Living on site while renovating. A new solvency standard for New Zealand’s insurers
Stage two: Interim Solvency Standard
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.
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.
Financial reinsurance testing
RBNZ requires financial reinsurance (that is debt-like in nature) to be treated differently to reinsurance that transfers risk away from the insurer. We understand that a thorough review of financial reinsurance may be deferred to stage two. In the meantime, the test in the draft ISS remains largely unchanged in nature from the existing Life Insurance Standard.
Our view is that RBNZ should consider alternative tests for financial reinsurance, including consideration of a gated approach that applies:
- Qualitative identification of features that may indicate a debt-like nature. Doing so would eliminate traditional risk transfer treaties from quantitative testing; and/or
- Quantitative testing of risk-transfer through the impact of adverse experience rather than through the overall profit/loss to the reinsurer.
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.
Standardised balance sheet for with-profits/participating business
The standardisation adjustments do not consider with-profits or participating business.
Further clarity is required regarding participating business in the context of the Variable Fee Approach valuation under the coming accounting standard, IFRS17. RBNZ notes that a key consideration for this business is to recognise risk sharing between shareholders and policyholders. It also notes that there are a number of issues relating to traditional business that still must be addressed and that this work will not be undertaken until stage two.
With the focus on traditional business left largely for stage two, there is a risk that during the interim period ambiguity remains or that excess capital is required.
We hope that as RBNZ works through the feedback from the formal consultation process, it continues to consult with industry to shape interim solvency capital requirements that will enable a sustainable insurance industry that fosters good customer outcomes.
We can help you to prepare for what may be coming by quantifying the impacts of the changes and helping you to adapt your capital management or reinsurance strategies. Please contact our team (details below) if you would like to discuss further.