(v 5) SCR Standard Formula: Operational Risk - FSCA

Solvency Assessment and Management:

Steering Committee

Position Paper 611 (v 5)

SCR Standard Formula: Operational Risk

1. INTRODUCTION AND PURPOSE

Solvency Assessment and Management (SAM) regulatory requirements are being developed in South Africa in line with solvency regulations in other jurisdictions in particular, Solvency II in the European Union (EU). To this end developments in other jurisdictions have been considered in order to formulate appropriate guidelines for the South African insurance industry. It is also important to note that the approach followed by the EU’s Solvency II is to capture broad operational risk based on the assumption that the size of the operation via various volume measures are indicative of operational risk. The same approach has been adopted for SAM.

In drafting this document we have also considered principles and prescriptions provided by the International Association of Insurance Supervisors (IAIS), as well as the regulatory bodies in Australia (APRA) and Canada (OSFI).

This document sets out the recommended approach for the Operational Risk Module of the Solvency Capital Requirement (SCR) calculation and supporting rationale for the recommendation.

2. INTERNATIONAL STANDARDS: IAIS ICPs

Since its inception in 1994, the International Association of Insurance Supervisors (IAIS) has developed a number of principles and standards in guidance papers to help promote the global development of well-regulated insurance markets. A further objective of the IAIS is to contribute to the broader stability of the financial system. In respect of operational risk, the IAIS’ Insurance Core Principles2 (ICP) recommends that operational risks should be considered for solvency purposes. The IAIS notes that operational risk is difficult to quantify and hence that regulators may base regulatory capital requirements on “simple proxies for risk exposure and/or stress and scenario testing” and suggests that in certain cases operational risks could rather be addressed through risk management and the ORSA. The IAIS does note that “the ability to quantify some risks (such as operational risk) will improve over time as more data become available or improved valuation methods and modelling approaches are developed”.

1 Position Paper 61 (v 5) was approved as a FINAL Position Paper by the SAM Steering Committee on 27 March

2015. 2 International Association of Insurance Supervisors, Insurance Core Principles, Standards, Guidance and Assessment Methodology (as amended 12 October 2012), http://www.iaisweb.org/Insurance-Core-Principles-material-adopted-in-2011-795 (page 208)

http://www.iaisweb.org/Insurance-Core-Principles-material-adopted-in-2011-795

Solvency Assessment and Management: Steering Committee Position Paper 61 (v 5) – SCR Standard Formula: Operational Risk

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3. EU DIRECTIVE ON SOLVENCY II: PRINCIPLES (LEVEL 1)3

The EU Level I Directive (dated November 2009) defines operational risk as “the risk of loss arising from inadequate or failed internal processes, personnel or systems, or from external events” (definitions, article 13, section 33). It also specifies that operational risk “shall include legal risks, and exclude risks arising from strategic decisions, as well as reputation risks” (calculation of the SCR, article 101). It is clearly specified that the risk management system (risk management, article 44, section 2) and the SCR calculation (calculation of the SCR, article 101) shall include operational risk. In the calculation of the SCR using the standard formula (structure of the standard formula, article 103), an operational risk capital requirement is an explicit component of the standard formula SCR calculation. Principles for the calculation of the operational risk capital requirement (on a standard formula basis) are provided in article 107 of the Directive which states: 1. The capital requirement for operational risk shall reflect operational risks to the extent

they are not already reflected in the risk modules referred to in Article 1044. That requirement shall be calibrated in accordance with Article 101(3)5.

2. With respect to life insurance contracts where the investment risk is borne by the policy holders, the calculation of the capital requirement for operational risk shall take account of the amount of annual expenses incurred in respect of those insurance obligations.

3. With respect to insurance and reinsurance operations other than those referred to in paragraph 2, the calculation of the capital requirement for operational risk shall take account of the volume of those operations, in terms of earned premiums and technical provisions which are held in respect of those insurance and reinsurance obligations. In this case, the capital requirement for operational risks shall not exceed 30 % of the Basic Solvency Capital Requirement relating to those insurance and reinsurance operations.

4. MAPPING ANY PRINCIPLE (LEVEL 1) DIFFERENCES BETWEEN THE IAIS ICP AND THE EU DIRECTIVE

The IAS ICPs do not contain detailed requirements for the calculation of operational risk capital requirements. Consequently there are no contradictions or differences between the EU directive and the IAS ICPs.

5. STANDARDS AND GUIDANCE (LEVELS 2 AND 3)

5.1 IAIS standards and guidance papers

5.1.1 ICP 17: Capital Adequacy6 ICP 17 as issued by the IAIS applies to insurance entities and insurance groups. This document seeks to establish capital adequacy requirements for solvency purposes so that

3 Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II), http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:335:0001:01:EN:HTML 4 Article 104 describes the calculation of the Basic SCR under the standard formula 5 Article 101(3) defines the calibration of the capital requirement as a 1 year VAR at a confidence level of 99.5% 6 International Association of Insurance Supervisors, Insurance Core Principles, Standards, Guidance and Assessment Methodology (as amended 12 October 2012), http://www.iaisweb.org/Insurance-Core-Principles-material-adopted-in-2011-795 (page 188-257)

http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:335:0001:01:EN:HTML



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insurers can absorb significant unforeseen losses and to provide for degrees of supervisory intervention. The ICP states that the regime should address all relevant and material categories of risk - including as a minimum:

Underwriting risk,

Credit risk,

Market risk,

Operational risk and

Liquidity risk. The IAIS however recognises that some risks are less readily quantifiable than the other main categories of risks. These risks include:

Strategic risk,

Reputational risk,

Liquidity risk and

Operational risk. Operational risk, according to IAIS, is diverse in its composition. The measurement of operational risk, in particular, may suffer from a lack of sufficiently uniform and robust data and well developed valuation methods. ICP 17 allows jurisdictions to choose to base regulatory capital requirements for these less readily quantifiable risks on:

Simple proxies for risk exposure, and/or

Stress and scenario testing. ICP 17 also notes that for these types of risks (including operational risk), holding additional capital may not be the most appropriate risk mitigant and it may be more appropriate for the supervisor to require the insurer to control these risks via exposure limits and/or qualitative requirements such as additional systems and controls. However, the IAIS envisages that the ability to quantify such risks (for example, operational risk) will improve over time as more data become available or improved valuation methods and modelling approaches are developed. Further, the IAIS notes that although it may be difficult to quantify risks, it is important that an insurer nevertheless addresses all material risks in its ORSA (Own Risk and Solvency Assessment).

5.1.2 ICP 16: Enterprise Risk Management for solvency purposes7 According to IAIS, where a risk is not readily quantifiable, for instance some operational risks, an insurer should make a qualitative assessment that is appropriate to that risk and sufficiently detailed to be useful for risk management purposes.

7 International Association of Insurance Supervisors, Insurance Core Principles, Standards, Guidance and Assessment Methodology (as amended 12 October 2012), http://www.iaisweb.org/Insurance-Core-Principles-material-adopted-in-2011-795 (page 155-187)



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5.2 CEIOPS' Advice for Level 2 Implementing Measures on Solvency II: SCR – Standard Formula – Operational Risk (former Consultation Paper no. 53)8

The guidance provided in respect of operational risk in the CEOIPS Level 2 Final Advice is as follows:

5.2.1 Definition

CEIOPS provided the following definition of operational risk:

“Operational risk is the risk of loss arising from inadequate or failed internal processes, or from personnel and systems, or from external events (Article 13(33) of the Level 1 text). Operational risk shall include legal risks, and exclude risks arising from strategic decisions, as well as reputation risks (Article 101(4)(f) of the Level 1 text). The operational risk module is designed to address operational risks to the extent that these have not been explicitly covered in other risk modules. For the purpose of this advice, reference to technical provisions is to be understood as technical provisions excluding the risk margin, to avoid circularity issues.”

5.2.2 Calibration

Regarding calibration, CEIOPS advised:

Based on the assumptions contained in the explanatory text, CEIOPS calibrated the sub-module according to 99.5% VaR and a one year time horizon. The overall conclusion was that operational risk in the QIS4 standard formula was under-calibrated. CEIOPS thus proposes the following operational risk factors:

Area Revised Risk Factors QIS4 Risk Factors

TP – life 0.6% 0.3%

TP – non-life 3.6% 2.0%

Prem – life 5.5% 3.0%

Prem – non-life 3.8% 2.0%

UL factors 25% 25%

BSCR cap - life 30% 30%

BSCR cap - non-life 30% 30%

5.2.3 Inputs

In respect of the calculation of the operational risk capital, the final advice listed the inputs required as:

TPlife = Total life insurance technical provisions (gross of reinsurance), with a floor equal to zero. This would also include unit-linked business and life like obligations on non-life contracts such as annuities.

TPSLT Health = Technical provisions corresponding to health insurance (gross of reinsurance) that correspond to Health SLT with a floor equal to zero.

TPlife-ul = Total life insurance technical provisions for unit-linked business (gross of reinsurance), with a floor equal to zero.

8 CEIOPS' Advice for L2 Implementing Measures on SII: SCR – Standard formula – Operational Risk (former Consultation Paper no. 53) https://eiopa.europa.eu/fileadmin/tx_dam/files/consultations/consultationpapers/CP53/CEIOPS-L2-Final-Advice-on-Standard-Formula-operational-risk.pdf

https://eiopa.europa.eu/fileadmin/tx_dam/files/consultations/consultationpapers/CP53/CEIOPS-L2-Final-Advice-on-Standard-Formula-operational-risk.pdf

https://eiopa.europa.eu/fileadmin/tx_dam/files/consultations/consultationpapers/CP53/CEIOPS-L2-Final-Advice-on-Standard-Formula-operational-risk.pdf


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TPnl = Total non-life insurance technical provisions (gross of reinsurance), with a floor equal to zero (excluding life like obligations of non-life contracts such as annuities).

TPNon SLT Health = Technical provisions corresponding to health insurance that correspond to Health non SLT (gross of reinsurance), with a floor equal to zero.

Earnlife = Total earned life premium (gross of reinsurance), including unit-linked business.

EarnSLT Health = Total earned premiums corresponding to health insurance that correspond to Health SLT (gross of reinsurance)

Earnlife-ul = Total earned life premium for unit-linked business (gross of reinsurance)

Earnnl = Total earned non-life premium (gross of reinsurance)

EarnNon SLT Health = Total earned premiums corresponding to health that correspond to Health non SLT (gross of reinsurance).

All the aforementioned inputs should be available for the last economic period and the previous one, in order to calculate their last annual variations.

Expul = Amount of annual expenses (gross of reinsurance) incurred in respect of unit-linked business. Administrative expenses should be used (excluding acquisition expenses); the calculation should be based on the latest past years expenses and not on future projected expenses.

BSCR = Basic SCR

5.2.4 Calculations

CEIOPS advised that the capital charge for operational risk is determined as follows:

SCRop = Capital charge for operational risk

where

SCRul = min{0.30 • BSCR;Oplnul} + 0.25 • Expul

where

Oplnul = Basic operational risk charge for all business other than unit-linked business (gross of reinsurance)

is determined as follows:

Oplnul = max (Oppremiums ; Opprovisions)

where

Oppremiums = 0.055 * ( Earnlife + EarnSLT Health – Earnlife-ul ) +

0.038 * ( Earnnon-life + EarnNon SLT Health ) +

Max( 0, 0.055 * ( ΔEarnlife – ΔEarnlife-ul )) +

Max( 0, 0.038 * ΔEarnnon-life )

and:

Opprovisions = 0.006 * ( TPlife + TPSLT Health – TPlife-ul ) +

0.036 * ( TPnon-life + TPNon SLT Health ) +


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Max(0, 0.006 * (ΔTPlife – ΔTPlife-ul )) +

Max(0, 0.036 * ΔTPnon-life))

where

Δ= change in earned premiums / technical provisions from year t-1 to t, for earned premiums / technical provisions increases which have exceeded an increase of 10%. Furthermore no offset shall be allowed between life and non-life Δ.”

5.3 CEIOPS QIS5 specification9

5.3.1 Calibration

The final Operational Risk SCR standard formula factors used for QIS5 were different from the factors proposed by CEIOPS. This was highlighted in the QIS5 cover letter Annex 210:

The following tables set out the changes made to the risk factors in the capital requirement for operational risk, the N-SLT health premium and reserve risk sub-module and the non-life premium and reserve risk sub-module.

The proposed calibration is based on the average of the factor used in QIS4 and the factor proposed by CEIOPS. However, where CEIOPS has proposed a lower factor than used in QIS4 this suggestion was adopted.

Area Revised Risk factor

proposed by the Commission

Risk factor proposed by CEIOPS

Technical Provisions - life 0.45% 0.6%

Technical Provisions - non-life 3.0% 3.6%

Premium - life 4.0% 5.5%

Premium – non-life 3.0% 3.8%

5.3.2 QIS5 formula change

A key change in the QIS5 formula (compared to the calculation proposed in the CEIOPS final advise) relates to health business, which has been removed from the operational risk capital formula. This is because health business is to be allocated according to its technical nature between life and non-life business in the operational risk calculation.

The QIS5 specification is provided below.

“Description

SCR.3.1. Operational risk is the risk of loss arising from inadequate or failed internal processes, or from personnel and systems, or from external events. Operational risk should include legal risks, and exclude risks arising from strategic decisions, as well as reputation risks. The operational risk module is designed to address

9 QIS5 Technical Specifications: http://ec.europa.eu/internal_market/insurance/docs/solvency/qis5/201007/technical_specifications_en.pdf 10 http://ec.europa.eu/internal_market/insurance/docs/solvency/qis5/cover-note_en.pdf

http://ec.europa.eu/internal_market/insurance/docs/solvency/qis5/201007/technical_specifications_en.pdf

http://ec.europa.eu/internal_market/insurance/docs/solvency/qis5/cover-note_en.pdf


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operational risks to the extent that these have not been explicitly covered in other risk modules.

SCR.3.2. For the purpose of this section, reference to technical provisions is to be understood as technical provisions excluding the risk margin, to avoid circularity issues.

Input

SCR.3.3. The inputs for this module are:

pEarnlife = Earned premium during the 12 months prior to the previous 12 months for life insurance obligations, without deducting premium ceded to reinsurance

pEarnlife-ul = Earned premium during the 12 months prior to the previous 12 months for life insurance obligations where the investment risk is borne by the policyholders, without deducting premium ceded to reinsurance

Earnlife = Earned premium during the previous 12 months for life insurance obligations, without deducting premium ceded to reinsurance

Earnlife-ul = Earned premium during the previous 12 months for life insurance obligations where the investment risk is borne by the policyholders without deducting premium ceded to reinsurance

Earnnl = Earned premium during the previous 12 months for non-life insurance obligations, without deducting premiums ceded to reinsurance

TPlife = Life insurance obligations. For the purpose of this calculation, technical provisions should not include the risk margin, should be without deduction of recoverables from reinsurance contracts and special purpose vehicles

TPlife-ul = Life insurance obligations for life insurance obligations where the investment risk is borne by the policyholders. For the purpose of this calculation, technical provisions should not include the risk margin, should be without deduction of recoverables from reinsurance contracts and special purpose vehicles

TPnl = Total non-life insurance obligations excluding obligations under non-life contracts which are similar to life obligations, including annuities. For the purpose of this calculation, technical provisions should not include the risk margin and should be without deduction of recoverables from reinsurance contracts and special purpose vehicles

Expul = Amount of annual expenses incurred during the previous 12 months in respect life insurance where the investment risk is borne by the policyholders.

BSCR = Basic SCR”

Note: The following was not included in the QIS5 technical specification and is defined as follow:

pEarnnl = Earned premium during the 12 months prior to the previous 12 months for non-life insurance obligations, without deducting premium ceded to reinsurance


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“SCR.3.4. In all the aforementioned input, life insurance and non-life insurance obligations should be defined in the same way as that set out in subsection V.2.1 on segmentation.”

Output

SCR.3.5. This module delivers the following output information:

SCRop = Capital requirement for operational risk

Calculation

SCR.3.6. The capital requirement for operational risk is determined as follows:

Where,

Op = Basic operational risk charge for all business other than life insurance where the investment risk is borne by the policyholders is determined as follows:

Where,

and:

5.4 Other relevant jurisdictions

5.4.1 The Australian Prudential Regulatory Authority (APRA)

APRA has updated its Prudential Standards (effective from 1 January 2013) to included detailed prudential capital requirements. These are defined for non-life (i.e. short term) insurance companies and life companies separately.

ulOP Exp.BSCR;Op.SCR 25030min

provisionspremiums OpOpOp ;max

)1.1(03.0,0

1.11.104.0,0

03.0

04.0

nlnl

ullifeullifelifelife

nl

ullifelifepremiums

pEarnEarnMax

pEarnEarnpEarnEarnMax

Earn

EarnEarnOp

lifenonullifelifeprovisions TPTPTPOp ,0max03.0,0max0045.0


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5.4.1.1 Non-Life Insurance (Individual Insurers and Groups)

APRA’s Prudential Standard GPS 11011 covers Capital Adequacy for non-life insurance companies and defines a prescribed capital requirement that allows for the full range of risks to which an insurer is exposed including risks relating to:

Insurance risk

Insurance concentration risk

Asset risk

Asset concentration risk, and

Operational risk

The standard requires insurers using the standard method to calculate the prescribed capital amount:

“For regulated institutions using the Standard Method, the prescribed capital amount is determined as:

(a) the Insurance Risk Charge; plus

(b) the Insurance Concentration Risk Charge; plus

(c) the Asset Risk Charge; plus

(d) the Asset Concentration Risk Charge; plus

(e) the Operational Risk Charge; less

(f) an „aggregation benefit‟, as defined in paragraph 31.”

Further:

“The Operational Risk Charge relates to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. The method for determining the Operational Risk Charge is set out in Prudential Standard GPS 118 Capital Adequacy: Operational Risk Charge12.”

APRA defines an operational risk capital calculation (under their standard method) that is similar to that used in Solvency II (i.e. a factor based approach dependant on premiums and reserves) – GPS 118 states:

“The Operational Risk Charge is the minimum amount of capital required to be held against operational risks. The Operational Risk Charge relates to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.”

GPS 118 defines the standard method for operational risk capital as:

7. The Operational Risk Charge for a regulated institution is calculated as the sum of:

(a) the Operational Risk Charge for inwards reinsurance business (ORCI) defined in paragraph 9; and

(b) the Operational Risk Charge for business that is not inwards reinsurance business (ORCNI) defined in paragraph 10.

The Operational Risk Charge for a Level 2 insurance group is calculated after consolidation of intra-group exposures.

11 APRA Prudential Standard GPS 110 http://www.apra.gov.au/GI/PrudentialFramework/Documents/GPS-110-Capital-Adequacy-January-2013.pdf 12 APRA Prudential Standard GPS 118 http://www.apra.gov.au/GI/PrudentialFramework/Documents/GPS-118-Capital-Adequacy-Operational-Risk-Charge-January-2013.pdf

http://www.apra.gov.au/GI/PrudentialFramework/Documents/GPS-110-Capital-Adequacy-January-2013.pdf

http://www.apra.gov.au/GI/PrudentialFramework/Documents/GPS-110-Capital-Adequacy-January-2013.pdf

http://www.apra.gov.au/GI/PrudentialFramework/Documents/GPS-118-Capital-Adequacy-Operational-Risk-Charge-January-2013.pdf

http://www.apra.gov.au/GI/PrudentialFramework/Documents/GPS-118-Capital-Adequacy-Operational-Risk-Charge-January-2013.pdf


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8. For the purposes of paragraphs 9 and 10:

(a) GP1 is written premium revenue (gross of reinsurance) for the 12 months ending on the reporting date;

(b) GP0 is written premium revenue (gross of reinsurance) for the 12 months ending on the date 12 months prior to the reporting date;

(c) Written premium revenue includes fire services levy, other levies imposed by state and territory governments, and revenue relating to portfolio transfers and unclosed business;

(d) NL is the central estimate of insurance liabilities (net of reinsurance) at the reporting date1; and

(e) |GP1 – GP0| is the absolute value of the difference between GP1 and GP0.

All of the values determined under this paragraph should correspond to the value in the regulated institution‟s statutory accounts. All transfers of insurance business made in accordance with the Act must be recognised in line with the corresponding requirements under Australian Accounting Standard AASB 1023 General Insurance Contracts.

9. The ORCI is calculated as follows:

ORCI = 2% × {maximum(GP1, NL) + maximum(0, |GP1–GP0| – 0.2 x GP0)}

10. The ORCNI is calculated as follows:

ORCNI = 3% × {maximum(GP1, NL) + maximum(0, |GP1–GP0| – 0.2 x GP0)}

5.4.1.2 Life Insurance (Individual Insurers and Groups)

The APRA Capital Adequacy Prudential Standard LPS 11013 requires that the life company

“maintain required levels of capital within each of its funds and for the company as a whole.”

The standard states that the Prudential Capital Requirement can be calculated using either a “standard method” or an internal model.

The standard notes that:

“For life companies using the Standard Method, the prescribed capital amount for a fund is determined as:

(a) the Insurance Risk Charge; plus

(b) the Asset Risk Charge; plus

(c) the Asset Concentration Risk Charge; plus

(d) the Operational Risk Charge; less

(e) an „aggregation benefit‟ as defined in paragraph 36; plus

(f) a combined stress scenario adjustment.”

13 APRA Prudential Standard LPS 110 http://www.apra.gov.au/lifs/PrudentialFramework/Documents/LPS-110-Capital-Adequacy-January-2013.pdf

http://www.apra.gov.au/lifs/PrudentialFramework/Documents/LPS-110-Capital-Adequacy-January-2013.pdf

http://www.apra.gov.au/lifs/PrudentialFramework/Documents/LPS-110-Capital-Adequacy-January-2013.pdf


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Further:

“The Operational Risk Charge relates to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. The method for determining the Operational Risk Charge is set out in Prudential Standard LPS 118 Capital Adequacy: Operational Risk Charge14.”

APRA defines an operational risk capital calculation (under their standard method) that is similar to that used in Solvency II (i.e. a factor based approach dependant on premiums and reserves) – LPS 118 states:

“The Operational Risk Charge is the minimum amount of capital required to be held against operational risks. The Operational Risk Charge relates to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.”

LPS 118 defines the standard method for operational risk capital as:

“Calculation of the Operational Risk Charge

9. The Operational Risk Charge is calculated as the sum of:

(a) the Operational Risk Charge for risk business (ORCR) defined in paragraph 11;

(b) the Operational Risk Charge for investment-linked business (ORCI) defined in paragraph 14; and

(c) the Operational Risk Charge for other business (ORCO) also defined in paragraph 14.

10. For the purposes of paragraphs 11 to 16:

(a) „Premium income‟ includes all premiums for life policies with the exception of premiums that are sourced from benefits paid under another life policy issued by the life company.

(b) „Claim payments‟ include all payments to meet liabilities to policy owners with the exception of payments that are used as premium income for another life policy issued by the life company.

11. The ORCR is calculated as follows:

ORCR = A× {maximum(GP1, NL1) + maximum(0, |GP1 – GP0| – 0.2 x GP0)}

where:

(a) A is 2 per cent for a statutory fund that is a specialist reinsurer and 3 per cent for other funds;

(b) GP1 is premium income (gross of reinsurance) for the 12 months ending on the reporting date;

(c) NL1 is the adjusted policy liabilities (net of reinsurance) at the reporting date;

(d) GP0 is premium income (gross of reinsurance) for the 12 months ending on the date 12 months prior to the reporting date; and

(e) |GP1 – GP0| is the absolute value of the difference between GP1 and GP0.

12. For the management fund of a friendly society, GP1, NL1 and GP0 must be summed across all of the risk business in the friendly society‟s benefit funds.

14 APRA Prudential Standard LPS 118 http://www.apra.gov.au/lifs/PrudentialFramework/Documents/LPS-118-Capital-Adequacy-Operational-Risk-Charge-January-2013.pdf

http://www.apra.gov.au/lifs/PrudentialFramework/Documents/LPS-118-Capital-Adequacy-Operational-Risk-Charge-January-2013.pdf

http://www.apra.gov.au/lifs/PrudentialFramework/Documents/LPS-118-Capital-Adequacy-Operational-Risk-Charge-January-2013.pdf


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13. For a statutory fund of a life company that is not a friendly society, GP1, NL1 and GP0 must be summed across all of the risk business in the statutory fund.

14. The ORCI and the ORCO are calculated as follows:

ORCI or ORCO = B× {NL1 + maximum(0, GP1 – 20% x GL0)

+ maximum(0, C1 – 20% x GL0)}

where:

(a) B is 0.15 per cent for a statutory fund that is a specialist reinsurer and 0.25 per cent for other funds;

(b) NL1 is the adjusted policy liabilities (net of reinsurance) at the reporting date;

(c) GP1 is premium income (gross of reinsurance) for the 12 months ending on the reporting date;

(d) GL0 is the adjusted policy liabilities (gross of reinsurance) at the date 12 months prior to the reporting date; and

(e) C1 is all payments to meet liabilities to policy owners (gross of reinsurance) for the 12 months ending on the reporting date.

15. For the management fund of a friendly society, NL1, GP1, GL0 and C1 in paragraph 14 must be summed across all of the investment-linked business of the society (for ORCI) and all the other business of the friendly society that is neither risk business nor investment-linked business (for ORCO).

16. For a statutory fund of a life company that is not a friendly society, NL1, GP1, GL0 and C1 in paragraph 14 must be summed across all of the investment-linked business in the statutory fund (for ORCI) and all of the other business in the statutory fund that is neither risk business nor investment-linked business (for ORCO).”

5.4.2 The Canadian Office of the Superintendent of Financial Institutions (OSFI)

5.4.2.1 Capital Requirement OSFI defines operational risk as “the risk that losses could materialize as a result of deficiencies in information systems or internal controls”. At present, life insurers have a 20% flat capital charge on business embedded in their 120% MCCSR to account for this risk. The MCCSR (Minimum Continuing Capital and Surplus Requirement) is the current system prescribed by the OSFI for determining required capital. In future, OSFI plans to implement a minimum capital charge of 25% of MCCSR gross capital requirements for life insurers to account for operational risk. This approach is intended to be temporary until an explicit capital charge for operational risk is developed.

5.4.2.2 Approach to Setting Capital Requirements

In October 2008 a Joint Committee consisting of OSFI, the Autorité des marchés financiers (AMF), and Assuris released a paper stating that the current MCCSR does not adequately account for risk concentration and risk diversification15.

15 Framework for a New Standard Approach to Setting Capital Requirements, Joint Committee of OSFI, AMF, and Assuris, http://www.assuris.ca/Client/Assuris/Assuris_LP4W_LND_WebStation.nsf/resources/Standard+Approach/$file/Framework+for+a+New+Standard+Approach+to+Setting+Capital+Requirements.pdf

http://www.assuris.ca/Client/Assuris/Assuris_LP4W_LND_WebStation.nsf/resources/Standard+Approach/$file/Framework+for+a+New+Standard+Approach+to+Setting+Capital+Requirements.pdf

http://www.assuris.ca/Client/Assuris/Assuris_LP4W_LND_WebStation.nsf/resources/Standard+Approach/$file/Framework+for+a+New+Standard+Approach+to+Setting+Capital+Requirements.pdf


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The Joint Committee recognised that the current framework does not provide explicitly for operational risk. It stated that these areas will need to be considered in the updated standard approach but provided no details of how this will be done.

5.4.2.2.1 Definition The committee defined operational risk as “the risk that the company‟s business processes will fail, or that the company will fail to comply with laws and regulations”. It recognised that the financial impact of loss of reputation should also be included in operational risk.

5.4.2.2.2 Approach to Operational Risk The paper states that a solvency buffer for operational risk will be calculated by applying a factor to a measure of exposure such as gross revenue. In addition, the solvency buffer will also contain a margin for future expenses that exceed those assumed in the calculation of best-estimate insurance obligations. It recognised that there are currently no explicit capital requirements for operational risk but argued that this is implicitly accounted for by requiring companies to hold more than 100% of the capital required by the MCCSR calculation. The paper stated that in the future, operational risk should be explicitly provided for e.g. by applying a factor to gross revenue

5.4.2.2.3 Operational risk categories The paper proposes that operational risk can be further divided into the sub-categories of process risk, legal and regulatory risk, and fraud and mismanagement risk. These are further defined as follows:

Process risk is the risk of loss due to the accumulation of small process errors. This occurs most often in processing high-volume, low-dollar-value transactions. The risk is best measured by using volume of transactions, but using gross revenue can give reasonable results.

Legal and regulatory risk is the risk of loss due to non-compliance with laws or regulations. This risk increases with the size of a company. Gross revenue is a reasonable measure of company size.

Fraud and mismanagement risk is the risk of loss due to significant fraudulent or negligent action by people in the organization. A classic example would be the unauthorized derivative trading that caused the failure of Barings bank. This type of risk has many of the same characteristics as catastrophic risk and it is difficult to find a suitable measure. The amount of such risks does tend to increase with company size, and gross revenue is a reasonable measure of size.

The paper suggests that different factors may be required for different lines of business and states that more study and thought is required in this area. It notes that IFRS best estimates may not include actual expenses, but may instead include standard expenses derived from a reference entity.


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It suggests that where the present value of actual future expenses is expected to be higher than the present value used in the valuation, the excess should be provided for in the solvency buffer.

5.5 Mapping of differences between above approaches (Level 2 and 3)

APRA, OSFI and Solvency II all adopt a relatively simplistic formula, but the capital drivers

are slightly different:

OSFI uses a margin on MCCSR temporarily; its proposed approach in future also looks to use a margin to allow for operational risk.

APRA uses premium income and adjusted policy liabilities and a different formula for life and non-life companies.

Solvency II uses earned premiums and technical provisions for each of life, non-life and health business and expenses for unit-linked business.

6. SOUTH AFRICAN QUANTITATIVE IMPACT STUDIES – SA QIS

6.1 SA QIS2

Qualitative feedback from SA QIS 2 indicated the following themes:

6.1.1 The operational risk capital charge formula tested under SA QIS2 is not reflective of Unit Linked businesses.

Work Group feedback:

Discussion with the Chairperson of the Unit Linked Insurers Working Group revealed that the

proxy used for Operational Risk is not indicative of risk. When assessing two identical

insurers in products, size of balance sheet, Insurer A which pays higher management fees

than Insurer B will generate a higher Operational Risk charge. The Chairperson of the Unit

Linked Work Group has suggested that a percentage of Assets under Management (AUM)

of linked assets is a more appropriate proxy.

Note: Post SA QI3 discussions resulted in the UL Insurers Working Group request a change

back to the original proxy.


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6.1.2 The operational risk capital charge formula tested under SA QIS2 is not reflective of operational risks because of the vast differences in business models.


In terms of the feedback that operational risk formula is not appropriate because of the vast

differences in business models; it is the view of the Work Group that the formula attempts to

capture broad operational risk based on the assumption that the size of the operation via

various volume measures that are indicative of operational risk. We maintain the view that

the lack of industry operational loss data requires the Work Group to follow a pragmatic

approach in the absence of suitable alternatives.

6.2 SA QIS3

Qualitative feedback from SA QIS 3 indicated the following themes:

In the SA QIS 3 qualitative questionnaire the Working Group asked the following question:

”Do you have other suggestions to improve the operational risk module formula for risk-sensitivity, including how such suggestions may be implemented?”

6.2.1 Asset under Management vs Expenses as a proxy for Unit Linked Insurers and the definition of Expenses

A few comments were made that asset management fees should not be included in the definition of expenses but no elaborations were provided. An insurer also indicated that Assets under Management (AUM) is a better proxy for risk than expenses. The insurer indicated that AUM is not affected by different business models.


In our view “expenses” should be used as the proxy for Unit Linked Insurers. This view is

supported by the Unit Linked Insurers Working Group that has subsequently requested the

removal of AUM as the proxy and the reintroduction of “expenses”. The definition for

expenses is defined below and it includes asset management fees paid by the insurance

company to the asset manager. Irrespective of the business model the insurer will incur

expenses to manage assets and it therefore makes sense that it should be included as this

is an indication of the equivalent expenses it would incur to manage these expenses

internally. The definition is therefore as follows

Expul =

The amount of annual expenses incurred during the previous 12 months in respect of life

insurance where the investment risk is borne by the policyholders. Annual expenses for the

purpose of this calculation shall include all expenses, including (non-exhaustive list):


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Acquisition expenses (excluding commissions)

Administrative expenses

Asset management fees

Investment management expenses

Claims management / handling expenses

Other expenses which are directly assignable to the individual claims, policies or transactions

Commission is excluded for the purpose of calculating the Operational Risk SCR.

The factor of 0.25 is also kept as this was based on EIOPA research. The formula then

becomes:

Additional to the above is a question raised on whether asset management fees

should form part of the expenses definition to determine OPS RISK for UL Insurers:

Our view is that we are adopting the principles of Solvency II, whereby we accept that the

size of the operation via various volume measures is indicative of the operational risk. The

Working Group agreed that asset management fees charged to an insurer would help

indicate the scale and size of an insurer – and the fact that someone else is managing these

assets adds operational risk. If these assets were managed internally, direct expenses would

be higher.

To the extent that we have accepted expenses as a valid proxy for UL business and given

that the expense of the management of assets is a considerable component we cannot see

why asset management fees should be excluded.

7. OTHER CONCERNS NOTED FROM THE INDUSTRY AND ISSUES LOG

7.1 EU DELEGATED ACTS: CHANGES FROM QIS 5 TO DRAFT ACT

The Working Group noted a change in the draft EU delegated act in terms of the Operational Risk capital charge. When using the premiums proxy a higher factor is now proposed for “pEarn”; up from 1.1 to 1.2. The EU change as contained in the draft delegated acts – 10 January 2014 is indicated below:

ulOP Exp.BSCR;Op.SCR 25030min


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The Work Group have previously indicated that we prefer following the Solvency II approach

because of its simplicity, that we agree with the view that size indicates risk and because it is

based on EU model data. In July 2014 EIOPA released a document “The underlying

assumptions in the standard formula for the SCR calculation”. Given the fact that we are

following Solvency II and taking into account the information below we agreed to make the

change from 1.1pEarn to 1.2pEarn. Below is an extract from the EIOPA document providing

more information:

Operational risk:

Operational risk increases together with the activity size as it stems from inadequate or failed

internal processes, personnel or systems, or from external events, unless the undertaking is

well diversified and managed which corresponds to a low value of the BSCR. The underlying

assumptions for the operational risk module can be summarized as follows:

• The overall assumption in the operational risk module is that a standardized level of risk

management is present.

• For unitlinked businesses the characteristics are similar to those of other life products.

Therefore, the parameters will evolve in line with the life parameter.

• In relation to the expense volume measure for unitlinked business, it is assumed that

acquisition expenses are exclusively relating to insurance intermediaries, which do not give

rise to any operational risk.

The overall assumption in the operational risk module is that a standardised level of risk

management is present. The operational risk module is based on a linear formula, and is

therefore not risk sensitive.

The calibrations of the operational risk factors have been a particular challenging task due

to the lack of information available. The underlying assumption of the operational risk

module is that the capital charge for operational risk can be set at a level of 99, 5 % VaR. As

there is no explicit way of measuring operational risk at the tail of the distribution, indications

from internal model users on operational risk charges were used as a benchmark for where

firms believe their 99.5% VaR for operational risk lies. In the standard formula, factors

should be chosen so that the standard formula operational risk charge is broadly in line with

the undiversified operational risk from a firm's internal model. This is due to the fact that

there is no allowance for diversification within the standard formula.

Several analyses were carried out and reference to external information for validation and

benchmarking purposes was used. One of these analyses was the basis for the factors set

in the operational risk charge of the standard formula. This analysis was based on 5 EU

countries and 32 entities in total, including both data on the pre diversification and

postdiversification charges. The sample of undertakings providing postdiversification

charges was different from the sample providing prediversification charges.


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The following data was used in for setting the factors:

• Internal models operational prediversification charge in relation to non-life technical

provisions.

• Internal models operational prediversification charge in relation to non-life earned

premiums.

• Internal models operational prediversification charge in relation to life technical provisions

excluding unitlinked business.

• Internal models operational prediversification charge in relation to life earned premiums

excluding unit linked business.

In the calibration summary statistics for each of the data subsets above were produced, and

a charge was selected based on the median of the pre diversification charge of the internal

models. For unitlinked businesses it was assumed that the characteristics were similar to

those of other life products. Therefore, the parameters will evolve in line with the life

parameter. In relation to the expense volume measure for unitlinked business it is assumed

that administrative expenses exclude acquisition expenses as these are primarily related to

insurance intermediaries. Acquisition expenses are excluded from operational risk.”

7.2 SINGLE PREMIUM BUSINESS AND CALCULATING EARNED PREMIUM An issue raised by some Insurers is regarding the treatment of single premium business in

the operational risk formula. The formula requires companies to base the operational risk on

earned premium if this results in a higher requirement that the factor based on technical

provisions. However, for long-term single premium business, it is not clear how earned

premium should be calculated. An example of a long-term single premium policy is a life

annuity, where in exchange for a single premium, an annuity payment is made for the rest of

the policyholder’s life.

For IFRS purposes, the single premium is usually recognised in the current reporting period

as Gross Premium. A provision equal to the present value of future expected claims and

expenses (plus risk margins) is set up, which is equivalent to a UPR.

It could be argued that the operational risk formula does take this issue into account in the

relationship between the factors applied to technical provisions and those applied to the

premiums (which differ by a factor of 10). For an insurer only writing single premium

business, the operational risk requirement for a block of new business will be fairly similar

between that based on premiums and that based on technical provisions (if earned premium

= single premium / 10). However, for a business selling a mixture of risk business and

annuity business, where the negative reserves for the risk business offset the positive

reserves for the annuity business, leading to the premium-based operational risk to increase,

you will end up with a volatile operational risk requirement.


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Potential options are:

1. Use written premium as earned premium for this business: The major issue with this is that single premiums received is not necessarily a good indicator

of the size of a company, and it can be very volatile (for example when a large, once-off

book of annuity business is placed with insurer), potentially leading to a volatile operational

risk requirement.

Challenges and comments with this option:

It is the view of the Working Group that this approach will most likely overstate the capital

requirement, especially in a growing business.

2. Develop a simple formula to calculate equivalent earned premium for single

premium business: This could be designed and only be used for the operational risk requirement. (E.g.

something like 10% of single premium). However, this will mean tracking the past single

premiums to calculate the earned premium, which is extra work that is not used anywhere

else.

Challenges and comments with this option:

Individual companies could elect to use this option by calculating earned premiums as by the

definition of “earned premium” noted below. This adds complexity but it would be needed for

any definition of earned premium for single premium business and could be done using an

approximation or full calculation for each tranche of business sold at the outset and stored

for use over time.

What is the definition of “earned premium”? For short term business, this is fairly obvious

and fairly often calculated and used for various purposes. For life business the term is

sometimes used but less commonly since reserves are based on prospective calculations

instead. Earned premiums also makes very little sense for products such as an annuity

where the term of the product depends on how long a person lives and is not defined as a

fixed number of years (the same issue would apply to whole of life business as well). In this

case, if a person lives longer than expected you end up with no earned premium in the latter

years. Earned Premium are premium payments received by an insurer for cover provided

during the current accounting period. Premiums received which relate to cover which will be

provided in a future period are known as unearned premiums.

However, given the complexities of formulating a formula for calculating earned premiums

the Working Group makes the following recommendation:


Working Group makes the following recommendation:

Insurer selling single premium must determine earned premiums based on their internal data and history.

Insurers are required to disclose the how this was determined in the QRTs to the Regulator.


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3. Appropriateness of the 100% correlation with other risk sub-modules and 30% BSCR maximum cap.

This is area where information from SA QIS 3 may not help with regard to the correlation

question.


Overall the view is that there is no evidence to suggest that operational risk can be

diversified away and no credit is therefore given for diversification. No action to be taken.

4. Treatment of new business for start-up insurers

A question was raised on whether and how the formula should cater for start-up insurers in

terms of new business.


According to our definition :

“Operational risk is the risk of loss arising from inadequate or failed internal processes, or

from personnel and systems, or from external events.

Operational risk should include legal risks, and exclude risks arising from strategic decisions,

as well as reputation risks. The operational risk module is designed to address operational

risks to the extent that these have not been explicitly covered in other risk modules.”

For the Working Group it is clearly not intended to be covered in the first sentence, and

arguably falls under strategic risk. The issue perhaps better picked up in providing firmer

guidance on the setting of long-term expense assumptions for start-ups in the calculation of

technical provisions. This will also focus management and shareholder attention more

closely on this risk.

8. ASSESSMENT OF AVAILABLE APPROACHES GIVEN THE SOUTH AFRICAN CONTEXT

8.1 Discussion of inherent advantages and disadvantages of each approach

8.1.1 Solvency II

The operational risk standard formula has been derived from extensive benchmarking exercises performed in Europe, and is based on internal model results from a variety of insurance participants. This provides a good starting point from which to leverage and develop South African requirements.

It needs to be acknowledged however, that the factors applied in the formula may not be appropriate for the South African insurance industry, if the operational risk profile of South African entities differs significantly to that of European entities.


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The formula proposed in the level 2 text is simplistic and easy to apply. Whilst its simplicity is an advantage, it needs to be recognised that any simplified formula will likely provide disparate results between individual companies.

For unit-linked business the current Solvency II formula specifies the use of “annual expenses”, however it is unclear exactly what expenses are to be included. It might be argued that this could be a significant miss-representation of the operational risks faced by certain companies – e.g. insurers that pass on all investment-related obligations and asset management expenses directly to asset managers.

Uncertainty exists regarding allowance for the risk of new start-up companies not meeting growth targets, especially relating to the impact of this on the appropriateness of the assumed expense basis. Clarification is needed regarding where this risk is to be allowed for and whether this will be covered by the Operational Risk SCR.

8.1.2 APRA

APRA also uses a simplistic formula based and similar advantages and disadvantages to that for Solvency II apply. In addition, the parameters used in Australia are likely to be significantly different to those applicable to South African companies.

8.1.3 OSFI

The plan of the Canadian regulator (OSFI) to implement a minimum capital charge based on a percentage of MCCSR gross capital again has the key advantage of simplicity. This approach is similar to the Basic Indicator Approach that bank’s are permitted to use under Basel III. An approach that calculates a solvency buffer for operational risk by applying a factor to a measure of exposure such as gross revenue is inherently easy to calculate. Allowing a similar approach locally (even as a temporary measure) would thus greatly reduce the costs of compliance for local insurance companies. It needs to be recognised however that results calculated under an approach of this nature will have almost no correlation to the actual risk exposure within the respective entities. This can result in greatly disparate results which will depend solely on the composition of the balance sheet and income statement of the relevant entities. Whilst the simplicity of the approach is attractive, an approach of this nature is likely to be widely criticised due to its lack of risk sensitivity.

8.2 Impact of the approaches on EU third country equivalence

Adopting the Solvency II requirements discussed in this document could provide the closest possible EU third country equivalence as the concept and approach would be easily understood by European regulators. Adopting an approach similar to the OSFI or APRA proposals may place South Africa at odds with the Solvency II recommendations that are likely to be adopted by European Union countries. An approach that is significantly different to Solvency II may increase compliance costs for companies that operate under both SAM and Solvency II.


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However, it is worth noting that the criteria in the CEIOPS Level 2 final advice on equivalence16 does not specify requirements at this level and focuses on the principles (i.e. equivalence at an overall level based on a 1 year VAR with a 99.5% confidence limit and a capital regime that “should aim at measuring all quantifiable unexpected risks of the undertaking”). The approach adopted under SAM should thus be robust and calibrated in accordance with the final advice as noted above and final Solvency II requirements (when available).

8.3 Comparison of the approaches with the prevailing legislative framework

The current prevailing legislation (CAR requirements under PGN104) merely specifies that allowance should be made for operational risk for life insurers, but does not provide detailed guidance on the calculation thereof. The current requirement for non-life Insurers is similar to the CEIOPS QIS5 formula.

8.4 Conclusions on preferred approach The Task Group has concluded that the formula for operational risk should be pragmatic. Size is considered by the Task Group as a reasonable proxy for operational risks and therefore the recommendations section below uses that as the basis for the final recommendation.

9. RECOMMENDATION

In conclusion, the use of the latest Solvency II formula based approach is to be recommended. Further work should be carried out to develop a long term solution. This work will need to be done over time to enable the industry to gather the required data. For SAM Level 1 it is recommended that the Solvency II Level 1 principles be adopted, but that some of the more specific elements in the calculation be moved to the Level 2 text – for example, the 30% limit and the capital drivers which are to be taken into account in the operational risk capital calculation in the standard formula. The detail of the recommendations is listed below:

Operational risk is the risk of loss arising from inadequate or failed internal processes, or from personnel and systems, or from external events.

Operational risk should include legal risks, and exclude risks arising from strategic decisions, as well as reputation risks. The operational risk module is designed to address operational risks to the extent that these have not been explicitly covered in other risk modules.

For the purpose of this section, reference to technical provisions is to be understood as technical provisions excluding the risk margin, to avoid circularity issues.

16 CEIOPS’ Advice for Level 2 Implementing Measures on Solvency II: Technical criteria for assessing 3rd country equivalence in relation to art. 172, 227 and 260 https://eiopa.europa.eu/fileadmin/tx_dam/files/consultations/consultationpapers/CP78/CEIOPS-L2-Advice-Equivalence-for-reinsurance-activities-and-group-supervision.pdf

https://eiopa.europa.eu/fileadmin/tx_dam/files/consultations/consultationpapers/CP78/CEIOPS-L2-Advice-Equivalence-for-reinsurance-activities-and-group-supervision.pdf

https://eiopa.europa.eu/fileadmin/tx_dam/files/consultations/consultationpapers/CP78/CEIOPS-L2-Advice-Equivalence-for-reinsurance-activities-and-group-supervision.pdf


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Risk Factors

Area Risk Factors

TP – life 0.45%

TP – non-life 3.0%

Prem – life 4.0%

Prem – non-life 3.0%

UL factors 25%

BSCR cap – life 30%

BSCR cap - non-life 30%

Inputs The inputs for this module are:

pEarnlife = Earned premium during the 12 months prior to the previous 12 months for life insurance obligations, without deducting premium ceded to reinsurance

pEarnlife-ul = Earned premium during the 12 months prior to the previous 12 months for life insurance obligations where the investment risk is borne by the policyholders, without deducting premium ceded to reinsurance

pEarnnl = Earned premium during the 12 months prior to the previous 12 months for non-life insurance obligations, without deducting premium ceded to reinsurance

Earnlife = Earned premium during the previous 12 months for life insurance obligations, without deducting premium ceded to reinsurance

Earnlife-ul = Earned premium during the previous 12 months for life insurance obligations where the investment risk is borne by the policyholders without deducting premium ceded to reinsurance

Earnnl = Earned premium during the previous 12 months for non-life insurance obligations, without deducting premiums ceded to reinsurance

TPlife = Life insurance obligations. For the purpose of this calculation, technical provisions should not include the risk margin, should be without deduction of recoverables from reinsurance contracts and special purpose vehicles

TPlife-ul = Life insurance obligations for life insurance obligations where the investment risk is borne by the policyholders. For the purpose of this calculation, technical provisions should not include the risk margin, should be without deduction of recoverables from reinsurance contracts and special purpose vehicles

TPnl = Total non-life insurance obligations excluding obligations under non-life contracts which are similar to life obligations, including annuities. For the purpose of this calculation, technical provisions should not include the risk margin and should be without deduction of recoverables from reinsurance contracts and special purpose vehicles

Expul = The amount of annual expenses incurred during the previous 12 months in

respect of life insurance where the investment risk is borne by the

policyholders. Annual expenses for the purpose of this calculation shall

include all expenses, including (non-exhaustive list):

o Acquisition expenses (excluding commissions) o Administrative expenses o Asset management fees o Investment management expenses


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o Claims management / handling expenses o Other expenses which are directly assignable to the individual claims,

policies or transactions

Commission is excluded for the purpose of calculating the Operational Risk SCR.

The list above provides guidance to the type of expenses to be included. All directly paid expenses as well as costs indirectly incurred such as fees deducted from investment income should be included in Expul.

BSCR = Basic SCR

In all the aforementioned input, life insurance and non-life insurance obligations should be defined in the same way as that set out in subsection V.2.1 on segmentation Output SCRop = Capital requirement for operational risk Calculation The capital requirement for operational risk is determined as follows:

Where, { }

Op = Basic operational risk charge for all business other than life insurance where the investment risk is borne by the policyholders is determined as follows: Where,

( ( ))

and:

Single Premiums within a Life Insurance company

Insurers offering single premium business must determine earned premiums based on their internal data and history.

Insurers are required to disclose the how this was determined in the QRTs to the Regulator.

provisionspremiums OpOpOp ;max

lifenonullifelifeprovisions TPTPTPOp ,0max03.0,0max0045.0

(v 5) SCR Standard Formula: Operational Risk - FSCA

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