Hello, I have a few questions mainly on capital tiers in Chapter 4, and one practice question from Chapter 9. Any ideas are welcome! Chapter 4 1. Under Solvency II, capital is tiered based on its loss absorbency and permanency. - What exactly do these terms mean? I've tried googling but I am still unsure... 2. What do these criteria for Tier 1 capital mean? - 'Absorbs losses at least on SCR breaches.' - 'Should not cause or accelerate insolvency.' - 'Contractually locked in or replaced at least equivalently on breach of SCR.' And for Tier 2: - 'Limited incentives to redeem are permissible after 10 years from date of issuance.' 3. Are Ancillary Tier 2 and Ancillary Tier 3 capital similar? 4. Is it right to say that there is no 'Ancillary Tier 1' capital, since by definition, Tier 1 capital should be immediately available to absorb losses, while ancillary capital does not currently exist within the insurer? 5. The notes say that Tier 3 instruments can continue to pay dividends even if the SCR is breached, but this is not true for Tier 1 instruments. Why is that so? - Also, since Tier 3 instruments consist partly of subordinated debt, wouldn't Tier 3 instruments rank below other instruments in dividend payments? Chapter 9: Practice Question 9.10 (ii)(b) 1. At the end of 2018, B will have a surplus of 4.05 arising from the 2017 account. But why is only 2.03 of this recognised in 2018, and how is 2.03 determined from the 4.05? (similarly for the 12.27 surplus arising from the 2018 account, where only 8.18 is recognised in 2019) - This is different from A's accounts where at the end of 2018, the full surplus arising from the 2017 account from the reduction in 2017 loss ratio assumption is recognised. I suspect it is due to B using a three-year accounting format, but how what is the justification for the different treatment between A and B? 2. At the end of 2019, there is a surplus of 4.03. But why can't this be recognised? Thank you!!
Hi there JL24, What a lot of questions. You may find you get a quicker response if you post fewer questions at a time. That would be more likely to encourage a response. Let’s tackle your Solvency 2 questions first. Perhaps someone else will have a go at Question 9 for you. Loss absorbency The idea is that capital be available to ‘absorb losses’ as they arise. This means that the capital needs to be sufficient in amount, quality and liquidity to be available when the liabilities they are to cover arise. Items with a fixed duration, or a right to redeem early may not be available when needed. Similarly, obligations to pay distributions or interest will reduce the amount available to the insurer. The rules on 'tiering' are designed to reflect the existence of such features. Locked in ‘Locked in’ means that an arrangement cannot be altered (at least, it cannot be altered by the party who does not hold the lock). The lock might be triggered when certain events take place, for example, when the SCR is breached. Permanency ‘Permanency’ relates to the duration of an insurer’s capital instruments. Any redemption date for Tier 2 capital will be later than Tier 3 capital for example, and Tier 1 capital must be irredeemable. Tiered capital Tier 1 capital is not redeemable under any circumstances. This means the insurer will not be required to pay back the capital. Tier 2 capital can be redeemed after 10 years, at least under certain circumstances (which, thankfully, the Core Reading does not go into). You are quite right that Tier 3 capital can consist of subordinated debt, and that servicing this debt ranks after equity commitments. Indeed the whole point of designating these sorts of instruments as Tier 3 is to limit the amount of these items that the company can employ. They are not particularly helpful in preventing insolvency, so insurers are only allowed to cover a maximum of 15% of SCR with Tier 3 capital. So you can see that the more Tier 1 capital a company has (and the less Tier 3), the more ‘secure’ that company will be. It doesn’t much matter that Tier 3 capital can continue to pay dividends even if the SCR is breached, because the insurer should be holding enough Tier 1 capital to ensure the ongoing viability of the company. Ancillary capital You’re quite right that ancillary own-fund items may not be classified in Tier 1. It’s not really helpful to discuss whether ancillary Tier 2 capital and ancillary Tier 3 capital is similar – they have different criteria and it is these criteria that matter. Now that we have discussed these core concepts, I recommend you go back to your list of questions and attempt to answer them yourself. You should now have enough knowledge to understand what even the more obscure Core Reading is getting at. Best wishes, Katherine.
Hi Katherine, Thank you for the explanation of the concepts! Sorry for the large number of questions, but I have some follow-up questions regarding capital tiering: 1. You mentioned that Tier 3 capital is not particularly helpful in preventing insolvency. With subordinated debts as an example, why is that so, when the coupons/dividends for these instruments are less guaranteed than non-subordinated debts (hence less need for the insurer to pay coupons/dividends for these instruments, and better in preventing insolvency)? 2. I still don't really understand the following criteria listed in the Core Reading: a. Absorbs losses at least on SCR breaches (under Tier 1 capital) - Does this mean that when capital available is below the SCR, Tier 1 capital is still available to pay for liabilities? - Is it right to say that on MCR breaches, losses may not be absorbed (i.e. capital available may be too low to pay for liabilities)? b. Should not cause or accelerate insolvency (under all Tiers) - Does this mean that usage of the capital to pay liabilities should not accelerate insolvency? c. Replaced at least equivalently on breach of SCR (under all Tiers) - Does this mean that on breach of SCR, since capital available is below SCR, the capital needs to be restored to the SCR level? Thank you again!
When we talk about subordinated debts being ‘less secure’, this means that they rank below other instruments on wind-up. So investors who have bought these instruments will get very little (if any) of their money back if the insurer is declared insolvent. Here though, we are the insurer, not the investor. We have issued these subordinated debts. We are therefore obliged to service these debts, ie by paying coupons and redemption payments. Since we are obliged to keep paying them regardless of our profits, you might regard this as ‘accelerating solvency’. Compare this to our share capital – we are not obliged to pay dividends to our shareholders every year. Yes, that’s how I interpret this. Possibly. We’re only told about the requirement to make good a breach of the SCR. You might like to search for the source regulations to see what it says about the MCR, perhaps you will have better luck than I have had! Broadly yes. Yes.
To answer your queries regarding Practice Question 9.10(ii)(b), you might take a look at the attached spreadsheet. Someone handed me this in the dim and distant past, I haven't checked it in detail but all the numbers tie up with the solution in Chapter 9, so it's probably worth looking at. (The pesky website won't allow me to upload a spreadsheet, so I've given you two PDFs, one with the results, one showing workings.) I'd stress though, I think this is probably not the best use of your time with the exam so close. It's always a risky business trying to predict the exam isn't it, but if I were the examiner I'd be more interested in IFRS17 (which is new and topical) rather than 3-year accounting.
