The changing landscape of solvency assessment management for South African insurers

March 2015  |  SPECIAL REPORT: GLOBAL RESTRUCTURING & INSOLVENCY

Financier Worldwide Magazine

March 2015 Issue

For the past four years, the National Treasury (NT) and the Financial Services Board (FSB) have been working on a framework for the implementation of solvency assessment management in South Africa (SAM). SAM is a new risk based solvency regime for South African insurers. One of the objectives for implementing SAM is to align the South African insurance industry with international standards. In this regard, SAM is modelled on the Solvency II capital adequacy, risk governance and risk disclosure regime which has been implemented for European insurers. This article will cover the following areas: the background of SAM in South Africa, the formal implementation of SAM, the three pillars of SAM and finally some thoughts on consequences of the framework.

SAM is a principles-based regulation based on the economic balance sheet of an insurer. SAM utilises three pillars. Pillar I deals with capital adequacy, Pillar II deals with systems of governance, and Pillar III deals with reporting requirements. Central to the adoption of SAM is the protection of policyholders. In addition, SAM has a number of objectives. Firstly, SAM attempts to align capital requirements with the underlying risks of an insurer. Secondly, SAM aims for the development of a proportionate, risk-based approach to supervision with appropriate treatment both for small insurers and large, cross-border groups. SAM also hopes to provide incentives to insurers to adopt more sophisticated risk monitoring and risk management tools. Finally, SAM hopes to maintain financial stability. The overarching principle is that SAM should help South African insurers to meet the requirement of third country equivalence as established by the European Union.

It was initially envisaged that the primary legislation for the implementation of SAM would be enacted in 2014. However, in April 2014, the FSB indicated that the primary legislation for the implementation of SAM had been withdrawn from parliament. Notwithstanding, the FSB has informed insurers that they need to be in a position to comply with most of the requirements of the SAM framework by 2015. Full implementation of SAM will only be from 1 January 2016. However, in a subsequent SAM update, it has come to light that the implementation of SAM will now be part of the adoption of the twin peaks model of financial regulation. In this regard, insurance regulation and supervision will be split between the South African Reserve Bank, which will supervise financial soundness, and the market conduct authority in the FSB, responsible for the conduct of the insurance business.

As previously mentioned, SAM is based on three pillars. Pillar 1 stipulates the quantitative requirements that insurers must satisfy in order to demonstrate that they have adequate financial resources. Liabilities are sub-divided into technical provisions and other liabilities. The capital requirements are divided into two, solvency capital requirements (SCR) and minimum capital requirements (MCR).

SCR is a target level of capital, and it must be continuously maintained. Insurers will be required to inform the FSB in the event that they have insufficient funds to cover SCR or in the event that there is a possibility of that situation occurring in the near future.

MCR establishes a lower band for the required solvency capital, below which policyholders and beneficiaries would be exposed to an unacceptable level of risk if the insurer were allowed to continue its operation.

Capital sources under SAM will be referred to as ‘own funds’. A distinction will be made between ‘basic own funds’ and ‘ancillary own funds’. Basic own funds refers to the excess of assets liabilities, plus subordinated liabilities. Ancillary own funds refers to off-balance sheet capital resources that can be called upon to absorb losses, such contingent capital items would include instruments such as letters of credit and guarantees.

Basic and ancillary own funds are classified into three tiers based on eligibility characteristics, which are determined according to the quality of own funds. The tiers are as follows: tier 1 capital, which should satisfy all quality criteria; tier 2 capital, which must not be able to absorb losses on an ongoing basis; and tier 3 capital, which comprises lower quality capital instruments. A rule will stipulate the proportion of each of the three tiers that must be available to support the SCR and MCR. Ancillary own funds are unlikely to qualify for inclusion under tier 1, nor are they available to support MCR.

Under SAM, insurers will be able to calculate SCR using their full or partial internal model as an alternative to the standard formula, subject to the approval of the FSB. The FSB has indicated that insurers need to familiarise themselves with the Solvency II own funds articles and level 2 implementing measures. This way they will gain insight to the implications of changing eligibility criteria, both for their existing capital instruments, and future capital planning. In the meantime the FSB is drawing up an appropriate framework for own funds in the South African context.

Pillar II of SAM deals primarily with risk management and governance. This pillar addresses shortcomings in the regulatory framework highlighted by the global financial crisis, namely the lack of sufficient mechanisms to provide supervisors with an early warning of potential solvency concerns, or sufficient powers to intervene. Pillar II addresses the issue by assessing the effectiveness of corporate governance and risk management. All insurers will be required to demonstrate that their risk management systems are embedded in key business decisions

In order to implement Pillar II, the FSB has issued Board Notice 158 of 2014 which sets out the governance and risk management framework for insurers (Board Notice 158). Board Notice 158, will come into effect on 1 April 2015. In terms of the board notice, an insurer must adopt, implement and document an effective governance framework that provides for the prudent management and oversight of its insurance business and adequately protects the interest of its policy holders. The governance framework must be proportionate to the nature, scale and complexity of the insurer’s business and risk and must address and provide for, at least, composition, governance and structure of the board of directors. In addition, an insurer must establish and maintain an effective risk management system, comprising the totality of strategies, policies and procedures for identifying, assessing, monitoring, managing and reporting of all reasonably foreseeable current and emerging material risks to which the insurer may be exposed. Finally, an insurer is required to establish, maintain and operate within an adequate and effective internal control system.

Pillar III seeks to create transparency with the aim of harnessing market discipline in support of regulatory objectives. Pillar III will require insurers to describe how risks are managed. The new disclosure documents, required as part of Pillar III, are the confidential report to the supervisor and the public solvency and financial conditions report. Both reports are required for each regulated solo insurer, as well as at an insurance group level. Amendments to the law were made in 2011 in order to enable a more risk-based approach to regulatory reporting.

One of the key aspects for ensuring effective supervision of compliance with SAM is the introduction of group supervision. This is in recognition of the fact that a number of South African insurers operate as part of a group structure. However, there was no legislation which provided for group supervision. In essence, supervision was done on a solo basis. A formal insurance group supervision framework will be provided through the Financial Sector Regulation Bill (FSR) which was published for public comment in December 2014. The FSR is aimed at implementing the twin peaks model of regulation. Chapter 11 of the FSR sets out a framework for the supervision of financial conglomerates, including insurance groups.

From the above, it is apparent that the implementation of SAM will have several consequences for South African insurers, key among them are that group supervision requires insurers that are part of a group companies to identify those group entities which have significant influence over its affairs. Those group entities that have significant influence over the affairs of the insurer will be subject to the supervision of the FSB as part of an insurance group for SAM purposes. This may require group entities to restructure in order to avoid falling under the supervision of the FSB. Equally, solvency and capital requirements prescribed under the SAM framework will require insurers to consider how they are going to meet the capital requirements. This will likely entail fundraising to ensure that insurers hold the right quality of capital. Much as in Europe, this may result in numerous issuances by South African insurers in order to meet SAM’s solvency and capital requirements. Insurers must assess and determine whether they have appropriate risk management systems and policies in place to meet the SAM requirements. Where there are gaps in the system, insurers must put in place the required systems and policies. The governance structures of insurers (e.g., their boards of directors) will be required to be restructured in order to meet the requirements of SAM. Finally, insurers will be required to implement reporting systems that are in line with the reporting requirements under SAM.

It remains to be seen whether SAM will deliver the envisaged protection of policyholders.

 

Francisco Jabulani Khoza is a partner at Bowman Gilfillan Incorporated. He can be contacted on +27 11 669 9308 or by email: f.khoza@bowman.co.za.

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Francisco Jabulani Khoza

Bowman Gilfillan Incorporated

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