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Discussion Paper

RISK BASED CAPITAL FRAMEWORK FOR GENERAL INSURERS IN SINGAPORE

RBC General Insurance Workgroup

20 December 2002

20 December 2002 2

Discussion Paper RBC FRAMEWORK FOR

GENERAL INSURERS IN SINGAPORE

Table of Contents

1 EXECUTIVE SUMMARY .............................................................................................5

2 INTRODUCTION............................................................................................................9

2.1 REASON FOR THE REVIEW...........................................................................................9 2.2 SHORTCOMINGS OF THE CURRENT FRAMEWORK ......................................................10

2.2.1 Solvency Requirement......................................................................................10 2.2.2 Asset Valuation ................................................................................................10

2.3 THE PROPOSED FRAMEWORK....................................................................................10 2.3.1 Proposed Risk-based Capital Framework.......................................................10 2.3.2 Proposed Asset Valuation Framework ............................................................11 2.3.3 Objectives of Proposed Framework.................................................................11 2.3.4 Principles of Proposed Framework .................................................................12

3 FUND SOLVENCY REQUIREMENT........................................................................13

3.1 GC1 – LIABILITY RISK COMPONENT ........................................................................14 3.1.1 Approach used in setting GC1 Risk Charges...................................................14 3.1.2 Qualitative Analysis – Grouping of the Lines of Business...............................14 3.1.3 Quantitative Analysis of Claims Liability........................................................16 3.1.4 Qualitative Analysis of Premium Liability.......................................................18 3.1.5 Proposed GC1 Risk Charges ...........................................................................18 3.1.6 Conversion Methodology .................................................................................19 3.1.7 Other Considerations.......................................................................................20

3.2 GC2 – MARKET AND CREDIT RISKS COMPONENT ....................................................20 3.2.1 Equity ...............................................................................................................21 3.2.2 Property ...........................................................................................................21 3.2.3 Interest-bearing Asset ......................................................................................21 3.2.4 Foreign Currency.............................................................................................22 3.2.5 Derivatives .......................................................................................................23 3.2.6 Outstanding Premiums.....................................................................................24 3.2.7 Loans and Other Assets ...................................................................................24 3.2.8 Effect on Liability Value ..................................................................................25

3.3 GC3 - CONCENTRATION RISK COMPONENT..............................................................26 3.3.1 Asset Concentration Risks................................................................................26 3.3.2 Liability Concentration Risks ..........................................................................27

4 CAPITAL ADEQUACY REQUIREMENT................................................................28

4.1 REQUIRED CAPITAL ..................................................................................................28 4.2 AVAILABLE CAPITAL ................................................................................................28 4.3 DEFINITION ...............................................................................................................29

4.3.1 Tier 1 – Core Capital.......................................................................................29 4.3.2 Tier 1 Limitations and Restrictions .................................................................29 4.3.3 Tier 2 – Supplementary Capital.......................................................................30 4.3.4 Tier 2 Limitations and Restrictions .................................................................30

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4.4 CAPITAL ADEQUACY REQUIREMENT (CAR) RATIO .................................................31

5 VALUATION OF ASSETS...........................................................................................32

5.1 ALIGNMENT WITH RBC LIFE ....................................................................................32 5.2 OVERVIEW ................................................................................................................32 5.3 FINANCIAL INSTRUMENTS .........................................................................................32 5.4 PROPERTY .................................................................................................................33 5.5 PLANT AND EQUIPMENT............................................................................................34

6 NEXT STEPS .................................................................................................................35

6.1 TESTING AND FINE-TUNING ......................................................................................35 6.2 OUTSTANDING ISSUES...............................................................................................35 6.3 SCOPE AND MODE OF INDUSTRY DISCUSSION...........................................................35

7 RELIANCES AND LIMITATIONS............................................................................37

8 REFERENCES...............................................................................................................38

9 ANNEX 1: JOINT WORKGROUP ON RISK-BASED CAPITAL FRAMEWORK DEVELOPMENT FOR GENERAL INSURERS...............................................................39

10 ANNEX 2: MAS 202 DATA ANALYSIS.................................................................41

10.1 INTRODUCTION .........................................................................................................41 10.2 DATA ........................................................................................................................41 10.3 METHODOLOGY ........................................................................................................43

10.3.1 Thomas Mack Method......................................................................................43 10.3.2 Bootstrap Method.............................................................................................44

10.4 RESULTS ...................................................................................................................46 10.5 SUMMARY.................................................................................................................47

11 ANNEX 3: MAJOR SOURCES OF RISK ..............................................................50

11.1 LIABILITY RISK.........................................................................................................50 11.2 ASSET RISK...............................................................................................................51

11.2.1 Credit Risk .......................................................................................................51 11.2.2 Market Risk ......................................................................................................52 11.2.3 Asset Concentration Risk .................................................................................52

11.3 MISMATCHING RISK..................................................................................................52 11.4 OPERATIONAL RISK ..................................................................................................53

12 ANNEX 4: RISK CHARGES FOR EQUITY .........................................................54

12.1 AFFECTED INSTRUMENTS..........................................................................................54 12.2 CALCULATION OF POSITIONS ....................................................................................55 12.3 CALCULATION OF RISK CHARGES .............................................................................55 12.4 NETTING ...................................................................................................................56

13 ANNEX 5: RISK CHARGES FOR INTEREST-BEARING ASSET...................57

13.1 AFFECTED INSTRUMENTS..........................................................................................57 13.2 METHODOLOGY ........................................................................................................57 13.3 INTEREST RATE DERIVATIVES ..................................................................................61 13.4 NETTING ...................................................................................................................62 13.5 SUMMARY OF TREATMENT OF INTEREST RATE DERIVATIVES...................................62

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14 ANNEX 6: RISK CHARGES FOR FOREIGN CURRENCY – GENERAL RISK REQUIREMENT...................................................................................................................64

15 ANNEX 7: TREATMENT OF OPTIONS...............................................................65

16 ANNEX 8: TREATMENT OF OUTSTANDING PREMIUMS............................67

16.1 AFFECTED INSTRUMENTS ..........................................................................................67

17 ANNEX 9: TREATMENT OF LOANS AND OTHER ASSETS..........................68

17.1 AFFECTED INSTRUMENTS ..........................................................................................68

18 ANNEX 10: COUNTER – PARTY RISK REQUIREMENT FOR DERIVATIVES......................................................................................................................70

18.1 AFFECTED INSTRUMENTS..........................................................................................70 18.2 CREDIT EQUIVALENT AMOUNT.................................................................................70 18.3 NETTING ...................................................................................................................71

19 ANNEX 11: RISK CHARGE FOR CONCENTRATION .....................................72

20 ANNEX 12: COMPARISON ON RISK CLASSIFICATION OF LINES OF BUSINESS ..............................................................................................................................73

21 ANNEX 13: WORKED EXAMPLES ......................................................................74

21.1 AVAILABLE ASSETS ..................................................................................................74 21.2 GC1 – LIABILITY RISK COMPONENT ........................................................................74 21.3 GC2 – MARKET AND CREDIT RISKS COMPONENT ....................................................76

21.3.1 Land and Buildings..........................................................................................76 21.3.2 Equities ............................................................................................................77 21.3.3 Interest Bearing Securities...............................................................................77 21.3.4 Loans................................................................................................................77 21.3.5 Cash and Deposits ...........................................................................................78 21.3.6 Reinsurance Receivables .................................................................................78 21.3.7 Outstanding Premiums and Agents’ Balance ..................................................79 21.3.8 All Other Assets................................................................................................79

21.4 GC3 – CONCENTRATION RISK COMPONENT .............................................................80 21.5 SUMMARY.................................................................................................................80

RBC Framework for General Insurers in Singapore – Discussion Paper

20 December 2002 5

1 EXECUTIVE SUMMARY

The Risk-based Capital Workgroup for general insurance business was

formed in April 2002 to review the asset valuation and solvency requirements

of general insurance business in Singapore. The purpose of this paper is to

set out the workgroup’s considerations in its review and to outline the

proposed framework for industry discussion.

General insurance companies are facing mounting complexities, in particular,

the increased volatility of asset risks and diversity of liability risks. Many of

such risks are not explicitly addressed in our current fund solvency margin

requirement, which is expressed as a function of net written premiums and

outstanding claims reserves for the year. The proposed risk-based capital

framework intends to address asset risks that are not reflected in the existing

framework, in addition to refining the allowance for liability and concentration

risks. It would also help to align prudential requirements for general insurance

with the global trend of adopting risk-adjusted capital requirements and

transparent valuation method. Further, the new capital requirements should

serve as an effective early warning indicator of financial strength and facilitate

progressive intervention by insurance companies and regulators.

The proposed risk-based capital framework is based on several principles,

which are summarized here. First, the framework should be risk-based, that

is, it reflects all relevant risks faced by the general insurance business.

Second, the capital adequacy requirements should be consistent with the

asset and liability valuation basis for capital to serve as an effective buffer to

absorb fluctuations in asset and liability values. Third, the requirements for

general insurers should, as far as possible, be consistent with that of other

financial institutions, such as life insurers and banks, so as to create a level

playing field and minimize capital arbitrage in an increasingly integrated

financial landscape. Fourth, the framework should be transparent, not unduly

complex, and enable comparability across companies. For this purpose, it is


20 December 2002 6

proposed that the standardized approach using deterministic risk charges be

adopted.

The proposed framework consists of two requirements - the fund solvency

requirement (FSR), applicable to each insurance fund; and the capital

adequacy requirement (CAR), applicable on the company level.

Fund Solvency Requirement

Each insurance fund must have Available Asset (AA) greater than its

Required Fund Solvency (RFS). Available Asset of an insurance fund is

defined as the difference between total assets and total liabilities, namely

shareholders' equity, less ineligible assets such as goodwill and other

intangibles.

Required Fund Solvency (RFS) takes into account liability, asset and

concentration risks, and can be grouped into the following three components:

Component 1 – “Liability Risk Component”

This component takes into account risk factors affecting policy liabilities

of each line of business to reflect the volatility of outstanding claims

and unexpired risks. Risk charges are derived based on a combination

of statistical analysis of historical claims experience and study of the

characteristics and risk profiles of major lines of business. The

workgroup acknowledges that the risk charges may not be entirely

relevant to offshore risks and risks underwritten by reinsurers as the

characteristics of such risks were not taken into account in our

analysis.

Component 2 – “Market and Credit Risks Component”

This component incorporates the risks that arise from changes in the

value of assets and liabilities due to changes in economic factors, as

well as credit risk of assets. These are captured by imposing specific


20 December 2002 7

and general risk charges for equity, property, interest rate and foreign

currency exposures. In developing these factors, reference was made

to the proposed risk-based capital framework for life insurers.

Component 3 – “Concentration Risk Component”

This reflects the additional risk of high concentration of investments in

a particular asset class, or with a particular obligator. In addition, due

regard should also be given to concentration risks arising out of natural

catastrophes or economic recessions.

Capital Adequacy Requirement

To meet the Capital Adequacy Requirement in our proposed framework,

general insurers must maintain a ratio of Available Capital to Required Capital

(CAR Ratio) above a stated minimum. The Required Capital for the insurer is

the summation of the Required Fund Solvency for all insurance funds and

asset risk charges of shareholders’ fund. The Available Capital includes

Available Assets of insurance funds and shareholders’ fund, comprising two

tiers depending on the quality of support provided by the various types of

capital instruments - Tier 1 Core Capital and Tier 2 Supplementary Capital.

Asset Valuation

The workgroup also proposed to adopt a realistic asset valuation basis for

general insurance funds. This will help to improve the level of transparency in

financial reporting of general insurance business.


20 December 2002 8

As the requirements of the proposed framework is fundamentally different

from the existing requirement, its impact on financial positions of general

insurance funds and companies is not directly obvious yet. It is envisaged that

companies with more volatile policy liabilities and higher asset risk exposures

will be more negatively affected.

With explicit charges on liability, asset and concentration risks based on a

more integrated approach, the workgroup believes that the proposed

requirements would provide a much better reflection of the insurer's

underlying risks. It is anticipated that this will further promote a higher and

more stringent level of asset and liability risk management amongst general

insurers, both in the process of underwriting new risks as well as the

continuous monitoring of their existing portfolios.

To further fine-tune this framework, the workgroup intends to work closely with

the industry to study various outstanding issues. The workgroup will conduct

thorough testing of the proposed framework and thereafter, make appropriate

modifications where necessary.


20 December 2002 9

2 INTRODUCTION

The Risk-based Capital Workgroup for general insurance business was

formed in April 2002 to review the valuation of and solvency requirements for

general insurance business in Singapore. The workgroup comprises

representatives from the Singapore Actuarial Society (SAS), General

Insurance Association of Singapore (GIA), Singapore Reinsurers Association,

Institute of Certified Public Accountants of Singapore (ICPAS) and Monetary

Authority of Singapore. Annex 1 shows a list of the members of the workgroup

and its terms of reference.

The purpose of this discussion paper is to set out the considerations that the

workgroup has made in the review thus far and to outline the proposed

framework for valuation and capital adequacy requirements of general

insurance business. In formulating the proposed framework for the Singapore

general insurance market, the workgroup has evaluated approaches adopted

in several countries, namely the UK, US, Canada and Australia.

The workgroup would like to seek feedback from the industry and intends to

work closely with the industry in the testing and further fine-tuning of the

proposed framework.

2.1 Reason for the Review

With the increasing complexities facing general insurance companies, in

particular, the increased volatility of asset risks and diversity in liability risks,

the current valuation and solvency requirements have shown signs of

inadequacy in coping with these challenges. For the general insurance

industry to remain competitive in this new environment, it is important that a

new valuation and capital adequacy requirement framework be put in place.

The review would also help to align prudential requirements for general

insurance with the global trend of adopting transparent valuation method

using "fair value" basis and risk-sensitive capital requirements.


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2.2 Shortcomings of the Current Framework

2.2.1 Solvency Requirement

The current solvency margin framework defines solvency margin as a

percentage of net written premiums or outstanding claims reserves. It

imposes asset concentration risk charge via asset admissibility rules. It has

the advantage of simplicity in implementation and calculation and leaves little

room for ambiguity and error.

However, it does not adequately reflect the relative volatility of different lines

and classes of general insurance business and does not take into account

market and credit risks of the assets.

2.2.2 Asset Valuation

The current asset valuation method of using the lower of book or market value

has the advantage of producing relatively stable results over time and not

being overly exposed to fluctuations in market value.

On the other hand, this valuation method gives rise to the accumulation of

hidden margins which could distort the 'true' or 'fair' values of the assets, and

in turn, the 'true' solvency position of the fund. Such distortion gives rise to

ambiguity in the interpretation of the financial condition of the insurer.

2.3 The Proposed Framework

2.3.1 Proposed Risk-based Capital Framework

The proposed framework consists of two requirements – the fund solvency

requirement (FSR) applicable to each insurance fund; and the capital

adequacy requirement (CAR), applicable on a company level.


20 December 2002 11

To meet the FSR, each fund must ensure that the Available Asset (AA) of the

fund is sufficient to cover the Required Fund Solvency (RFS). Details of the

FSR are given in section 3.

To meet the CAR, the company must maintain a CAR ratio above a stated

minimum. The CAR ratio is derived from the ratio of the company’s Available

Capital to the Total Required Capital. The Total Required Capital is the sum of

RFS from all the funds including the shareholders’ fund. Details of the CAR

are given in section 4.

2.3.2 Proposed Asset Valuation Framework

The proposed asset valuation framework will be aligned with the Singapore

Accounting Standards. Briefly, the new standard will be using a ‘fair value’

approach to reflect the realistic value of the assets. The accounting treatment

for various categories of assets is given in Section 5. The main changes are:

(a) Move from Lower of Book or Market to Fair Value

(b) The asset inadmissibility rules will be removed for the purpose of asset

valuation under the RBC regime

2.3.3 Objectives of Proposed Framework

The workgroup has identified the following primary objectives from which the

framework should be developed:

Solvency Requirement

• As a protective cushion against risks of mis-estimation and unexpected

events.

• As an indicator of financial strength and a trigger to facilitate

progressive intervention by insurance companies and regulators

• As an incentive to encourage prudent risk management.


20 December 2002 12

Valuation

• To move towards a more transparent and fair value reporting of profits.

• To reduce the differences between company’s account and statutory

returns.

2.3.4 Principles of Proposed Framework

The proposed Risk Based Capital framework encompasses the following

principles in its formulation:

• Reflective of the relevant risks faced by the general insurance

business.

• Consistent with asset and liability valuation basis so that the capital can

serve as an effective buffer to absorb fluctuations in the asset and

liability values.

• Ensure consistency with other financial institutions, such as banks and

life insurers, so as to create a level playing field and minimize capital

arbitrage in an increasingly integrated financial landscape.

• Transparent, not unduly complex and enable comparability across

companies.


20 December 2002 13

3 FUND SOLVENCY REQUIREMENT

Risk pooling and risk bearing are at the core of insurance business. To

develop a set of risk-based capital requirements, it is necessary to identify the

major sources of risk to which general insurance businesses are exposed.

These are discussed in Annex 3. Briefly, the main risks faced by the general

insurers are under-estimation of the liability, adverse claims experience,

diminution of asset values due to defaults and market fluctuations, and risk

associated with a deficient operation. The proposed capital framework intends

to address most of these risks.

Under this proposed Fund Solvency Requirement (FSR), each insurance fund

is required to maintain Available Asset (AA) in the fund in excess of the

Required Fund Solvency (RFS). The AA of an insurance fund is defined as

the difference between total assets and total liability, namely shareholders'

equity, less ineligible assets such as goodwill and intangibles.

This chapter focuses on describing the RFS. RFS takes into account three

major sources of risk – liability risk, asset risk and concentration risk. No

explicit charges are recommended for operational risk as it is envisaged that

operational risks can be better dealt with by the company’s internal risk

management systems and supervisory effort.

For ease of calculations and simplicity in presentation, the workgroup

proposes that the RFS of a statutory fund in Singapore be grouped into the

following three components:

a) Component 1 (GC1) – Liability Risk Component;

b) Component 2 (GC2) – Market and Credit Risks Component; and

c) Component 3 (GC3) – Concentration Risk Component.

With this framework, the sum total of GC1, GC2, and GC3 of each general

insurance fund represents the fund’s total risk charges, or its RFS.


20 December 2002 14

RFS = GC1 + GC2 + GC3

3.1 GC1 – Liability Risk Component

GC1 takes into account the risk of under-estimation of the policy liability and

an adverse claims experience, creating a buffer on top of the policy liability.

The charges will apply to both the claims liability and the premium liability

components of the policy liability and are expressed as a percentage on these

components with different quantum for different classes of business.

The total risk charge for GC1 is as follows:

x% Claims Liabilities (CL) + y% Premium Liabilities (PL)

For consistency, the CL and PL (higher of URR (Unexpired Risk Reserve) or

UPR (Unearned Premium Reserve)) are taken from the policy liabilities that

have been certified by an Approved Actuary in accordance with the guidelines

under MAS210. The factors x and y varies with the class of general insurance

business. In addition, the factors are applied on the 75th percentile of CL and

PL net of diversification discount to allow for the effect of diversification arising

from writing diversified lines of business.

3.1.1 Approach used in setting GC1 Risk Charges

To derive the risk charges on CL, the workgroup studied the volatility of

outstanding claims reserve qualitatively and quantitatively. The qualitative

analysis enables grouping of various lines of business into categories with

similar characteristics, and the quantitative analysis assists in the

determination of the quantum of the risk charges. Details of the process are

described below.

3.1.2 Qualitative Analysis – Grouping of the Lines of Business

For the purpose of deriving the risk charges on CL, different lines of business

are grouped into 3 categories according to their volatility in terms of the

outstanding claims – Low Volatility, Medium Volatility or High Volatility. Given


20 December 2002 15

the difficulty in establishing the exact volatility for each line of business, this

categorization exercise seeks only to establish the relative volatility between

lines of business such that the volatility of those lines of business in the same

category are broadly similar.

To distinguish more clearly the difference in volatility between different lines of

general insurance business, the workgroup has proposed a further breakdown

of the lines of business defined in current statutory reporting requirement.

The following table summarizes the proposed groupings of the lines of

business.

New Classification of Volatility Category SIF Lines of Business

Personal Accident (includes Travel) Fire – Residential Low Health – Daily Cash Fire - Non-residential Marine & Aviation – Cargo Motor - Property Damages Workmen's Compensation Bonds Medium Engineering CAR/EAR Credit/Political Risk Health – Others Others – Non-liability Classes Marine & Aviation - Hull & Liability Motor – Bodily Injury High Professional Indemnity Others - Liability Classes

The broad characteristics of the three categories are as follows:

Low - Broadly consists of personal lines business with stable claim

experience. Personal lines with fixed benefits such as personal

accident, and health insurance that provides fixed income during

hospitalization would fall under this category. Residential fire

business is also included in this category as the sum assured

per policy is relatively small.


20 December 2002 16

High - Broadly consists of liability insurance business with

unpredictable and volatile claim experience. These lines also

tend to be exposed to super-imposed inflation and fluctuations

arising from court decisions and judicial awards. Motor (bodily

injury), professional indemnity, marine and aviation hull and any

other liability classes of business are hence grouped in this

category.

Medium - Broadly consists of most of the commercial lines and personal

lines with volatile claim experience. These lines of business are,

however, not subjected to the same level of super-imposed

inflation as the High Category.

From a risk-based perspective, a line of business with higher volatility is

riskier and therefore should attract a higher risk charge compared to one with

lower volatility. This concept will be reflected in the proposed risk charges.

Annex 12 compares the categorization of the various lines of business with

that used by other jurisdictions.

3.1.3 Quantitative Analysis of Claims Liability

Data analysis was carried out on the experience of domestic risks to assess

the quantum of risk charges for CL. We relied on information provided in year-

end 2001 MAS 202 submission of all Singapore Insurance Fund direct

insurance business. We did not perform detailed data verification but have

excluded results from some portfolios in forming our overall assessment.

In our analysis, two statistical methods were employed – the Thomas Mack

method and the Bootstrap method. Results from Bootstrap method (based on

1000 simulation runs) were finally selected using incurred claims data, as they

provide a more stable and reliable description of claims distribution at 95% to

99% confidence intervals.


20 December 2002 17

The table below ranks the volatility of outstanding claims reserves by classes

of business. It also shows the ratios of the outstanding claims reserves

estimates at various levels of sufficiency between 95 to 99 percent, to the

outstanding claims reserves estimates at the 75 percent level of sufficiency.

All results presented in the following table are based on data from portfolios

with outstanding claims of more than S$2 million:

Confidence Level Class of Business 95%/75% 97.5%/75% 99%/75%

Workmen’s Compensation 118% 126% 135% Motor 119% 126% 132% Fire 123% 132% 140% Miscellaneous 133% 146% 158% Cargo 137% 151% 166% Hull 149% 207% 288%

We have limited data on fire, cargo and hull classes as the portfolios from

these classes tend to be small, with very few exceeding the minimum size of

$2 million. Therefore the derived results for these classes may not be

statistically significant. For miscellaneous class, the mix of business varies

significantly between companies and the derived volatility may not be

representative of any single homogeneous portfolio.

Results for motor and workmen's compensation are more statistically

significant, representing substantially larger number of portfolios in Singapore.

The analysis implies that appropriate risk charges for these classes should

range between 20% and 30%. As these classes fall broadly under the

medium risk level category, we propose a risk charge of 25% to be used for

the medium risk category. In the absence of more reliable information, we

propose risk charges of 20% and 30% to be used for the low risk and high risk

categories respectively, to reflect their relative volatility over the medium risk

category. We recommend that further analysis on this to be conducted when

more reliable information is available in the future.

Please see Annex 2 for further details on the data analysis.


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3.1.4 Qualitative Analysis of Premium Liability

Conceptually, premium liability (PL) should be more volatile than the

outstanding claim reserve as it is in respect of future event as opposed to the

outstanding claims reserve which is in respect of events that have already

occurred. Therefore, the risk charges on PL should be higher than the risk

charges for the CL of the corresponding line of business. In addition, the risk

charges should be imposed on unexpired risk reserve (URR) rather than

unearned premium reserve (UPR) as it represents the liability required to

cover future cashflow.

We have not been able to perform detailed analysis in setting the risk charges

for URR, as there is limited information available on claims frequency and

historical profitability by line of business. As such, we propose a broad-brush

factor of 20% to represent the additional risk of URR, such that the risk charge

on URR for each line of business will be 120% of the corresponding risk

charge on CL.

3.1.5 Proposed GC1 Risk Charges

Our proposed GC1 risk charges comprising CL risk charge and PL risk charge

can be summarised in the table below:

New Classification of GC1 Risk Charges

SIF Lines of Business

CL Factor URR Factor

(x%) (y%)

Personal Accident (includes Travel) 20% 24% Fire – Residential 20% 24% Health – Daily Cash 20% 24% Fire Non-residential 25% 30% Marine & Aviation – Cargo 25% 30% Motor - Property Damages 25% 30% Workmen's Compensation 25% 30% Bonds 25% 30% Engineering CAR/EAR 25% 30% Credit/Political Risk 25% 30% Health – Others 25% 30% Others – Non-liability Classes 25% 30% Marine & Aviation – Hull & Liability 30% 36%


20 December 2002 19

Motor – Bodily Injury 30% 36% Professional Indemnity 30% 36% Others - Liability Classes 30% 36%

The current valuation standard for premium liabilities (PL) requires the higher

of URR and UPR to be used. The difference between PL and URR will

represent an implicit buffer in the premium liability. This buffer should be

allowed to meet the PL risk charges, such that GC1 charge on PL should be

GC1 charge on PL = (1+ URR Factor) x URR - PL

Recognising the risk of under-estimating URR, we propose a minimum

condition of 5% of UPR, tentatively, to be imposed, such that

GC1 charge on PL = Max [ (1 + URR Factor) x URR – PL , 5% x UPR ]

3.1.6 Conversion Methodology

For companies that cannot provide the breakdown of policy liability into the

new business line classification above, a conversion factor will be applied to

derive the risk charge for the broader classification (the minimum combination

of lines must be at least similar to the Form 7 classification). The risk charge

will then be based on the weighted average of the risk charge factors given in

the table above. The conversion factor for the broad classification can be

derived as follows:

Form 7 Classification Conversion Methodology Fire Based on insurer’s own proportion of commercial and residential

net written premium Miscellaneous Based on insurer’s own proportion of net written premium for each

line of business Motor A fixed conversion factor of 50% Motor Damage and 50% Motor

Injury will be used.

It is envisaged that the conversions will no longer be needed once the RBC

Framework is formally adopted as the workgroup recommends that insurers

file their statutory returns according to the new lines of business classification.


20 December 2002 20

3.1.7 Other Considerations

3.1.7.1 Reinsurance

MAS202 data on reinsurance companies and inward reinsurance are not

sufficiently homogeneous for proper analysis to be carried out. The workgroup

recognizes that reinsurance business, especially excess of loss arrangements

at the higher layers, is likely to be more volatile than direct business. It may,

however, benefit from greater diversification that leads to reduced volatility. In

the absence of more concrete evidence and information, the workgroup’s

tentative proposal is to use the same factors for reinsurance business. The

workgroup recommends specific analysis on these classes to be conducted

when more information is available. Feedback from reinsurers is welcomed.

3.1.7.2 Other lines of business

There may be specialized lines of business that companies write but may not

have been considered by the workgroup at the time this recommendation is

made. Therefore, we would recommend that company should attempt to

classify these business based on the highlighted characteristics as defined in

section 3.1.2. We welcome feedback from companies on this issue.

3.1.7.3 Periodic Review of the Risk Charges

Finally, the workgroup recognizes that this set of risk charges may not

represent the volatility of each class of business accurately due to data

limitations and the ever-changing risk environment of the general insurance

business. Therefore, it is our recommendation and wish that the charges will

be reviewed periodically to assess their appropriateness for future usage.

3.2 GC2 – Market and Credit Risks Component

This component includes market and credit risks as discussed in Annex 3. It

does not include asset concentration risk, which is covered in GC3, and thus

is not applicable to inadmissible assets as defined in GC3.


20 December 2002 21

In establishing the risk charges for market risk and credit risk for each asset

class, reference is made to the proposed framework for life insurers.

3.2.1 Equity

Affected Instruments: Equity shares, venture capital and private equity

investment, and all instruments that exhibit market behaviour similar to

equities (but not to non-convertible preference shares which are covered by

interest rate risk requirements)

Equity risk charge is the sum of specific risk requirement and general risk

requirement where:

• Specific risk requirement is 8% of gross equity positions (sum of all long

equity positions and all short equity positions); and

• General risk requirement is 8% of overall net equity position (difference

between the sum of the longs and the sum of the shorts).

For more details, please refer to Annex 4.

3.2.2 Property

Affected Instruments: Land and buildings.

Similar to equity risk charge, property risk charge is the sum of specific risk

requirement and general risk requirement where:

• Specific risk requirement is 8% of property exposure; and

• General risk requirement is 8% of property exposure.

3.2.3 Interest-bearing Asset

Affected Instruments: Fixed-rate and floating-rate debt securities and other

interest rate related instruments including government/public authority

securities, other securities of companies (quoted and unquoted bonds and

bills of exchange) and instruments that behave like them for example, non-

convertible preference shares.


20 December 2002 22

The risk charge is the sum of:

• Specific risk requirement, applicable to both short or long position; and

• General risk requirement, where long and short positions in different

securities or instruments may be offset.

Specific risk requirement

The specific risk requirement is applied to each debt security and is calculated

by applying a specific risk factor on the sum of individual net debt position at

market value, depending on the credit-worthiness of the issuer and residual

time to maturity.

General risk requirement

The general risk requirement measures the risk arising from changes in the

market rate and is determined by assuming that the yields for all interest rate

instruments affected rise or fall by 60 to 100 basis points (subjected to a

minimum yield of 0%), depending on the residual term to final maturity.

The methodology to compute the interest rate risk charge is described in

Annex 5.

3.2.4 Foreign Currency

Affected Instruments: Foreign currency denominated assets and currency

derivatives.

The prescribed market movement for the foreign exchange market assumes

that the exchange rate of Singapore Dollar against a foreign currency

appreciates or depreciates by 8%. The risk charges apply to the net foreign

currency exposure taking into account both assets and liabilities denominated

in foreign currencies.

Please refer to Annex 6 for the methodology in determining the risk charge for

foreign exchange.


20 December 2002 23

3.2.5 Derivatives

Affected Instruments: Equity derivatives, interest rate derivatives, currency

derivatives, credit derivatives and instruments with embedded derivatives

including convertible preference shares and convertible debt securities.

Insurers may use derivatives for hedging or efficient portfolio management as

set out in MAS Notice 104 on Investment of Singapore Insurance Fund

Assets.

Netting

Where the use of derivatives reduces investment risk, capital relief will be

granted appropriately by applying capital charges to the net basis. Matched

positions in each identical equity or stock index in each market may be fully

offset, resulting in a net long or short position to which the risk factors will

apply. Likewise, insurers may offset debt positions against long or short

positions in the underlying debt security if these positions are in the same

actual debt security of identical issuer, coupon, currency and maturity.

Risk Exposure to Underlying Asset

If additional risk exposure is taken on with the use of derivatives, risk charges

which commensurate with the underlying exposure should apply. The

derivatives are converted into positions of the relevant underlying asset and

subject to both specific and general risk requirements. For example, equity

derivatives (except for options, which are dealt with in Annex 7) affected by

changes in equity prices are subject to equity risk charges.

Counter-party Risk

In the use of derivatives, the insurer further assumes a separate risk of default

of the counter-party to the transaction. This counter-party risk attracts an

additional capital charge. Please refer to Annex 10 for determining the

counter-party risk charge.


20 December 2002 24

3.2.6 Outstanding Premiums

Affected Instruments: Outstanding premiums, agents’ balances.

Only the specific risk requirement is applicable.


The risk charges for outstanding premiums are as follows:

• 8% on premiums outstanding for 90 days or less

• 50% on premiums outstanding for more than 90 days

The specific risk requirement is consistent with the Insurance (Amendment

No.2) Regulations. The Regulations require direct general insurance brokers

to pay to each insurer any amount received under or in relation to insurance

contracts, within the period agreed between the broker and insurer, or 90

days from date of commencement of cover, whichever is earlier.

For premiums outstanding due from recognized financial institutions, the

charges will follow that of receivables from these financial institutions. For

example, reinsurers may have outstanding premiums from insurers, the risk

charge on these outstanding premiums for reinsurers will be lower depending

on the credit rating of their clients.

More information is available in Annex 8 and Annex 9.

3.2.7 Loans and Other Assets

Affected Instruments: Loans (including loans to policyholders), cash and cash

deposits, cash items in process of collection, e.g. reinsurance receivable from

an insurer, other receivables from financial and non-financial institutions and

individuals, and other assets, e.g. furniture and fixture, plant and equipment,

etc.


20 December 2002 25

The risk charge is the sum of specific risk requirement and general risk

requirement where:

• Specific risk requirement is applied to each affected asset.

• General risk requirement is required for assets that are exposed to

interest rate fluctuations. The requirement is the same as that for

interest bearing assets.


The specific risk requirement is the product of the specific risk factor for the

affected asset and the fair value of the asset. Please refer to Annex 9 for

details on the specific risk factor.


SAS 33 requires loans to be recorded at their amortised cost and the value of

a loan asset is independent of interest rate movements. Therefore, for the

purpose of determining the general risk requirement only, the loan portfolio

with fixed interest is subjected to general risk requirement that is similar to

that for interest-bearing assets to allow for a corresponding movement in

asset value due to interest rate movements. Non-interest bearing assets in

this category are not subjected to general risk requirements.

3.2.8 Effect on Liability Value

Interest Rate Risk

The current valuation standard of policy liabilities allows for discounting,

hence the value of these liabilities can be sensitive to interest rate changes.

Changes in interest rates would have some impact on the policy liabilities in

the same way (but not the same magnitude) as their impact on interest

bearing assets. Some offsetting should therefore be allowed due to

movements in interest rates, though the impact is likely to be immaterial for

most general insurance operations.


20 December 2002 26

3.3 GC3 - Concentration Risk Component

Inadmissible asset risk charges are imposed for asset concentration risks. As

inadmissibility has the same effect as 100% risk charge, assets that attract

capital charges under GC3 are not subject to market and credit risk charges

under GC2.

3.3.1 Asset Concentration Risks

The move towards the risk-based capital framework provides an opportune

time to review the existing investment limits. Given that the proposed fund

solvency requirements should reflect asset risk, there is room to relax some of

the existing investment limits. At the same time, it is proposed that certain

investment limits be tightened in recognition of the additional risk of high

concentration of investments in these asset classes and sectors. Assets that

exceed the investment limits will be deemed inadmissible assets and subject

to a 100% risk charge.

Asset concentration risk may be mitigated by two sets of limits, expressed as

a percentage of the total insurance fund assets.

• Asset class or sectoral concentration limit; and

• Counter-party limit for asset class.

The counter-party limits for asset classes apply in addition to the counter-

party exposure limits set out in Insurance Regulation 18A as summarised

below.

Counter-party Investment Limit Percent of Total Assets

Approved financial institution or group of approved financial institutions related to one another

20%

Company listed on any stock exchange or group of companies related to one another

10%

Unlisted company or group of unlisted companies related to one another, a merchant bank or a finance company, and all other cases

5%

Equity investment in a single counter 2.5% Unsecured Loans in any one company or group 1%


20 December 2002 27

Please refer to Annex 11 for details of proposed investment limits.

3.3.2 Liability Concentration Risks

General insurers can also be exposed to concentration risks arising out of

natural catastrophes - such as earthquakes, windstorm and floods - or

economic recessions. The workgroup has not attempted to calculate a

charge for the risk, but instead expects insurers to take into consideration

such potential risks in the context of their risk management program.


20 December 2002 28

4 CAPITAL ADEQUACY REQUIREMENT

In addition to surpluses in insurance funds, shareholders' capital is also

available to absorb risks of insurance business. The workgroup proposed a

capital adequacy requirement at the company level, which takes into account

the total risks of insurance funds, and shareholders' fund vis-à-vis the total

available capital in all funds. This measure would serve as an indicator of the

overall financial strength of the company.

4.1 Required Capital

The required capital for the insurer is the sum of the fund solvency

requirements of all the insurance funds, and risk charges of the shareholders'

fund. The risk charges applicable to shareholders’ assets are derived in the

same way as the charges on insurance funds' assets, as described in Section

3 above.

Required capital = ∑funds

FSR + Shareholders' fund risk charges

4.2 Available Capital

In defining the available capital for purposes of measuring capital adequacy,

the quality of support provided by the various types of capital instruments

must be considered. Considerations include the extent to which each capital

instrument:

1. provides a permanent and unrestricted commitment of funds;

2. is freely available to absorb losses from business activities;

3. is free from mandatory servicing charges against earnings; and

4. ranks behind the rights of policyholders and other creditors in the event

of insolvency of the insurer.

An insurer must hold eligible available capital in excess of its required capital.

Certain assets will be excluded from the calculation of available capital. The

ineligible assets classified in this category include:


20 December 2002 29

- Goodwill

- Amount due from shareholders

- Deferred tax assets

- Other intangibles

4.3 Definition

The available capital of an insurer comprises two tiers – Tier 1 Core Capital

and Tier 2 Supplementary Capital.

4.3.1 Tier 1 – Core Capital

Tier 1 capital comprises the highest quality capital elements that meet the

essential characteristics described above and includes:

a) Issued and fully-paid up ordinary shares/common stock;

b) General reserves;

c) Non-cumulative irredeemable preference shares;

d) Other capital instruments issued by the insurer;

e) Shareholders retained earnings in funds;

f) Current year’s earnings;

4.3.2 Tier 1 Limitations and Restrictions

1) An insurer is advised to consult MAS before issuing any capital instrument

to confirm eligibility of instrument for capital measurement purposes.

2) MAS’s approval is required if an insurer wishes to include instruments

covered in (c) and (d) as Tier 1 capital. This approval may be revoked in

relation to an instrument if MAS becomes aware that the instrument does

not meet the relevant criteria and becomes ineligible.

3) Aggregate amounts of instruments covered in (c) and (d) cannot exceed

15% of aggregate Tier 1 capital. Any amount ineligible for inclusion may

be eligible for inclusion as Tier 2A capital.


20 December 2002 30

4.3.3 Tier 2 – Supplementary Capital

Tier 2 capital is limited to a maximum of 100% of Tier 1 Capital.

Tier 2 capital comprises elements that fall short of the quality of Tier 1 capital,

but contributes to the overall strength of the insurer as a going concern. Tier 2

capital is sub-divided into Tier 2A and Tier 2B capital.

Tier 2A capital includes:

a) Cumulative irredeemable preference shares;

b) Mandatory convertible notes and similar capital instruments;

c) Perpetual subordinated debt; and

d) Any other hybrid (debt/equity) capital instrument of a permanent

nature;

e) Capital amounts that are ineligible for inclusion as Tier 1 capital as a

result of the 15% limit referred to in point 3 of Section 4.3.2.

Tier 2B capital includes:

a) Term subordinated debt;

b) Limited life redeemable preference shares; and

c) Any other similar limited life capital instrument.

4.3.4 Tier 2 Limitations and Restrictions

1) All capital instruments that an insurer wishes to include in Tier 2 capital will

require MAS’s approval. MAS may revoke its approval in relation to an

instrument if the instrument does not meet the relevant criteria.

2) Tier 2B capital is limited to 50% of eligible Tier 1 capital.

3) Capital instruments with a limited life must have an original maturity

greater than 5 years. These instruments are also subject to amortisation

over the last 5 years of their life according to the following schedule.


20 December 2002 31

Term to maturity Issued Amount Eligible for Inclusion in Tier 2 Capital

5 years or more 100% 4 to less than 5 years 80% 3 to less than 4 years 60% 2 to less than 3 years 40% 1 to less than 2 year 20% Less than 1 year 0%

4.4 Capital Adequacy Requirement (CAR) Ratio

The minimum CAR ratio for a general insurer is expressed as:

)%100(Capital RequiredCapital Available

y+≥

where y is tentatively set at 20.

This margin is imposed to address risks that have not been explicitly provided

for, such as operational risks and the high level of uncertainty involved in the

calculation of policy liability. In addition, it is anticipated that as part of the

supervisory action of the Authority, higher CAR ratios may be set for

companies with higher risk inherent in their operations


20 December 2002 32

5 VALUATION OF ASSETS

5.1 Alignment with RBC Life

The asset valuation standard will be similar to the standard recommended for

RBC Life. The new proposed asset valuation standard will be based on a fair

value approach to show the realistic value of the assets. With this new

standard, differences between company’s accounts and statutory returns, and

hence any hidden margins, caused by the use of book values will be

minimised.

SAS 33 generally requires companies to recognise all financial instruments on

the balance sheet. The asset inadmissibility rules will be removed for the

purpose of asset valuation under the RBC regime.

5.2 Overview

The Singapore Statement of Accounting Standards (SAS) 33, which is

adopted for asset valuation, establishes the principles for recognising and

measuring financial instruments of business enterprises. The SAS 33 was

approved by the Council of the Institute of Certified Public Accountants of

Singapore in July 2000 and is expected to be effective by 1 January 2004.

For valuation of certain types of investments, reference is also made to SAS

14 and SAS 25.

5.3 Financial Instruments

The workgroup propose that all financial instruments should be valued based

on realistic valuation basis – “fair value”. The situations in which fair value can

be reliably measured include:

§ A financial instrument for which there is a published price quotation in an

active public securities market;

§ A debt instrument that has been rated by an independent rating agency

and whose cash flows can be reasonably estimated; and


20 December 2002 33

§ A financial instrument for which there is an appropriate valuation model

with input data coming from active markets.

In circumstances where published quotations and active markets are not

present, estimation techniques may be used to determine the fair value

concerned. These estimation techniques include reference to the current

market value of another instrument that is substantially the same, 1discounted

cash flow analysis and option pricing models.

In light of these principles, the challenge lies in finding comparable quoted

bonds against which a fair value for 'substantially similar' unquoted bonds

could be derived, since the bond market in Singapore is relatively

undeveloped.

In all instances, the insurer must disclose the methods and significant

assumptions applied in the estimation of fair values.

5.4 Property

The workgroup feels that property investments in Insurance Fund should be

treated as investment property.

Under SAS 25, there are three allowed accounting treatments for investment

properties. A company holding investment properties should either:

• Treat them as property in accordance with SAS 14 and depreciate

them in accordance with that Standard; or

• Account for them as long-term investments, carrying them in the

balance sheet at cost; or

1 The insurer may use a discount rate that is equal to the prevailing rate of return for financial instruments having substantially the same terms and characteristics, including the creditworthiness of the debtor, the term-to-maturity of the instrument and the currency in which payments are to be made.


20 December 2002 34

• Account for them as long-term investments, carrying them in the

balance sheet at their open market values (revalued amounts2) and

recognising increases/decreases in their carrying amounts accordingly.

5.5 Plant and Equipment

Under the new framework, the accounting principles for the recognition and

measurement of plant and equipment will continue to be addressed under

SAS 14 (Revised).

Under SAS 14 (Revised), companies are generally required to recognise

property, plant and equipment in the balance sheet when:

• It is probable that future economic benefits associated with an asset

will flow to the enterprise; and

§ The cost of an asset to the enterprise can be reliably measured.

Subsequent to initial recognition, the benchmark treatment for valuation would

be an asset's cost less any accumulated depreciation, subject to a regular

assessment of its final recoverable amount.

An alternative treatment, however, would be to carry an asset at its fair value,

less any subsequent accumulated depreciation. In this instance, revaluation

should be undertaken with sufficient regularity and on a consistent basis, such

that the carrying amount does not differ materially from the fair value of the

asset at the balance sheet date. Under the Standard, revaluation every three

to five years may be sufficient.

2 Revaluation should be carried out on a regular and consistent basis and an entire category of long-term investments should be revalued at the same time.


20 December 2002 35

6 NEXT STEPS

6.1 Testing and Fine-tuning

The workgroup recognizes that the proposed CAR is fundamentally different

from the current solvency margin requirement, in terms of risk considerations

and underlying calculation mechanism. While the CAR, together with the

proposed Asset and Liability Valuation, represents a more transparent and

risk-focused framework compared to the current framework, its impact on

insurers is not obvious. It is therefore critical that thorough testing on both

CAR and valuation are conducted and, where justifiable, appropriate fine-

tuning be made to the proposed risk charges.

6.2 Outstanding Issues

While every effort has been put in to ensure the overall consistency and

comprehensiveness of the proposed framework, the workgroup recognizes

that further adjustments may be required to reflect any risks that may not have

been adequately addressed. These issues include risk charges on offshore

liabilities and risk charges for reinsurance business.

6.3 Scope and Mode of Industry Discussion

Feedback is sought on the proposal put forth in this discussion paper.

Industry players may submit written comments on the proposal through the

following means:

Email: [email protected]

Normal mail: Please mail to –

Monetary Authority of Singapore

Insurance Supervision Department

MAS Building

10 Shenton Way

Singapore 079119

Fax: (65) 6229 9694


20 December 2002 36

All submission shall be made before 14 February 2003. Submissions may be

made available to the public unless confidentiality is expressly requested.


20 December 2002 37

7 RELIANCES AND LIMITATIONS

7.1 The workgroup has carried out analysis on industry data and in particular the

year-end 2001 MAS 202 submissions of all Singapore Insurance Fund direct

insurance business. The results of the analysis will therefore depend upon

the accuracy of the data provided. The workgroup did not perform detailed

data verification, however, it did exclude results for some portfolios, where the

data appeared incorrect. It should be clearly understood that even if the data

was perfectly accurate, the insurance portfolios in Singapore are small, and

hence are subject to considerable random variation.

7.2 In estimating the various risk margins techniques such as the Mack method

and Bootstrapping method have been used. Whilst these techniques are

used widely, they have their own particular limitations. It must be recognised

that considerable actuarial research is currently being undertaken to improve

estimates of uncertainty, and accordingly a new methodology may produce

different results from those obtained in this document.

7.3 Due to data availability, modelling has been undertaken only for the direct

insurance written in Singapore Insurance Fund direct insurance business.

Therefore, whilst the workgroup has in some cases attempted to relate these

results to reinsurance portfolios and to the Offshore Insurance Fund business,

it must be understood that this will be highly subjective in nature.


20 December 2002 38

8 REFERENCES

• Risk-based Capital (RBC) for Life Insurers – Exposure Draft (Feb 01)

MAS-SAS Joint Workgroup on Risk-based Capital Model Development for Life Insurance Companies

• Valuation of Assets and Liabilities for Traditional Life Policies – Discussion Paper (Aug

01)


• Capital Adequacy Requirements for Life Insurers in Singapore – Discussion Paper (Jan

02)


• Research and Data Analysis Relevant to the Development of Standards and Guidelines

on Liability Valuation for General Insurance (Nov 01)

Tillinghast - Towers Perrin for The Institute of Actuaries of Australia

• APRA Risk Margin Analysis (Nov 01)

Trowbridge Consulting for The Institute of Actuaries of Australia

• APRA: Prudential Standard GPS 110 – Capital Adequacy for General Insurers

Australian Prudential Regulation Authority

• APRA: Prudential Supervision of General insurance – Policy Discussion Paper (Mar 01)

Australian Prudential Regulation Authority

• OSFI: Minimum Capital Test (MCT) for Canadian Property and Casualty Insurers

Office of the Superintendent of Financial Institutions Canada


20 December 2002 39

9 ANNEX 1: JOINT WORKGROUP ON RISK-BASED CAPITAL

FRAMEWORK DEVELOPMENT FOR GENERAL INSURERS

MEMBERS

MAS - Insurance Supervision Department Mr Tan Hak Leh Director (Chairperson) General Insurance Association of Singapore Mr Klaus-Peter Mangold Allianz Insurance Singapore Reinsurers Association Mr Andreas Zell Gerling Global Re Singapore Actuarial Society Mr David Richardson PricewaterhouseCoopers Mr John Tucci Trowbridge Mr Verne Baker Watson Wyatt Mr Julian Lipman Ace Asia Pacific Institute of Certified Public Accountants of Singapore Mr Mak Keat Meng Ernst & Young MAS - Insurance Supervision Department Mrs Portia Ho Director Mr Hoe Yeow Chong Deputy Director Mr Khoo Kah Siang Deputy Director Ms Felicity Chia Assistant Director Mr Khoo Kay Hwee Assistant Director Mr Mike Wong Assistant Director Mr Shih Yueh Assistant Director Ms Tan Siew Yen Assistant Director Mr Alex Lee Associate Ms Koh Hong Eng Associate Ms Lim Pei Bin Associate TERMS OF REFERENCE The Terms of Reference of the Workgroup is to submit a recommendation for the introduction of a Risk-Based Capital framework. This includes:

− Examining approaches employed by other regulators to highlight key

strengths and weaknesses;

− Reviewing the solvency requirements and valuation basis (in particular asset valuation) in Singapore;


20 December 2002 40

− Recommending a suitable Risk-Based Capital framework accompanied by its testing and implementation steps.

The workgroup has focused mainly on the liability risks. Results from the RBC Life workgroup, which had addressed asset valuation, and market and credit risks, have been largely adopted in this paper.


20 December 2002 41

10 ANNEX 2: MAS 202 DATA ANALYSIS

10.1 Introduction

The workgroup has carried out detailed analysis on the MAS202 data of the

direct insurers to provide insight into the volatility of the different classes of

general insurance business in Singapore. The aim of this exercise was to

provide additional information to the workgroup for the derivation of the risk

charges for the outstanding claims liability component. Although the results

could not be directly translated into the final set of risk charges recommended

by the workgroup, the analysis highlighted some interesting information about

the risk profile of the local general insurance market and reaffirmed some of

the assumptions used by the workgroup in setting the risk charges.

This annex contains a brief description of the approach used by MAS in

studying the MAS202 data, a summary of the overall results and some

interesting insights and observations made from the study.

10.2 Data

The analysis was carried out on the data submitted by direct general

insurance companies in Singapore under MAS202 in respect of year 2001.

MAS202 submissions contain run-off triangles of paid and incurred claims

data by calendar year of coverage and development year of claims. As

MAS202 classifies the lines of business according to the format in Form 7 in

the MAS returns, the analysis is confined to this classification. The workgroup

has attempted to gather data from the industry on finer classifications for

certain business class such as miscellaneous, motor, and fire, but the data

received was insufficient and not as reliable as the data obtained from the

MAS202 submissions, to carry out this type of analysis.

The analysis focuses only on the general insurance business of the Singapore

Insurance Fund, as the data for offshore insurance business is not sufficient

for any analysis to be credible or meaningful. The direct insurance business


20 December 2002 42

and the reinsurance business under the Singapore Insurance Fund were

analysed separately so as to observe any difference in characteristics.

For data relating to direct insurance business, analysis was performed on

both the incurred claims and paid claims data. For reinsurance business, only

paid claims data were analysed. However, the results derived, together with

the lack of inward reinsurance data, suggested that further analysis was

unlikely to yield any meaningful results. Eventually, only the results using

incurred claims data from the direct insurance business written under the

Singapore Insurance Funds were taken into account in setting the risk

charges.

The data was slightly modified to adjust for some of the negative entries that

might have invalidated the analysis. The amount of modification was very

small and it was more likely to reduce the volatility than to increase it,

although the impact was likely to be minimal. The data was neither adjusted

for any extraordinary claims nor recoveries as such information were not

available in the MAS202 returns.

Projection of the claims was based on the average loss development factors

derived directly from the data. We had adopted a mechanical approach with

no human intervention and judgment in the selection of the loss development

factors.

The output of the analysis was grouped by size of outstanding claims reserve

and class of business. The volatility of the business was ascertained by

comparing the percentile at the tail of the distribution with the 75th percentile,

the theoretical level for policy liability. We have further excluded a few outliers

from the result so as to avoid any distortion of the averages of companies.


20 December 2002 43

10.3 Methodology

Two main methodologies were adopted in this analysis namely, the Thomas

Mack method and the Bootstrap method. Details of these two methods are

described below.

10.3.1 Thomas Mack Method

The Thomas Mack Method derives a measure of standard error for

outstanding claims reserves based on the chain ladder method. It does not

provide the distribution of the outstanding claims and therefore relies on the

assumptions made by the user before the tail statistics of the outstanding

claim reserves can be derived.

Assumptions

Some basic assumptions underlying this method are as follows:

1. Accident years are independent.

2. The expected values of a development factor for a particular period is

independent of prior development.

In our analysis, we have also assumed that for a given accident year, the

variance of the value in period n+1 is proportional to the value in period n

(irrespective of prior development). Further information on alternative

possibilities can be obtained from “APRA Risk Margin Analysis, The Institute

of Actuaries of Australia, 25 - 28 Nov 2001”.

Thomas Mack’s methodology also assumes that there is no further

development beyond what is represented in the data triangle. In our case, we

have applied this assumption such that the maximum number of development

year for any class is 8 years. The consequence of this is an underestimate of

the potential volatility, especially for long tail classes.


20 December 2002 44

Application

As can be seen, the method may be applied to claims paid data or claims

incurred data. The method involves deriving ultimate losses. So, when applied

to claims incurred data, one gets a measure of IBNR/IBNER rather than the

outstanding claims reserve.

The chosen chain ladder factors are mechanically derived, with no allowance

for judgment. The method is based on the weighted average of the individual

factors.

The final output is a coefficient of variation giving an indication of the

underlying volatility of the claims experience.

10.3.2 Bootstrap Method

Under the bootstrap method, the raw observations are not being

“bootstrapped” directly. Instead, some suitably defined residuals are subjected

to bootstrapping. From these residuals, suitable ones are chosen and

resampled with replacement to fit into the claims liability for the effect of

randomness. In our case, we used all the residuals mechanically without

screening for unsuitable residuals.

Assumptions

The bootstrapping technique does not make any assumption about the

underlying distribution of the claims. The distribution is derived implicitly from

the simulation on the empirical data.

We further have to assume that the standardized residuals derived from the

bootstrapping method are independent and identically distributed.


20 December 2002 45

Application

Before applying the bootstrapping technique, we fitted a chain ladder model to

the available data, and calculated a central estimate of the net outstanding

claims liability. For this purpose, the loss development factors are identical to

the one calculated in the Mack method using an automated mechanical

process.

A fitted cumulative claims for a development year of a particular accident year

can be derived by dividing the cumulative claim from the next development

year in the same accident year with the average loss development factors

derived earlier from the raw triangle. Working backwards from the latest

development year, the fitted cumulative claim triangle can be derived.

The residual can then be calculated by taking the difference between the

empirical (raw) cumulative claim data and the fitted cumulative claim data. For

this purpose, we took the logarithmic number as we assume further that the

residuals derived would be normally distributed. We further standardized the

residuals for each development year by dividing the residuals with the

standard deviation of each development year. This will help to standardize the

residuals across the different development year.

A random sample (with replacement) is drawn from the set of standardised

residuals for each entry in the fitted cumulative claims triangle. These

sampled residual will be added to the fitted cumulative claims after multiplying

back the standard deviation factor of the respective development year derived

and utilized earlier. By doing so, a new triangle is formed.

By recalculating the outstanding claims reserve based on this new set of

triangle, a simulated sample of the potential deviation from the central

estimate is derived.


20 December 2002 46

These steps have been repeated 1000 times, redrawing different random

samples from the residuals each time. As a result, 1000 estimates of the

value of outstanding claims liability are produced. From these results, we can

form a simulated distribution of the outstanding claims and therefore can

derive tail statistics from it.

10.4 Results

In interpreting the results from our study, we took into account various factors:

- Average size of companies operating in this industry

- Size of the different classes of business

- Effects on volatility attributable to size

- Stability of results in portfolios of different sizes

With these considerations, we have set the benchmark level of claims

(whether it is claims paid or claims incurred basis) at S$2 million. In other

words, we have assumed that a portfolio with outstanding claim reserve of

more than S$2 million would provide meaningful result on the analysis of the

volatility. Smaller portfolio may not have enough credible experience for the

analysis.

Hence we have taken the arithmetic average of the indicators (coefficient of

variation for Mack method and the various ratios of percentiles for Bootstrap

method) derived from the data of all the companies with outstanding claims

reserve greater than S$2 million. This will be taken to be an indication of the

volatility experienced by the industry.

The following table gives the coefficient of variation (CV) for each class of

business derived using the Mack method:

Class of Business CV of Paid Claims CV of Incurred Claims Cargo 31% 13% Fire 123% 22% Hull 64% 39% Miscellaneous 48% 44%


20 December 2002 47

Motor 24% 33% Workmen’s Compensation 33% 23%

Note that the Thomas Mack method only gives the coefficient of variation as

the output. Hence without further assumption on the distribution of the claims,

our knowledge of the claims portfolio is limited to this single statistic.

As for Bootstrap method, the full distribution of the claims can be derived from

the output of the procedure. The simulations we did give us 1000

observations of the possible claims arising out of the portfolio. The results

from the bootstrap simulation will be more useful and meaningful to

determine the distribution of the claims for each insurer and for the industry as

a whole. (Note that for our case, we will base our interpretation of the volatility

of each class of business on claims portfolios amounting to S$2 million or

more.)

The following table summarises some of the results that we have derived from

our analysis based on bootstrap methodology:

Results based on Paid Claims Data (A

percentile of claims / B percentile of claims) Results based on Incurred Claims Data (A

percentile of claims / B percentile of claims) Class of Business

75/50 95/75 97.5/75 99/75 75/50 95/75 97.5/75 99/75 Cargo 119% 125% 133% 141% 130% 137% 151% 166% Fire 149% 200% 343% 416% 117% 123% 132% 140% Hull 149% 204% 235% 292% 130% 149% 207% 288% Miscellaneous 133% 155% 178% 205% 150% 133% 146% 158% Motor 116% 121% 128% 137% 115% 119% 126% 132% Workmen’s Compensation 122% 130% 140% 156% 114% 118% 126% 135%

10.5 Summary

The relevant results of this analysis are:

- Understanding the volatility of the claims arising out of the different classes

of business in the Singapore general insurance business

- Understanding the volatility of the claims in relation to the size of each

operation

- Provide a range of ratios to the policy liability as proxy to the appropriate

amount of capital required for each type of operation


20 December 2002 48

Shortcomings of the analysis include:

- Lack of data, due to the size of the market and the size of the market players

- Problems of data, leading to some unreasonable results and hence these

results were excluded from the analysis

- Lack of human judgment in the process of projecting claims for the analysis

Some interesting observations that we have made in the process of our study

are:

- Size of individual companies affects the volatility of the claims they

experience.

- Volatility of claims in the Singapore market seems higher than that

experienced by the Australian market, this may be due to the size effect

and the low penetration of the local market.

- Very high volatility at high confidence intervals, eg big jump from 95% to

99%, even for major lines of business such as Motor and Workmen’s

Compensation. This contributes to the difficulty in determining risk charges

based solely on a single target confidence interval.

- Results of our analysis provides a good benchmark volatility especially for

major lines of businesses with adequate statistical significance, eg Motor

and Workmen’s Compensation is along the 25% level, which is

representative of the medium risk category.

The following table summarises our observations on the volatility of the

different classes of business:

Rank Mack Method Bootstrap Method

1 – Least Volatile Cargo Motor 2 Workmen’s

Compensation Workmen’s Compensation

3 Motor Miscellaneous 4 Miscellaneous Fire 5 Hull Cargo 6 – Most Volatile Fire Hull


20 December 2002 49

The two methods give slightly different results due to the assumptions

underlying each of the methods and the amount of information that we can

extract from the results of the process. In general, we have taken the stand to

give more weight to the results of Bootstrap method on incurred claims data

because:

- We are able to extract more information on the underlying claims from the

simulations of the claims triangle.

- They provide the most stable/ reliable description of claims distribution at

95% to 99% confidence intervals.


20 December 2002 50

11 ANNEX 3: MAJOR SOURCES OF RISK

Risk pooling and risk bearing are at the core of insurance business. To

develop a set of risk-based capital requirements, it is necessary to identify the

major sources of risk that general insurance businesses are exposed to. The

risks may be broadly categorised into liability risk, asset risk, mismatching

risk and operational risk.

The section below broadly discusses the risks faced by general insurance

businesses. The list of risks is by no means exhaustive and these risks may

not be mutually exclusive.

11.1 Liability Risk

These risks are unique to insurance business and are commonly associated

with the technical or actuarial bases of valuation of insurance policy liabilities.

Given the volatile nature of insurance claims and the estimation involved in

valuing insurance liabilities, the value at which the liabilities are reported may

not be sufficient to meet the obligations of the insurance contracts.

It is therefore important to provide for liability risks taking into account all risk

factors affecting policy liability valuation such as

• Claims severity;

• Claims frequency;

• Delays in claims settlement;

• Claims handling expense;

• Discount rate; and

• Inflation (price or otherwise)

The risks pertaining to each factor include the risk of deviation and risk of

adverse event. Deviation risk relates to:

• Risk of mis-estimation of the mean (or best estimate);

• Risk of deterioration of the mean; and


20 December 2002 51

• Risk of unexpected changes in the experience of the underlying

distribution due to legislative, social, political or economic reasons.

Adverse event risk refers to the risk of adverse fluctuation to the mean caused

by, for example, a catastrophe such as an earthquake.

11.2 Asset Risk

These risks arise from changes in values of the assets held by the insurance

companies and include:

• Credit risk

• Market risk

• Asset Concentration risk

11.2.1 Credit Risk

Credit risk is the risk that the value of the asset will decline as a result of

default or borrowers’ failure to perform an obligation. An insurer is exposed to

credit risk in four main areas:

a) Counter-Party risk - risk that a counter-party fails to perform an

obligation, for example, risk that a reinsurer fails to meet its contractual

obligations to the direct company, or significant amount of outstanding

premiums due to the company or loans from its intermediaries and

affiliated firms.

b) Invested Asset Credit risk - risk of deterioration in invested asset value

due to the changing likelihood of the issuer’s non-performance of

contractual payments, for example, likelihood of default of issuer of

debt securities.

c) Political risk - risk that changes in political climate or government

policies affect the credit worthiness of invested assets

d) Sovereign risk - risk of default or inability to meet payment obligations

of securities issued by governments or government entities.


20 December 2002 52

11.2.2 Market Risk

This refers to the risk of fluctuation of the value of assets due to changes in

broad economic factors. To the extent that the policy benefits (and thus the

value of liabilities) are not directly dependent on the performance of assets

backing the liabilities, an adverse movement in the value of assets may have

a significant impact on the solvency of the fund. Therefore, sufficient buffer

should be held such that the insurer is still able to meet the obligations to

policyholders following an adverse market movement.

Market risk includes:

a) Equity and Property risk – risk of depreciation of investments in equity

and property.

b) Foreign exchange risk – risk that movements in currency value affects

the value of foreign assets and/or the value of obligations denominated

in foreign currencies resulting in a decrease in net value of the

insurance fund.

c) Interest rate risk – risk of fluctuation in the values of assets and

liabilities due to movements in interest rates.

11.2.3 Asset Concentration Risk

This reflects the additional risk of high concentration of investments in a single

company, group of companies, instrument, industry, geographical area,

currency, etc. It is well recognised that diversification of investment portfolio

reduces risk. Therefore, extra capital should be set aside to buffer the

probable loss when the insurance fund is excessively concentrated in a

particular asset, or with a particular obligator.

11.3 Mismatching Risk

Matching has the advantage of lowering the overall risk charges, as the

impact of an economic factor on liabilities will be offset by the corresponding

adjustment in the matching assets. But such offsetting will not exist for a

mismatched portfolio.


20 December 2002 53

Typical causes of mismatching include:

a) Durational mismatch

This occurs when the duration of liability cashflow exceeds or falls

short of the duration of asset cashflow.

b) Mismatching of guaranteed liability

This applies to backing of guaranteed insurance policy liabilities by

assets with non-guaranteed returns.

c) Currency Mismatch

This occurs when assets and liabilities are exposed to different

currency risks.

11.4 Operational Risk

This refers to various types of risks that are normally associated with the

running of insurance business. Examples of operational risk include:

a) Management risk – the risk that an insurance company is exposed to,

due to an incompetent management or one that has criminal intent.

b) Technological and Business risk – risk associated with events such as

fraud, systems failure, litigation breach, etc.

Operational risks are generally difficult to quantify, although there has been

some developments in this area of risk measurement and quantification.


20 December 2002 54

12 ANNEX 4: RISK CHARGES FOR EQUITY

12.1 Affected Instruments

Equity Securities The insurer must calculate an equity risk charge for the following equity

securities:

a) Shares (whether voting or non-voting)

b) convertible preference shares

c) convertible debt security

d) venture capital

e) private equity investments

f) instruments that exhibit market behaviour similar to equities

Equity security - An equity security includes a single equity, a basket of

equities or an equity index.

Convertible preference shares and convertible debt security – Debt issues or

preference shares that are convertible, at a stated price, into common shares

of the issuer, will be treated as debt securities if they trade like debt securities

and as equities if they trade like equities.

Equity Derivatives Equity derivatives include:

a) Futures and forward contracts on individual equities or stock indices

b) Equity swaps

c) Equity options and stock index options

Except for options, which are dealt with in Annex 7, equity derivatives that are

affected by changes in equity prices are subject to equity risk charges. Where

equities are part of a forward contract, a future or an option, any interest rate

or foreign currency exposure from the other leg of the contract should be

reported as set out in Annex 5 and Annex 6.


20 December 2002 55

12.2 Calculation of Positions Unless specified in the table below, the equity equivalent position of equity

security is given by the market value of the security.

Equity Derivatives or Convertible Securities Equivalent Positions Futures or forward contracts relating to

individual equity

Market value of underlying equity

Futures relating to stock index Market Value of notional underlying equity portfolio

Equity swaps* Will be treated as two notional positions*

Equity options and stock index options See Annex 7

Convertible preference share or convertible

debt securities

Market value of underlying equity, less an adjustment by the amount equal to any profit (or loss) on conversion, bounded at zero

* An equity swap in which the insurer receives an amount based on the change in value of a particular equity or stock index and paying a different index will be treated as a long position in the former and a short position in the latter. Where one of the legs of transaction involves receiving/paying a fixed or floating interest rate, that exposure should be slotted into the appropriate repricing time-band for interest rate-bearing instruments as set out in Annex 5. The stock index should be covered by the equity position.

12.3 Calculation of Risk Charges

The equity exposure risk charge is the sum of specific risk requirement and

general risk requirement.

Specific risk requirement is the product of the gross equity position (sum of all

long equity position and all short equity positions) and the specific risk factor.

.

General risk requirement is 8% of overall net equity position (difference

between the sum of the all longs and sum of all shorts).

The computation of the equity exposure risk charges may be summarised as

follows:


20 December 2002 56

Instrument Specific risk factors* General risk factors Equity security 8% x equity equivalent position 8% x equity equivalent position Futures or forward contracts relating to individual equity

8% x equity equivalent position 8% x equity equivalent position

Futures relating to stock index** 2% x equity equivalent position 8% x equity equivalent position

Equity swaps* 8% or 2% of equity equivalent position, depending on whether underlying security is individual or index respectively

8% of equity equivalent position

Equity options 8% of equity equivalent position See Annex 7.

Stock index** options 2% of equity equivalent position 8% of equity equivalent position

Convertible preference share or

convertible debt securities

8% of equity equivalent position 8% of equity equivalent position

* This is the specific risk charge relating to the issuer of the instrument. There remains a separate risk of default of the counter-party to the transaction and this counter-party risk attracts an additional risk charge. ** A 2% specific risk factor may apply only to well-diversified indices, and not, for example, to sectoral indices, in which case an 8% risk factor should be used.

12.4 Netting

Matched positions in each identical equity or stock index in each market may

be fully offset, resulting in a net long or short position to which the risk factors

will apply.


20 December 2002 57

13 ANNEX 5: RISK CHARGES FOR INTEREST-BEARING ASSET


The methodology described below is applicable to insurer’s assets that

include debt securities and other interest rate related instruments. These

instruments covered all fixed-rate and floating-rate debt securities and

instruments that behave like them (such as non-convertible preference

shares). Loans are excluded from this section and explanation for the

treatment for loans (as categorised according to SAS 33) is set out in Annex

9.

13.2 Methodology

The interest bearing asset risk charge is the sum of the specific risk

requirement and general risk requirement.

Specific risk requirement Specific risk requirement is applied to each debt security (regardless whether

it is long or short position) and is given by:

∑ × factorrisk specific ) luemarket vaat (position debt net Individual

The specific risk factor for a debt instrument is graduated in five categories as

follows:

Qualifying Government Less than 6

months Between 6 and 24

months More than 24

months

Other

0% 0.25% 1% 1.6% 8%

Government debt security refers to any government paper including a bond,

treasury note or other short term instruments where it is issued, fully

guaranteed or fully collateralised by a debt instrument issued by the

Singapore Government, or a central government or central bank within a

country with a sovereign rating of at least B from one internationally reputable

credit rating agency.


20 December 2002 58

Qualifying debt instrument refers to a debt instrument that is:

• Rated investment grade by at least one reputable credit rating

agencies, e.g., Baa or higher by Moody’s and BBB or higher by

Standard and Poor’s; or

• Issued or guaranteed by a public authority or statutory board in

Singapore; or

• Issued or guaranteed by a state or local government of a country with a

sovereign rating of at least B from one internationally reputable credit

rating agency, and which represents no higher risk than the central

government; or

• Issued or guaranteed by a supranational agency or regional

development bank; or

• Issued or guaranteed by a bank licensed under the Singapore Banking

Act, or a bank with a long-term debt rating of at least investment grade

by an internationally reputable credit rating agency, and provided the

instrument ranks as a senior debt; or

• Issued or guaranteed by a bank without a long-term debt rating of at

least investment grade by an internationally reputable credit rating

agency, and has a residual maturity of one year or less, and provided

the instrument ranks as a senior debt.

Securities other than those specified above are subject to a specific risk

requirement of 8%.

General risk requirement The general risk requirement is designed to capture risk of loss arising from

changes in market interest rates. The steps to calculate the general risk

requirement amount are as follows:

a) First, slot each debt instrument to a “maturity ladder” which consists of

13 time-bands (or 15 time-bands in case of low coupon instruments) in

the manner spelt out in Table 1. Fixed rate instruments should be


20 December 2002 59

allocated according to the residual term to maturity and floating-rate

instruments according to the residual term to the next repricing date.

Note also that the treatment of zero-coupon bonds and deep-discount

bonds (defined as bonds with a coupon of less than 3%) is different

from that of other debt instruments. Separate maturity ladders should

be used for each currency and general risk requirements should be

calculated for each currency separately.

b) Next, the estimated price movement in an adverse interest rate

environment is determined. It is calculated by multiplying positions in

each time-band by a factor designed to reflect the price sensitivity of

those positions to assumed changes in interest rates. The weights of

each time-band are set out in Table 1 below.

Table 1: Time-band and Risk Factors Zones Time-band

Number Coupon less than

3% Coupon 3%or

more Risk

Factor Assumed

changes in yield

1 1 month or less 1 month or less 0.00% 1.00

2 1 to 3 months 1 to 3 months 0.20% 1.00 3 3 to 6 months 3 to 6 months 0.40% 1.00

Zone 1

4 6 to 12 months 6 to 12 months 0.70% 1.00 5 1 to 1.9 years 1 to 2 years 1.25% 0.90 6 1.9 to 2.8 years 2 to 3 years 1.75% 0.80

Zone 2

7 2.8 to 3.6 years 3 to 4 years 2.25% 0.75 8 3.6 to 4.3 years 4 to 5 years 2.75% 0.75 9 4.3 to 5.7 years 5 to 7 years 3.25% 0.70 10 5.7 to 7.3 years 7 to 10 years 3.75% 0.65 11 7.3 to 9.3 years 10 to 15 years 4.50% 0.60 12 9.3 to 10.6 years 15 to 20 years 5.25% 0.60 13 10.6 to 12 years Over 20 years 6.00% 0.60 14 12 to 20 years 8.00% 0.60

Zone 3

15 Over 20 years 12.00% 0.60

c) Slot the resulting estimated price movement figures back into the

“maturity ladder”.

d) Sum all the long positions and the short positions in each time band

and subject the long and short positions in each time-band to a 5%

“vertical disallowance” which is designed to capture basis risk. For

example, if the sum of all long positions in a time band is $200m and

the sum of all short positions in the same time band is $10m, the

“vertical disallowance” in this instance is $0.5m (5% of $10m).


20 December 2002 60

e) Within each zone, sum the long positions and short positions. This is

subject to a horizontal offsetting by multiplying the lesser of the

absolute value by the appropriate zone factor (ZF1) as set out in Table

2 below.

f) Next, repeat step (e) for adjacent zones and applying the appropriate

zone factor (ZF2) as well as non-adjacent zone factor (ZF3) as set out

in Table 2.

g) The total risk charge for interest rate is the sum of:

1. the net short or long position for all debt instruments 2. the vertical disallowance in each time-band 3. the horizontal disallowance across different time-bands

Table 2: Horizontal Disallowances

Zones Time Band Number Within the zone

(ZF1)

Between adjacent zones

(ZF2)

Between zones 1 and 3

(ZF3)

1

2 3

Zone 1

4

40%

5 6

Zone 2

7

30%

8 9 10 11 12

Zone 3

13 14 15

30%

40%

40%

100%

h) The whole calculation process is repeated for a change in interest rate

in the other direction.

In reality, the market yield curve does not merely shift upwards or downwards

as prescribed. It may become steeper, flatter, humped, or even inverted.

Actuaries should use their judgment to determine the additional reserves

required to meet these situations that are not covered by the prescribed yield

change.


20 December 2002 61

13.3 Interest Rate Derivatives

Interest rate derivatives include:

a) Future or forward contract on a debt security or interest rate;

b) Option on a debt security or interest rate

c) Option on a future on a debt security or interest rate

d) Forward rate agreement (FRA) or other contract (including interest rate

swaps)

The derivatives are converted into positions in the relevant underlying asset

and subject to both specific and general risk requirements as above.

However, where instruments do not have a specific underlying issuer, these

debt instruments are not subject to a specific risk requirement, e.g., interest

rate swaps, forward rate agreements and options on an interest rate.

To calculate the risk requirements, the positions reported should be the

market value of the principal amount of the underlying or of the notional

underlying.

Futures and forward contracts [including forward rate agreements (FRAs)] are

treated as a combination of a long and short position on the notional

underlying debt instrument. The maturity of a future or FRA will be the period

until delivery or exercise of the contract, plus (where applicable), the life of the

underlying instrument. In the case of a future on a corporate bond index,

positions will be included at the market value of the notional underlying

portfolio of securities.

Example A long position in interest rate future, $10m, delivery date after 6 months, life of underlying security is 3.5 years. This is to be reported as a short position in the security with a maturity of 6 months and a long position in the underlying security with a maturity of 4 years Swaps will be treated as two notional positions in the underlying securities

with relevant maturities.


20 December 2002 62

Example An interest rate swap under which the insurer receives floating rate interest and pays fixed interest will be treated as : • long position in the floating rate instrument of maturity to the next re-pricing date, and • short position in a fixed rate instrument of maturity equivalent to the residual life of the

swap

For treatment of options, please see Annex 7.

13.4 Netting

Insurers may offset debt positions against long or short positions in the

underlying debt security if these positions are in the same actual debt security

of identical issuer, coupon, currency and maturity.

An insurer may also net long and short positions in swaps and FRAs subject

to the following conditions:

• They are in the same currency

• The interest rates are within 15 basis points of each other;

• The interest rate fixing dates are the same, if the maturity dates of the

agreement are 30 days or less, or the interest rate fixing dates are

within 7 days of each other, if the maturity dates are greater than 30

days.

13.5 Summary of Treatment of Interest Rate Derivatives

Instrument Specific risk requirement* General risk requirement Futures or forward contracts relating to - Government debt security - Corporate debt security

No Yes, relating to underlying

Yes, as two positions Yes, as two positions

Futures or forward relating to index on interest rates (e.g. LIBOR)

No Yes, as two positions

Forward rate agreements, swaps

No Yes, as two positions

Options - Government debt security - Corporate debt security - Index on interest rates - FRAs, Swaps

No Yes, relating to underlying No No

} } } See Annex 7: } Treatment of Options }


20 December 2002 63

*This is the specific risk charge relating to the issuer of the instrument. There remains a separate risk of default of the counter-party to the transaction and this counter-party risk attracts an additional risk charge. Please see Annex 10 for calculation of counter-party risk charge.


20 December 2002 64

14 ANNEX 6: RISK CHARGES FOR FOREIGN CURRENCY – GENERAL RISK

REQUIREMENT

To calculate the risk charge for foreign exchange, the exposure in a single

currency position is first measured and the mix of long and short positions in

different currencies is then determined.

The insurer’s net open position in each currency is calculated by adding:

• The net open spot position (all assets less liabilities denominated in the

foreign currency)

• The net forward position (i.e. all amounts to be received less all

amounts to be paid under the forward foreign exchange transactions,

including currency futures).

The amount of net position in each foreign currency is converted to spot rates

into Singapore dollar and the overall net open position is measured by

summing the net short positions or the sum of the net long positions,

whichever is greater. The risk charge is 8% of the overall net open position.


20 December 2002 65

15 ANNEX 7: TREATMENT OF OPTIONS

Insurers are generally expected to use derivatives for hedging purposes and

efficient portfolio management (EPM). Guidelines for the permitted use of

derivatives are set out in MAS Notice 104 on Investment of Singapore

Insurance Fund Assets (4 Dec 2001).

For insurers that handle a limited range of purchased options, the risk charge

for options may be calculated as follows:

Table 3 Position Treatment of options Long cash and Long put Or Short cash and Long call

Market value of underlying security multiplied by the sum of specific risk requirement and general risk requirement for the underlying less the amount the option is in the money (if any) bounded at zero.

Long call or Long put Lesser of: (i) the market value of the underlying security

multiplied by the sum of specific and general risk requirements for the underlying security

(ii) the market value of the option Example Assuming an insurer holds the following covered position: a) 100 shares currently value at $15 per share; and b) an equivalent long put option position with strike price $17. The risk charge is computed as follows: a) (8% + 8%) of MV of shares = 0.16 x $15 x 100 = $240 b) Amount option is in the money = ($17 - $15) x 100 = $200 c) Risk charge for combined position = $240 - $200 = $40

As part of EPM, insurers are permitted to write options. However, all positions

in options taken by insurers should be covered and insurers would need to

assess the appropriate exposure to the underlying and subject to the

respective risk charges.


20 December 2002 66

Example Assuming an insurer holds the following covered position: a) 100 shares currently valued at $S per share; and b) An equivalent short call option position with strike price $17. So long as the call option is not exercised by the option-holder, and that the covered call position is not reversed, the risk charge is computed as follows: If S = $20 (and greater than strike price)

a) (8% + 8%) of MV of shares = 0.16 x $20 x 100 = $320 b) Amount option is in the money = ($20- $17) x 100 = $300 c) Risk charge for combined position = $320 - $300 = $20

If S = $15 (and less than strike price)

a) 16% of MV of shares = 0.16 x $20 x 100 = $320 b) Amount option is in the money = $0 c) Risk charge for combined position = $320 - $0 = $320

For the approach described above, the positions for the options and the

associated underlying investment instrument, whether cash or forward, are

“carved out” and not subject to that the standardised methodology as

described in Annexes 4 – 6 above. Instead, the “carved-out” positions are

subject to separately calculated capital charges that incorporate both specific

risk requirements and general risk requirements. The amounts thus generated

are added to the risk charges for the relevant category, i.e., interest rate

bearing instruments, equities and foreign exchanges as described in Annexes

4 – 6.


20 December 2002 67

16 ANNEX 8: TREATMENT OF OUTSTANDING PREMIUMS

16.1 Affected instruments

This section is applicable to an insurer’s outstanding premiums and agents’

balances.

Specific risk requirement Specific risk requirement is applied to each category of outstanding premiums

based on the duration that they have been outstanding and is given by:

∑ × or Risk FactSpecific asset of eFair valu

The specific risk factors are as given below:

Assets Duration Specific Risk Factor 90 days or less 8% Outstanding Premiums and Agents’

Balances More than 90 days 50%


20 December 2002 68

17 ANNEX 9: TREATMENT OF LOANS AND OTHER ASSETS

17.1 Affected instruments

This section is applicable to an insurer’s assets that include:

a) Loans (including loans to policyholders)

b) Cash, cash deposits with financial institutions and cash items in

process of collection from financial institutions, including reinsurance

recoverable and outstanding premiums from financial institutions;

c) Other receivables from non-financial institutions or individuals

(excluding outstanding premiums and agents balances which are

covered in Annex 8); and

d) Other assets such as furniture and fixtures.

Specific risk requirement Specific risk requirement is applied to each loan portfolio and other affected

assets and is given by:

∑ × or Risk FactSpecific asset of eFair valu

The specific risk factors are as given below:

Description Credit Rating / Duration

Specific Risk Factor

Cash 0% AAA to AA- 0% A+ to A- 1.6% BBB+ to BBB- 4% BB+ to B- 8% Under B- 12%

Central governments or central banks

Unrated 8% AAA to AA- 1.6% A+ to A- 4% BBB+ to B- 8% Under B- 12%

Financial institution with an issuer or long-term debt rating of at least investment grade by an internationally reputable credit rating agency; and loans to companies owned by both public and private sectors

Unrated 8%

Housing loans secured by mortgage on residential property 4%

Loans fully secured by mortgage on commercial property 8%

Loans

Other loans 8%


20 December 2002 69

Less than 6 months 0.25%

6 to 24 months 1%

Financial institution with an issuer or long-term debt rating of at least investment grade by an internationally reputable credit rating agency

More than 24 months 1.6%

Deposits

Other deposits 8% AAA to AA- 1.6% A+ to A- 4% BBB+ to B- 8%

Licensed by MAS

Under B- 12% Unrated 8%

12%

Receivables from insurers and reinsurers Not licensed by MAS

Other Assets 8%


Unlike other interest-bearing assets like bonds and other debt securities, SAS

33 requires loans to be recorded at their amortised cost and the value of a

loan asset is independent of interest rate movements (prescribed or

otherwise). This creates a situation whereby a movement in liability value (due

to the prescribed interest rate movement of 0.6 - 1.0%) will not move in

harmony with the loan assets supporting the liability.

Therefore, for the purpose of determining the general risk requirement only,

the loan portfolio is to valued at market basis and is then subject to general

risk requirement that is similar to that for the interest bearing assets as

described in Annex 5.

This is to allow for a corresponding movement in asset value due to interest

rate movements to offset the movement in liability value.

There is no general risk requirement for cash deposits and other assets.


20 December 2002 70

18 ANNEX 10: COUNTER – PARTY RISK REQUIREMENT FOR DERIVATIVES


This section is applicable to OTC derivative contracts. No additional counter-

party requirement is required for exchange-traded derivatives.

18.2 Credit Equivalent Amount

Insurers shall calculate a counter-party exposure arising from OTC derivatives

contract held as the credit equivalent amount of the contract.

Credit equivalent amount is defined as:

1. the sum of replacement cost of the contract and a potential credit

exposure, if the replacement cost of the contract is positive; and

2. the potential credit exposure, if the replacement cost of the contract is

zero or negative.

The replacement cost of the contract is the current mark-to-market value of

the contract.

Potential credit exposure is the product of the absolute value of the nominal or

notional principal underlying the contract and the appropriate credit exposure

factor as prescribed in the following table.

Type of Transaction Credit Exposure Factor

Equity Contracts

One year or less

Over one year and up to 5 years

Over 5 years

Include: cash-settled forward contracts, equity or equity

referenced options purchased, derivatives referenced on a

bond which is not a qualifying debt security

6%

8%

10%

Foreign Exchange Contracts

One year or less


1%

5%


20 December 2002 71

Over 5 years

Include: cross-currency interest rate swaps, forward foreign

exchange contracts, currency options purchased

7.5%

Debt or Interest Rate Contracts

One year or less


Over 5 years

Include: single currency interest rate swaps, FRAs, interest

rate options purchased, derivatives referenced on a

qualifying debt security

0%

0.5%

1.5%

The additional counter-party risk requirement for an OTC derivative contract is

calculated as: counter-party exposure x counter-party risk weight x 12%. The

counter-party risk weight depends on the nature of the obligor and the

applicable risk weight schedule is the same as deposits with financial

institutions.

18.3 Netting Netting of negative replacement cost against positive replacement cost on

OTC transacted with the same counter-party is permitted.


20 December 2002 72

19 ANNEX 11: RISK CHARGE FOR CONCENTRATION

The following table shows some of the proposed investment limits exceeding

which, inadmissible asset risk charges under GC3 will apply.

Investment Limit Single Party Limit - General limit

- 20% in approved financial institution or group of related approved

financial institutions - 10% in company listed on any stock exchange or group of related

companies - 5% in unlisted company or group of unlisted companies related to

one another, a merchant bank or a finance company and all other cases

- Specific limit • Equity • Unsecured

Loans

- 2.5% in any single counter - 1% to any one company of group

Property Exposure 35% property exposure, applicable to all property exposure including

land and buildings, equity, debt securities and mortgage loans; with

internal limits by asset class.

Foreign Currency 50% foreign currency exposure, applicable to foreign currency-

denominated and overseas assets*

Other Limits - Unlisted Equity - Unsecured

Loans

- 5% in unlisted equity in aggregate

- 2.5% in unsecured loans in aggregate

Derivatives Insurers are permitted to use derivatives for hedging and efficient portfolio management as set out in MAS 104. Any additional exposure taken on with the use of derivatives will be considered for the purposes of determining admissibility under the investment limits. The use of derivatives is subject to the following conditions: - Insurers should not take uncovered positions in derivatives; - Counter-party to the transaction has an individual/financial strength

rating of above C by Fitch Inc. or Moody’s; - Use of complex or exotic derivatives is not allowed.

*Foreign currency denominated fixed income or floating rate securities that are fully hedged to the Singapore dollar will be deemed as synthetic Singapore dollar assets subject to conditions set out in MAS 104. Synthetic Singapore dollar assets will not be subject to the 30% limit for foreign-currency denominated and overseas assets.

The above table is not meant to be an exhaustive list of investment limits.

Industry discussions and thorough testing of the proposed framework will be

conducted before determining final investment limits and inadmissible risk

charges.


20 December 2002 73

20 ANNEX 12: COMPARISON ON RISK CLASSIFICATION OF LINES OF BUSINESS

Volatility S'pore's New Classification of APRA OSFI

SIF Lines of Business

Personal Accident (includes Travel) Householders (Domestic Fire) Personal & commercial property

LOW Fire – Residential Commercial Motor (Damage only) Automobile - Other Health – Daily Cash Domestic Motor (Damage only) Travel (Personal Accident)

Fire - Non-residential Fire & ISR (Commercial Fire) Automobile - Liability & personal accident Marine & Aviation – Cargo Marine & Aviation Motor - Property Damage Consumer Credit

MEDIUM Workmen's Compensation Mortgage Bonds Other Accident (Work Comp) Engineering CAR/EAR Other Credit/Political Risk

Health – Others Others – Non-liability Classes

Marine & Aviation – Hull & Liability Compulsory Third Party (Injury) Liability HIGH Motor - Bodily Injury Public & Product Liability All others (except Accident & Sickness Ins)

Professional Indemnity Professional Indemnity Others - Liability Classes Employers' Liability


20 December 2002 74

21 ANNEX 13: WORKED EXAMPLES

We shall demonstrate with an example the derivation of the applicable risk

charges. Risk charges will be derived in the following order:

• GC1 – Liability Risk Component

• GC2 – Market and Credit Risks Component

• GC3 – Concentration Risk Component

Consider XYZ Insurance balance sheet summarized below:

Assets $ Liabilities $ Tangible Assets 75,000,000 Policy Liabilities Goodwill and Intangibles 5,000 Claim Liabilities 8,400,000 Premium Liabilities 11,395,500 Other Liabilities 950,000 Total Liabilities 20,745,500 Shareholders' Equity Capital 49,754,500 Retained Earnings 4,505,000 Total Shareholders' Equity 54,259,500 Total Assets 75,005,000 Total Liabilities and Shareholders' Equity 75,005,000 Available Assets 54,254,500

Under the proposed RBC framework, XYZ Insurance has to satisfy the

following condition:

Available Assets > GC1 + GC2 + GC3

21.1 Available Assets

Available Assets = Total Assets – Total Liabilities – Ineligible Assets = 75,005,000 – 20,745,500 – 5,000 = 54,254,500

21.2 GC1 – Liability Risk Component

XYZ Insurance has the following business portfolio:

Class of Business Net Claims Liabilities after Diversification

Net Written Premiums

Cargo 75,000 250,000


20 December 2002 75

Hull 112,500 350,000 Fire – Residential 350,000 Fire – Non-Residential

562,500 1,000,000

Motor 2,625,000 4,000,000 Workmen’s Compensation 1,875,000 4,000,000 Miscellaneous – Personal Accident 3,000,000 Miscellaneous – Engineering 100,000 Miscellaneous – Health Daily Cash 4,000,000 Miscellaneous – Health Reimbursement 4,000,000 Miscellaneous – Professional Indemnity and Other Liability 1,000,000 Miscellaneous – Others

3,150,000

250,000 All Classes 8,400,000 22,300,000

XYZ Insurance’s actuarial certification in accordance with MAS210 has the

following results:

Class of Business URR + PAD After Diversification

UPR

Cargo 89,800 125,000 Hull 89,800 175,000 Fire – Residential 175,000 Fire – Non-Residential

583,850 500,000

Motor 2,245,500 2,000,000 Workmen’s Compensation 1,347,300 2,000,000 Miscellaneous – Personal Accident 1,500,000 Miscellaneous – Engineering 50,000 Miscellaneous – Health Daily Cash 2,000,000 Miscellaneous – Health Reimbursement 2,000,000 Miscellaneous – Professional Indemnity and Other Liability 500,000 Miscellaneous – Others

3,143,750 125,000

All Classes 7,500,000 11,150,000

Taking the higher of UPR or URR after diversification for each class, we can

arrive at a total premium liability for XYZ Insurance of $11,395,500.

Based on the risk charges set out in Section 3.1.5 and the conversion factors

prescribed in Section 3.1.6, we arrive at the GC1 risk charges for XYZ

Insurance. Details tabulated below:


20 December 2002 76

New Classification of GC1 Risk Charges

SIF Lines of Business $ $

On Claims Liability On Premium Liability

Cargo 18,750 6,250 Hull

33,750 8,750

Fire 133,333 74,923

Motor 721,875 741,015 Workmen’s Compensation 468,750 100,000 Miscellaneous 710,982 308,750

Total Risk Charges 2,087,440 1,239,688 Total GC1 Risk Charges $ 3,327,128

Note that the risk charge calculations are based on liability estimates after

taking into account the effects of diversification.

21.3 GC2 – Market and Credit Risks Component

We have identified part of XYZ Insurance’s assets to have exceeded the

proposed investment limits. This amounts to $5,000,000. Suppose the

remaining assets have the following information extracted from the balance

sheet of XYZ Insurance:

Asset Class Value ($) Land and Buildings 5,600,000 Equities 21,000,000 Interest-Bearing Securities 21,000,000 Loans 12,600,000 Cash and Deposits 7,000,000 Reinsurance Receivables 350,000 Outstanding Premium and Agents Balance 350,000 All Other Assets 2,100,000 Total 70,000,000

21.3.1 Land and Buildings

Specific risk charge = 8% x 5,600,000 = $448,000

General risk charge = 8% x 5,600,000 = $448,000


20 December 2002 77

21.3.2 Equities

Specific risk charge = 8% x 21,000,000 = $1,680,000

General risk charge = 8% x 21,000,000 = $1,680,000

21.3.3 Interest Bearing Securities

XYZ Insurance holds the following interest bearing securities portfolio:

Government 7,000,000 Less than 6 months 0 6 months to 24 months 0 Qualifying More than 24 months 14,000,000

Others, 0 Total 21,000,000 Specific risk charge = 1.6% x 14,000,000 = $224,000

For deriving the general risk charge, we have to look into the details of the

assets in this category:

• SGS, $7 million market value, residual maturity 2 months, coupon

3.5%;

• Qualifying corporate bond, $14 million market value, residual maturity 8

years, coupon 5%;

General risk charge = 0.2% x 7,000,000 + 3.75% x 14,000,000 = $539,000

21.3.4 Loans

Assume XYZ Insurance has the following loans portfolio:

Description Credit Rating / Duration Value Specific Risk Charge

AAA to AA- $1,750,000 $0

A+ to A- $1,750,000 $28,000

BBB+ to BBB- - -

BB+ to B- - -

Under B- - -

Central governments or central banks

Unrated - - Financial institution with an issuer or long-term debt rating of at least investment grade by an internationally reputable credit rating agency; and loans to companies owned by both public

AAA to AA- $2,100,000 $33,600


20 December 2002 78

A+ to A- - - BBB+ to B- $1,750,000 $140,000 Under B- - -

and private sectors

Unrated - -

Housing loans secured by mortgage on residential property

$3,500,000 $140,000

Loans fully secured by mortgage on commercial property

- -

Other loans $1,750,000 $140,000

Total specific risk charges = $481,600

For determining general risk charges, loans will be subject to market valuation

in a rising interest rate environment. Risk charges will be based on risk

weights depending on the duration of the loan portfolio. The application is

similar to the case for interest bearing assets.

For the case of XYZ Insurance, we shall assume that the total general risk

charges after calculation amounts to $140,000.

21.3.5 Cash and Deposits

Assume XYZ Insurance holds $3,500,000 in cash and $3,500,000 in deposits.

Cash attracts no risk charges. The deposits held by XYZ Insurance has the

following characteristics:

Description Duration Value Specific Risk Charges

Less than 6 months $700,000 $1,750

6 to 24 months $2,100,000 $21,000

Financial institution with an issuer or long-term debt rating of at least investment grade by an internationally reputable credit rating agency More than 24

months - -

Other deposits $700,000 $56,000

Total specific risk charges = $78,750

21.3.6 Reinsurance Receivables

XYZ Insurance has the following receivables outstanding from reinsurers:

Description of Reinsurers Value of Receivables Specific Risk Charge Licensed by MAS AAA to AA- $35,000 $560


20 December 2002 79

A+ to A- $140,000 $5,600 BBB+ to B- $140,000 $11,200

Under B- - -

Not licensed by MAS

$35,000

$2,800

Total Specific Risk Charge = $20,160

21.3.7 Outstanding Premiums and Agents’ Balance

The profile of this asset is as tabulated below:

Duration Outstanding Value 90 days or less 280,000 More than 90 days 70,000

Specific risk charge = 8% x 280,000 + 50% x 70,000 = $57,400

General risk charge = $0

21.3.8 All Other Assets

Specific risk charge = 8% x 2,100,000 = $168,000

General risk charge = $0

Assuming that effects of interest rates on liabilities are negligible, the table

below summarizes GC2 risk charges:

Asset Class Specific Risk Charge General Risk Charge Land and Buildings 448,000 448,000 Equities 1,680,000 1,680,000 Interest-Bearing Securities 224,000 539,000 Loans 481,600 140,000 Cash and Deposits 78,750 0 Reinsurance Receivables 20,160 0 Outstanding Premium and Agents Balance 57,400 0 All Other Assets 168,000 0 Total 3,157,910 2,807,000

Total GC2 risk charges = $5,964,910


20 December 2002 80

21.4 GC3 – Concentration Risk Component

Assets that exceed the investment limits are subjected to GC3 risk charges.

This amounts to 100% of the asset values.

For XYZ Insurance,

Total GC3 risk charges = $5,000,000

21.5 Summary

The risk charges and solvency status of XYZ Insurance can be summarized

by the following :

GC1 Risk Charges $3,327,128



Required Fund Solvency $14,292,038

Available Assets $54,254,500

XYZ Insurance meets the fund solvency requirement.

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