statements or not” and, if contingent liabilities are not quantified, then an estimate is required. The issue to clarify is ‘how do you do this and what is the scope’. Revocation and restructure 67. The Solvency Standard for Non-life Insurance Business – AMI Insurance Limited (AMI Standard) and the Solvency Standard for Captive Insurers Transacting Life Insurance Business (Captive Life Standard) no longer apply to any entities. Maintaining the Standards in useable form incurs administrative costs to the Reserve Bank and potential confusion to the public. 68. Further the Solvency Standard for Captive Insurers Transacting Non-life Insurance Business (Captive Non-life Standard) and the Solvency Standard for Non-life Insurance Business in Run-off (Run-off Standard) are variations of the Non-life Standard. It would be more administratively efficient to structure these Standards by referring to the Non-life Standard and only articulating differences in a supplementary Standard. (b) Objectives 69. The technical clarifications and minor policy changes are motivated to clarify the existing Solvency Standards, improve consistency and reduce administrative costs. Definition of Capital 70. The purpose of the additional requirements in respect of the definition of capital is to clarify the Reserve Bank’s expectations in respect of the quality of capital and ensure that licensed insurers’ capital is of sufficiently high quality across the industry. High quality capital instruments are important because only such instruments will provide the most effective financial protection to policy holders and other unsubordinated creditors in the event that an insurer incurs unexpected financial losses. The intention is that this framework will also be helpful to insurers’ boards in managing their required capital for solvency and business purposes. Summation of charges 71. The purpose of changes in this area is to ensure that the amount of capital insurers are required to hold is proportional to the risks they are taking. 16

17 Asset concentration risk 72. The purpose of this amendment is to ensure that all concentrations of exposures, including contingent liabilities, are subject to the ACRC and that different business lines are treated the same in respect of the same exposures. Off-balance sheet exposures 73. The aim of the amendments is to clarify is how insurers go about compliance with this requirement. Revocation and restructure 74. The purpose of the revocation and restructure of certain Standards is to reduce administrative costs. (c) Options analysis Definition of Capital 75. Below we discuss the benefits, costs and risks of the revised definition of capital for solvency purposes in relation to the objectives outlined in paragraph 70. We then go on to discuss the option of introducing tiers of capital in the insurance sector. Benefits of revised definition of capital 76. Improving the definition by including minimum standards for the quality of capital instruments should improve insurers’ financial strength. In the event of actual or potential insurer distress, any potential losses to policyholders or damage to policyholder confidence should be reduced because the capital position of insurers will be stronger. 77. The improved definition should result in greater consistency in financial strength prudential requirements across the New Zealand financial sector and will better meet international expectations. 78. More detailed principles for the quality of capital instruments is useful to insurers and the Reserve Bank when interpreting the regulatory effectiveness of capital instruments issued by insurers. The detail also provides greater transparency to the Solvency Standards in this area. 79. If the minimum standards for the quality of capital instruments encourage insurers to issue higher quality capital instruments, this should improve insurers’ own capital management practices and may improve the external rating which licensed insurers are required to maintain. 80. Intervention in the form of minimum standards for the quality of capital instruments is justified because it is considered there is a net benefit 17

18 (considering the costs and risks below) compared to the status quo. The expected benefits are assessed as moderate and will accrue to policyholders and wider society (taxpayers, economy). Costs of revised definition of capital 81. Any capital instruments that do not qualify (for solvency purposes) against the minimum standards for the quality of capital instruments will be less attractive for insurers to issue. This may increase insurers’ cost of capital, some of which may be passed on to policyholders, via increased premiums, which could reduce insurance take-up. However, it is likely that any increase in the costs of capital will primarily fall upon those insurers whose capital is currently of a relatively weak quality; and therefore whose risks may be disproportionate to their financial strength. 82. There will be compliance costs to insurers and the Reserve Bank in respect of the revised definition of capital including those relating to the interpretation and application of the new requirements for capital instruments. The marginal compliance costs will be less for insurers who already have high quality capital instruments that meet the definition. It is likely that any initial costs will be higher than ongoing costs and also compliance costs may be proportionately higher for smaller insurance entities. It is possible that some of insurers’ increased compliance costs may be passed on to policyholders, via increased premiums, which could reduce insurance take-up. 83. There will also be costs to the Reserve Bank of implementing and monitoring the revised definition of capital. Risks of revised definition of capital 84. The two main risks associated with the revised definition of capital are set out below. These risks are currently assessed as low. 85. As it is not proposed to introduce tiers of capital to the definition of capital for the insurance sector, there could be adverse industry comment that the Reserve Bank is penalising the insurance industry compared to the banking industry. 86. It is possible that the proposed definition of capital could be seen as too restrictive and industry may argue that it will limit the types of capital instruments, and thereby perhaps the quantum of capital, that can be issued by insurers. The Reserve Bank considers this risk low because most of the proposed requirements are based on international precedent. Tiers of Capital 87. A tiered approach to qualifying regulatory capital is worth future consideration. 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: 18

19 (a) 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; (b) 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 (c) Lower quality capital instruments are currently uncommon within the New Zealand insurance sector. 88. This policy position may be reconsidered by the Reserve Bank in the future. Summation of charges 89. Two main options are possible in relation to ensuring that the sum of capital charges does not result in a capital requirement out of proportion to the possible loss to the insurer: (a) allowing that the ACRC be reduced to the extent that sum of the Risk Weighted Exposures charge and the ACRC exceed the value of the asset; (b) Limiting the sum of all charges (that is including the interest rate and foreign currency risk charge) to the value of the asset. 90. The value of an exposure may change from that disclosed in financial statements due to movements in interest rates or foreign currency rates. Accordingly, there may be instances in which the potential reduction in capital to an insurer exceeds the disclosed value of an exposure (for example, a derivative position may change as a result of changes in interest rates). For this reason the Reserve Bank considers that the first option is the better option as the second option would result in capital not being held in respect of certain market risks. Asset concentration risk 91. Two main options are possible in relation to this proposal: (a) to add contingent liabilities into ACRC; or 19

20 (b) to not add contingent liabilities into the ACRC. The Reserve Bank considers bringing contingent liabilities into the ACRC is better as it recognises the risks associated with insurers’ total concentrations to a counterparty. Off-balance sheet exposures 92. Three main options are possible in relation to clarifying the off-balance sheet exposures requirements: (a) Revised Solvency Standards: in June 2013, the Reserve Bank proposed text requiring an insurer to: include any contingent liabilities that are not disclosed within the NZ GAAP financial statements but which are likely to be disclosed in the next financial statements of the licensed insurer or which are able to be reasonably identified and give rise to a possibility, even if remote, of a net outflow of resources from the licensed insurer over the next 3 years. Responses to the June 2013 consultation noted that clarity was not improved. For example, the terms “reasonably identified” and “remote” are not defined and are accordingly likely to lead to wide ranging interpretation. (b) Formal interpretation guidelines: The Reserve Bank considers that it is not obviously in the interests of supervisors to always clarify uncertain areas through more prescriptive and detailed rules – particularly when prudent judgement is desirable. We wish to encourage regulated entities to use prudent judgement in good faith rather than promulgate ever more prescriptive and detailed rules. In addition, non-binding guidance, as opposed to prescriptive rules, would allow for further illustration and examples as these emerge over time. Production of guidelines has not been ruled out in this area for the future. However, its usefulness, particularly when many related clarification concerns in the Asset Risk Charge context are addressed by the Solvency Standards reissue, depends on clear examples that inform the boundary between the contingent liabilities not caught by NZ GAAP statements, but caught as the ‘off-balance sheet exposures’. On reflection, the Reserve Bank does not consider there are adequate examples suitable for this exercise at the present time. (c) Changes to appointed actuary requirements: The Solvency Standards can be amended to clarify that the appointed actuary will have a role to exercise professional judgement to decide what is caught as an off-balance sheet exposure in the Solvency Standards. Revocation and restructure 20

21 93. Two main options are possible in relation to this proposal: (a) to revoke out of date Standards and restructure the Standards; or (b) not to revoke out of date Standards and restructure the Standards. The Reserve Bank considers revoking and restructuring the Standards is more administratively efficient and avoids potential confusion. (d) Consultation 94. The Reserve Bank consulted on certain technical clarifications, as well as on its requirements for capital instruments in December 2012. The Reserve Bank consulted on off-balance sheet exposures in June 2013. 95. The Reserve Bank will consult on all material in September 2014. (e) Conclusion and recommendations Definition of Capital 96. Under the Solvency Standards the following will be recognised as qualifying capital instruments, within a single pool of capital: • ordinary shares; • perpetual non-cumulative preference shares; and • credit union securities. 97. The revised definition of capital includes general requirements together with qualifying criteria for each of the above types of capital instrument. These criteria must be met for a capital instrument to be included within a licensed insurer’s capital, for solvency purposes. Summation of charges 98. The Reserve Bank has added a provision into each Standard to the effect that the total capital charge in relation to a given exposure arising from the Risk Weighted Exposure Charge and the ACRC shall not exceed the value of the asset. Asset concentration risk 99. Contingent liabilities must be included in the ACRC under all the Standards. Drafting changes to clarify the application of the ACRC will be made. Off-balance sheet exposures 100. The text on off-balance sheet exposures has been revised to provide greater clarity on how to determine the appropriate capital factor to apply to a 21

22 contingent liability under the Solvency Standards. In addition a new requirement has been included that the appointed actuary must, as part of the Financial Condition Report, comment on whether the licensed insurer is exposed to any off balance sheet exposures that are not disclosed in the insurer’s financial statements and how these have been treated under the Solvency Standards. Revocation and restructure 101. The AMI and Captive Life Standards are to be revoked. The Captive Non-life and Run-off Standards will be restructured in simplified form. 102. For completeness, we note that a number of other clarifications have been made that are of a minor and technical nature and not discussed in this RIS. VI. IMPLEMENTATION 103. The proposal will be given effect through the reissue of the Insurance Solvency Standards. 104. As the key proposals have been subject to rigorous consultation over two years, and the further amendments are largely about clarification, the Reserve Bank considers that there is no impact on the integrity of the Insurance Solvency Standards being amended. 105. The Standards will come into force in January 2015 for all provisions except for the amendments to the Life Standard in respect of reinsurance and the amendments to the reporting requirements that will commence in January 2015. 106. The Standards will be applied to particular insurers through changes to the insurer’s conditions of licence. Hence the new Standard will apply to a particular insurer as at their first balance date post January 2015. 107. The Life Standard will provide that the provisions on financial reinsurance (repayable amounts) and the asset recognition tests for reinsurance will come into force in January 2016. 108. However the repayable amount requirements will only apply in relation to new business written from 2016-2019. Hence a repayable amount will be defined to exclude amounts in relation to existing business from the years 2016-2018 until January 2019. 109. The Reserve Bank will be able to assess compliance with the requirements through existing supervisory processes. 22

23 VII. MONITORING, EVALUATION AND REVIEW 110. The policy will be reviewed consistent with the regulatory impact analysis requirements in section 162AB(1)(b) of the Reserve Bank of New Zealand Act 1989. The main sources of information the Reserve Bank will rely on to assess the effectiveness of legislation are discussions with supervisory contacts in registered insurers which the Reserve Bank supervises, as well as contacts such as actuaries and other regulatory agencies. 23