Reserve Bank of New Zealand Consultation on Financial Reinsurance Solvency Standards

Consultation Paper
Insurance Solvency Standards: Financial Reinsurance The Reserve Bank invites submissions on this Consultation Paper by 9 December 2013. Submissions and enquiries about this consultation should be addressed to:
Felicity Barker
Adviser
Prudential Supervision Department
Reserve Bank of New Zealand
PO Box 2498 Wellington 6140
Email: felicity.barker@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. October 2013 Ref #5454025

Insurance Solvency Standards: Financial
Reinsurance
Introduction

Under the Insurance (Prudential Supervision) Act 2010 (“the Act”) the Reserve Bank is
the regulator and supervisor of all insurers carrying on insurance business in New Zealand. The Reserve Bank regulates and supervises to:

promote the maintenance of a sound and efficient insurance sector; and
promote public confidence in the insurance sector.

Under section 55 of the Act the Reserve Bank may issue solvency standards. These
standards may prescribe the methods for determining or calculating the amount of capital that an insurer must maintain (section 56).
On 7 December 2012 the Reserve Bank released a consultation paper entitled
“Insurance solvency standards: the quality of capital and the regulatory treatment of financial reinsurance.” The consultation paper consisted of three parts. The first part clarified the attributes the Reserve Bank expects regulatory capital instruments to have.
Part two addressed concerns the Reserve Bank has with certain types of reinsurance
arrangements that can be broadly referred to as financial or finite reinsurance. The third
part consisted of some technical refinements to the solvency standards. Respondents
were invited to make a submission by 28 February 2013.
The Reserve Bank has been considering the submissions received on that consultation
paper. This consultation paper provides the Reserve Bank’s response and proposed policy in respect of financial reinsurance. The Reserve Bank will issue a separate response on the subject of the quality of capital and other technical issues.
This consultation paper is structured as follows. Part 1 provides an overview of
submissions, part 2 explains the current treatment of reinsurance and what the Reserve Bank considers to be the problem with the current standards, part 3 sets out the proposed solution and part 4 discusses the transition period. Finally attached to this document is an exposure draft of the changes to the solvency standards proposed by the Reserve Bank. Given the technical nature of this topic the Reserve Bank invites members of the public to make submissions on the approach, as well as on the detail of the changes proposed.
This proposal and exposure draft is only in respect of the life standards. The Reserve
Bank will consider the appropriateness of similar changes to the non-life standards in due course.
Submissions close on 9 December 2013. The Reserve Bank welcomes comments on
any aspect of this paper and draws the reader’s attention to the points raised in paragraphs 39, 43 and 51. Ref #5454025

Part 1 Overview of submissions
8. The Reserve Bank received eighteen submissions on the consultation paper “Insurance
solvency standards: the quality of capital and the regulatory treatment of financial reinsurance.” Twelve of these submitters commented on financial reinsurance. In this
section we provide a short discussion of some of the points raised by submitters; this
summary is not intended to be comprehensive but identifies the main themes.
9. Overall there were a wide range of views on the proposals and these views were in
many cases divergent. However, the vast majority of respondents agreed that it would be useful for the Reserve Bank to clarify the regulatory treatment of financial reinsurance in order to provide greater certainty to industry.
10. Several respondents agreed with the Reserve Bank’s concerns. 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.
11. Some submitters expressed support for a restriction on the level of financial reinsurance
undertaken, although in some cases this was because the interpretation that was taken of the December consultation paper was that the Reserve Bank was of the view that all commission payments would be considered as financing even if persistency risk was fully transferred. Other submitters considered that any debt obligations implicit in reinsurance arrangements should be properly accounted for as debts in the solvency calculations.
12. A small number of respondents disagreed with the Reserve Bank’s concerns and a
number disagreed with the proposals in the consultation paper. The reasons given for disagreeing with the proposals included:

the proposals are not consistent with international regulatory or accounting
practice and are more restrictive than a number of other jurisdictions;
obligations that are subordinated to policyholders should be treated like
capital rather than debt;
financial reinsurance has some benefits as it allows risks to be spread and it
might constitute a cheaper source of capital;
the proposals are technically difficult to implement;
given New Zealand’s limited access to development capital, the proposed
policy would make it harder to start up insurance companies in New Zealand;
the movement in policy liabilities in the statement of financial performance
reflects the reinsurance liability hence the current rules are adequate;
the Reserve Bank already has a number of tools to deal with insurers making
inappropriate use of financial reinsurance arrangements;
the proposed approach provided insufficient distinction between the different
forms of financial reinsurance;
the Reserve Bank should focus on ensuring the solvency standards
appropriately account for the obligations that do exist rather than imposing bans or restrictions over the top of the standards. Ref #5454025

Submitters expressed a wide range of views on how to treat financial reinsurance in our
solvency standards. Views expressed included that:

the solvency standards should follow IFRS in order to determine which
arrangements are reinsurance;
the solvency standards must ensure potential financial liabilities in
reinsurance agreements are correctly identified;
the Reserve Bank should implement a system to pre- approve individual
treaties as reinsurance (one insurer suggested the approval be undertaken by an independent panel of experts). This mechanism was seen as particularly important if certain persons would be required to attest that reinsurance arrangements were not financial reinsurance;
annual reporting on reinsurance arrangements should be required;
insurers should submit key reinsurance information and attest to its accuracy;
stress testing or profit testing should be undertaken to determine the level of
risk transfer/likelihood of loss to the reinsurer. In order to do this the Reserve Bank could set prescribed stress scenarios to test;
insurers should be able to recognise, for solvency purposes, commission
payments that transfer persistency risk;
the Reserve Bank should specify criteria for reinsurance arrangements,
where these requirements are met full recognition should be given to the arrangement.

The Reserve Bank has endeavoured to address the comments of submitters in
paragraphs 12 and 13 throughout this paper. Given the wide range of views on financial reinsurance this consultation paper revisits the Reserve Bank’s view on the problem. The solution proposed in this paper is of a similar nature to those proposed in the earlier consultation paper, in that the intent is to identify and appropriately account for aspects of reinsurance arrangements that are more debt like than insurance like in nature. However the solution operates at a more decomposed level than that previously proposed, allowing insurers to identify different obligations within the contract rather than applying to the contract as a whole.
In developing this solution the Reserve Bank has had regard to the financial reinsurance
regimes in a number of other jurisdictions. However as noted by the International Association of Insurance Supervisors (IAIS), “there are a range of approaches that supervisors can take in order to ensure that these transactions are being disclosed and accounted for properly”.1 The Reserve Bank considers that the solution proposed in this paper is tailored to the problems that arise with the Reserve Bank’s solvency standards and to the small size of the New Zealand market. 1 IAIS Guidance Paper on Risk Transfer, Disclosure and Analysis of Finite Reinsurance October 2006. Ref #5454025

Part 2 Status quo and problem definition
16. As stated in the December 2012 consultation paper the Reserve Bank considers that
reinsurance is an important element of an insurer’s risk management strategy as it allows risks to be spread across insurers and regions. Reinsurance can also have other benefits to insurers such as increasing underwriting capacity and providing access to technical expertise. However in the December 2012 consultation paper the Reserve Bank also articulated some concerns with how the solvency standards account for financial reinsurance. The Reserve Bank continues to hold the concern that financial reinsurance arrangements may contain debt like obligations for the insurer that are not appropriately recognised in the calculation of minimum solvency capital (MSC).
17. That reinsurance contracts may contain debt like elements is well recognised in the
literature. For example the Financial Accounting Standards Board (FASB) state “finite contracts likely have both insurance components and deposit components but they are generally accounted for in their entirety as insurance contracts”. 2
18. Based on information to date the Reserve Bank considers that a small number of
reinsurance agreements held by New Zealand insurers contain obligations that are more debt like than insurance like in nature. The Reserve Bank considers that the effect of these obligations on the insurer’s MSC should be the same as if the obligation were treated as a loan. The Reserve Bank however accepts that the distinction between debt and insurance can be a fine one and that in many cases obligations will sit at the boundary. Further the Reserve Bank stresses that its concern is in ensuring the appropriate recognition in the solvency standards of reinsurance obligations, rather than the appropriateness of any particular arrangement in itself.
19. The following paragraphs outline how reinsurance is currently accounted for in the
Reserve Bank’s life solvency standard and the problem with the current treatment of reinsurance. Under the life standard, an insurer is required to maintain actual capital in excess of the MSC requirement as calculated under the standard. MSC is calculated as the excess of the Total Solvency Requirement (TSR) over the sum of the policy liability and other liabilities (paragraph 55). The TSR is the sum of the various charges calculated under the solvency standards, as set out in paragraph 56 of the standard. 2 FASB “Invitation to comment Bifurcation of Insurance and Reinsurance Contracts for Financial Reporting”. See also IAIS “Guidance Paper on Risk Transfer, Disclosure and Analysis of Finite Reinsurance” Assets Policy Liability Other Liability Min Cap TSR:
IRCC +
CRCC +
ARCC +
ACRC +
RRRC
Actual capital
Ref #5454025

The most relevant elements of the calculation, for the consideration of financial
reinsurance, are the calculation of the Insurance Risk Capital Charge (IRCC) and its relationship to the policy liability. The IRCC is, for each related product group, the greater of (paragraph 61):

the current termination values of the relevant policies; and
the solvency liability.

This means that the solvency liability is only relevant to the calculation of the IRCC when
it is of greater value than the policy current termination values (CTV).
The solvency liability is calculated using the Best Estimates Liability (BEL) methodology
and is calculated net of reinsurance.3
The BEL also forms part of the calculation of the policy liability, which is also calculated net of reinsurance. Essentially the BEL calculations require that the present value of receipts and payments under the insurance policies in the relevant group be calculated and netted from this amount is the present value of receipts and payments expected under any relevant reinsurance agreement (termed reinsurance balance for this paper).
A reinsurance balance may represent a net outflow of payments over time from the
insurer to the reinsurer (if premiums are expected to exceed claims and other payments received from the reinsurer) or a net inflow of payments from the reinsurer to the insurer. When an agreement is negotiated one would expect that the reinsurer would be expecting a profit and the agreement represents a net outflow of resources for the insurer.
The netting of the reinsurance balance in the policy and solvency liability means that any
expected payments from the insurer to the reinsurer under the reinsurance agreement are effectively captured in the calculation. For example, if an insurer receives a commission that will be repaid through a premium loading over time, then this expected outflow of resources will be included in the reinsurance balance. Subject to the discussion in paragraph 264 , as reinsurance is netted in both the policy and solvency liability, the change in MSC from netting reinsurance reflects the difference in the size of the reinsurance balance added to the policy and solvency liability. Note however that the policy/solvency liability do not value contingent obligations or provide for a range of scenarios and hence cannot capture all reinsurance obligations.
The Reserve Bank considers that where the solvency liability exceeds the CTVs of the
relevant policies (and hence the solvency liability is the basis of the IRCC) that the solvency standards appropriately capture any repayable aspects of reinsurance arrangements. Although debt like reinsurance obligations may be captured in the solvency liability the Reserve Bank considers that this is of little concern as the valuation methodology will result in a broadly appropriate result.
However, the Reserve Bank considers that debt like features of reinsurance agreements
are likely not appropriately captured in solvency calculations in the case that the The solvency standards prescribe certain solvency assumptions in respect of the solvency liability. 4 Ignoring the Catastrophe Risk Charge. Ref #5454025

solvency liability is less than the CTVs. For example, assume that the policy and solvency liabilities are negative in value (that is assets to the insurer) and that the CTV minimum exceeds the solvency liability. If the insurer receives a reinsurance payment (treated as reinsurance for financial accounting purposes) for which there is a premium loading to repay over time, in the financial accounts there will be a reduction in the asset value of the policy liability to reflect this amount (i.e. the value of the asset is reduced to account for future repayments). However in the solvency calculation due to the operation of the CTV minimum the repayable element of the obligation is not recognised in the TSR. Hence when the policy and other liabilities are compared to the TSR in order to calculate MSC, the MSC requirement for the insurer is reduced by the amount of the reinsurance liability.
27. This is illustrated diagrammatically below. The blue box represents the policy liability
before reinsurance (A), the green box the reinsurance balance (being a liability). Abstracting from all other charges, before reinsurance the MSC is calculated as the excess of the CTV minimum over the policy liability (A). Post reinsurance this amount is reduced to B due to the netting of reinsurance in the policy liability but not the IRCC.
28. In the view of the Reserve Bank the reduction in the MSC requirement is appropriate
when the reinsurance obligation represents a full transfer of insurance or lapse risk to the reinsurer. The solvency standards do not give the insurer credit for insurance contract assets, therefore the Reserve Bank considers it appropriate that a reduction in the size of that asset that arises from a genuine transfer of risk does not result in an increase in the insurer’s MSC. However where the obligation is more in the nature of a debt obligation, the Reserve Bank notes that the outcome is different from that which would arise if the obligation had been treated as a loan. If an obligation were treated as a loan there would be no reduction in MSC. The Reserve Bank considers that the reduction in MSC is not appropriate when the obligation is more debt like than insurance like in nature.
29. The above discussion implies that the Reserve Bank does not always consider that
financial reporting standards can be relied upon to provide a consistent outcome with the solvency standards. In part this is because the Reserve Bank considers that even debt like obligations that have not been unbundled under accounting standards should be treated consistently with loans under the solvency standards and in part because the Gross policy liability CTV min Rein balance A B Ref #5454025

CTV minimum applies in the solvency standards and not in financial reporting standards.5
30. The above discussion relates to the IRCC. The Catastrophe Risk Capital Charge
(CRCC) also allows insurers to take account of reinsurance, however in this case insurers simply deduct the benefit of any reinsurance from the CRCC. The Reserve Bank is not aware of any problems with the way reinsurance is being netted from the CRCC. However the proposed solution provides some minimum criteria as to the legal certainty of reinsurance payments that must be met before a benefit may be accounted for in order to ensure that any claimed benefit can be relied on.
Part 3 Solution
31. The objective of the proposed solution is to ensure that debt like obligations of a licensed
insurer are properly accounted for in solvency calculations. This objective derives from the purposes of prudential regulation under the Act, as discussed in paragraph 1.
32. Appendix 1 sets out an exposure draft for the Reserve Bank’s proposed solution. This
section explains the content and intent of that solution. The solution builds on the
options previously consulted on, taking into account the feedback received.
33. An addition is made to current paragraph 60 of the solvency standards to state that an
insurer should net reinsurance from the calculation of the solvency liability if such netting has been undertaken in respect of the policy liability. Essentially this means that the Reserve Bank will generally accept netting consistent with financial reporting standards. However, as will be obvious from the discussion below this does not mean that the Reserve Bank considers that reliance on financial reporting standards always provide an appropriate outcome in terms of the solvency standards.
34. New paragraphs 61- 64 provide provisos to paragraph 60. New paragraph 62 also
applies to the CRCC. In considering the effect of a reinsurance agreement all subsequent agreements that impact on the obligations in the reinsurance agreement must be considered. An agreement may only be accounted for as reinsurance if it is legally binding. This would require, for example, that any agreement be signed by both parties. Further, credit may only be taken for a reinsurance balance that is an asset if the reinsurer does not have the right to unilaterally cancel the agreement in relation to existing business (an agreement may be cancelled for future business) or otherwise avoid payment. These provisions are to provide a minimum level of certainty that the reinsurer will be legally bound to make payments in the event of claims being made. Paragraph 63 provides some exceptions to this rule.
35. Paragraph 64 specifies that potential contingent assets of the insurer cannot be included
in the solvency reinsurance balance which is netted from the solvency liability. For example, if a reinsurance agreement provides for profit commission or a persistency 5 The IAIS note “in cases where there is not significant insurance risk transfer and the disclosure and GAAP accounting do not reflect the true economic value of the transaction, supervisors should have the power to take corrective action that could include not allowing credit for the transaction as reinsurance and requiring restatement of the financial position where material:
Guidance Paper on Risk Transfer, Disclosure and Analysis of Finite Reinsurance October 2006. Ref #5454025

bonus the insurer may not assume these payments will occur in the calculation of the solvency reinsurance balance.
36. New paragraphs are proposed to be added following existing paragraph 61 which
provide an adjustment to the IRCC when it is considered that a reinsurance agreement contains debt like elements that will not otherwise be appropriate recognised under the existing standards.
37. Paragraph 65 defines the concept of a ‘repayable amount’. The intent is to capture
elements of a reinsurance agreement which are essentially debt like in nature that the insurer has accounted for as reinsurance under financial reporting standards.
38. Paragraph 66 defines the circumstances under which an amount will (and will not) be
considered repayable. The Reserve Bank considers an amount should be considered repayable if it is highly unlikely that the reinsurer will not be repaid that amount over time, if the amount may be repayable otherwise than out of future profits or if the insurer is or may be under an obligation to repay the amount, for example on the occurrence of a uncertain future event such as sale of the business or insolvency. An amount will not be considered repayable if the reinsurer bears full mortality, morbidity or lapse risk in relation to the repayment of that amount. Thus where a reinsurer bears full lapse risk in relation to commissions those commissions will not be considered a repayable amount. The consideration of whether these risks are passed should take into account the entirety of the contractual arrangements. For example if commission payments are entered into an experience account and remain payable even if the underlying policy to which they relate expires then lapse risk will not have been transferred.
39. Paragraph 68 requires that in making an assessment of whether an amount is repayable
stress tests should be performed to quantify the mortality, morbidity and lapse rates, or combination thereof, which would result in the reinsurer not being repaid that amount. If the scenario required to result in a loss to the reinsurer is highly improbable then the amount should be considered repayable. The Reserve Bank would be interested in opinions on the extent to which stress testing is useful to identify debt elements of reinsurance contracts and whether the ‘reverse stress testing approach’ proposed is first best or whether alternatively the Reserve Bank should require that certain scenarios be run, and if so which scenarios.
40. In defining the financing element of reinsurance, the Reserve Bank has had regard to
definitions used in other jurisdictions, both in regulatory and tax regimes, and considers that the criteria articulated in the exposure draft are consistent with the approach taken by a number of other regulators and tax authorities. In defining financial reinsurance other jurisdictions generally focus on the level of risk passed to the reinsurer (i.e. whether the reinsurer’s return is based on experience), the probability of the reinsurer not be repaid (or suffering a loss) and explicit consideration of the time value of money.
Appendix 2 provides some information on some approaches in other regimes. The
Reserve Bank notes that although the intent is similar a number of different wordings exist and hence considers that a definition appropriate to New Zealand is required rather than directly copying another regulator. Ref #5454025

One issue that has been raised with the Reserve Bank is the effect of subordination.
The Reserve Bank does not consider that subordination of a debt obligation to policy holders is a sufficient condition for an obligation to not be considered a debt. As stated by the IAIS in order to be considered capital, an obligation “must be legally subordinated to the rights of policy holders and senior creditors of the insurer in insolvency or winding up…in some jurisdictions subordination to other creditors may also need to be taken into account”. 6 It is sometimes argued that subordinated reinsurance obligations are similar to Tier 2 capital in the banking regime. The Reserve Bank does not share this view. Although subordination and the ability to delay distributions may feature in both reinsurance arrangements and Tier 2 capital these features are only two of several requirements that apply to Tier 2 capital. Importantly under the new Basel III requirements, any instrument that is recognised as Tier 2 capital must include a contractual term to the effect that the instrument can be converted to ordinary shares or written off at the direction of the Reserve Bank (or a statutory manager) should the Reserve Bank judge that the bank is non-viable. Tier 2 instruments hence are required to have going concern loss absorbency capacity.
One technical issue is the issue of unbundling debt like and insurance like obligations
from within the same contract. The proposed approach (new 67) is that where the reinsurance agreement contains both debt like and insurance like elements that have not been unbundled for financial reporting purposes the insurer has two choices. If the insurer is of the view that the payments are so intertwined that they cannot be separated, then the insurer should treat all of the solvency reinsurance balance as a repayable amount (unless the repayable component is merely incidental). Where alternatively the insurer is able to separate the different elements of the agreement the reinsurer may separate the solvency reinsurance balance into repayable and non-repayable amounts. The Reserve Bank considers that this approach provides an incentive to unbundle hybrid contracts but does not require such unbundling.7
The Reserve Bank would be interested in opinions on whether the solvency standards
should dictate a particular approach to unbundling. The current proposal is that unbundling be determined by the insurer but that the method of unbundling must be disclosed to the Reserve Bank. The Reserve Bank considers that there are likely to be a number of different ways to identify the debt element inherent in reinsurance agreements and is not at this stage convinced that a prescriptive approach is warranted.
One criticism of unbundling that is raised in relation to proposals in relation to accounting
standards is that unbundling insurance and debt elements is inaccurate and may lead to misstatement of accounts. The proposed approach to financial reinsurance is to provide an adjustment to the IRCC that reflects the risk inherent in the debt elements of the reinsurance contract. What is important is that a reasonable approximation of the size of the obligation is made rather than complete accuracy. In this respect the objective of 6 IAIS: Guidance Paper on the Structure of Capital Resources for Solvency Purposes October 2009 p13. Hence contrary to one submission the Reserve Bank does not consider that this paper leads to the conclusion that subordination to policyholders in itself is a sufficient condition for treating a liability as capital for regulatory capital purposes. The paper notes that not all jurisdictions provide policy holder priority: “some jurisdictions treat policyholders and other creditors equally” and “views about the specific characteristics [of capital instruments] that are acceptable may differ from jurisdiction to jurisdiction. 7 The unbundling of insurance premiums is not unprecedented by regulatory authorities. Under the Canadian GST/HST reinsurance premiums must be unbundled into a risk premium and loading. Ref #5454025

unbundling in the solvency standards differs from the objective of unbundling for financial reporting purposes.
45. Once an element has been identified as a repayable amount, paragraph 69 requires that
an adjustment be made to the IRCC to reflect this amount. However, the adjustment need only be made where the amount is not already accounted for in the IRCC. Generally where the solvency liability exceeds the CTVs of policies any repayable components will have been accounted for through the solvency liability methodology. The amount that should be added to the IRCC is the portion of the solvency reinsurance balance considered to be a repayable amount. This essentially means the debt obligation is valued based on the present value of future payment obligations in the reinsurance contract.
46. The Reserve Bank is conscious that the add-on to the IRCC could be in respect of an
obligation that also meets the definition of contingent liability. The Reserve Bank intends to exclude any amount added to the IRCC from the definition of contingent liability.
47. The final elements of the proposal are to require greater information provision to the
Reserve Bank in respect of reinsurance in the Financial Condition Report and to extend the current director (or chief executive officer) certification requirements to include a requirement that the insurer has systems in place to identify whether a reinsurance agreement contains a repayable amount. The information to be provided to the Reserve Bank would include an inventory of reinsurance agreements and also information on whether the insurer has treated all or any part of the reinsurance balance as a repayable amount. The insurer’s appointed actuary would need to comment on the insurer’s assessment of whether the reinsurance agreement gives rise to repayable amounts and detail all assumptions in calculating the value of that amount.
48. The proposed approach does not include a formal system to pre-approve all (or a subset
of) reinsurance agreements such as is the case in Australia and Singapore. The Reserve Bank does not consider that the size of the problem in the New Zealand market warrants this approach. However, should an insurer have doubts as to the appropriate treatment of a reinsurance agreement the insurer should discuss that agreement with their Reserve Bank supervisor. The Reserve Bank will be able to provide the insurer with guidance on the appropriate treatment of that agreement.
49. One point raised in some submissions that has not been addressed above is the impact
of the proposal on start up businesses. The argument has been made that increasing the capital requirement for financial reinsurance will harm start up businesses as they disproportionately rely on reinsurance for financing. The Reserve Bank stresses that its concern in not that any reinsurance agreements are inappropriate but that all debt like aspects of reinsurance agreements should be accounted for on a consistent and transparent basis. This is consistent with the view of the IAIS that policyholders are best protected “if technical provisions and other liabilities are expected to remain covered by assets over the defined period of time”.8 For this to be the case all liabilities must be properly accounted for in solvency calculation. The Reserve Bank is however conscious that the proposed changes will have a significant impact on a small number of insurers 8 IAIS Guidance Paper on the Structure of Capital Resources for Solvency Purposes October 2009 Ref #5454025

and that these insurers may have to seek additional capital or otherwise change their business to meet the new requirement. The Reserve Bank considers this issue is best dealt with through appropriate transition rules, discussed next.
Part 4 Transition
50. In the December 2012 consultation document the Reserve Bank proposed a 2 year
transition arrangement. Some submitters argued that the proposed 2 year transition period is too short, given financial reinsurance arrangements are long term arrangements and the changes could have a significant financial impact on effected insurers. However others argued this transition period was too long.
51. The Reserve Bank continues to hold the view that a 2 year transition period is
appropriate. The Reserve Bank would be interested in views on how the 2 year transition path could be applied to particular existing reinsurance relationships. Ref #5454025

Appendix 1
Exposure Draft
Add to definitions
Solvency reinsurance balance: The present value of the licensed insurer’s net contractual rights and obligations under a reinsurance agreement calculated using the Prescribed Solvency Assumptions set out in Appendix A. The balance should be calculated as the present value of expected payments to the reinsurer net of expected receipts from the reinsurer (hence the balance will be more than 0 where there is an expected net outflow of resources from the insurer to the reinsurer: “net outflow”). Existing reinsured business: means insurance business that has already been ceded under a reinsurance agreement. Gross Solvency Liability: is the Solvency Liability before the netting of the solvency reinsurance balance. Add to and following existing 60
60. The Insurance Risk Capital Charge requires a calculation of the Solvency Liability. The
Solvency Liability is determined using the methods used to determine the Best Estimate Liability, but:
a) allowing for current and future bonuses, subject to the appropriate application of discretions (refer Section 4.2 of this solvency standard); b) adopting the Prescribed Solvency Assumptions, set out in Appendix A; and c) net of the solvency reinsurance balance if, and only if, the licensed insurer has netted reinsurance from the calculation of the policy liability in its financial accounts, subject to paragraphs 61 - 64. New 61. In applying the following paragraphs attention should be directed to the economic substance of the reinsurance agreement rather than the legal form. The licensed insurer must include any side letters or other agreements, including retrocessions agreements, or correspondence that may alter the obligations of the parties under the reinsurance agreement in its assessment of the reinsurance agreement. The words reinsurance agreement are to be read to include all such side letters or other agreements or correspondence that alter the obligations under the reinsurance agreement. New 62. A licensed insurer may only account for an agreement as reinsurance in these solvency standards if the agreement is legally binding and if the licensed insurer has an unconditional legal right to the receipt of reinsurance payments under that agreement. Where any of the following terms are present in a reinsurance agreement the licensed insurer must not include any solvency reinsurance balance that is less than 0 (net inflow) in the calculation of the solvency liability or include the benefits of that agreement in the Catastrophe Risk Capital Charge. For the avoidance of doubt, where the solvency reinsurance balance is greater than 0 (net outflow) the licensed insurer must account for this balance as would otherwise be the case under these solvency standards. The terms are any term that, otherwise than in the case that paragraph 63 applies:
a) gives any party except the licensed insurer the right to unilaterally cancel the reinsurance agreement in relation to existing reinsured business; b) allows for the reinsurance agreement to automatically terminate, or requires that the licensed insurer terminate the agreement, in relation to existing reinsured business at a point of time or on the occurrence of an event; Ref #5454025

c) may prevent the reinsurer from being obliged to pay out monies otherwise due under the reinsurance agreement, including in the case of the insolvency of the licensed insurer; or d) requires the licensed insurer to reimburse the reinsurer for negative experience under the reinsurance agreement. New 63. Paragraph 62 does not apply where any of the events specified occur as a result of fraud, misrepresentation or non-payment of monies due in each case by the licensed insurer; if the licensed insurer transfers the portfolio insured without the prior consent of the reinsurer or as a result of war or civil unrest (or a similar event) that effects the licensed insurer or reinsurer. New 64. Potential reinsurance cash receipts for the licensed insurer that are contingent on factors or conditions other than the reinsured risks must not be included in the solvency reinsurance balance. This includes, for example, potential reductions in future premiums payable to reinsurers, profit commissions or persistency bonuses. Calculation Add following existing 61 The principle to be applied in interpreting paragraphs 65 and 66 is that the intended application is to obligations that are in substance debt like in nature but have been included in the policy liability for financial reporting purposes. The express intent is therefore to provide a treatment that differs from that under financial reporting standards. New 65. A repayable amount exists if, in respect of a reinsurance agreement:
a. a licensed insurer is subject to an obligation to pay an amount to the reinsurer that meets any of the criteria a-d of paragraph 66 otherwise than in the case any of the criteria in e-g of paragraph 66 apply; and b. that amount is not treated as a liability under financial reporting standards other than as a component of the policy liability. New 66. An amount will be considered a repayable amount if:
a. the licensed insurer has received an amount from the reinsurer (or an agent of the reinsurer) and it is highly unlikely that, in the case that the licensed insurer remains solvent, the reinsurer will not receive full repayment of that amount over time, taking into account the time value of money, when the entirety of the contractual arrangement is considered. The time period over which repayment is made need not be certain at the outset; or b. the licensed insurer has received an amount from the reinsurer (or an agent of the reinsurer) and that amount is repayable otherwise than from out of future income realised from reinsured policies; or
c. the licensed insurer is under an obligation to pay an amount to the reinsurer (or an
agent of the reinsurer) as a result of an agreement to delay any payment due to the reinsurer (or an agent of the reinsurer); or d. the licensed insurer is, or may in the future be, under an obligation to pay an amount to the reinsurer (or an agent of the reinsurer), including where that obligation crystallises on the occurrence of an uncertain future event (irrespective of whether that obligation is subordinated to policyholders), including without limitation in the event of:
 financial deterioration, insolvency, receivership, liquidation or statutory management of the licensed insurer; or  termination of the agreement or withdrawal of the portfolio; or  lapse of an underlying policy; or Ref #5454025

 poor experience on the underlying policy, such as a higher than expected loss ratio; Despite anything in a-d above, an amount will not be considered a repayable amount if:
e. in respect of repayment of an amount, the reinsurer fully bears insurance risk, being mortality or morbidity risk, in relation to the portion of the risk ceded to it; or f. in relation to commissions paid by the reinsurer to the licensed insurer, the payment reflects the acquisition costs of the licensed insurer and the reinsurer fully bears lapse risk in relation to that commission. A full transfer of lapse risk would not occur if following the expiry of the underlying insurance contract to which the commission relates the licensed insurer is obligated to repay that commission out of future profits derived from other policies; or g. the amount is payable to the reinsurer only in the case where the licensed insurer has received that same amount in relation to the underlying insurance contract (e.g. claw-back commissions that flow through from the direct agent). New 67. A repayable amount shall be valued as the portion of the solvency reinsurance balance which is attributable to repayable amounts. Where repayable and non-repayable amounts exist within the same reinsurance agreement but are so intertwined such that the licensed insurer takes the view that they cannot be separated the licensed insurer must consider the entire solvency reinsurance balance as a repayable amount, unless the repayable amount is incidental to the reinsurance agreement. Where a licensed insurer is of the view that the repayable and non-repayable amounts can be separated, then the licensed insurer may separate the solvency reinsurance balance into a repayable amount and a nonrepayable amount. New 68. In making an assessment of whether a repayable amount exists the licensed insurer must have due regard to stress testing performed by the Appointed Actuary. These stress tests must quantify the mortality, morbidity and lapse rates, or combination of those, which would result in the reinsurer not being repaid an amount in full at some point of time taking account of the time value of money. Where the likelihood of occurrence of such mortality, morbidity or lapse rate is highly improbable that amount should be considered a repayable amount. New 69. The licensed insurer must add the portion of the solvency reinsurance balance that is attributable to repayable amounts to its Insurance Risk Capital Charge (adjusted Insurance Risk Capital Charge) in accordance with this paragraph, provided that no amount less than 0 (net inflow) may be added on. The requirements of this paragraph are that:
a. where the Gross Solvency Liability exceeds the Current Termination Values for the relevant product group no amount is added on to the Insurance Risk Capital Charge; b. where both the Gross Solvency Liability and the Solvency Liability are less than the Current Termination Values for the relevant product group the full amount of the solvency reinsurance balance attributable to repayable amounts is to be added to the Insurance Risk Capital Charge; and
c. where the Gross Solvency Liability is less than the Current Termination Values for
the relevant product group but the Solvency Liability exceeds the Current Termination Values for the relevant product group then the amount to be added to the Insurance Risk Capital Charge is the amount of the solvency reinsurance balance attributable to repayable amounts less the amount by which the solvency liability exceeds the Current Termination Values for the relevant product group. Add to existing 66 In arriving at the Catastrophe Risk Capital Charge, a licensed insurer can deduct the benefit of any appropriate reinsurance in place, provided the reinsurance agreement(s) represents a Ref #5454025

true transfer of the risk of loss in respect of the pandemic or other extreme event and subject to [new] paragraphs 61-64. Disclosure Amend paragraph 132 of the Life Standards to include a requirement (f):
(f) a reinsurance report that includes all of the following information:
i. a list of all reinsurance agreements currently in place, including the name of the
reinsurer, the starting and termination date of the agreement and the form of the agreement (i.e. quota share, excess of loss, facultative etc);
ii. the retention of the licensed insurer and capacity provided by each reinsurance
agreement, and whether (excluding the retention) the licensed insurer retains any exposure that is not reinsured;
iii. the amount of any commissions payable by the reinsurer under the reinsurance
agreement;
iv. whether in the licensed insurer’s assessment the reinsurance agreement gives
rise to a repayable amount;
v. any amount added to the Insurance Risk Capital Charge under paragraph 69 and
any other amounts included as contingent liabilities in respect of the reinsurance agreement;
vi. if the amount added under paragraph 69 is less than the solvency reinsurance
balance, the method used to separate repayable and non-repayable amounts; and
vii. the morbidity, mortality and lapse rates, or combination thereof, needed to result
in the reinsurer not being repaid any amount in present value terms.
Amend paragraph 151 on the matters to be included in the financial condition report to include:
(l) comment on the adequacy of the licensed insurer’s assessment as to whether any obligation in respect of a reinsurance agreement should be treated as a repayable amount. Detail all assumptions used to calculate the portion of the solvency reinsurance balance attributable to repayable amounts. Amend the current certification required by directors [NZ incorporated insurers] or the New Zealand chief executive officer [an overseas insurer] to require a further certification that to the best of their knowledge and belief having made appropriate enquiries:
(d) the insurer has systems in place to identify whether any aspects of a reinsurance agreement result in a repayable amount. Ref #5454025

Appendix 2
Singapore
A financial reinsurance contract means a contract of insurance which includes terms for:
(i) The transfer of assets to the cedant or creation of a debt owed to the cedant, or both; and (ii) Either an obligation for the cedant to return (with or without interest) some or all of such assets or a provision for the diminution of such debt, in each case, in specific circumstances. Insurers must seek approval to enter a financial reinsurance contract. Where risk transfer is not significant than the obligations shall be treated as a deposit. Significant risk transfer occurs when:

It is reasonably possible that the assuming insurer may realise a significant loss from
the contract;
It is reasonably possible to have a significant range of outcomes under the contract;
The assessment is prospective.
EU
‘Finite reinsurance’ means reinsurance under which the explicit maximum loss potential, expressed as the maximum economic risk transferred, arising both from a significant underwriting and timing risk transfer, exceeds the premium over the lifetime of the contract by a limited but significant amount, together with at least one of the following two features:
(i) explicit and material consideration of the time value of money; (ii) contractual provisions to moderate the balance of economic experience between the parties over time to achieve the target risk transfer. Supervisors may decrease the credit for reinsurance in the solvency test if there is no or limited risk transfer. Australia APRA requires that life insurers must not enter into reinsurance contracts of a certain type unless approved by APRA. These contracts are contracts which provide for:
(i) the provision of a financial benefit by the reinsurer to the insurer or to any other entity (whether in any event or only in certain contingencies); and (ii) the provision of a financial benefit by the insurer to the reinsurer or any other entity (whether in any event or only in certain contingencies). The provision of a financial benefit includes a reference to:
(i) the payment of money; or
(ii) the making of a loan; or
(iii) the provision of credit; or
(iv) the giving of a guarantee; or
(v) the provision of security; or
(vi) the waiver, release or setting off of a debt or obligation, or its variation in a way that is favourable to the debtor or the person owing the obligation; whether for consideration or otherwise. Ref #5454025

California Department of Insurance: Bulletin 97-5 Under the requirements no insurer shall for reinsurance ceded reduce any liability or establish any asset in any financial statement if the treaty is not of a form which transfers all of the significant risks inherent in the business being reinsured. The significant risks in different insurance products are identified in the standard. Income Tax Act 2007 Insurance contracts are excepted from the financial arrangements rules unless the contract is a life financial reinsurance contract. Paraphrasing, life financial reinsurance is a contract of insurance that secures against financial risk unless, in the contract, it is incidental to securing against life risk. Financial risk means risk that is contingent on a valuation or disposal of financial arrangements or contingent on profitability or creditworthiness or contingent on a variable such as future expenditure and does not include like risk. HMRC The terms financial or finite reinsurance are generally used to describe contracts which are (or purport to be) contracts of insurance which have the characteristics that:
(i) the time value of money is an integral (and often explicit) part of the pricing of the contracts, and (ii) there terms are such that the discounted value of the premiums to be paid under them is similar to the discounted value of the payments that are likely to be made by the insurer or reinsurer, whether in response to claims or otherwise. Whereas conventional insurance involves the spreading of the losses of the few among the many, financial insurance is rather the spreading of one’s own losses across a series of fiscal periods. Ref #5454025

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