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The Actuary The magazine of the Institute & Faculty of Actuaries

A capital idea

Standard and Poor’s (S&P) has been using its revised risk-based capital model since 1 December 2000 to assess the
capital adequacy of British life insurance companies and groups in order to determine their financial strength ratings. This article looks at how the model works and why it matters to actuaries.

How does it work ?
The model output is one important element of the information used by S&P to decide on an overall rating. Some allowance is made to reflect situations not adequately treated by the model. The ratio is calculated as:

The model uses information mostly from Companies Act accounts and FSA returns to calculate each of these elements. What follows is a brief description of each.

Total adjusted capital (TAC)
This is made up of shareholders’ capital and retained earnings and various other items from the Companies Act accounts, and the FSA returns with some adjustment made. The main features are as follows:
– Deferred acquisition costs (DAC) and value of in force (VIF) Only 50% credit is allowed for these items, with provision made to avoid any double counting of future margins.
– Goodwill Only 50% of the goodwill value of any non-core businesses can be included in TAC, and this credit will be written off over four years. Where the goodwill is in respect of the VIF of an acquired life company, provision is made (as with DAC) to avoid double counting. The company cannot take credit for future profits on the acquired business and goodwill in the consolidated balance sheet in respect of the acquired VIF.
– Fund for future appropriation (FFA) For mutuals, the FFA gets 100% credit towards TAC. For proprietary offices a notional policyholders’ share of the FFA (as defined by articles of association, or recent practice, eg 90%) is available to support the financial strength of the fund in which it is situated. The notional shareholders’ share is also available capital for that fund. However, it is also available, after a 20% discount, to support other funds within the insurance group.
– Subordinated debt This typically gets equity credit while the outstanding term is at least ten years, and is then amortised at 20% pa. However, in the case of life insurers it is regarded as another way of taking credit for future profits so, again, provision is made to avoid double counting.

Asset risk
This is calculated by applying various risk charges to the Form 13 assets. Equities attract a higher charge than gilts, etc. Assets which are not hypothecated to back reserves attract a higher charge than those assets that are. For example, hypothecated equities attract a 5% risk charge while other equities attract a 20% charge.
As with many other aspects of the model, the measure of strength is from the point of view of the regulator. Shareholders and policyholders would probably want to see ‘free’ assets (in the sense of the previous paragraph) invested in equities, or other higher-risk, higher expected return assets, to the extent that this is consistent with the desired degree of security.
The formula shows that with-profits and other asset risks are treated differently. In other S&P models, asset risk is treated as a deduction from TAC. The differing treatment for UK-style with-profits insurers reflects the much greater significance of asset risk for them. Standard & Poor’s website explains:
If an insurer is to merit a (capital adequacy ratio) CAR of, say, 150% then it would be inappropriate to deduct asset risk charges from the numerator of the ratio, as this implies that the dominant part of the capital requirements is covered only 100% rather than 150%. Consequently for with-profit business, the CAR is modified such that the asset risk charges for with-profit business are included with other risk charges in the denominator.

Pricing risk and reserving risk
A similar approach is taken to calculating pricing and reserving risks, by applying a series of charges, sums at risk and premiums received during the year (for pricing risk) and reserves (for reserving risk). Classes of business that are exposed to greater risk attract a higher charge, eg for pricing risk, conventional non-profit business attracts a higher charge than corporate pensions business, and so on.

General business risk
General business risk attempts to evaluate the exposure to regulatory and other business risks. For example, it includes a charge for exposure to individual pension business in view of future market conduct risks, as exemplified by the current personal pension review.
The output from the model is assessed on a scale, normally from AAA to BBB depending on the ratio shown in table 1 above.

Why does it matter?
The S&P rating will have a direct impact on:
– perceived financial security and hence new business performance;
– the cost of external borrowing, and hence, the cost of capital.
A high rating, say AAA, will avoid any possible negative opinion on the grounds of financial strength in parts of the insurance-buying community; it is now necessary to have a strong rating to get onto the best advice panels of many independent financial advisers, particularly for with-profits business. It will also help to reduce the cost of raising external debt by lowering the market’s demand for a credit risk premium. Unfortunately, an AAA rating may also be associated with inefficient use of capital a situation shareholders, and hence managers, would want to avoid.
These factors dictate that the S&P (or some other) rating model should be used to provide input to the strategic planning process, especially where these plans include capital management initiatives. Various scenarios can be modelled to assess, for example, the rating impact of capital restructuring/repatriation, acquisitions, reinsurance strategies, or asset allocation strategy. The expected net benefit from the proposed initiative can then be assessed against the likely cost of the rating impact.
Also, companies often arrange their financial affairs with an eye to how they will look through the FSA, Companies’ Act, or achieved profits looking-glass. There are compelling reasons to take account of the structures and features of the S&P rating model as well. This may suggest some practical steps that can be taken to optimise the capital adequacy ratio.
In the current highly competitive market for life assurance and pension products, the prospect of improving the return on capital by increasing margins on business sold is remote. One alternative reducing the amount of capital employed has to be carefully managed to ensure that there is no offsetting downgrading of debt. To do this effectively, it is essential to understand the models used by the rating agencies, and other aspects of the rating process, such as the agencies’ tolerance limits for debt and hybrid instruments.