Moving towards Solvency II ( Solvency Modernization) Buenos Aires November 22 -24, 2011 Serap Oguz GONULAL World Bank 3/17/2018 1
Agenda Challenges of insurance sector in emerging economies Solvency II Main regulatory elements International experience Implementation plan 3/17/2018 2
Challenges of insurance sector in emerging economies-1 • Buyer issues • Generally very low awareness of the value of insurance • Compulsory insurance often seen as a tax • Capital market issues • Market small or nascent • Rather low capital base and solvency margins • After adjustments on the asset side, many companies are insolvent • Insurance market issues • Small and highly fragmented market – in terms of insurance premium • Lack of awareness of importance of reserving • Lack of data and lack of awareness of value of data • Competition on prices should be replaced with competition on quality of service 3/17/2018 3
Challenges of insurance sector in emerging economies-2 • Claims payment standards • Low claims payment capacity, particularly for smaller companies • Long delays in settling claims - which undermines consumer confidence and results in low insurance penetration (trust) • Absence of a regulatory process to ensure good claim settlement standards • Relations between companies and agencies are not regulated • The regulator doesn’t play the role of a developer • Lack of willingness? • Lack of technical capacity? 3/17/2018 4
Typical Supervisory Challenges in Emerging Economies-1 Supervisors may have multiple objectives (protect policy holders, promote insurance development, protect state owned insurance companies) Data issues Data needed by the supervisor for analysis and monitoring of the industry unreliable or non existent Financial data is not timely, and often received too late by the supervisor to take action on it Legal issues Outmoded legislative requirements that do not reflect the attributes of a modern supervisory system nor recognize the needs of a healthy, vibrant insurance industry The legal system itself may contribute to a lack of determination by the supervisor if the enforcement of legal contracts within the country tends to be a frustrating and difficult process 3/17/2018 5
Typical Supervisory Challenges in Emerging Economies-2 Supervisory personnel issues Supervisory personnel require training and upgrading of skills; Supervisory personnel are not adequately compensated, even by local standards, thus making it difficult to attract and retain high caliber personnel Supervisory personnel lack access to computer systems to analyze and monitor financial information efficiently and effectively Standards of financial reporting, auditing and actuarial reporting are not consistent and cannot be relied upon by the supervisor Boards of directors frequently lack independence from shareholders and management and so are often not in a position to provide direction and leadership 3/17/2018 6
Agenda Challenges of insurance sector in emerging economies Solvency II Main regulatory elements International experience Implementation plan 3/17/2018 7
Main regulatory elements under Solvency II 1. 2. 3. 4. Official supervisory oversight – on and offsite monitoring and enforcement Solvency (inc. reserving), guaranteed return and consumer protection rules The professions – actuaries, auditors and financial journalists The governance structure – management and supervisory boards The relative weighting of these depends on: Legal framework – particularly strength of capital rules (i. e. how much leverage is allowed) and wind up rules Stage of development of governance mechanisms and professions History of failures In emerging markets the supervisor is almost always key!! 3/17/2018 8
Solvency II-Why ? No clarity on the objectives of supervision Solvency is based largely on mathematical reserve calculation – no explicit allowance for asset side risks Rules based investment limits – can restrict innovation and capital market development Limited guidance on supervisory interventions Net approach – no explicit allowance for reinsurance A need for improvement in the regulation and supervision of insurance companies 3/17/2018 9
Philosophy Liability fair value (with resilience) - the management team is ultimately responsible for the reliable and adequate calculation of technical provisions Liability uncertainty, asset risk and operational risk – mainly covered by capital requirement Solvency Capital Requirement (SCR) & Minimum Capital Requirement (MCR) Pillar II – supervisor can force solvency capital increase Supervisor intervenes if solvency less than SCR – license revoked if less than MCR 3/17/2018 10
New ICPs - ICP 16 & 17 Solvency II: Two levels of capital requirements under Solvency II: Solvency Capital Requirement (SCR) and Minimum Capital Requirement (MCR) SCR is a target level of capital while the MCR is a minimum threshold below which companies are not permitted to trade (conceptually similar to Solvency I capital) Between SCR and MCR: ‘ladder of intervention’ allowing regulators progressive interventions In reality, most companies will exceed target SCR to minimize regulatory intrusion New ICPs: ICP 16 (Entreprise Risk Management for Solvency Purposes): The supervisor establishes enterprise risk management requirements for solvency purposes that require insurers to address all relevant and material risks ICP 17 (Capital Adequacy): The supervisor establishes capital adequacy requirements for solvency purposes so that insurers can absorb significant unforeseen losses and to provide for degrees of supervisory intervention 3/17/2018 11
Solvency II Market risk, credit risk, operational risk, insurance risk, liquidity risk Pillar 1 -Quantitative Requirements Capital requirements Valuation Assets and liabilities Own Funds 3/17/2018 Pillar 2 -Qualitative Requirements & Rules on Supervision Regulation on financial services supervision Own Risk and Solvency Assessment ( ORSA) Capabilities and powers of regulators, areas of activity Pillar 3 -Supervisory Reporting and Public Disclosure Transparency Disclosure requirements 12
Pillars I and II framework 3/17/2018 13
Agenda Challenges of insurance sector in emerging economies Solvency II Main regulatory elements International experience Implementation plan 3/17/2018 14
International perspectives on solvency modernisation: the USA National Association of Insurance Commissioners (NAIC) Solvency Modernization Initiative (SMI) NAIC: voluntary association of insurance regulators; primary vehicle for interstate coordination re. insurance regulation 1994: introduced a Risk-Based Capital (RBC) system, as a factor-based approach that considers an insurers' size and risk profiles when determining capital requirements What's changing: Based on a review of international developments in insurance supervision, solvency assessment, and international accounting standards, will upgrade the US solvency framework The impact: The SMI will: Strengthen the supervision of re/insurance groups Introduce requirements for enterprise risk management and prospective solvency assessment, taking account of related international action and insurance core principles adopted by the International Association of Insurance Supervisors (IAIS). Allow for ratings-based collateral for "certified" reinsurer Introduce principles-based reserving in life insurance Refine the current RBC system However, not expected to move to full economic-based methods of Solvency II 3/17/2018 15
International perspectives on solvency modernisation. Europe Solvency II - European Economic Area (EEA) What's changing: Solvency II is the new proposed EU legislation which will govern the riskand economic- based capital requirements of insurance companies operating in the EEA as well as define enterprise-wide risk management requirements. Replaces Solvency I, introduced in the 70 s , and based on defining capital requirements by specifying simple, factor-based solvency margins. Solvency I capital margins were designed to act as a buffer to absorb potential risks and protect policyholders, but experience showed they do not always reflect the true risks of insurance portfolios The impact: Solvency II combines total balance sheet and economic-based solvency assessment, strong reliance on qualitative risk management requirements, and enhanced market discipline through increased disclosure requirements and transparency. This represents a paradigm shift in insurance supervision, the outcome of which should be insurance companies with a better understanding of the risks they take and regulatory incentives that promote state-of-the-art risk management and greater transparency Current status: after 5 rounds of industry testing, technical standards are being finalized for implementation on 1 January 2013 3/17/2018 16
International perspectives on solvency modernisation- Switzerland Swiss Solvency Test (SST): economic-based regulatory approach that takes an all-risks view of the re/insurer’s business Came into effect in 2006; mandatory for all companies by 1 January 2011; applies to all Swiss-based companies Scope of regulation: Obliges groups, conglomerates and reinsurers to use an internal model to calculate their solvency requirements Groups and conglomerates must report their available and required capital twice a year to Swiss regulator FINMA. Similarity with Solvency II: Basic concepts of SST and Solvency II are similar Both based on a three-pillar approach that includes quantitative and qualitative risk management requirements Both value assets and liabilities on a market consistent basis Both take an all-risks approach and acknowledge the benefits of diversification that reinsurance provides 3/17/2018 17
International perspectives on solvency modernisation - Asia Current status: Risk-Based Capital (RBC) regime applied in Japan (1997), Indonesia (2000), Taiwan (2002), Singapore (2004), Malaysia (2009), Thailand (2011) and South Korea (2011) Regulatory regime similar to Solvency I – i. e. based on a solvency ratio/margin approach – used in many other Asian countries China, Hong Kong, the Philippines and Vietnam considering moving to an RBC regime India has not yet announced plans to change its solvency regime What's changing: Tightening of insurance supervision and regulation, including solvency modernization Higher minimum capital requirements, adoption of RBC solvency systems, and introduction of dynamic stress tests and use of scenarios Increased focus on consumer protection Alignment of accounting standards with the International Financial Reporting Standards 3/17/2018 18
International perspectives on solvency modernisation Asia China: Expected to move towards a RBC approach, though no timeline has been announced Expected to consider diversification and its benefits Also expected that capital requirements will be driven by higher charges on underwriting risk Singapore: Introduced an RBC approach in 2004 While no plans have been announced regarding a move towards Solvency II, Singapore's authorities generally respond quickly to global standards and are expected to be interested in equivalency amongst Asian regimes Further solvency development should address issues of diversification and operational risk, as well as Group calculation. South Korea: Has also been closely observing Solvency II developments in Europe Having just introduced a RBC approach in April 2011, solvency regime is quite close to Solvency II Future solvency developments expected to address Group-level calculation and 3/17/2018 diversification 19
International perspectives on solvency modernisation- Australia New development: Australian Prudential Regulation Authority (APRA) introduced the Life and General Insurance Capital (LAGIC) which has strong parallels to Solvency II Implementation planned for the beginning of 2013 Right now APRA is working on refinements as the industry is going through the second Quantitative Impact Study (QIS) Scope of regulation: Aplies to all Australian insurance companies What's changing: As with Solvency II, LAGIC is a three-pillar regulatory regime with a risk-based approach Considers market, credit, operational, insurance and liquidity risks Current status : APRA will respond to the industry about its second QIS in November 2011 Final Standards due in April 2012 and Final Reporting Standards in October 2012 3/17/2018 20
Agenda Challenges of insurance sector in emerging economies Solvency II Main regulatory elements International experience Implementation plan 3/17/2018 21
Initial steps Set up prudential standards: Focus on risk management through improved risk measurement and a link to capital planning Fundamentally the business of insurance is about informed and controlled risktaking, and legal framework should respond to that ( no regulation for the sake of regulation but for the better regulation) First: Pillar 2’ supervisory review process to heighten focus on risk management; involves introduction of improved disclosure through ‘Pillar 3’, so that market discipline complements regulation Second: market-consistent valuation standards, including in assessing the scale of liabilities to policyholders Third: capital requirements must reflect risk in both assets and liabilities (including any interactions between the two); must reward real risk diversification; and must take account of the extent to which risk-transfer instruments mitigate and transform risks that a firm retains Fourth: firms allowed to use own internal models to determine their regulatory capital requirements, subject to appropriate controls over the adequacy of those models 3/17/2018 22
Technology requirements of Solvency II The insurer IT system must capture the data as needed to assist in efficiently calculating and valuing quantitative requirements Demonstrate controls, transparency in disclosure and governance of system to the regulator IT system need to be capable of reporting on solvency assessment and demonstrate the use of regular tracking and forecasting in the strategic decision making process of the insurer 3/17/2018 23
Impact of Technology Ability to screen large volumes of financial information, analyze trends in ratios and monitor large amounts of financial data require use of modern electronic technology Modern insurance supervisory office typically receives electronically a well designed package of financial data annually from insurers, with supplemental data on a quarterly basis Often, a specific software is available to companies, instead of a “statutory form” Typically the data received from insurers is stored electronically in a data base, so that the application software can carry out pre-programmed routines such as calculation of ratios and indicators Ability to carry out ad hoc analysis and screening of information in the data base Important, because difficult to say in advance what types of situations might arise which will trigger a need for customized analysis For example, if a major, publicly traded corporation becomes insolvent, it would be useful to be able to quickly find out which institutions have investments in that entity and whether any investments are sufficiently large to imperil the financial position of an insurer. Or in case of concerns with a particular type of insurance product, specific tests could be developed to test this hypothesis against the companies’ financial data 3/17/2018 24
RBS in emerging economies Simplified Solvency II approach – IRIS, basic RBC (plus margin), formal intervention and enforcement levels On site inspection based in part on IRIS ratios Move from rules based to principles based in steps based on level of supervisory, professional and governance capacity Maintain investment limits initially Allow a move away from strict limits based on company by company assessment of skills and CM development – but replace with capital requirements (may be 100% for related party assets) Apply gross accounting in statutory returns (i. e. reinsurance shown separately) Require full reinsurance for catastrophe risk Have a formal crisis recovery plan 3/17/2018 25
Risk Based &Solvency II Risk Based Supervision is an approach to supervision in which the action of the regulator is determined by: the risk profile of the institution the extent to which the institution can manage the risk with minimal impact on policyholders and market interest Risk based supervision is predicated on the relationship between risk and capital: the higher the risk profile of the insurer, the higher the capital it must hold 3/17/2018 26
Risk Based –Solvency II Solvency I is a weak predictor Solvency II Tool for companies for managing risk and capital Early warning system for supervisors and for companies Internal Models: only solution to determine required capital and risk for complex companies and groups Ideally, insurers and regulators should develop solvency framework together 3/17/2018 27
Moving towards risk based /Solvency II With an increased risk focus in insurance supervision, the regulator will: direct its attention to essential areas of supervision and make effective use of limited resources concurrently aim for wider supervisory coverage by introducing more automated routines The goal is to create an effective and well-balanced supervision of the insurance sector based on solvency and other issues of importance for insurance supervision 3/17/2018 28
SII directive: Aim of introducing risk-based supervision Improvement to prioritizing tools of supervision in progress using a different angle compared with our present classification system The new prioritizing tool will become a complement to supervisory planning, aimed at better capturing trends and risk on markets and in companies The purpose of the Solvency II project is to: review all the prudential rules in the insurance field devise a solvency system more sensitive to the risks incurred by insurance companies enable supervisors to protect policyholders' interests as effectively as possible in accordance with common principles 3/17/2018 29
Rules based/Risk based Rules based Risk based 3/17/2018 • Compliance audit • Compliance reviews and examinations • Move towards; • risk based supervision • focused reviews • cross sector reviews • reliance on the work others • board of directors • other regulator 30
Risks in insurance Aside from the direct business risks, significant risks to insurers are generated on the liability side: • These risks are referred to as technical risks and relate to the actuarial or statistical calculations used in estimating liabilities • On the asset side of the balance sheet, insurers incur market, credit, and liquidity risk from their investments and financial operations, as well as risks arising from asset-liability mismatches • Life insurers also offer products of life cover with a savings content and pension products that are usually managed with a long-term perspective. The supervisory framework must address all these aspects 3/17/2018 31
THE STAKEHOLDERS REGULATORY FRAMEWORK MACRO ECONOMY OUTLOOK INSURANCE SECTOR POLICYHOLDERS APROACH 3/17/2018 32
Key regulatory issues for insurance-1 • Preventing pyramid schemes arising from competitive pressure on guaranteed returns - ensuring reserves (called math. reserves) are adequate ( Life) • Ensuring that sufficient capital is in place to cover normal credit, market, liquidity, underwriting, and operating risks ( life and non-life) • Securing assets – including asset quality – preventing related party lending and asset concentration ( life and non-life) • Ensuring enough competition to sustain innovation and efficiency – minimum capital, entry conditions (Life and non-life) 3/17/2018 33
Key regulatory issues for insurance 2 • Ensuring adequate internal controls - record keeping is accurate and backed up (Life and non-life) • Having a crisis mechanism in place – guarantee funds etc while minimizing moral hazard • Set up claims management • Better coordination between the regulator and the sector • Built up technical capacity in the regulator as well as in the insurance sector • Training 3/17/2018 34
How to measure success Key indicators and benchmarks • Penetration measures • Expense structures • Delivery alternatives • Product choice and transparency • Rate of insolvency – true financial position • Claim paying track record • Profits relative to domestic cost of capital • Investments – risk/ return performance 3/17/2018 35
The regulators as developers • Striking a right balance between developing and regulating the industry • Considering the interests of policy holders as primary objective while framing regulation • Shouldering the responsibility of developing a nascent insurance market 3/17/2018 36
Moving towards Solvency II-Why? to increase policyholders protection A requirement to get a risk-sensitive level of required capital Greater market discipline through increased public disclosure More information on firms to allow supervisors to have a total view of the business model Much stronger emphasis on risk management and forward-looking risk governance leading to a stronger risk culture in firms 3/17/2018 37
Conclusion We need a system designed to create incentives for sound risk management Insurance regulators/supervisors should benefit from best practices and Strengthen their risk management capabilities Create sustainable products Remain competitive in the global market place The supervisory architecture Solvency should be highest priority RBC Data quality Consistent accounting and actuarial valuation 3/17/2018 38
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