Reading the Financial Soundness Standards for Insurers (FSIs) is an exercise that can only end in madness. I’m sufficiently familiar with them now that I mostly refer back to them for particularly tricky or thorny issues. Without fail, the words fail to clearly communicate exactly what was intended.
Take ancillary capital as an example. To my mind, the basic principle is clear. I’ve validated this principle in discussions with Capital Requirements Task Group members, SAM Pillar 1 Subcommittee members, multiple actuaries familiar with the Solvency II principles and delegated acts on which we have based on South African rules. Here is the practical definition of “Ancillary Own Funds”
Ancillary own funds are sources of capital that are not on the balance sheet, but could become Basic Own Funds in certain circumstances. As such, they can still sometimes be used to demonstrate solvency.
Basic Own Funds then are on balance sheet items that contribute capital. These are the excess of assets of total liabilities, with very specific types of subordinated liabilities “added back” because they can absorb losses and meet other criteria. There are a few specific rules about other regulatory deductions form Own Funds, but generally, that is it.
(As an aside, the tiering of capital has almost nothing to do with how your assets are invested, and almost everything to do with the sources of capital. This is another recurring puzzle I find myself explaining a couple of times a month for some reason.)
Here’s one odd thing. Since the Solvency Capital Requirement (SCR) is determined as the change in Basic Own Funds in various adverse scenarios, the possible change in credit worthiness or even outright default of a provider of a letter of credit or guarantee or undrawn loan facility has no impact on the SCR. This is part of the reason the use of Ancillary Own Funds requires explicit approval from the Prudential Authority.
If I were to change the formula, I would add change in Ancillary Own Funds to the SCR. I have yet to see a compelling reason to exclude it.