Hong Kong's Risk Based Capital Regime

Prior to the introduction of the risk-based capital regime, the capital adequacy of a Hong Kong insurer was assessed under a rules based capital adequacy regime focused on the insurer’s solvency margin, meaning the surplus of the insurer’s assets over its liabilities. The rules based capital adequacy regime was inconsistent with the global evolution towards risk based regimes and failed to reflect individual risk factors specific to each insurer.

To align Hong Kong with international standards and to recognize these individual risk facts, Hong Kong transitioned to a risk-based capital regime comprised of 3 pillars.

Pillar 1 – Valuation and Capital

Pillar 1 imposes quantitative capital requirements on insurers other than special business insurers, prescribing minimum capital and valuation methodologies. These requirements apply consistently across all insurers (“authorized insurers”) authorized in Hong Kong other than marine insurers, captive insurers and Lloyd’s. For authorized insurers incorporated in Hong Kong as well as non-Hong Kong incorporated authorized insurers (“designated insurers”) designated by the Insurance Authority on the basis that they carry on the majority of their insurance business in Hong Kong, these requirements apply on a group consolidated basis except to the extent members of the group are themselves regulated financial entities. In contrast, these requirements only apply to assets, liabilities and capital related to the business carried on in Hong Kong for authorized insurers incorporated outside Hong Kong which have not been so designated.

Individual insurers may apply to the IA to phase in certain Pillar 1 requirements over a 3 year transition period that began on July 1, 2024 and will end on June 30, 2027.

Capital Base

The capital base of an insurer is the sum of their Unlimited Tier 1 capital, Limited Tier 1 capital and Tier 2 capital.

For a HK incorporated authorized insurer or a designated insurer, Unlimited Tier 1 capital normally includes paid-up ordinary shares and share premium and retained earnings. For non-HK incorporated authorized insurers that are not designated insurers, Unlimited Tier 1 capital is, in broad terms, the sum of the surplus of assets over liabilities of all funds required to be maintained in respect of linked long term and retirement policies or in respect of general business. Unlimited Tier 1 capital may be subject to deductions.

Subject to prescribed deductions, Limited Tier 1 capital may include paid-up capital instruments which enjoy priority over Unlimited Tier 1 capital but which are subordinate to Tier 2 capital.

Minimum Capital

Insurers must ensure at all times that their capital base is not less than each of the following:

• PCA - the prescribed capital amount (“PCA”);

• MCA – the minimum capital amount (“MCA”); and

• K$20 million.

Unless otherwise prescribed, the MCA is 50% of the PCA. An insurer must immediately notify the IA if any of its directors, controllers or key persons knows or has reason to believe that the insurer has failed to meet these capital requirements or has reached a view that the insurer is at risk of doing so.

Limited Tier 1 capital cannot exceed 10% of the PCA and Tier 2 capital cannot exceed 50% of the PCA.

Prescribed Capital Amount

The PCA relies upon prescribed methods to calculate and then aggregate risk capital amounts for each of market risk, life insurance risk, general insurance risk and counterparty default as well as risk capitals amount for operational and other risk. Under this approach:

• The prescribed risk capital amounts for market risk, life insurance risk, general insurance risk and counterparty default and other risk are each calculated by aggregating risk capital for individual sub-risks. So, for example, the prescribed risk capital amount for market risk will aggregate risk capital amounts for interest rate risk, credit spread risk, equity risk, property risk and currency risk.

• Aggregation methodology uses prescribed correlation matrices to recognize that risk scenarios may be uncorrelated. There is no need, for example, for risk capital sufficient to cater for the unlikely event where 2 worst case scenarios both occur simultaneously.

• Where applicable, in broad terms, the calculation of individual risks and sub-risks adopts mathematical approaches calibrated to impose risk capital sufficient to ensure solvency from those risks with a 99.5% confidence over a one year period.

Pillar 2 – Risk Management

Pillar 2 mandates principles rather than rules which individual insurers should apply in establishing their risk management framework, including in respect of risk governance, the identification and assessment of risks, the maintenance of capital for risks either omitted or insufficiently addressed in Pillar 1 and the development and enhancement of techniques to monitor and manage risk exposures.

Pillar 2 principles apply to all authorized insurers, including those incorporated outside Hong Kong, other than captive insurers, marine insurers, Lloyd’s as well as run-off insurers (i.e. insurers which have ceased accepting new insurance business and are in the course of running-off their liabilities).

Pillar 2 charges the board of an authorized insurer with responsibility for defining risk management responsibilities and reporting lines, a risk appetite statement that articulates the level and types of risk the insurer is prepared to assume and policies and procedures to identify risk, measure and quantify risk, monitor and report risk, review, mitigate or transfer risk and evaluate and enhance the foregoing from time to time. In the context of an insurer which is part of a group, risk management should address group risk in relation to other entities and cross-border issues.

Identification and Quantification of Risk

A risk management framework should identify all material risks, including insurance risk, market risk, counterparty default risk, concentration risks, liquidity risk, operational risks, group risks and political risks. An insurer should assess the potential impact of risks and the probability of their occurrence, using forward looking techniques such as scenario and stress testing (“SST”) and continuity analyses to assess the ability of the insurer to continue its business in adverse scenarios. Irrespective of regulatory capital requirements which may arise under Pillar 1, an insurer should maintain a level of capital (“Target Capital”) sufficient to address these risks.

Policy Scope

Risk management policies must specifically address business areas where risk is actively undertaken or transferred, including, in accordance with their own specific circumstances, in respect of underwriting, asset liability management, investment, reinsurance and risk transfer and liquidity as well as actuarial policy, conduct in the treatment of customers, cyber security threats, claims management, internal controls and data quality. These policies should be proportionate to the nature, scale and complexity of business operations.

ORSA

Pillar 2 requires the insurer to conduct an own risk and solvency assessment (“ORSA”) on at least an annual basis. The ORSA should enable the insurer to determine its overall financial resources needs given its risk appetite and business plans and the quality and adequacy of its capital resources to meet regulatory capital requirements, all bearing in mind both normal and stressed business conditions.

Amongst other things, an ORSA should address the insurer’s risk appetite statement, describe and assess the effectiveness of its risk management framework, analyze its risk against business strategy, consider foreseeable material risks, describe risks and how they are measured, assess capital relative to risk appetite and business plans, and analyze the quality and adequacy of financial resources in both normal and adverse scenarios.

For both Hong Kong and non-Hong Kong incorporated authorized insurers, the ORSA should focus on the entire company with separate specifics to cover Hong Kong operations. However, for non-Hong Kong incorporated authorized insurers, only the Hong Kong branch must meet Hong Kong regulatory requirements in respect of the ORSA.

The effectiveness of the ORSA should be regularly validated through independent review by experienced individuals who report directly to or who are members of the board of the insurer.

Pillar 3 – Reporting and Disclosure

Pillar 3 establishes both requirements for authorized insurers to file returns with the IA and to publicize and file with the IA prescribed disclosures. These disclosures provide transparency to the public, thereby both enhancing market discipline and empowering policy holders to make decisions on insuring risks with insurers and market participants in making decisions about the provision of resources to insurers.

Regulatory Reporting

Hong Kong incorporated authorized insurers must file with the IA each year their audited financial statements prepared in accordance with Hong Kong company law. Non-Hong Kong incorporated authorized insurers must file with the IA each year audited financial statements required under the laws of their place of incorporation and must include in such statements such information as the IA may consider necessary to accord with Hong Kong company law requirements.

In addition to financial statements, all authorized insurers must file annual and other periodic returns with the IA. These returns cover the insurer’s financial position, its capital adequacy, its business results, its governance, and, for insurers carrying on long-term business, its anti-money laundering and counter-terrorist financing program.

Finally, authorized insurers must submit an auditor’s report together with their annual return as well as an actuary’s report.

Amongst other things, the auditor’s report opines on whether the insurer maintains proper records in accordance with statutory requirements, whether the insurer’s annual forms are prepared in accordance with the insurer’s books and comply with applicable regulations, whether the insurer has breached capital requirements and whether separate funds are maintained for linked long-term, retirement and general business in accordance with statutory requirements.

The actuary’s report covers the general principles, methods, assumptions and analysis used by the actuary in valuing insurance liabilities.

For long-term business, the report must include the actuary’s opinion as to the adequacy of the insurer’s records, the integrity of the data used for valuation, compliance with valuation rules, the existence of adequate provisions for policy obligations, compliance with requirements for maintenance of accounts and funds, and the prudence of the relationship between assets and liabilities.

For general business, the report must include the actuary’s confirmation as to the integrity of the data used for valuation, compliance with valuation rules, and the existence of adequate provisions for policy obligations.

Public Disclosures

Authorized insurers (other than marine insurers, captive insurers and special purpose insurers) and Lloyd’s must make annual public disclosures except to the extent they have not yet phased fully into Pillar 1 under transitional arrangements. These disclosures must be made online over an internet website.

The disclosures include:

• Audited financial statements

• Company profile – including name, nature of business, place of business operations and a description of its corporate structure

• Financial position and performance – including the balance sheet and an explanation of any year-on-year changes in the balance sheet as well as a breakdown of performance for long-term, participating and general business and an explanation of any material change in the components of performance analysis

• Investments – including assumptions and methods for valuing investments and an explanation of any year-on-year changes in these methodologies

• Insurance liabilities – including reinsurance assets and reinsurance liabilities for long term business, a description of the assumptions used to value insurance liabilities and the methods used to derive those assumptions and an explanation of any material changes in these assumptions

• Pricing adequacy – including a breakdown of the components of pricing adequacy and an explanation of any material change in these components

• Capital adequacy – including the PCA and its components, the capital base and its components, the ratio of its capital base to its PCA and an explanation of any material change in the foregoing

• Risk management – including a description of risk appetite, risk governance framework and both insurance and investment risk management

A controller or director of the insurer should confirm that he is satisfied with the completeness, accuracy and integrity of the disclosure and that the information in the disclosures complies with statutory requirements for valuation and regulatory capital.