Global regulation steers towards quality
Regulators around the world are converging in their assessment of insurer creditworthiness. Even with the impact of the global credit crunch likely to increase the rigour of quantitative rules-based tests, the trend is for a wider qualitative approach, embodied in Enterprise Risk Management (ERM). Vikas Newatia, Managing Director of EMB India explores why.
Indian observers of the world insurance market will be aware that, if all goes to plan, thirty European countries will be united in 2012 by a single set of rules, known as Solvency II, governing what constitutes an acceptable level of insurer creditworthiness.
Europe’s ambition, both in terms of scale and scope, is acting as a catalyst, spurring regulators in other jurisdictions to review their supervisory policies. Across the globe we are seeing a growing convergence of two core, related, strands: principles-based regulation and Enterprise Risk Management (ERM).
Does this mean that we are heading for a world where regulation of the industry is identical in all major centres? Not quite. Whilst there may be an emerging alignment in the fundamental principles, implementation approaches are likely to differ significantly. Europe is by no means unique, nor even the first, in its move to a risk-based regulatory regime.
There is no doubt, however, that the traditional rules-based solvency standard is now widely viewed as inadequate. It bears no relation to the risks that are in the business. It means that capital may be tied up unnecessarily. And it encourages an attitude of box-ticking regulatory compliance rather than supporting dynamic business management.
Principles-based regulation moves the onus of assessing a firm’s explicit level of solvency from the regulator to the company management. One benefit is that the market will have a stronger notion of the capital necessary to support their operations. But possibly the most important advantage is that firms become much more risk aware in their management and culture.
Enterprise Risk Management is becoming established as a management discipline covering the methods and processes used by firms to identify, assess, measure and monitor risks within their business. And it has recently gained greater prominence through legislation such as Sarbanes-Oxley, and its inclusion in ratings agencies’ credit assessments.
What we are seeing is not only a convergence of regulatory standards, important as that is, but also a growing consensus as to what constitutes best management practice.
The global picture
The UK became the first major jurisdiction to put self-assessment at the heart of regulation when the Financial Services Authority introduced the ICAS (Individual Capital Adequacy Standard) regime in 2004. One distinctive feature is that, in practice, all but the smallest of UK insurers are required to produce models to demonstrate and support their financial strength. This has forced them to review all aspects of the business and to consider the financial impact of risk.
Despite initial complaints about the burden imposed, executives in the UK recognise that ICAS has brought advantages. Switzerland followed suit in 2006 with the risk-based Swiss Solvency Test (SST) that again can be calculated either by a standard formula or through the use of an internal model.
There is, however, no doubt that Solvency II represents the biggest single move towards ERM the world is ever likely to see. However, the inherent complexity of the exercise is compounded by the tremendous diversity of companies and countries within today’s European Union and European Economic Area. The decision to offer firms a choice between a formula and an internal model for capital calculations is a practical approach to dealing with this diversity.
The Americas – tentative first steps Until recently, North America and Bermuda would have been off any list of territories adopting risk-based regulation. But now there are signs of movement. In the United States, where insurance regulation is at state level, Minnesota has already laid out plans for a risk-based audit of insurers within its own jurisdiction.
More importantly, New York has openly discussed change, not only for companies domiciled in the state but also everyone who is licensed there. If New York moves, other states will need to follow.
In January 2008 the Bermuda Monetary Authority announced the phased introduction of risk-based capital requirements to replace the current solvency margin regime, to be known as the Bermuda Solvency Capital Requirement (BSCR).
In Latin America, Brazil is leading the drive towards risk-based solvency regulation with rules regarding underwriting risk that took effect in January 2008. While an internal model cannot yet be used to determine an insurer’s capital requirement, any company that has such a model receives a discount.
Middle East and Africa – driven by international standards
The growing influence of ratings agencies in the Middle East is driving many local insurers towards ERM and internal modelling to keep up with their larger international competitors.
In South Africa, which operates as an insurance hub for all of sub-Saharan Africa, the regulator has issued draft regulations to be implemented by 2011/12. According to the draft regulations, most companies are expected to move towards a full internal model within five years of implementation. Most of the larger South African insurers and some smaller ones are already developing internal models, mainly for competitive reasons
Asia-Pacific – toe in the water
The Australian regulator APRA was a very early pioneer introducing a risk-based regulatory framework at the start of this decade. As with other regimes, companies are offered a choice of internal model or formula to calculate their required capital.
Many Asian regulators are watching the Solvency II process closely. Japan, with the biggest insurance industry in Asia, currently has a formula-system, although the regulator is exploring a more principles-based approach and insurers have been warned to prepare for the future introduction of internal models. The Chinese regulators are also experimenting with internal models and risk-based solvency regulation.
India
In South Asia, India has been using a formula-based system and is considering a risk-based model. However, it is at a very early stage of its development. In the environment where caution is necessary, risk-based solvency regulation seems to be more ideal. How would India proceed with this goal – perhaps observe Solvency-II in Europe, look at Brazil and see what happens there? Or take the bull by the horns and outline its’ own goals and deadlines. Irrespective of what and when, Indian companies and regulators would need to adopt a robust framework to be credible in the global arena.
There can be no doubt about the direction of the tide. Indeed, so widespread has its practice become, that it is difficult to envisage international companies ignoring ERM, particularly with ratings agencies and competitive pressures all pushing in the same direction.
The fact that regulators around the world are moving towards adopting the principles of ERM as the standard is good news. It makes business sense.
Some compromise has been necessary on the part of regulators. Many countries do not have the actuarial resources with the knowledge and experience to design, build, parameterise, and implement internal models. But with the global emergence of ERM and the requisite dynamic financial models, the spread of this knowledge will come sooner rather than later.
In the meantime, Indian re/insurers need to define their aspirations towards ERM. Those that recognise the opportunity it presents to improve business management processes will have much to gain over their less ambitious competitors.
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