The increased focus and attention on the insurance industry are illustrated by the acceleration of regulatory efforts across the globe. Keeping up with the pace of regulatory change in the current environment is one of the greatest challenges facing any insurance company.
While the goal of global regulatory cooperation has been pursued for some time, the recent financial crisis has sped up the drive toward financial stability reform initiatives globally. In November 2008, the G-20 stressed the need to “review the differentiated nature of regulation in the banking, securities, and insurance sectors” and to “identify areas where systemic risks may not be fully captured.”1 Under the differentiated nature of regulation in the various sectors, regulatory arbitrage opportunities arise where the banking, securities, and insurance sectors overlap –such as “shadow banking” – an area in which Paul Tucker of the Bank of England recently identified that regulators need to up their game.2
Even within insurance regulation, there are fundamental concerns. The current regulatory regime varies widely from country to country, which is exacerbated by the differing nature of the products offered, as these variances have frequently arisen for historical reasons (e.g., local investment markets and taxation basis). In Figure 1, the Insurance Regulatory Radar outlines upcoming regulations by region. Many countries retain valuation systems that allow the capitalization of risk premiums and employ capital measures that are not risk based. A common international standard of regulatory regimes could potentially reduce costs for multinational insurers and remove the opportunity to headquarter in a less regulated regime.
In response, the International Association of Insurance Supervisors (IAIS) developed proposals to harmonize and strengthen insurance regulations globally – notably the IAIS-revised Insurance Core Principles (ICPs), released in October 2011. The ICPs provide a globally-accepted framework for the supervision of the insurance sector and aim to increase regulatory convergence of local supervisory regimes. Among other things, the ICPs request that local supervisors introduce guidelines in terms of enterprise risk management, risk-based assessment of capital, and group-wide supervision and reporting. Moreover, the IAIS proposed the Common Framework for Supervision (ComFrame), a set of supervisory requirements based on the ICPs, for effective group-wide supervision of internationally-active insurance groups (IAIG). ComFrame is designed to promote confidence in insurance markets and to ensure that policyholders are properly protected.
Among other things, ComFrame and the ICPs focus on the three main areas: solvency assessment, enterprise risk management and ORSA, and supervisory review and reporting.
Solvency assessments should be conducted in the context of IAIS risk-based solvency requirements. This requirement implies that insurers should use a total balance sheet approach that values assets and liabilities market-consistently and address all reasonably foreseeable and relevant risks.
Early adopters of risk-based capital methods in Europe (including Solvency II) have proposed a measure that requires them to hold sufficient capital to remain solvent (on a market-consistent basis) with 99.5% confidence at a one-year horizon. This market-consistent valuation can provide meaningful insights into the asset and liability positions of an insurer and help regulators understand the financial situation of an insurer relative to their peers. It also provides insights into which actions may be taken by insurers and their supervisors in respect of those positions.
The Insurance Core Principles recognize the importance of an enterprise risk management (ERM) framework from a supervisory perspective in underpinning robust insurance solvency assessments. As a result, an insurer must demonstrate its ability to control, mitigate, and manage its risk exposures as part of an ERM framework.
An insurer’s ERM framework (illustrated in Figure 2) should comprise the processes, controls, and procedures set up for managing risk, taking into account its business strategy and operations. The framework should involve a self-assessment of all relevant material risks that they may face and outline the quantitative and qualitative measures used to identify and manage these risks. The cornerstone of this self-assessment is the Own Risk and Solvency Assessment (ORSA). The ICPs request insurers to perform their ORSA regularly to assess the adequacy of their risk management and current and future solvency positions. Moreover, an insurer’s board and senior management are responsible for the ORSA.
The IAIS principles promote the harmonization of reporting requirements at a group level in order to ensure consistency and reduce redundant disclosure requirements. They also promote market discipline through improved risk disclosure to the public and confidential disclosure to supervisory authorities.
Supervisory authorities have also released specific proposals to address systemic risks. In particular, the Financial Stability Board has worked with the IAIS to define a list of global systemically important insurers (G-SII) and to draft policy measures that will apply to them. The IAIS has recognized that insurance does not naturally create systemic risk. Classification as a G-SII is not solely based on size, but includes measures such as scale of non-insurance and non-traditional insurance activities, the extent of global activities, and degree of interconnectedness.
As of December 2013, nine insurers have been designated as systemically important.3 Additionally, the US Financial Stability Oversight Council has designated three firms (AIG, GE Capital, and Prudential Financial) as the first non-bank SIFIs under the US Dodd-Frank Act. These firms will also be subject to Fed supervision and capital requirements.
With these initiatives, supervisors seek to align regulatory approaches and reduce regulatory arbitrage opportunities. These measures should also provide regulators with a more consistent approach to overseeing insurances companies across jurisdictions.
Beyond these global insurance standardized frameworks, many jurisdictions have defined risk-based solvency regimes. The Swiss Solvency Test (SST) is a risk-based capital standard for insurance companies in Switzerland, in use since 2008. The EU-based regulatory framework, Solvency II, (scheduled to start as of January 1, 2016) consists of three pillars (quantitative requirements, supervisory review, and market disclosure) and represents a fundamental upheaval of insurance risk management practices. Moreover, Solvency II exercises a dominant influence on international insurance regulations and several countries have announced that they will be seeking equivalence with this regime.
Both the US and Canada are first adopting the key component of Pillar 2, the Own Risk and Solvency Assessment (ORSA). Mexico, on the other hand, plans to introduce a Solvency II-type regime called “Solvencia II” by 2015, one year earlier than the effective date of Solvency II in the European Union.
Regulators in many Asia-Pacific countries are also moving toward risk-based insurance supervisory regimes similar to those of Western countries. Japan, Australia, and Singapore are among the more advanced risk-based capital regimes. India and China are currently defining their roadmaps to introduce risk-based capital regulations.
While the efforts of the IAIS create a powerful reason for insurers to examine the effect of the coming new regulatory regime on their products and balance sheet, there are other reasons why an early investigation of the coming changes may be desirable. The International Accounting Standards Board and the Financial Accounting Standards Board are working toward a new Insurance Contracts standard. This work appears likely to adopt a balance sheet similar to the market-consistent model contained in the IAIS’s Core Principles. When finalized, the Insurance Contracts standard will apply to financial reporting worldwide – even to countries that don’t immediately adopt the IAIS’s Core Principals. Of course, the accounting standards are primarily concerned with the balance sheet rather than the risk measures, but an insurer whose financial reporting is based on a market-consistent balance sheet would be well advised to understand the volatility of that measure.
The emerging regulatory standard typically has the following elements:
- A market-consistent balance sheet: Determines the amount of capital an insurer has available.
- A capital requirement based around a one-year VaR: Determines the amount of capital the regulator requires the insurer to have available to remain open for new business.
The implications of the new regulatory standard can be considered from two perspectives:
- Operations in the insurance market: The demand for, and structure of, the insurance products offered in the market, which directly affects the consumer (i.e., the prospective policyholder).
- New systems and processes: Insurers will have to introduce these to comply with the new standard, although firms should be solely concerned with the new internal technical requirements.
Of course, in practice there is no clear split between the two perspectives. The continued viability of current products depends on the new processes and the capital resources available to the insurer. An early examination of the existing product range under the metric of the new regulatory standard will identify any areas that require further investigation.
While the capital available (i.e., the balance sheet) is largely fixed (depending on the size and nature of the liabilities), the capital required can frequently be managed (e.g., by de-risking exercise).
In many markets, the adoption of a market-consistent balance sheet and a risk-based capital requirement has led to changes in the available insurance products. Some forms of traditional “with-profits” contracts offer inter-generational smoothing of policy payments – a feature that relies on opaqueness in an insurer’s financial position. In the new regime, such contracts might not be viable. Other products will be developed that are aligned to the new regulatory standard. For example, Solvency II contains a “matching adjustment” mechanism that favors products where consumers exchange liquidity (i.e., the ability to surrender their contract) for a high (long-term) guaranteed return. Gabriel Bernardino, the Chairman of the European Insurance and Occupational Pensions Authority (EIOPA) – the European body charged with designing the detailed Solvency II requirements – recently gave a speech about the changes he expects to see in products offered by European insurers.4
Elsewhere, insurers are likely to review the level of guarantees present in their products. A switch to unit-linked structures, where the market risk is born by the policyholder, is one example. Another example would be the introduction of a periodic re-pricing as a function of evolving longevity experience into a pension’s annuity as a means to limit the long-term mortality guarantee (and associated capital).
The specific examples identified above may not emerge in any individual market, but it is surely inevitable that insurers will review their offered guarantees and ensure they charge appropriately for them. Of course, consumers will not welcome all these changes, particularly in markets where insurers have traditionally undercharged for guarantees. The counter-argument is that the new regime will be more robust and the likelihood of a policy payout will be higher.
The new regulatory standard requires many new systems and processes. Typically an insurer will require governance, data management, and the adoption of new calculations.
In order to perform a market-consistent valuation, and calculate a VaR-based capital requirement, it is necessary for everyone to have a common understanding of what is being valued. For a guaranteed contract this may be straightforward, but for a with-profits, or participating, contract it can be difficult to gain a common understanding. Frequently, a with-profits contract will have discretion on terms, such as bonus rates and asset allocation, and codifying the boundaries of permitted actions can prove challenging.
With the new regulatory regime, many companies have found it beneficial to create a new system to manage the data, perform the calculations, and produce the reports required. The alternative is to make ad-hoc enhancements to often already over-loaded existing systems. The new regulatory regime often requires data that was not needed under the existing regulatory regime. For example, the total balance sheet approach requires granular information on the assets and the liabilities, whereas the existing regulatory regime might only need highly summarized data on the assets.
The calculation of a market-consistent value for liabilities will be a new challenge for many insurers. For a guaranteed contract, this may be relatively straightforward. For a with-profits contract, a simulation approach is likely to be required as the bonus rate and asset allocation algorithms introduce path-dependency (frequently at the aggregated fund, rather than contract level) to the embedded option.
The assets and liabilities should both be valued on numerous scenarios to assess the variability of an insurer’s balance sheet (and hence the capital requirement). The volume of calculations is likely to require a highly automated system. In special circumstances a “proxy” model is required, as it is not practical to perform multiple valuations of a liability that itself requires a simulation approach to value. Proxy valuation techniques, such as Least-Squares Monte Carlo, make application of the new regulatory standards possible.
The “risk margin” is a component of the liability value that is present in most new regulatory standards (and is also present in the IASB's Insurance Contracts Exposure Draft). The risk margin is the recognition that an insurer will demand a lower premium for a fixed liability of CU100 in 10 years than for a liability that will average CU100 in 10 years. Where the risk can be hedged, as with many market risks, the market provides the risk margin – hence, only non-hedgeable risks need to be considered when calculating the risk margin.
While the basics of performing a market-consistent valuation are generally agreed on, there are certain elements that usually generate a discussion – for example, the appropriate yield curve to adopt, and in particular, whether to include an illiquidity premium (and how much). Frequently, insurance liabilities involve cash flows at longer durations than risk-free tradable assets. This introduces a dependency on the extrapolation basis used to extend the yield curve derived from tradable instruments. Other complications arise when considering the volatility surfaces required.
It is clear that Solvency II and similar regulations will transform the risk management practices and infrastructure systems of insurance firms. While keeping up with evolving regulatory change across multiple countries is challenging, the insurance industry is moving toward global regulatory cooperation.
The IAIS has developed proposals to harmonize and strengthen insurance regulations globally, focusing on solvency assessment, enterprise risk management and ORSA, and supervisory review and reporting. This new regulatory standard may impact the insurance products offered in the market and require many new systems and processes.
An early investigation of the potential effects of the new regulatory regime is desirable. A proof-of-concept exercise would let an insurer assess if the new regime is likely to disrupt its existing operating model. With the timescale for the introduction of much of the regulatory change measured in years, action can still be taken to make the initial new regulatory regime balance sheet look substantially better.
1 G-20 Summit on Financial Markets and the World Economy, November 15, 2008.
2 BOE, Paul Tucker, Shadow banking: thoughts for a possible policy agenda, April 27, 2012. http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech566.pdf.
3 The list includes AIG, MetLife, Prudential Financial in the US, Allianz in Germany, Axa in France, Prudential and Aviva in the UK, one Generali in Italy and Ping An Insurance Group in China.
4 Bernardino speech to the EIOPA Annual Conference, November 20, 2013.
Scott is a Director in the Regulatory and Accounting Solutions team responsible for providing accounting expertise across solutions, products, and services offered by Moody’s Analytics in the US. He has over 15 years of experience leading auditing, consulting and accounting policy initiatives for financial institutions.
Addresses the challenges and opportunities in the global insurance sector, and how they impact the risk management practices of insurers.
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