On Dec. 6, 2021, S&P Global Ratings published its request for comment (RFC) on proposed changes to its risk-based capital adequacy methodology for insurers and reinsurers (see "Request For Comment: Insurer Risk-Based Capital Adequacy--Methodology And Assumptions"). Since publication of the RFC, we have discussed the proposed criteria with various market participants and received questions about the application of some of the more technical aspects of the proposal. We are publishing this article to provide additional transparency to help market participants with their evaluation of our proposed criteria, and we have extended the comment period to March 18, 2022 (see "Comment Period Extended For Proposed Methodology And Assumptions For Insurer Risk-Based Capital Adequacy").
Frequently Asked Questions
How would S&P Global Ratings determine the diversification benefit under the proposed criteria?
For illustrative purposes, we have constructed three hypothetical risk profiles with an indicative view of the diversification benefit under the proposed criteria. The diversification benefit represents the reduction in capital requirements due to diversification effects.
Risk assumptions for these examples. These examples, based on the "Diversification" section of the proposed criteria, should be viewed as indicative only, and the figures presented as approximate. The diversification benefit for an actual insurer will depend on its specific risk profile, including the variety and concentration of risks as defined in our proposal.
In these three examples, the diversification mainly results from the level 3 diversification (see table 3).
Example 1. Example 1 is an insurer with a highly diverse and balanced risk profile with exposures to all risk types (see charts 1a-1d). The total diversification benefit for this insurer under the proposed criteria is high, at around 42% at the 99.5% confidence level.
Example 2. Example 2 is a non-life insurer writing only liability risks and with relatively low investment risk (see charts 2a-2b). The total diversification benefit for this insurer under the proposed criteria is modest, at around 19% at the 99.5% confidence level.
Example 3. Example 3 is a life insurer that bears significant investment risk and writes mainly life savings products (see charts 3a-3c). This insurer is highly exposed to interest rate risk and bears relatively low life technical risk. The total diversification benefit for this insurer under the proposed criteria is relatively low, at around 13% at the 99.5% confidence level.
|Non-Life Capital Requirements At 99.5% Confidence Level|
|--Example 1--||--Example 2--|
|(Mil. $)||Non-life premium risk||Non-life reserve risk||Total||Non-life premium risk||Non-life reserve risk||Total|
|1H||Non-life premium and reserve (undiversified)||1,493||350|
|1I||Level 1 diversification||92||22|
|1J||Non-life technical risk (undiversified) (=1H - 1I)||1,401||328|
|1K||Level 2 diversification||358||0|
|1L||Non-life technical risk (diversified) (=1J - 1K)||1,043||328|
We have assumed risks are modeled at the 99.5% confidence level for these three examples. For this stress scenario, no haircut is applied to the total diversification benefit (e.g., $3.3 billion in example 1). At higher stress levels, we expect the relative diversification to be lower than at the moderate stress level because of the haircuts applied to the absolute amount of diversification benefit at the substantial, severe, and extreme stress scenarios of 10%, 20%, and 30%, respectively. The indicative capital requirements used for these examples (see tables 1 and 2) can be linked to the figures in table 3.
|Capital Requirements At 99.5% Confidence Level|
|(Mil. $)||Example 1||Example 2||Example 3|
|2F||Nat cat risk||1,500||0||0|
|2G||Non-life technical risk (=1L)*||1,043||328||0|
|2H||Life technical risk*||1,387||0||3,239|
|*Post level I and II diversification.|
|Illustrative Diversification Benefit At Levels 1-3 And Total For Examples 1-3 At 99.5% Confidence Level|
|--Example 1--||--Example 2--||--Example 3--|
|(Mil. $)||Undiversified risk (a)||Diversification benefit (b)||Relative diversification (c)=(b)/(a)||Undiversified risk (a)||Diversification benefit (b)||Relative diversification (c)=(b)/(a)||Undiversified risk (a)||Diversification benefit (b)||Relative diversification (c)=(b)/(a)|
|3A||Level 1||Non-life premium and reserve (=1H in table 1)||1,493||92||6%||350||22||6%||0||0|
|3B||Level 2||Non-life technical risk (=1J in table 1)||1,401||358||26%||328||0||0%||0||0|
|3C||Level 2||Life technical risk (=2I + 2J + 2K + 2L + 2M in table 2)||1,825||438||24%||0||0||3,542||303||9%|
|3D||Level 2||Market risk (=2B + 2C + 2D in table 2)||1,470||220||15%||60||7||12%||23,750||390||2%|
|3E||Level 3||Between risk categories (=2A + 2E + 2F + 2G + 2H + 2N in table 2)||6,915||2,230||32%||407||52||13%||36,188||3,983||11%|
|Total||Undiversified total risk (=3A + 3C + 3D + 2E + 2F + 2N)||8,023||3,339||42%||436||81||19%||36,880||4,676||13%|
How would you determine the interest rate risk capital requirements under the proposed criteria?
For illustrative purposes, we have constructed a hypothetical example with an indicative view of the interest rate risk capital requirements in each of steps 1, 2, and 3 under the "Interest rate risk" section of the proposed criteria.
In this example, an insurance group operates in three countries--the U.S., Switzerland, and Brazil--and is domiciled in the U.S. The company has life businesses in each of these countries and non-life businesses in the U.S. and Switzerland.
We assess the insurer's relevant exposures after making reserve adjustments in total adjusted capital (see table 4). We also include the relevant interest rate stresses (at the 99.5% confidence level) and the duration mismatch assumptions shown in tables 16, 17, 41, and 42 of the proposal. In this example, we assume the mean term of the insurer's non-life liabilities is three years, and we assume the non-life duration mismatch is one-third of the mean term of an insurer's liabilities, subject to a floor of one year.
|Relevant Exposures And Assumptions Including Capital|
|--Relevant exposure (mil. $)--||--Interest shock (basis points)--||--Duration mismatch assumption (years)--|
|Country||Capital||Life liabilities||Non-life liabilities||Up||Down||Life||Non-life||Capital|
|*Only relevant for step 1.|
We also assume the excess of interest-sensitive assets over the sum of relevant life and non-life insurance liabilities is $10 million, which we allocate to the capital segment. Further, we assume the modified duration of the assets is two years. Because the group is domiciled in the U.S., the corresponding interest rate stress for capital in the up interest rate stress is 255 basis points at the 99.5% confidence level.
Below we illustrate the interest rate risk capital requirements for this example at the 99.5% confidence level under each of the three steps.
Step 1. For the purposes of this example, we assume we are able to determine a company-specific modified duration mismatch, i.e., the direction and its value. We assume the insurer is exposed to the down interest rate stress and the duration mismatch is 1.5 years. The relevant exposure includes the life and non-life liabilities of each country and capital (see table 5 for the calculation of interest rate risk).
|Calculation For Step 1|
For instance, we calculate the $9.45 million interest rate risk capital requirement for U.S. life liabilities as the product of the company-specific modified duration mismatch (1.5 years in this example), the down interest rate stress (210 basis points for the U.S.), and the exposure (i.e., the relevant life liabilities of $300 million).
The interest rate capital requirement for the 99.5% confidence level is $21.36 million, based on step 1.
Step 2. If we are not able to determine a company-specific mismatch but we know the direction of the mismatch, we apply step 2. In this example, we assume the insurer is exposed to the down interest rate stress for its life business and the up interest rate stress for its non-life business.
The interest rate stress in the down scenario applies in this example only to life business and in the up scenario only to non-life business and capital (see table 6). The interest rate risk capital requirement is the higher of these two scenarios, which in this example is the down scenario (in this case, the result is above the floor proposed in the RFC).
|Calculation For Step 2|
The interest rate risk capital requirement for the 99.5% confidence level is $24.70 million, based on step 2.
Step 3. If the direction of the mismatch is unknown, we apply step 3. The interest rate risk capital requirement is the sum of the interest rate risk for life, non-life, and capital for the up scenario (see table 7).
|Calculation For Step 3|
The interest rate risk capital requirement for the 99.5% confidence level is $31.61 million, based on step 3.
How would you interpolate the natural catastrophe risk charge?
This example illustrates the interpolation for the natural catastrophe risk charge based on the one-in-200-year and one-in-500-year capital charges. The interpolation is based on scaling factors relative to the results at the 99.5% confidence level--namely, 1.2x, 1.4x, and 1.65x for each of the other confidence levels.
In this example, the one-in 200-year and one-in 500-year loss estimates are $150 million and $350 million, respectively. Both amounts are calculated net of reinsurance and other forms of mitigation, such as catastrophe bonds. We then deduct a catastrophe-related premium, which we assume to be $50 million for this example. Under the proposed criteria, the capital charges for 99.5% and 99.99% are $100 million and $300 million, respectively.
The capital charge for 99.8% is $100 mil. + ($300 mil.-$100 mil.)*(1.2-1)/(1.65-1)=$162 mil.
The capital charge for 99.95% is $100 mil. + ($300 mil.-$100 mil.)*(1.4-1)/(1.65-1)=$223 mil.
Can you provide an example of how you would determine the hybrid capital and debt-funded capital tolerance limits?
We have created a hypothetical example showing how we would determine the hybrid capital and debt-funded capital tolerance limits for both group capital models based on consolidated financials and group capital models that are not based on consolidated financial statements under the proposed criteria.
In this example, we assume that the group is funded with $100 million of equity and $50 million of debt (see table 8) and that these funds are invested in the regulated operating entities. We assume the debt is eligible as debt-funded capital.
|Nonoperating Holding Company (Stand-Alone Financial Statements)|
|Investment in subsidiaries||150||Equity||100|
Below we show the summary financials for the consolidated operating entities (i.e., excluding the nonoperating holding company) (see table 9).
|Consolidated Operating Entities|
We also calculate adjusted common equity (ACE) and total adjusted capital (TAC) for the consolidated group (see table 10).
|Total Adjusted Capital Calculation For Group Consolidated|
|Adjusted common equity (ACE)||100|
|Tolerance for debt-funded capital (25% of ACE)||25|
|Total adjusted capital (TAC)||125|
|Note: We assume all adjustments to equity to determine ACE are $0 mil. in this example.|
In our calculation of ACE for the consolidated operating entities, we deduct the debt-funded capital that has been downstreamed to the insurance entities from equity (see table 11).
|Total Adjusted Capital Calculation For Consolidated Operating Entities|
|Consolidated operating entities|
|Downstreamed debt-funded capital included in equity||50|
|Adjusted common equity (ACE)||100|
|Tolerance for debt-funded capital (25% of ACE)||25|
|Total adjusted capital (TAC)||125|
|Note: We assume there are no other adjustments to equity to determine ACE in this example.|
In this example, $25 million of the debt is included in TAC, and $25 million is excluded because it exceeds the maximum tolerance limits.
What is the potential impact of the proposed criteria on banks that own insurance companies?
In line with the impact statement we issued with the RFC, and based on current credit conditions, we do not expect the proposed criteria to affect issuer credit ratings or issue credit ratings on banks that own insurance companies. The proposed criteria could, however, lead to changes in the risk-adjusted capital (RAC) ratios for some of these banks, due to changes in our view of the capital adequacy of their insurance subsidiaries. Still, we don't expect the changes in the RAC ratios, which we anticipate to be positive for some banks but negative for others, to affect any ratings.
We expect capital adequacy could improve for some insurers, primarily due to our proposal to capture diversification benefits more explicitly and due to increases in TAC, owing to the removal of various haircuts to liability adjustments. On the other hand, some insurers could face declines in capital adequacy because of factors including the recalibration of our capital charges to higher confidence levels.
A change in our view of an insurance subsidiary's capital adequacy may affect the RAC ratio of its parent bank because of the way that the insurance subsidiary is reflected in the RAC calculations. We capture the risk of a parent's potential unexpected losses arising from investments in insurance subsidiaries by deducting these investments from reported shareholder funds in calculating ACE (apart from some cases where the bank invests in regulatory capital instruments issued by the insurer).
However, our calculation of risk-weighted assets also reflects the potential additional impact on a financial institution's capital position of under- or overcapitalization of its insurance subsidiary, with respect to the subsidiary's ability to withstand stress at the 'A' level. We define 'A' stress as substantial in our ratings definitions (corresponding to the 99.8% confidence level in our proposal).
This report does not constitute a rating action.
|Analytical Contacts:||Ali Karakuyu, London + 44 20 7176 7301;|
|Carmi Margalit, CFA, New York + 1 (212) 438 2281;|
|Eunice Tan, Hong Kong + 852 2533 3553;|
|Sebastian Dany, Frankfurt + 49 693 399 9238;|
|Charles-Marie Delpuech, London + 44 20 7176 7967;|
|Ricardo Grisi, Mexico City + 52 55 5081 4494;|
|Methodology Contacts:||Ron A Joas, CPA, New York + 1 (212) 438 3131;|
|Mark Button, London + 44 20 7176 7045;|
|Michelle M Brennan, London + 44 20 7176 7205;|
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