1 February 2011

Eligible capital

Do you know how ‘eligible’ your capital is?

The Bermuda Monetary Authority (BMA) has recently issued a revised consultation paper on its proposed eligible capital rules. Although largely based on the consultation paper published in September 2009, the paper has been amended to include references to additional consultations on the ‘life regime’, the introduction of the Bermuda Solvency Capital Requirement (BSCR) for Class 3A and 3B companies, and its consultations on the introduction of a ‘groups regime’.

The consultation paper proposes the introduction of a three-tiered capital system to complement the minimum solvency margin (MSM)— the solvency level below which firms are deemed insolvent for regulatory purposes, and enhanced capital requirement (ECR)—the solvency capital level determined by the BSCR or internal model. This tiered capital system will govern the admission of capital for solvency purposes. The eligibility of capital and the proportion of each tier of capital that is admitted will be based on the capital’s loss absorbency characteristics.

The regime will be introduced at the end of 2011 for all Class E life re/insurers, Class 3As and Bs, and all Class 4 companies, with the intention that the same tiered capital system will be introduced to Class C and D life companies for the 2012 year end. There are no plans to extend the regime to Class 3, 2 or 1 companies at this time.

With the introduction of group-wide supervision, the regime will also apply to groups for whom the BMA is the group-wide supervisor.

The BMA’s approach is consistent with the approach being taken internationally and with the standards set out by the International Association of Insurance Supervisors (IAIS), the National Association of Insurance Commissioners (NAIC) modernisation programme, and the approach adopted by the Australian Prudential Regulatory Authority (APRA).

A tiered approach

For those unfamiliar with the tiered approach proposed by the BMA, the methodology allocates capital to three distinct tiers.

Tier 1: Tier 1 capital is the highest form of admissible capital and can fully absorb losses at all times. This form of capital satisfies five characteristics in a going concern—full loss absorbency, subordination, permanency, perpetuality, and absence of fixed charges or encumbrances.

Tier 2: Tier 2 capital demonstrates only some of the five characteristics of tier 1 capital, but still allows for capital to be available to policyholders in the event of insolvency.

Tier 3: Tier 3 capital meets a fewer number of the characteristics of tiers 1 and 2, but is fully subordinated on winding up.

Under the new regime, only tier 1 and tier 2 capital will be admissible to cover the MSM, whereas all tiers of capital will be admissible to cover the ECR, subject to percentage admissibility limits defined by the BMA.

Under the proposed eligible capital regime, the amount of capital admitted to support the regulatory capital requirement will be the aggregate sum of basic capital (capital stock, contributed surplus, statutory surplus and adjustments determined on a case-by-case basis by the BMA under Section D of the Insurance Act), and ancillary capital (off balance sheet items that have first been approved by the BMA).

For an asset to be admissible as tier 1 basic capital, the asset must be absent of any encumbrances. In the reinsurance market, collateralisation of specific contracts or specific obligations under reinsurance contracts is a common practice and assets pledged under these arrangements would not be admissible as tier 1 basic capital. This is because these assets (such as assets pledged to collateralise letters of credit) are not available to the general population of policyholders until the specific obligation underlying the pledge has been discharged.

Despite this, the BMA recognises the importance of admitting these assets and ensuring their availability to all policyholders once the specific obligation has been discharged. To take account of this, the BMA proposes that the statutory surplus is adjusted to calculate the difference between the encumbered assets and the higher of either the policyholders’ obligations recognised in the statutory balance sheet and the capital requirements arising from the encumbered assets. Provided these assets are encumbered to satisfy an insurer’s policyholder obligations and would be available to all policyholders upon the winding up these assets, they would be admissible as tier 2 basic capital.

In additional to the basic capital described above, the revised eligible capital regime allows ancillary capital to be called upon as a potential reserve. For capital to be admissible as ancillary capital, the company must first seek prior approval from the BMA.

Ancillary capital is described as an off balance sheet item, such as letters of credit or contingent capital. As part of the approval process, the BMA will consider the following: the ability and willingness of the counterparty to honour its obligations, the terms, counterparty credit risk, and any other additional information it deems relevant. Once an asset is approved, the BMA may also impose certain restrictions on the firm or may mandate additional reporting requirements.

Under the regime, some debt instruments such as subordinated liabilities (normally tier 2 or 3) could meet all the tier 1 criteria and be considered as tier 1 ancillary capital, provided they behave on a going concern basis or winding-up basis similar to common shares. Under these circumstances, the debt instrument must contain explicit terms satisfying the prescribed characteristics of tier 1—for example, lossabsorbency or subordination— and the asset must be prior approved bythe BMA. Alternatively, if the asset is not approved as tier 1 ancilliary capital, the instrument may still be admitted as tier 2 or tier 3 ancillary capital and subsequently be potentially admissible for the ECR.

In its most recent consultation paper, the BMA has maintained the proportions of tier 1 and tier 2 capital for use in the MSM as 80 percent and 20 percent respectively. For the ECR, the BMA has increased the proportion of tier 3 capital admissible for the ECR from a maximum of 10 percent (stated in the earlier consultation paper Eligible capital, September 2009) to a maximum of 15 percent.

The BMA’s eligible capital proposals are intrinsically linked with its current thinking on economic balance sheets and the economic valuation of assets and liabilities, which are currently still subject to consultation. It is inevitable therefore that the final rules for economic balance sheets and economic valuations will ultimately have an impact on the final eligible capital rules. The BMA proposes to consult further with the market on its economic balance sheet proposals in 2011, with proposed implementation of these rules in 2013 and 2014.

Implications for companies

The implementation of new regulations is rarely straightforward and very often the devil is in the details, even if the proposals appear fairly innocuous. In light of the recent consultation paper, companies should begin to examine their current capital sources to evaluate the impact of the tier system. The focus should be on whether capital is basic or ancillary, with the goal being to identify those instruments that firms may wish to be considered for admissibility. Particular focus should be given to hybrid instruments, specific reserves, assets encumbered by parental or third-party guarantees, and any other arrangements where capital is subordinated.

In addition, companies should begin to examine existing letters of credit and the arrangements for the collateralisation of facilities with third parties, to determine whether this is unnecessarily encumbering assets that would normally be eligible as tier 1 basic capital. It is also important to note that capital held in excess of the admissible limits prescribed for each tier are non-admissible as own funds.

Shareholder value, cost of capital and capital flexibility are very much on every CFO’s and CEO’s agenda. Gaining an early understanding of the implications of the eligible capital consultation paper issued by the BMA is vital to any company maximising its capital resources in a way that meets both shareholder expectations and regulatory compliance.

Thomas Kelly is a partner at KPMG, Bermuda. He can be contacted at: tkelly@kpmg.bm

Paul O’Neill is a senior manager at KPMG, Bermuda. He can be contacted at: pauloneill@kpmg.bm