RISK BASED CAPITAL
Capital requirement
The standardized requirements in place for banks and other depository institutions, which determines how much capital is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements, Federal Deposit Insurance Corporation or Federal Reserve Board. These requirements are put into place to ensure that these institutions are not participating or holding investments that increase the risk of default and that they have enough capital to sustain operating losses while still honoring withdrawals. Also known as "regulatory capital".

The Basel Accords, published by the Basel Committee on Banking Supervision housed at the Bank for International Settlements, sets a framework on how banks and depository institutions must calculate their capital. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as Basel I. This framework has been replaced by a significantly more complex capital adequacy framework commonly known as Basel II. After 2012 it will be replaced by Basel III [2]. Another term commonly used in the context of the frameworks is Economic Capital, which can be thought of as the capital level bank shareholders would choose in absence of capital regulation. For a detailed study on the differences between these two definitions of capital, refer to [3].
The capital ratio is the percentage of a bank's capital to its risk-weighted assets. Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant Accord. Basel II requires that the total capital ratio must be no lower than 8%.
Each national regulator normally has a very slightly different way of calculating bank capital, designed to meet the common requirements within their individual national legal framework.
Most developed countries implement Basel I and II, stipulate lending limits as a multiple of a banks capital eroded by the yearly inflation rate.
The 5 Cs of Credit - Character, Cash Flow, Collateral, Conditions and Capital- have been replaced by one single criterion. While the international standards of bank capital were laid down in the 1988 Basel I accord, Basel II makes significant alterations to the interpretation, if not the calculation, of the capital requirement.
Examples of national regulators implementing Basel II include the FSA in the UK, BaFin in Germany, OSFI in Canada, Banca d'Italia in Italy.
In the United States, depository institutions are subject to risk-based capital guidelines issued by the Board of Governors of the Federal Reserve System (FRB)[4]. These guidelines are used to evaluate capital adequacy based primarily on the perceived credit risk associated with balance sheet assets, as well as certain off-balance sheet exposures such as unfunded loan commitments, letters of credit, and derivatives and foreign exchange contracts. The risk-based capital guidelines are supplemented by a leverage ratio requirement. To be adequately capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. To be well-capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratio of at least 10%, and a leverage ratio of at least 5%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. These capital ratios are reported quarterly on the Call Report or Thrift Financial Report. Although Tier 1 capital has traditionally been emphasized, in the Late-2000s recession regulators and investors began to focus on tangible common equity, which is different from Tier 1 capital in that it excludes preferred equity.[5]
Regulatory capital
In the Basel II accord bank capital has been divided into two "tiers" ( "International Convergence of Capital Measurement and Capital Standards:A Revised Framework:Comprehensive Version". Pg 14: Basel Committee on Banking Supervision. 2006. ), each with some subdivisions.
Tier 1 capital
Tier 1 capital, the more important of the two, consists largely of shareholders' equity and disclosed reserves. This is the amount paid up to originally purchase the stock (or shares) of the Bank (not the amount those shares are currently trading for on the stock exchange), retained profits subtracting accumulated losses, and other qualifiable Tier 1 capital securities (see below). In simple terms, if the original stockholders contributed $100 to buy their stock and the Bank has made $10 in retained earnings each year since, paid out no dividends, had no other forms of capital and made no losses, after 10 years the Bank's tier one capital would be $200. Shareholders equity and retained earnings are now commonly referred to as "Core" Tier 1 capital, whereas Tier 1 is core Tier 1 together with other qualifying Tier 1 capital securities.
Tier 2 (supplementary) capital
Main article: Tier 2 capital
Tier 2 capital, or supplementary capital, comprises undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt.
Undisclosed Reserves
Undisclosed reserves are not common, but are accepted by some regulators where a Bank has made a profit but this has not appeared in normal retained profits or in general reserves. Most of the regulators do not allow this type of reserve because it does not reflect a true and fair picture of the results.
Revaluation reserves
A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example may be where a bank owns the land and building of its headquarters and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve.
General provisions
A general provision is created when a company is aware that a loss may have occurred but is not sure of the exact nature of that loss. Under pre-IFRS accounting standards, general provisions were commonly created to provide for losses that were expected in the future. As these did not represent incurred losses, regulators tended to allow them to be counted as capital.
Hybrid debt capital instruments
They consist of instruments which combine certain characteristics of equity as well as debt. They can be included in supplementary capital if they are able to support losses on an on-going basis without triggering liquidation.
Subordinated-term debt
Subordinated debt is classed as Lower Tier 2 debt, usually has a maturity of a minimum of 10 years and ranks senior to Tier 1 debt, but subordinate to senior debt. To ensure that the amount of capital outstanding doesn't fall sharply once a Lower Tier 2 issue matures and, for example, not be replaced, the regulator demands that the amount that is qualifiable as Tier 2 capital amortises (i.e. reduces) on a straight line basis from maturity minus 5 years (e.g. a 1bn issue would only count as worth 800m in capital 4years before maturity). The remainder qualifies as senior issuance. For this reason many Lower Tier 2 instruments were issued as 10yr non-call 5 year issues (i.e. final maturity after 10yrs but callable after 5yrs). If not called, issue has a large step - similar to Tier 1 - thereby making the call more likely.
Different International Implementations
Regulators in each country have some discretion on how they implement capital requirements in their jurisdiction.
For example, it has been reported[6] that Australia's Commonwealth Bank is measured as having 7.6% Tier 1 capital under the rules of the Australian Prudential Regulation Authority, but this would be measured as 10.1% if the bank was under the jurisdiction of the UK's Financial Services Authority. This demonstrates that international differences in implementation of the rule can vary considerably in their level of strictness.
Common capital ratios • Tier 1 capital ratio = Tier 1 capital / Risk-adjusted assets >=6% • Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 and Tier 2) / Risk-adjusted assets >=10% • Leverage ratio = Tier 1 capital / Average total consolidated assets >=5% • Common stockholders’ equity ratio = Common stockholders’ equity / Balance sheet assets • Measure of a bank's financial strength, taking into account capital reserves for loans, investments, and certain other items off the balance sheet. In general, assets with higher credit risk require more capital in reserve than low-risk assets. The aim of risk-based capital is to: (1) encourage banks to keep a sufficient cushion of equity capital, including common stock, to support balance sheet assets; (2) include off-balance sheet items in the computation of capital adequacy; (3) eliminate disincentives to holding low-risk, liquid assets; and (4) set uniform international guidelines for bank capital adequacy in the Group of Ten countries. • In the United States, the risk-based capital formula raises the mandatory capital from 5.5% of assets to 8%, 4% of which must be in Tier 1 capital (common stock plus noncumulative preferred stock); and 4% in other types of qualifying capital, including loan loss reserves, perpetual preferred stock, hybrid capital instruments, such as Mandatory Convertible debentures, and subordinated debt. • The risk-based guidelines, approved by the Basle Committee on Banking Regulations and Supervisory Practices (the Basle Supervisors' Committee), are a fundamental change in calculation of bank capital from previous measures of calculating capital adequacy. It shifts capital determination from the liability side of the balance sheet to the asset side, using a formula that assigns specific risk weights to different groups of assets. A bank's risk-based capital ratio is computed by dividing its qualifying capital by its weighted risk assets. Assets given a 100% risk rating, such as commercial loans and consumer installment loans, require an institution to maintain total equity capital (tier 1 and Tier 2 capital) equal to 8% of the asset's book value. So-called riskless assets, having a risk rating of zero (cash, U.S. Government securities), require no capital held in reserve. • The risk weights for balance sheet assets are summarized as follows: • -0% risk weight: cash, gold bullion, loans guaranteed by the U.S. Government, balances due from Federal Reserve Banks. • -20% risk weight: demand deposits, checks in the process of collection, risk participations in bankers' acceptances and letters of credit, and other short-term claims maturing in one year or less. • -50% risk weight: 1-4 family residential mortgages, whether owner occupied or rented; privately issued mortgage backed securities and municipal revenue bonds. • -100% risk weight: cross-border loans to non-U.S. Borrowers, commercial loans, consumer loans, derivative mortgage backed securities, industrial development bonds, stripped mortgage backed securities, joint ventures, and intangibles such as interest rate contracts, currency swaps, and other derivative financial instruments. • Ratio of authorized control level risk - based capital of an insurance company to its total adjusted capital . This statistic determines regulatory action taken by the state’s insurance commissioner. If the RBCS is greater than 200%, no regulatory action is required. If the RBCS is between 150 and 200%, the insurer must file a plan of corrective action with the insurance commissioner as well as provide an explanation of why the RBCS standards were not met. If the RBCS is between 100 and 150%, the insurer must file a plan of corrective action with the insurance commission and the insurance commissioner will examine the insurer. If the RBCS is between 70 and 150%, the insurance commissioner may seize the insurer. If the RBCS is below 70%, the insurance commissioner is required to liquidate or rehabilitate the insurer.
|Risk-Based Capital to Change Paradigm of Insurance Industry |
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The adoption of risk-based capital (RBC), an evaluation system designed to provide a capital adequacy standard related to risks and to raise a safety net for insurers, will change the paradigm of the insurance industry, Allianz Life Insurance CEO said.

"The adoption of RBC means much more than the strengthening of regulations on insurers' solvency ratio. It means the paradigm of the whole industry would change," said Cheong Mun-kuk, president & CEO of Allianz Life Insurance, in an interview with The Korea Times. Solvency ratios are measures to assess a company's ability to meet its long-term obligations.

Currently, the regulator simply assesses insurers' ability to pay out insurance money. With the adoption of RBC system, however, the regulator will be assessing the level of risk each insurance firm faces in asset management from 2011.

The new rule, which is used to set capital requirements considering the size and degree of risk taken by the insurer, is likely to pull up the solvency ratio of Allianz, which has managed its assets conservatively.

"In the past, it was OK to do business in a risky way as long as you generated profit. It won't be so anymore. The insurers will have to think about risk," Cheong said. As the risk will be linked with capital, risky management will result in shareholders having to pay more as companies will need to hold more capital.

Risk Management Key of Insurers

Cheong said that Allianz's solvency ratio in terms of RBC stands at 361.1 percent as of September, 142.4 percentage points higher than the industry average of 218.7 percent. In fact, Allianz adopted a strict risk management system of its own in 2002, watching the duration of liability, cash flow and the interest rate of each product and liability.

"Insurance is a long-term product that lasts for decades. You get pension insurance after retirement. Financial stability matters more than anything else to pay the insurance money one has promised to customers," Cheong said.

Cheong expected Allianz to have the best risk management system in the country in 2011 when the RBC system will become obligatory.

He added that Allianz Group, the global insurer based in Germany, rose to the top of the world in market cap without getting any government support, while some global giants faltered amid the global financial crisis. "It shows that Allianz Group was good at risk management," Cheong said.

He added that as an insurance CEO, he would choose things that benefit Allianz in the long-term perspective rather than focus on short-term profit. "Obsessing on short-term performance could eat into growth engines in the longer term. I don't think it's the right strategy for the insurance business, which should be managed conservatively and last for longer periods of time." Hence, Allianz refrained from headhunting competition when other life insurers only concentrated on increasing the number of salespeople, on the determination that it would do harm in the long-term perspective.

He added that insurers should stick to their core business. "Allianz, for example, sold Dresdner Bank to Commerzbank before the outbreak of the global financial crisis. There was some talk about diversification, but the key should be concentrating on one's core business," he said.

He added that insurance companies should also put more weight on traditional insurance products rather than on investment products like derivative insurances. "Non-savings insurance such as whole-life insurance should be the very first, and only then should the rest of the products come."

Insurance Should Turn Customer-Oriented

Cheong pointed out that the financial market in Korea had been supplier-focused rather than customer-oriented, unlike the manufacturing industry where customer satisfaction is the key for each process of the business.

"It is, however, changing. NGOs, including consumer groups, are actively making their voices heard, and consumers are becoming more sophisticated, knowing how to voice their demand on products. Only those who adapt to these changes in the financial market will survive," Cheong said.

The CEO believes whole-life insurance and annuity insurance will lead the market.

Regarding whole-life insurance, Cheong said the market isn't saturated yet. Though many people have subscribed to whole-life insurance for their family, the return is still too low. "Whole-life insurance aims at guaranteeing the financial stability of the family when the subscriber passes away. However, the average payout the family can get stands at far less than 100 million won here. Few people would say it is enough to sustain a family. There is still room for more subscriptions."

He attributed the low insurance coverage to the seller-oriented market. "It wouldn't have been easy for salespeople to convince the subscribers that they need, say, 500 to 600 million won insurance money for their family since the premium would go up. They didn't think about the consumer's needs. They just wanted to sell," he added.

Allianz focuses on up-selling, or selling additional insurance products to its old subscribers through tailored marketing and customer management. "How to secure a loyal customer base would determine the competitive edge of the insurance businesses. I ask sales managers to continue studying portfolios of subscribers to provide them with adequate products and services."

Annuity Insurances to Lead Market

Cheong said that the market is likely to need annuity insurance most. "Korea is one of the most rapidly aging societies in the world, and the birth rate is historically low. The baby boomers, who were born between 1956 and 1963, are about to retire."

He said Koreans are not prepared for retirement. "In other developed countries, insurance and annuity take between 30 and 40 percent of people's financial assets. In Korea, however, they take only around 17 to 18 percent.

"People would want to maintain the level of life they enjoyed before retirement, but they can't do that with only national and corporate pensions. The best way to create income for then is annuity insurance," Cheong said, stressing that the money for retirement should be managed safely.

The CEO said retirement planning and old age provision seem to have become the main theme of the global insurance market. A new silver market is being formed in products such as long-term care insurance policies.

He added that as a global insurer, Allianz has a stock of experience regarding the retirement market from its experience in Germany and the United States. Its "Powerdex Annuity Insurance," which is linked to the stock market index, was first launched by Allianz in the United States, and later introduced to the Korean market with success. Cheong has also subscribed to the retirement product.

Diversification of Sales Channel

The insurance industry has seen a diversification of the sales channels. Bancassurance, or insurances sold at banks, telemarketing, and general agencies led the market while traditional models depending on salespeople are slowing down.

While some insurance companies regard such new channels as threats, Cheong said the diversification of channels means more access to customers. "In other words, consumers have more access to insurance products," he said.

He explained that the diversification enabled Allianz to dig up a new customer base. "The bancassurance customers, for example, are mostly wealthy private banking (PB) customers. They were hardly accessible to salespeople," he said, adding that it means a new customer group for the insurer.

The CEO thus believes there should be ''innovative management.'' "It is about who attracts wealthy customers, loyal customers. There were only six life insurance companies when I started my career in the business, but now there are 22. Insurers also have to compete with other financial businesses like banks and investment companies over the retirement market."

He said that Allianz should differentiate itself from others to win the competition, citing "Powerdex Annuity Insurance" as a prime example.