In our last article, we highlighted the concern that the Interim Solvency Standard (ISS) may result in a temporary increase in capital requirements for the insurance industry until the calibration exercise is carried out during stage two. Here we discuss some stage two ideals but, as anyone who has been without a kitchen or bathroom during a renovation will attest, we caution that the ISS needs to be workable in the meantime.

The Reserve Bank of New Zealand’s (RBNZ) explanatory note to the draft ISS states that RBNZ does not intend to significantly alter the way risks are quantified in the existing standards. However, below we consider the potential intended and unintended impacts that may result from implementation of the draft ISS if updates are deferred to stage two.

Prescribed stresses

For existing risks, the alignment of the Life and Non-Life Standards may have led to unintended impacts that the RBNZ should be able to fix during stage one through tweaks to the wording or charges.

Previously the Life Solvency Standard was based on a central estimate of risk. By aligning with the Non-Life Standard (as well as IFRS 17 and Insurance Core Principles) liabilities will include a risk adjustment but the scale of the prescribed insurance risk stresses currently applied to these liabilities has not been updated to reflect this.

It could be that the RBNZ intends to use the Quantitative Impact Assessment (QIA) to recalibrate the prescribed insurance risk stresses to remove double counting of adverse stress already included in the risk adjustment. Or, if the prescribed solvency assumptions are to remain unchanged from the existing standard until stage two, RBNZ could alter the wording in the ISS to apply these stresses in place of the risk adjustment.

In the meantime, the way in which the mathematical test of risk transfer is applied is much more explicitly specified by RBNZ than before. It is, therefore, unlikely to align with the way in which the industry has applied the test in the past. Even with the additional guidance, we note that:

• The potential for a 10% allowance against reinsurance premiums for the reinsurers’ own costs/profit may not be sufficient compensation for a 1 in 10 chance of loss over the lifetime of the treaty at a risk-free rate (because pricing is not usually done using risk-free rates).

• For their historic testing, insurers are likely to have applied a “highly unlikely” calibration similar to the solvency standard calibration of 1 in 200, (although they may not have made allowances for reinsurer’s own cash flows/margin).

• The calibration of 1 in 10 still requires some subjective judgement about mis-estimation or trend risk, particularly for lapses that tend to be driven by policyholder behaviour that can change rapidly based on either the competitive or economic landscape.

• There is still uncertainty about issues such as how to allow for re-pricing rights and what allowance for historic cashflows should be made when re-testing treaties.

RBNZ has also not confirmed whether insurers will need to re-test their existing treaties if their testing has historically been based on a different interpretation. Insurers may not have the time or ability to re-negotiate reinsurance treaties or raise additional capital should existing treaties fail the re-calibrated test.