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The Supervision of Financial Conglomerates
Appendix 3: Capital Adequacy: Worked Examples
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Example A An insurance company parent with 100% participations in a bank and a securities firm. It is assumed that, apart from the participations, there are no intragroup exposures (or that these have been netted out). Capital and General reserves are assumed to represent the externally generated own funds of each entity (and are recognised as such by the regulators in question).
(i) Assume that capital requirements / solvency margins are as follows: Insurance company A1 200 Bank B1 1,200 Securities firm B2 400 (ii) The buildingblock prudential approach would use the consolidated balance sheet as its basis. Capital requirements would be calculated for the three types of regulated entity and aggregated (200 + 1,200 + 400 = 1,800). This figure would then be compared with the prudential consolidated capital (capital 400 + general reserves 2,000 = 2,400). So the group has a solvency surplus of 600. (iii) Under riskbased aggregation, the consolidating supervisor would aggregate the capital requirements for the regulated subsidiaries (these requirements being greater than the investments by the group in the subsidiaries), producing a figure of 1,600 (B1 1,200 + B2 400), which would then be added to the parent's own requirement (200) to produce the group requirement of 1,800. This figure is then compared to the externally generated capital of the group, typically the parent company's own capital (capital 400 + general reserves 900 = 1,300). This reveals a deficit of 500. However, if the general reserves of the subsidiaries are freely available and suitable for transfer (as was assumed under the building-block prudential approach), then the deficit is translated into a group surplus of 600 (500 + 700 + 400). (iv) Under riskbased deduction, the value of the participation in each subsidiary would be replaced by a figure representing the "lookthrough" net value of assets less tangible liabilities and less the minimum capital requirement of the subsidiary. So the book-value participation in B1 (800) would be replaced by a figure of 300 (assets 15,000 other liabilities 13,500 capital requirement 1,200 = 300). The write-down in the value of the participation is balanced by a similar writedown in the value of general reserves. In the case of the securities firm, the bookvalue figure at 200 remains the same (assets 5,000 other liabilities 4,400 capital requirement 400 = 200). So the revised "balance sheet" of the parent company looks as follows:
This assumes that the parent is able to satisfy its supervisor that the solvency surplus assets in the subsidiaries are both available and suitable to be taken into account. The solvency surplus of the group can then be calculated by deducting the parent's own capital requirement (200) from its own funds (capital and general reserves). (Capital) 400 + (Reserves) 400 200 = 600 (v) So a group solvency surplus of 600 is revealed under all three supervisory approaches discussed above. (vi) The total deduction method, however, would produce a different outcome. Under this method, the bookvalue of all investments in subsidiaries (plus any capital shortfalls in subsidiaries) is deducted from the parent's capital (1,300 800 200). The result (300) is then compared with the parent's solo capital requirement (200), showing a surplus of 100. Example B A bank parent with a 60% participation in a regulated insurance company. Again, it is assumed that, apart from the participations, there are no intragroup exposures (or that these have been netted out). Capital and General reserves are assumed to represent the own funds of each entity (and are recognised as such by the regulators in question). Subsidiaries are held at cost in the accounts of their parent company.
The shape of the Group (consolidated) balance sheet would depend upon whether full or prorata integration of the subsidiary is adopted:
Assume that capital requirements / solvency margins are as follows: Bank A1 (Parent) 1,100 Insurance Co. B1 (Subsidiary) 600
(a) Full Integration (i) Under the buildingblock prudential approach, the capital requirements of the two types of entity would be aggregated [1,100 + 600 = 1,700] and this figure compared with the prudential consolidated group capital (600 capital + 1,600 general reserves = 2,200). Thus a solvency surplus of 500 would be revealed. (ii) Under riskbased aggregation in its simplest form, the capital requirements of the parent and subsidiary would again be aggregated (1,700) and this figure compared to the own funds of the group (own funds of parent 1,500 + own funds of subsidiary 1,000 book value of participation 300 = 2,200). Thus a solvency surplus of 500 is identified. (iii) Under riskbased deduction, the value of the participation in the subsidiary would be replaced in the balance sheet of the parent by a figure representing the "lookthrough" net value of assets less tangible liabilities and less the minimum capital requirement of the subsidiary. If the fact that the subsidiary is not wholly owned is ignored, the book-value participation (300) would be replaced by a figure of 400 [assets 15,000 technical provisions 14,000 capital requirement 600 = 400]. And the revised "balance sheet" of the parent bank would look as follows (the General reserves being written up to reflect the increased value of the participation):
This assumes that the parent is able to satisfy its supervisor that all the solvency surplus assets in the partlyowned subsidiary are both available and suitable to be taken into account (as they were under the building block prudential approach and riskbased aggregation). The solvency surplus of the group can then be calculated by deducting the parent's own capital requirement from its own funds (capital and general reserves). (Capital) 400 + (Reserves) 1,200 1,100 (Parent's capital requirement) = 500 (iv) So a group solvency surplus of 500 is revealed under all three supervisory approaches if a partly owned subsidiary is fully integrated as long as the same assumptions are made about the availability and suitability of surplus capital. (v) Under total deduction, the book value of the investment in the subsidiary is deducted from the parent's capital (400 + 1,100 300 = 1,200) and the result is compared with the parent's solo capital requirement (1,100), revealing a surplus of 100. (b) ProRata Integration (i) Under the buildingblock prudential approach, the capital requirements of the two types of entity would be aggregated [1,100 + (60% of 600) = 1,460] and this figure compared with the prudential consolidated group capital (400 capital + 1,400 general reserves = 1,800). Thus a solvency surplus of 340 would be revealed. (ii) Under riskbased aggregation in its simplest form, the capital requirements of the parent and subsidiary would again be aggregated (1,460) and this figure compared to the own funds of the group (own funds of parent 1,500 + 60% of subsidiary's own funds 600 book value of participation 300 = 1,800). Thus a solvency surplus of 340 is again revealed. (iii) Under riskbased deduction, the value of the participation in the subsidiary would be replaced in the balance sheet of the parent by a figure representing the "lookthrough" net value of assets less tangible liabilities and less the minimum capital requirement of the subsidiary. So the bookvalue participation in the subsidiary (300) would be replaced by a figure of 240 [assets 15,000 technical provisions 14,000 capital requirement 600 = 400 x 0.6 (i.e. prorata) = 240]. So the revised "balance sheet" of the parent bank would look as follows:
Again, this assumes that the parent is able to satisfy its supervisor that the solvency surplus assets in the partlyowned subsidiary are both available and suitable to be taken into account. The solvency surplus of the group can then be calculated by deducting the parent's own capital requirement from its own funds (capital and general reserves). (Capital) 400 + (Reserves) 1,040 1,100 (Parent's capital requirement) = 340 (iv) So a group solvency surplus of 340 is revealed under all three supervisory approaches if a prorata approach is adopted to integration of the partly owned subsidiary. (v) The total deduction method would yield the same result as under full integration (i.e. a surplus of 100) since it involves subtracting the book value of the participation from the parent's capital. Example C An unregulated holding company with two regulated whollyowned subsidiaries (i.e. sister companies) in the banking and insurance sectors. The bank is heavily overcapitalised. Again, it is assumed that, apart from the participations, there are no intragroup exposures (or that these have been netted out). Capital and general reserves are assumed to represent the own funds of each entity (and are recognised as such by the regulators in question). Again, subsidiaries are held at cost in the accounts of their parent company.
(i) Assume that capital requirements / solvency margins are as follows: Bank B1 100 Insurance Company B2 300 (ii) Under the buildingblock prudential approach, the capital requirements for the bank and insurance company would be aggregated (100 + 300 = 400) and this figure compared with the prudential consolidated capital (capital 1,000 + general reserves 400 = 1,400). So the group is seen to have a solvency surplus of 1,000, most of which is situated in the bank.
(iii) Under riskbased aggregation in its simplest form, the capital requirements of the two subsidiaries would again be aggregated (400) and this figure compared to the own funds of the group (own funds of parent 1,000 + own funds of bank 1,000 + own funds of insurance company 400 book value of the participations 1,000 = 1,400). Again, the group is seen to have a solvency surplus of 1,000. If the more prudent form of riskbased aggregation described in paragraphs [] of the main report is adopted, however, the consolidating supervisor aggregates either the regulatory capital requirement or the investment by the group in a subsidiary (whichever is the greater). Since the investment by the group in the bank (800) exceeds the bank's capital requirement (100), it is this which is included in the aggregation: 800 + 300 (Insurance Co.'s capital requirement) = 1,100 This figure is then compared to the own funds of the group (own funds of parent 1,000 + own funds of bank 1,000 + own funds of insurance company 400 book value of the participations 1,000 = 1,400). A surplus of only 300 is revealed. The difference between this figure and the 1,000 surplus identified under the simpler form of riskbased aggregation (and under the buildingblock prudential approach) is accounted for by the fact that the group's investment in the banking subsidiary (800) was included in the aggregation instead of the bank's capital requirement (100). (iv) Under riskbased deduction, the value of the participation in each subsidiary would be replaced in the balance sheet of the parent by a figure representing the "lookthrough" net value of assets less tangible liabilities and less the minimum capital requirement of the subsidiary. So the bookvalue participation in B1 (800) would be replaced by a figure of 900 (assets 1,300 other liabilities 300 capital requirement 100); and the book-value participation in B2 (200) would be replaced by a figure of 100 (investments 7,000 technical provisions 6,600 capital requirement 300). So the revised "balance sheet" of the parent holding company would look as follows:
Under riskbased deduction, the group's solvency surplus would normally be calculated by deducting the parent's own capital requirement from its own funds. However, in this example, the unregulated parent has no capital requirement of its own and its capital of 1,000 therefore represents the group solvency surplus. (v) So a group solvency surplus of 1,000 is revealed under the buildingblock prudential approach, under the simpler form of risk-based aggregation and under riskbased deduction. The more prudent form of riskbased aggregation comes to a different conclusion, essentially because the investment by the group in the banking subsidiary has been included in the aggregation instead of the bank's actual solo regulatory capital requirement. (vi) When there is an unregulated holding company, the total deduction method is not applicable.
Example D (DoubleGearing with Full Consolidation) PARENT
SUBSIDIARY 1 (100%)
GROUP
If the parent regulator's rules do not require the deduction of the participation's book value at solo level, both institutions (parent and subsidiary 1) comply with their respective solo requirements. The assessment of capital adequacy at group level reveals that there is an element of doublegearing, which would call for supervisory action from the parent's regulator. However, in a situation where the parent also has a 60% participation in a second subsidiary with a considerable surplus at solo level, SUBSIDIARY 2 (60%)
the Group position would be as follows: GROUP
Full integration of the second subsidiary in the group calculation reveals no element of doublegearing. The second subsidiary's surplus compensates for the previous deficit at group level. This is because full integration regards capital elements attributable to minority interests as available to the Group as a whole. Of course, if the second subsidiary had a capital deficit at solo level: SUBSIDIARY 2 (60%)
then full integration would reveal a larger deficit at group level than prorata integration: GROUP
This is because full integration has the effect of placing full responsibility for making good the deficit on the controlling shareholder. Example E (Use of Surplus Capital in One Entity to Cover a Deficit in Another Entity)
SUBSIDIARY 1 (50% participation)
GROUP
The surplus at group level stems exclusively from the partly-owned subsidiary. However, in the event that the parent also had a participation in an undercapitalised unregulated entity, the group position would be as follows: UNREGULATED SUBSIDIARY 2 (100% participation)
GROUP
Under the full integration approach, the surplus in subsidiary 1 is regarded as available to the group as a whole and it thus more than compensates for the deficit in subsidiary 2. The prorata approach, on the other hand, only takes account of that part of the surplus in subsidiary 1 which is attributable to the parent and, as shown, this is not sufficient to offset the deficit in subsidiary 2. Example F (Higher Risk Lower Standards)
SUBSIDIARY
GROUP
The parent increases its share in the subsidiary from 25% to 50% which induces its regulator to apply full instead of prorata integration because full responsibility for the subsidiary (and full availability of its surplus capital is assumed. The group surplus increases from 45 to 70 and some members would argue that this automatically increases the scope for potential doublegearing in other parts of the group. A change from prorata to full integration, which might be regarded as taking a more conservative view of the parent's risks now that it has increased its participation, in fact has the opposite effect.
Example G: The purpose of this example is to show that, when definitions of banking and insurance capital differ, it is possible that, at group level, insurance risks are covered by banking capital (or viceversa), even when the bank and the insurer that constitute the group each fulfil their solo capital requirements.
A parent life insurance company has own funds of 500, of which 200 is paid-up share capital (also recognised by banking regulators); The remaining 300 stems from profit reserves appearing in the balance sheet and future profits, capital components which are only recognised by insurance regulators; The insurance company has a 100% participation in a bank subsidiary with a book value of 250. It therefore complies with its capital requirement of 250. In addition to the 250 paidup share capital furnished by the insurance parent, the banking subsidiary has hidden reserves and reserves for general banking risk of 50 which by definition are not elements recognised as liable funds by insurance regulators. Its capital requirement is 300. An undifferentiated, purely quantitative, calculation at group level identifies a balanced capital position with the sum of the capital elements equalling the capital requirements:
Further analysis, however, reveals that coverage is inadequate:
The capital charge for insurance risk of 250 is more than covered by the 300 units of capital recognised only by insurance regulators; there is an excess of 50 units. The capital charge for banking risk of 300 is covered by 50 units of capital recognised only by banking regulators and by 200 units of capital recognised under both supervisory regimes; but the remaining charge of 50 is effectively covered by insurance capital i.e. by capital components which banking regulators have deemed unsuitable for covering banking risks.Example H (Subordinated Debt)
SUBSIDIARY (100% participation)
The solvency surplus at group level stems from the subsidiary's subordinated debt. Although subordinated debt may be an acceptable form of capital under the parent's own regulatory rules, the group surplus in this example is arguably only available to the subsidiary, in which case the regulator of the parent will need to guard against the possibility that this excess is used to cover risks at group level (e.g. a notional deficit in an unregulated entity). Example J (RiskBased Deduction) (Specimen simplified balance sheets) Company A (Parent Life Insurer, With a 60% Holding in B)
A's solvency margin is 40 (4% of 1000). It has free reserves of 128 to cover it.
Company B (Life Insurer)
B has free reserves of 100 (60 share capital plus 40 profit carried forward) to cover its solvency margin of 20 (4% of 500). The surplus of net assets over liabilities and solvency margin = 80. 60% share of 80 = 48, which is therefore the value of A's participation in B which is allowable for the purposes of A's balance sheet.
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The Supervision of Financial Conglomerates
