ICP 17 Capital Adequacy The supervisor establishes capital adequacy requirements for solvency purposes so that insurers can absorb significant unforeseen losses and to provide for degrees of supervisory intervention. Capital adequacy in the context of a total balance sheet approach 17.1 The supervisor requires that a total balance sheet approach is used in the assessment of solvency to recognise the interdependence between assets, liabilities, regulatory capital requirements and capital resources and to require that risks are appropriately recognised. Establishing regulatory capital requirements 17.2 The supervisor establishes regulatory capital requirements at a sufficient level so that, in adversity, an insurer’s obligations to policyholders will continue to be met as they fall due and requires that insurers maintain capital resources to meet the regulatory capital requirements. Structure of regulatory capital requirements - solvency control levels 17.3 The regulatory capital requirements include solvency control levels which trigger different degrees of intervention by the supervisor with an appropriate degree of urgency and requires coherence between the solvency control levels established and the associated corrective action that may be at the disposal of the insurer and/or the supervisor. Structure of regulatory capital requirements - triggers for supervisory intervention in the context of legal entity capital adequacy assessment 17.4 In the context of insurance legal entity capital adequacy assessment, the regulatory capital requirements establish: • a solvency control level above which the supervisor does not intervene on capital adequacy grounds. This is referred to as the Prescribed Capital Requirement (PCR). The PCR is defined such that assets will exceed technical provisions and other liabilities with a specified level of safety over a defined time horizon. • a solvency control level at which, if breached, the supervisor would invoke its strongest actions, in the absence of appropriate corrective action by the insurance legal entity. This is referred to as the Minimum Capital Requirement (MCR). The MCR is subject to a minimum bound below which no insurer is regarded to be viable to operate effectively. Structure of regulatory capital requirements - Triggers for supervisory intervention in the context of group-wide capital adequacy assessment 17.5 In the context of group-wide capital adequacy assessment, the regulatory capital requirements establish solvency control levels that are appropriate in the context of the approach to group-wide capital adequacy that is applied. Structure of regulatory capital requirements - approaches to determining regulatory capital requirements 17.6 The regulatory capital requirements are established in an open and transparent process, and the objectives of the regulatory capital requirements and the bases on which they are determined are explicit. In determining regulatory capital requirements, the supervisor allows a set of standardised and, if appropriate, other approved more tailored approaches such as the use of (partial or full) internal models. 17.7 The supervisor addresses all relevant and material categories of risk in insurers and is explicit as to where risks are addressed, whether solely in technical provisions, solely in regulatory capital requirements or if addressed in both, as to the extent to which the risks are addressed in each. The supervisor is also explicit as to how risks and their aggregation are reflected in regulatory capital requirements. 17.8 The supervisor sets appropriate target criteria for the calculation of regulatory capital requirements, which underlie the calibration of a standardised approach. Where the supervisor allows the use of approved more tailored approaches such as internal models for the purpose of determining regulatory capital requirements, the target criteria underlying the calibration of the standardised approach are also used by those approaches for that purpose to require broad consistency among all insurers within the jurisdiction. Variation of regulatory capital requirements 17.9 Any variations to the regulatory capital requirement imposed by the supervisor are made within a transparent framework, are appropriate to the nature, scale and complexity according to the target criteria and are only expected to be required in limited circumstances. Identification of capital resources potentially available for solvency purposes 17.10 The supervisor defines the approach to determining the capital resources eligible to meet regulatory capital requirements and their value, consistent with a total balance sheet approach for solvency assessment and having regard to the quality and suitability of capital elements. Criteria for the assessment of the quality and suitability of capital resources 17.11 The supervisor establishes criteria for assessing the quality and suitability of capital resources, having regard to their ability to absorb losses on both a going-concern and wind-up basis. General provisions on the use of an internal model to determine regulatory capital requirements 17.12 Where a supervisor allows the use of internal models to determine regulatory capital requirements, the supervisor: • establishes appropriate modelling criteria to be used for the determination of regulatory capital requirements, which require broad consistency among all insurers within the jurisdiction; and • identifies the different levels of regulatory capital requirements for which the use of internal models is allowed. Initial validation and supervisory approval of internal models 17.13 Where a supervisor allows the use of internal models to determine regulatory capital requirements, the supervisor requires: • prior supervisory approval for the insurer’s use of an internal model for the purpose of calculating regulatory capital requirements; • the insurer to adopt risk modelling techniques and approaches appropriate to the nature, scale and complexity of its current risks and those incorporated within its risk strategy and business objectives in constructing its internal model for regulatory capital purposes; • the insurer to validate an internal model to be used for regulatory capital purposes by subjecting it, as a minimum, to three tests: “statistical quality test”, “calibration test” and “use test”; and • the insurer to demonstrate that the model is appropriate for regulatory capital purposes and to demonstrate the results of each of the three tests. Statistical quality test for internal models 17.14 Where a supervisor allows the use of internal models to determine regulatory capital requirements, the supervisor requires: • the insurer to conduct a “statistical quality test” which assesses the base quantitative methodology of the internal model, to demonstrate the appropriateness of this methodology, including the choice of model inputs and parameters, and to justify the assumptions underlying the model; and • that the determination of the regulatory capital requirement using an internal model addresses the overall risk position of the insurer and that the underlying data used in the model is accurate and complete. Calibration test for internal models 17.15 Where a supervisor allows the use of internal models to determine regulatory capital requirements, the supervisor requires the insurer to conduct a “calibration test” to demonstrate that the regulatory capital requirement determined by the internal model satisfies the specified modelling criteria. Use test and governance for internal models 17.16 Where a supervisor allows the use of internal models to determine regulatory capital requirements, the supervisor requires: • the insurer to fully embed the internal model, its methodologies and results, into the insurer’s risk strategy and operational processes (the “use test”); • the insurer's Board and Senior Management to have overall control of and responsibility for the construction and use of the internal model for risk management purposes, and ensure sufficient understanding of the model's construction at appropriate levels within the insurer's organisational structure. In particular, the supervisor requires the insurer’s Board and Senior Management to understand the consequences of the internal model's outputs and limitations for risk and capital management decisions; and • the insurer to have adequate governance and internal controls in place with respect to the internal model. Documentation for internal models 17.17 Where a supervisor allows the use of internal models to determine regulatory capital requirements, the supervisor requires the insurer to document the design, construction and governance of the internal model, including an outline of the rationale and assumptions underlying its methodology. The supervisor requires the documentation to be sufficient to demonstrate compliance with the regulatory validation requirements for internal models, including the statistical quality test, calibration test and use test outlined above. Ongoing validation and supervisory approval of the internal model 17.18 Where a supervisor allows the use of internal models to determine regulatory capital requirements, the supervisor requires: • the insurer to monitor the performance of its internal model and regularly review and validate the ongoing appropriateness of the model’s specifications. The supervisor requires the insurer to demonstrate that the model remains fit for regulatory capital purposes in changing circumstances against the criteria of the statistical quality test, calibration test and use test; • the insurer to notify the supervisor of material changes to the internal model made by it for review and continued approval of the use of the model for regulatory capital purposes; • the insurer to properly document internal model changes; and • the insurer to report information necessary for supervisory review and ongoing approval of the internal model on a regular basis, as determined appropriate by the supervisor. The information includes details of how the model is embedded within the insurer’s governance and operational processes and risk management strategy, as well as information on the risks assessed by the model and the capital assessment derived from its operation.