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Risk Based Supervision of Insurance Companies - Experiences from Developed Markets

Risk Based Supervision of Insurance Companies - Experiences from Developed Markets. Teus Mourik, actuary Kampala, 25 February 20 16. Agenda. Introduction Definition of Risk Based Supervision Old solvency requirements in Europe: ‘Solvency I’ Solvency II (‘SII’) development process

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Risk Based Supervision of Insurance Companies - Experiences from Developed Markets

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  1. Risk BasedSupervision of Insurance Companies- ExperiencesfromDeveloped Markets Teus Mourik, actuary Kampala, 25 February 2016

  2. Agenda • Introduction • Definition of Risk Based Supervision • Old solvency requirements in Europe: ‘Solvency I’ • Solvency II (‘SII’) development process • Overview of contents of SII • Consequences of SII for the European insurance industry • Risk Based Supervision of Ugandan insurers + Room forquestions and discussion. Pleasefeel free!

  3. 1. Introduction Who am I? • Teus Mourik, Life actuary from The Netherlands • Working experience: 1983-1991: Dutch Central Bank (researcher econometrics) 1991-2003: Mercer (actuarial consultant) 2003-2007: KPMG (actuarial consultant) 2007-2013: EY (actuarial consultant) 2013-2015: AEGON Holding (senior actuary) Feb 2016 - Feb 2018: actuary at the IRA of Uganda

  4. 2. Definition of Risk Based Supervision Risk Based Supervision is a supervisory approach that is designed to identify activities and practices of greater risk to the soundness of financial institutions and accordingly deploying supervisory resources towards the assessment of how those risks are being managed.

  5. 3. Old solvency requirements in Europe: ‘Solvency I’ • Developed in the beginning of the 1970ties. • Key elements: • Assets and liabilities are valued in accordancewithfinancial accounting principles (local GAAP/IFRS), withsomerestrictionsonadmissableassets → ‘AvailableCapital’ (= Assets -/- Liabilities = AC). 2. ‘RequiredCapital’ (= RC) for • Life insurers: 1% or 4% of TechnicalProvision + 0.3% of Sum at Risk, with a discount of maximum 15% for Reinsurance. • Non-Life insurers (roughly): MAX[18% of premium with a discount of maximum 50% for the ratio between claims net and gross of reinsurance, 26% of (average claims in last 3 years + change of Technical Provision over last 3 years) times the same ratio for the reinsurance discount] Requirement: AC / RC > 100%

  6. 4. Solvency II development process (1) During the second half of 1990ties increasingawareness of inadequacy of Solvency I, particularybecause • Financial accounting principlesforassets and liabilities are generally inconsistent (→ ACs are disputable). Moreover, a less prudent technicalprovisionfor Life and/ormorecapitalization of acquisitionexpenses (DAC) wouldresult in a higher AC!? • Requiredcapitalrules are somehowproportionate to the size of the portfolio, butthey are not ‘risk-based’. Moreover, a less prudent technicalprovisionfor Life wouldresult in a lower RC!? • RC formula does notinclude ‘fair’ discounts for risk mitigationpolicies, in particularreinsurance. As a result: introductions of ‘EmbeddedValue’ concept by the industry and ‘LiabilityAdequacyTesting’ by the IASB (‘IFRS 4 Phase I’, 2005) and someEuropeaninsurancesupervisiors (e.g., Dutch supervisor).

  7. 4. Solvency II development process (2) • SII development process started in 2004, also triggered by research reports from KPMG and, particularly, IAA (→ ‘total balance sheet approach’). • Many parties were involved, in particular 1. Developer: European Insurance and Occupation Pensions Authority (‘EIOPA’) 2. Representatives of the insurance industry: Insurance Europe, CRO Forum 3. Professional bodies: e.g., FEE, EAA (European accountants/actuaries) 4. Final approvers: European Commission and European Parliament (EU). • 2009 Milestone: Approval of the ‘Solvency II Directive’ (framework) • 2010-2015: More details and implementation in laws of individual EU countries. • In total five Quantitative Impact Studies across Europe! 1 January 2016: Solvency II in force.

  8. 5. Overview of contents of Solvency II (1) Pillar 1 Quantitative Requirements Pillar 2 Supervisory Review Pillar 3 Disclosure Balance sheet valuation & capital requirements Harmonised standards for the valuation of assets and liabilities and the calculation of capital requirements (SCR and MCR). Market discipline and disclosure Harmonisation of disclosure requirements, allowing capital adequacy to be compared across institutions. Review process To ensure that insurers have good monitoring and management of risks and adequate capital.

  9. 5. Overview of contents of Solvency II (2) Key elements of SII Pillar 1 (1) The SII Balance Sheet (ACnew): • All assets and liabilities need to be valued consistently at ‘fair value’, i.e. only items that have cash flows matter! (therefore DAC is notallowedunder SII). • The FV of insuranceliabilites is defined as the sum of 1. the ‘Best Estimate’ value, discounted at currentrisk-free interest rates 2. a ‘Risk Margin’ definedby the ‘Cost of Capital’ method (6%), and 3. the fair value of embeddedoptions and guarantees (ifapplicable). → SII Balance Sheet is generallyvery different from IFRS balance sheet! • ‘Tiering’ approachfordefiningadmissableelements of resultingequity (like in Basel II and III forbanks) → ACnew

  10. 5. Overview of contents of Solvency II (3) Key elements of SII Pillar 1 (2) Required Capital (RCnew): • Basedon shocks onindividual types of risk (market risk, credit risk, underwriting risk, operational risk), net of reinsurance. • Supposed to reflect 0.5% worst case scenarios. • Effectsonequity in SII BS to becalculatedbymeans of either a ‘Standard Formula’ or a (possiblyonlypartial) ‘Internal Model’; internal models must have been approvedbeforehandby the company’s (lead) supervisor. • Aggregation of effects of shocks allowsforcorrelationbetweenrisks → RCnew Requirement: ACnew / RCnew > 100%

  11. 5. Overview of contents of Solvency II (4) Key elements of SII Pillar 2 • Requires clear risk management policies (including outsourcing). • Need to establish internal audit, risk management, control and actuarial function, with detailed descriptions of tasks and responsibilities. • Fit and proper requirements for management. • Requires periodical reporting of approach and outcomes of the company’s ‘Own Risk and Solvency Assessment’. This ‘ORSA’ must show that the company will be able to meet the future solvency requirements, at least for the next 3-5 years, when the business plan is executed (including new business assumptions).

  12. 5. Overview of contents of Solvency II (5) Key elements of SII Pillar 3 Definesreportingrequirements, in particular: • The contents of the ‘Solvency and Financial Condition Report’ (SFCR, annually). • The contents of the QuantitativeReportingTemplate’ (QRT, quarterly).

  13. 6. Consequences of SII for the European insurance industry (1) Developing SII has costEuropeaninsurancecompanies a lot of money, particularybecause of 1. Pillar 1: • Major adjustments of IT systems in order to (also) allowfor the calculation of the SII balance sheet (ACnew) and RCnew. • Largercompanies: development of (partial) internal model(s). 2. Pillar 2: • Organisationalchanges, in particularbecause of the requirement to have a risk management function and actuarialfunction. • Defining concrete risk management policiesforindividual types of risk. • Muchstricterrequirementson data quality and substantiation of (best estimate) assumptions. 3. Pillar 3:Preparation of IT systemsforPillar 3 reportingrequirements. Furthermore: • Mandatoryparticipations in Quantitative Impact Studies (5!). • Participation in SII workinggroups of national/Europeaninsurersassociations and/or professional bodies (voluntary, in order to influence SII development).

  14. 6. Consequences of SII for the European insurance industry (2) • During the SII developmentprocess, in particularfollowing the outcomes of the Quantitative Impact studies, itbecameobviousthatfor most Europeaninsurancecompanies : ACnew / RCnew < AC / RC. • For a substantialnumber of insurers even ACnew / RCnew < 100%! Consequently, in order to meet the new SII requirementsfrom 2016 onwards, these companies had to • attract more capitalfrom the capitalmarket (→ ACnew ↑), and/or • ‘derisk’, e.g. byinvesting more in lessriskyinstruments (bondsinstead of shares) and/orbyincreasingreinsurance (→ RCnew ↓), and/or, c. forlargercompanies: change the groupstructure.

  15. 6. Consequences of SII for the European insurance industry (3) Several (smaller) insurancecompanies even decidedthat meeting the new SII requirementswouldbecometoocostly/impossibleforthem. Theythereforelookedforotherinsurancecompaniesthatwouldbewilling to buythem → consolidation of the Europeaninsurancemarket. NB: This trend may continue in the upcomingyears. Furthermore, many Life insurancecompanies are nowchangingtheir product portfolios. In particular, many have stoppedoffering (minimum) investment return guarantees (specificsavingsproductslikeendowments and UL/variableannuitieswithoptions/guarantees) and/orproductswith significant longevity risk (pensions), because the correspondingrisksimply significant RCnewunder SII. NB: This is of courseenforcedby the current low market interest rates and the increaseddecrease of mortalityrates. Both developmentscouldgenerallybeignoredunder SI. Notanymoreunder (risk-based) SII!

  16. 7. Risk Based Supervision of Ugandan insurers (1) CurrentsolvencyrequirementsforUgandaninsurancecompanies Quantitatively: • Life companies: Minimum = 3 billion UGX. • Non-Lifecompanies: Minimum = MAX(4 billion UGX, 15% of net written premiums). In addition, minimum premium rates and maximum commissionrates. Qualitatively: • Restrictionsonadmissableassets and liabilities. • Maximum limitsonretention percentages (reinsurance); however, without affecting minimum quantitativesolvencyrequirements. • Fit and proper requirementsfor management. Consequently: • No quantitative requirements regarding the adequacy of technical provisionsfor Life business. • Solvencyrequirementsfor Life are notproportionate to the size of the liability portfolio. • In general: quantitativesolvencyrequirements are not ‘risk-based’.

  17. 7. Risk Based Supervision of Ugandan insurers (2) New requirements from 2014 onwards: CARAMELS • Onlyqualitatively, in particular 1. companieswillberequired to have internalaudit, risk management, actuarial and specificcontrolfunctions, and 2. theyalsoneed to define business plans and risk management policies. These newrequirements, that show similaritieswith SII Pillar 2, willbeincluded in the new Insurance Bill. • However, CARAMELS alsocomprises a newrisk-basedframeworkforanalysing/ assessing the performance of insurancecompaniesthat are supervisedby the IRA, includingquantitativeearlywarning test ratios. Consequently:Sofar, Ugandanlawwillonly support somequalitativeelementsoifrisk-basedsupervision. Nevertheless, the IRA willfurtherelaborate CARAMELS, includingquantitativeelementsfollowingexperience, in order to furtherimproveitsrisk-basedsupervision.

  18. 7. Risk Based Supervision of Ugandan insurers (3) Possiblefuturechanges in Ugandanlaw/regulationsregardingrisk-basedsupervision of Ugandaninsurancecompanies • The IRA fully supports the principles of risk-based supervision as expressed in, e.g., Solvency II, as these principles improveour understanding of the (risks associated with) insurance business. This is primarily in the interest of ourpolicyholders (Ugandancustomers), butalso in the interest of shareholders, management and employees in the industry. • Consequently, furtherelements of risk-basedsupervisionwillbeintroduced in the future. However, the industrywillbeconsultedregarding contents and timing, as commitmentfrom the industry is keyfortheirsuccess.

  19. 7. Risk Based Supervision of Ugandan insurers (4) Possiblefuturechangesmaycomprise: • introduction of ‘liabilityadequacytesting’ (of technicalprovisions) • a newreportingtemplatefor the regulatorybalance sheet (in whichassets and liabilities are valued more consistently) → ACnew • eventually, a newapproachforcalculatingsolvencyrequirements (which are proportiate to the size of the portfolio, and, most importantly, which are risk-based) → RCnew The IRA therefore wishes to encourage the Ugandaninsuranceindustry to develop SII similar, i.e. more ‘risk-based’ elements in theirinternalassesments of the performance and solvencyposition of theirfirm(s). NB: Likefor SII relative to SI in Europe, itcannotbeexcludedthat ACnew / RCnew < AC / RC

  20. Questions? Thank you

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