An essential part of capital adequacy is identifying the amount of available capital or in Solvency II terms, the own funds. Now, we are used to looking at a balance sheet from an accounting perspective, but the regulator is not interested in the accounting balance sheet as they tend to want to focus instead on market-based valuations of assets and liabilities and we refer to this as the regulatory balance sheet. So how do we get from the accounting balance sheet that we know, to the regulatory balance sheet? Well, the first thing we're going to do is to remove the equity from the picture. Now, let's have a think about reserves. Well, the first thing to remember is that the regulator wants liabilities to be closer to market-based valuations, but insurance reserves don't have market values. So instead, the regulator replaces these with technical provisions and these technical provisions are based on market equivalent values. But what on earth do we mean by market equivalent values? Well, for a start, it means ensuring that all the cash flows in reserves are discounted. So that's not just the life insurance reserves but also PNC reserves. Secondly, it means ensuring that the discount rates used in these calculations are current market discount rates, not just the rates that were used when the policies were taken out. Now, that's not all because regulators like to be prudent. So the discount rate used is usually a risk-free rate, plus a risk margin, rather than the insurance company's expected return. So that's the liability side of things, but what about the assets? Well, as I mentioned, regulators like to be conservative. They apply a prudential filter to the assets and this means assigning a nil value to assets which are highly illiquid or a likely to have a nil value on liquidation of the company. And this includes intangible assets, DAC assets and deferred tax assets. Then the remaining assets are adjusted to market values so that they are now consistent with the approach used for insurance liabilities. So now that we've adjusted assets and reserves what's left over used to be equity, but is now owned funds, and note that this includes subordinated liabilities. By making these adjustments, we can reconcile accounting equity, such shareholders equity with regulatory owned funds and this is shown in this calculation here. In this example, we start off with accounting equity of 500 and then deduct the intangibles DAC assets and deferred tax assets. We then adjust the assets, financial liabilities and insurance liabilities to get them closer to market value. And this typically increases the values of both assets and liabilities, but increases the value of the assets more. Once this is done, the balance is referred to as the excess of assets over liabilities, and in this situation it's 650. Finally, there's just two more adjustments to make, firstly to add in subordinated liabilities into own funds. And finally, for prudence to deduct any proposed dividends which haven't yet been deducted from equity. And we get to own funds of 700, which is slightly higher than the accounting equity of 500, but that is usually the case. Now, own funds is also split into three tiers with tier one being the most high quality capital that's typically owned funds before any subordinated debt is included. Tier two would include subordinated liabilities with a maturity of more than 10 years and tier three reflects all other subordinated liabilities. This split is important as there are limits on how much tier two and tier three capital can contribute to satisfying the capital requirement as these are lower quality forms of capital.
