Abstract

This article analyses the importance of the solvency capital requirement (hereafter SCR) and the minimum capital requirement (hereafter MCR) formulae and why an insurer's external auditor should audit these and disclose its contents in the insurer's financial statements. When calculating the SCR, the reason for requiring such a disclosure is to allow the Prudential Authority an opportunity to understand whether the assumptions, parameters and techniques (also referred to as economic considerations) applied by actuaries comply with section 36 of the Insurance Act 18 of 2017. Administrative costs and written premiums are considered when calculating the MCR, although written premiums could be subjected to different interpretations, which might affect this formula. Accordingly, had Constantia Insurance Company Limited's auditor audited these formulae in 2018 and disclosed their contents in the financial statements, the Prudential Authority would have commenced liquidation procedures in 2019, not choosing instead to wait and monitor the company's solvency requirements on a weekly basis for four years. As a result, owing to the lack of transparency in the financial statements and non-compliance with the SCR and MCR, Constantia spent nearly R733 000 000 over the three-year period to fund its business activities.

Keywords

Solvency capital requirement; minimum capital requirement; audit minimum capital requirement; auditor duties in insurance law; liquidation of an insurer; just and equitable; public purpose.

………………………………………………………

1 Introduction

The Prudential Authority lodged an ex parte application (during July 2022) to place Constantia Insurance Company Limited (hereafter Constantia) under provisional curatorship. 1

 Neels Kilian. MA (Regensburg) LLM (UP) LLD (UFS). Associate Professor, Faculty of Law, North-West University, South Africa. E-mail: corneliuskilian@hotmail.com . ORCiD: https://orcid.org/ 0000-0002-2890-9350.

1 Ex parte the Prudential Authority (Gauteng Local Division, Johannesburg) (unreported) case number 717/2022 of 18 August 2022 (hereafter Ex parte Prudential Authority). Contact the author for a copy of the affidavit or see SARB 2023 https://www.resbank.co.za/en/home/publications/publication-detail-pages/media-releases/2022/Order-granted-for-the-liquidation-of-Constantia-Insurance-Company-Limited; Xuba Role of the Prudential Authority 15.

The ex parte application for provisional curatorship is not complex and is based on an affidavit stating why curatorship is important. However, there is no clear guidance on what constitutes a successful ex parte application with regard to insurers. In this regard it would appear that there must be an educated opinion that the insurer will become solvent in future. 5

5 Ex parte Prudential Authority paras 6-10 of the affidavit of Johan Heyneke. Contact the author for a copy of the affidavit.

(in October 2022). 6

6 The Prudential Authority v Constantia Insurance Company Limited (Gauteng Local Division, Johannesburg) (unreported) case number 2022-19765 of 14 September 2022 (hereafter Prudential Authority v Constantia Insurance) para 17.1 of the affidavit of Kerwin Martin states that Constantia is in "a worse financial position than what was reported to" the Prudential Authority. Contact the author for a copy of the affidavit or see SARB 2023 https://www.resbank.co.za/en/home/publications/publication-detail-pages/media-releases/2022/Order-granted-for-the-liquidation-of-Constantia-Insurance-Company-Limited.

If the Prudential Authority believes that any value calculated by an insurer … in respect of its financial soundness does not reflect a reasonable value for the purposes of this Act, the Prudential Authority may direct the insurer or controlling company –

To appoint, at the cost of the insurer … a suitably qualified person to be approved by the Prudential Authority to determine a reasonable value … .

To calculate a value in a manner determined by the Prudential Authority, which value so calculated will be deemed to be the value.

Section 36(3)(b) of the Insurance Act provides for a possibility to argue that the Prudential Authority could recommend "improvements" to any SCR formula. For example, when the method of calculation, assumptions and

techniques used, adjustments made, calibration effected or parameters used by any insurer are inappropriate for calculating an effective SCR. 11

11 Section 36(5) of the Insurance Act or Minimum Capital Requirements (MCR); Pfeifer and Strassburger 2008 Scandinavian Actuarial Journal 62. The square root formula or standard formula can severely underestimate the true SCR required by regulators.

the Prudential Authority had since June 2019 requested weekly solvency calculations from Constantia, this monitoring process was in fact a fruitless exercise. 18

18 Prudential Authority v Constantia Insurance para 27 of the affidavit of Kerwin Martin.

Subsequently, the Court granted the ex parte application and a provisional curator was appointed. 19

19 Sections 39 and 54 of the Insurance Act requires the insurer to notify the Prudential Authority without delay in the event of a deteriorating financial position and makes provision for curatorship instead of business rescue, among other things.

This article explains the term "cumulative excesses" to enable an understanding of how flexible SCR can be. 22

22 See part 2 of the article below.

only if an auditor observes the language that requires the disclosure of SCR and MCR formulae in the financial statements of insurers. 25

25 Huneberg 2019 Obiter 170-190.

2 A simple explanation of the phrase "cumulative excess" and the way this explanation relates to more complex phrases or calculations

Constantia has recently been liquidated by the Prudential Authority of the Reserve Bank in terms of section 32 of the Financial Sector Regulation Act 9 of 2017 (the FSRA). The purpose of this Act is to establish inter alia the Prudential Authority and the FSCA to ensure that the South African economy remains stable, as well as to enhance financial stability by conferring powers on the Reserve Bank. 27

27 Godwin and Schmulow 2015 SALJ 756-768.

A cumulative excess serves a similar purpose, but its calculation is flexible and depends on the relevant circumstances of an accident. For example, whether the accident occurred after 1 a.m., the driver is under the age of 25, the driver obtained his or her driver's licence within the last two years, there are no witnesses or no third parties involved in the accident and lastly, the accident

occurred within six months of the inception of the policy. Each of these circumstances could be assigned a separate excess of 10%. 30

30 This example is underwriting at the claim stage, which is generally prohibited. See, for example, Deonandan Insurance Warranties 8.

Most financial customers or policyholders would agree to an excess or even a cumulative excess, but very few of them would understand the financial implications of a cumulative excess unless the cumulative effect were explained in detail. The purpose of a non-life broker (commonly known as a registered financial services provider) is to explain the above non-life products to a prospective policyholder to allow him or her to make an informed decision as to whether the non-life insurance product is suitable or not. Even if the policyholder agrees to a cumulative excess – without any form of explanation – it is assumed that the policyholder has been misled in concluding a policy of insurance. 33

33 See, generally, Huneberg 2019 Obiter 170-190.

2.1 More complex calculation than cumulative excesses – the loss ratio

Section 1 of the Insurance Act does not define a written premium. For this reason, it is possible to calculate the loss ratio for a particular binder holder with different end results based on the same written premium. 35

35 See, generally, Haight 1967 Dick L Rev 605. This article explains the importance of consensus between an insurer and an insured. In addition, an agent of an insurer should issue a binder to an insured to keep an insurer liable. This is also possible in South Africa where an agent sells a policy without an insurance company and acts as a

binder holder is an underwriting manager who will participate in the profits of an insurer. That is, if the binder holder is profitable as evidenced by a low loss ratio. The loss ratio calculation is based on various economic considerations which are relevant to the business of an insurer. Legislation is not too clear on how these considerations should be identified in practice to calculate a loss ratio. For example, considerations that affect the loss ratio calculation could include reinsurance commission, unearned premium reserve (UPR) and/or claims incurred but not reported (IBNR), to mention a few. 36

36 See Regulations under the Short-Term Insurance Act, 1998. See, generally, the calculation for loss ratios in Hardy 1888 JIA 256, the author explaining administrative costs; Nelson 1877 Journal of Statistical Society of London 42-89.

Example 1 – simple calculation: 37

37 Example 1 does not include all relevant economic considerations.

Example 2:

Generally, the binder holder agreement between the insurer and the binder holder could either agree with example 1 (to exclude reinsurance commission etc.) or example 2 (to include reinsurance commission etc.). The consequence of this is clearly evident in example 2 above – a lower loss ratio. Therefore, the binder holder is more profitable and could share in a larger amount of profits.

Whether the binder holder is more profitable in example 1 or example 2 depends on the relevant economic considerations (e.g., reinsurance commission etc.) included in the binder holder agreement relevant to a loss ratio calculation. Nevertheless, if the excesses or loss ratios are designed to fit the risk profile of a specific policyholder or binder holder, then although such a policyholder enjoys insurance coverage or the binder holder is able to make profits, the financial implications could be severe for both parties owing to the flexibility of these calculations. 38

38 Anderson Insurance Underwriting Managers v Constantia Insurance paras 15-19, where the Court explained the difficulty finding new insurer for a binder holder in an instance when the previous insurer is liquidated. A new insurer will consider the binder application as a financial risk. This unfortunate outcome occurs without recourse to factual evidence. As a result, Constantia acquired 16 000 policyholders for free at the expense of Anderson.

calculation if it does not include all such considerations. 39

39 Pfeifer and Strassburger 2008 Scandinavian Actuarial Journal 62. The square root formula or standard formula can severely underestimate the true SCR required by regulators.

Where:

SCRi denotes the sub-module i and SCRj denotes the sub-module j, and where Corr 'i,j' means that the sum of the different terms should cover all possible combinations of i and j. In the calculation, SCRi and SCRj are replaced by the following: SCR nl premium and reserve denotes the non-life premium and reserve risk sub-module and SCR nl catastrophe denotes the non-life catastrophe risk sub-module. 41

41 The factor Corr i,j denotes the items set out in row i and in column j of the following correlation matrix:

In terms of the FSRA the Reserve Bank, the Prudential Authority and the Financial Services Conduct Authority (hereafter the FSCA, which was previously known as the FSB) could consult one another to consider what should be included in the SCR formula to support the financial stability of South African policyholders or insurers; in other words, what assumptions, techniques or parameters should be taken into account when calculating a more complex SCR. 42

42 Preamble of the Financial Sector Regulation Act 9 of 2017; Pfeifer and Strassburger 2008 Scandinavian Actuarial Journal 62. The square root formula or standard formula can severely underestimate the true SCR required by regulators.

would prevent any form of misrepresentation in the SCR or MCR calculation when financial statements are submitted to the FSCA. 43

43 See, for example, FSB 2015 https://www.fsca.co.za/Regulated%20Entities/ SAM%20DOCUMENTS/Position%20Paper%2068%20(v%204)%20FINAL.pdf with reference to the EU position.

The following paragraphs focus on the powers of the Reserve Bank, the Prudential Authority and the FSCA in this regard.

3 The Reserve Bank – the SCR as a more complex calculation than loss ratios

Cumulative excesses, as explained above, were implemented by an underwriting firm in South Africa, Anderson Insurance Underwriting Managers. An underwriting manager is a type of binder holder that can act on behalf of an insurer as if it were an insurance company; for example, to complete binder functions (to settle or reject claims, calculate premiums etc.) on behalf of an insurer. In the case of Anderson Insurance Underwriting Managers v Constantia Insurance Company Ltd 44

44 Anderson Insurance Underwriting Managers v Constantia Insurance.

the purpose or scope of the FSRA. 47

47 Godwin and Schmulow 2015 SALJ 756-768.

The powers of the Reserve Bank are regulated in Part 1 to 6 of the FSRA. Section 11 of the FSRA stipulates that the Reserve Bank may make use of any power to protect the financial stability of consumers and policyholders. Any power is regulated to some extent in the FSRA; for example, section 12(a)(ii) of the FSRA, which allows a financial sector regulator (e.g. the Prudential Authority or the FSCA) to dictate to the Reserve Bank how it (the Reserve Bank) should exercise its powers. 48

48 See Godwin and Schmulow 2015 SALJ 756-768.

intervention of the regulator to rectify the insurer's solvency – ex parte an application to appoint a provisional curator. 51

51 Norton Rose Fullbright 2015 https://www.nortonrosefullbright.com/en/knowledge/ publications/f12a4a4a/ten-things-you-need-to-know-about-insolvency-ii.

In South Africa the SCR is known as the prescribed capital requirement (hereafter PCR), while the MCR is the absolute minimum capital required to protect the policyholders when conducting the business of an insurer; that is, the minimum capital required to settle policyholders' claims successfully in the future. 52

52 FSB 2015 https://www.fsca.co.za/Regulated%20Entities/SAM%20DOCUMENTS/

Position%20Paper%2068%20(v%204)%20FINAL.pdf.

4 The Prudential Authority

The Prudential Authority is a juristic or legal person operating side by side with the Reserve Bank, as indicated by section 32(2) of the FSRA. The objective of the Prudential Authority is to promote the financial soundness of insurers and to protect policyholders should an insurer fail to meet its PCR. 54

54 Godwin and Schmulow 2015 SALJ 756-768.

to the well-known insolvency law principle – concursus creditorum (e.g. policyholders who submitted claims and are awaiting payment of these claims are considered creditors – continuously decreasing the R700 000 000 has a direct impact on the pro rata settlement of claims).

4.1 A comparison of Constantia's MCR and PCR

The Prudential Authority submitted an affidavit attesting to why Constantia should be liquidated (in October 2022) and why the provisional appointment of a curator should be terminated immediately. Section 48(2)(a) of the FSRA allows an individual working for the Prudential Authority to bring such an application on behalf of the CEO of the Prudential Authority and the Governor of the Reserve Bank. It is clear that the Prudential Authority and the FSCA had been working together on Constantia's financial position from 2019 to 2022, since Constantia had been required to send weekly insolvency calculations. It is also clear that after the appointment of the provisional curator, the provisional curator had recalculated the PCR based on the true financial information pertaining to Constantia.

The curator focussed on the calculated MCR and PCR as presented by the board of directors of Constantia in the past, which showed the PCR as R304 158 000 and the MCR as R272 178 000. However, the curator realised that Constantia required R909 342 000 to cover its PCR requirements (a deficit of R600 000 000). 56

56 Prudential Authority v Constantia Insurance paras 45 and 46 of the affidavit; Godwin and Schmulow 2015 SALJ 756-768.

MCR. However, R908 342 000 exceeds the MCR by far more than the required 25%. The questions relating to the auditor above were not answered or explained in the affidavit for liquidation submitted by the Prudential Authority. After realising that the weekly calculations submitted had been incorrect since 2019, the Prudential Authority used its own actuaries to calculate the PCR. 60

60 Prudential Authority v Constantia Insurance para 47 of the affidavit.

5 The relationship between the annual financial statements and PCR

Constantia's financial statements complied with section 44 of the Insurance Act and section 29 of the Companies Act 71 of 2008 as well as with the International Financial Reporting Standards (hereafter IFRS). 64

64 Section 29(2) of the Companies Act 71 of 2008 that financial statements should not be incomplete in any material matter; IFRS date unknown https://www.ifrs.org.

PCR and MCR. 66

66 See, generally, Ex parte Prudential Authority para 36 of the affidavit; Prudential Authority v Constantia Insurance para 48 of the affidavit.

Whatever the case, the reason why Constantia's financial statements showed the company to be solvent is because the balance sheet had a positive equity amount in line with accounting principles, which are not the same as actuarial calculations. In terms of accounting principles, liabilities plus equity equal assets, and if there is no equity owing to an increase in liabilities, such a company is considered insolvent. In the 2021 balance sheet the equity disclosed was R84 000 000. The cash flow position had also improved significantly, from R75 000 000 to R191 000 000. 69

69 Ex parte Prudential Authority para 36.3 of the affidavit.

In addition, a balance sheet is merely a snapshot of the business affairs of a company on a specific day, while the cash flow statement indicates all incoming and outgoing cash during the financial year. 70

70 Ex parte Prudential Authority para 36 of the affidavit.

Constantia had also invested in equity portfolios which amounted to nearly R733 000 000 in 2019 but decreased to R133 000 000 in March 2022. 71

71 Ex parte Prudential Authority para 36 of the affidavit.

Conduit Capital. These investments together with reinsurance in 2019 had allowed for PCR compliance and it would probably have been much easier to achieve the required PCR in 2019 than in 2022, when the equity portfolios decreased to approximately R133 000 000. 72

72 Ex parte Prudential Authority para 38 of the affidavit.

Accordingly, it would appear that Constantia used the basic PCR formula, the auditor neglected to audit the formulae and Constantia never disclosed the basic PCR formula to either the Prudential Authority or the FSCA. The Prudential Authority realised the material differences only when a provisional curator was appointed, who indicated that the actual PCR was closer to R900 000 000. The audited financial statements indicated liquidity and solvency for Constantia, which is contrary to the actual PCR and MCR calculations. In this regard, one wonders what the value of the financial statements relevant to the business of an insurer is if an auditor did not audit these formulae and did not give a relevant explanation of them in the financial statements. 74

74 See, generally, Hanion 2003 Nat'l Tax J 831-863. In specific circumstances the value of financial statements is "not much".

6 The relationship between actual equity investments and dividends

In the above paragraph it is said that Constantia's equity portfolio was divided between Finbond, Trustco and Conduit Capital. The exact percentage of shares or investments in each of these companies is uncertain. Whatever the case, Trustco also tried to purchase shares in Constantia in 2019 (i.e., 32.2% in total). The Prudential Authority granted it permission to continue with this transaction, the sole purpose being to invest in or inject capital into Constantia as a way of improving its solvency requirements. The reason why Constantia did not continue with the Trustco transaction remains unclear and is not disclosed in the ex parte affidavit for provisional curatorship. 75

75 Ex parte Prudential Authority para 38.5 of the affidavit.

very difficult to use Constantia as a finance vehicle in this case. 76

76 Ex parte Prudential Authority para 38.4.2 of the affidavit.

Additionally, Constantia (through Conduit Capital) approached Mmuso Consortium (a broad-based black economic empowerment company) to invest R500 000 000 in Constantia. In return Mmuso would have become a significant owner or shareholder of Constantia by subscribing to new Constantia shares subject to certain conditions. 78

78 Ex parte Prudential Authority para 38.17 of the affidavit.

7 When being placed under curatorship, is there a possibility of finding future investors?

It is clear that the Prudential Authority had not recognised the severity of the PCR and MCR in 2019, 2020, 2021, since it believed that if a provisional curator was appointed in 2022 there was a possibility of finding a suitable investor to rectify Constantia's solvency requirements. 81

81 Ex parte Prudential Authority para 44.2 of the affidavit.

provisional curator to encourage any investor to invest in Constantia on fair contractual terms to secure its economic or financial stability. 82

82 Ex parte Prudential Authority para 44.4 of the affidavit.

8 Balance sheet on the day of application for liquidation

When the application for liquidation was lodged in October 2022, the Prudential Authority stated that the equity in Constantia's balance sheet was a negative R85 000 000. This position implied that Constantia's liabilities exceeded its assets. A balance sheet is not a true reflection of solvency since, as discussed earlier, it is merely a snapshot of a company's business affairs on a specific day. In this regard more emphasis should be placed on the cash flow statement, as was discussed earlier. 83

83 Ex parte Prudential Authority para 48.1 of the affidavit.

Based on the MCR, the application for liquidation clearly stated that Constantia was not sufficiently solvent to continue with its business activities, since the MCR does not deviate more than 25% of the PCR. 85

85 Ex parte Prudential Authority para 48.4 of the affidavit.

capital. 89

89 Prudential Authority v Constantia Insurance para 51 of the affidavit. It should be pointed out that there is no realistic expectation of finding a few investors who not only are able to invest R900 000 000, but also have the additional capital to comply with s 7(2) of the Insurance Act pertaining to the significant owners of an insurer.

9 Just and equitable to liquidate?

In the above discussion we have noticed public purpose being stated as a ground for liquidating Constantia. In terms of section 344(H) of the Companies Act 61 of 1973, when a company is liquidated the liquidation must also be just and equitable. 90

90 The Companies Act 61 of 1973 is still valid under exceptional circumstances such as the liquidation of a company. In this regard, see for example Wynand Cornelius van Zyl v Boat Lodge Investments CC (High Court of Kwa-Zulu Natal) unreported case number 9417/2019P of 31 May 2021. In this case there was a deadlock in the management of the close corporation. The Court had to decide whether it was just and equitable to wind up the close corporation due to a deadlock in management decisions. See, further, Chesterman 1973 MLR 129-152.

submitted, thus making it impossible to settle the full amount of the claims. 95

95 Ex parte Prudential Authority para 59 of the affidavit.

10 Conclusion

It is clear that the Reserve Bank and the Prudential Authority now have a greater responsibility to protect the South African economy than prior to the promulgation of the FSRA. 97

97 FSCA, previously known as the FSB, had to liquidate insurers; See SaXum Insurance date unknown http://saxuminsurance.com; Kruger 2016 https//www.moonstone.co.za/

liquidation-of-saxum-insurance.

nature of an insurer's business is insurance, and more focus should be placed on section 36 of the Insurance Act to promote a stable South African economy. Financial statements that contain no auditing of the PCR and MCR should not be relied on. 100

100 See part 1 of this article.

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SaXum Insurance date unknown http://saxuminsurance.com

SaXum Insurance (In Liquidation) date unknown Main http://saxuminsurance.com accessed 5 September 2022

SARB 2023 https://www.resbank.co.za/en/home/publications/publication-detail-pages/media-releases/2022/Order-granted-for-the-liquidation-of-Constantia-Insurance-Company-Limited

South African Reserve Bank 2023 Order Granted for the Final Winding Up (Liquidation) of Constantia Insurance Company Limited https://www.resbank.co.za/en/home/publications/publication-detail-pages/media-releases/2022/Order-granted-for-the-liquidation-of-Constantia-Insurance-Company-Limited accessed 24 September 2023

Todd 2022 https://m.youtube.com/watch?v=wUuFgSFkAjk

Todd P 2022 Constantia Insurance's Remarkable Turnaround https://m.youtube.com/watch?v=wUuFgSFkAjk accessed 17 October 2022

List of Abbreviations