Buenos AiresNovember 22-24, 2011Serap Oguz GONULAL

World Bank

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Agenda

Challenges of insurance sector in emerging economies

Solvency IIMain regulatory elementsInternational experienceImplementation plan

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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 service304/19/23

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?

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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 itLegal 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

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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

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Agenda

Challenges of insurance sector in emerging economies

Solvency IIMain regulatory elementsInternational experienceImplementation plan

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Main regulatory elements under Solvency II

1. Official supervisory oversight – on and offsite monitoring and enforcement

2. Solvency (inc. reserving), guaranteed return and consumer protection rules

3. The professions – actuaries, auditors and financial journalists4. 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!!

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Solvency II-Why ?

No clarity on the objectives of supervisionSolvency is based largely on mathematical reserve

calculation – no explicit allowance for asset side risksRules based investment limits – can restrict

innovation and capital market developmentLimited guidance on supervisory interventionsNet approach – no explicit allowance for reinsurance

A need for improvement in the regulation and supervision of insurance companies

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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

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New ICPs - ICP16 & 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

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Solvency II

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Pillars I and II framework

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Agenda

Challenges of insurance sector in emerging economies

Solvency IIMain regulatory elementsInternational experienceImplementation plan

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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 regulation1994: introduced a Risk-Based Capital (RBC) system, as a factor-based approach that considers an insurers' size and risk profiles when determining capital requirementsWhat's changing: Based on a review of international developments in insurance supervision, solvency assessment, and international accounting standards, will upgrade the US solvency frameworkThe 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

Source; Swiss Re-Sigma

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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 risk- and 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 70s , 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

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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

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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

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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 diversification

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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

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Agenda

Challenges of insurance sector in emerging economies

Solvency IIMain regulatory elementsInternational experienceImplementation plan

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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 risk-taking, 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

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Technology requirements of Solvency II

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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

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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 ratiosMove 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 riskHave a formal crisis recovery plan

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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

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Risk Based –Solvency II

Solvency I is a weak predictorSolvency 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

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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 resourcesconcurrently 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

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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 companiesenable supervisors to protect policyholders' interests

as effectively as possible in accordance with common principles

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Rules based/Risk based

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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

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THE STAKEHOLDERS

REGULATORY FRAMEWORK

INSURANCE SECTOR

POLICYHOLDERSAPROACH

MACRO ECONOMYOUTLOOK

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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)

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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

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How to measure successKey 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

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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

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Moving towards Solvency II-Why?

to increase policyholders protectionA requirement to get a risk-sensitive level of

required capitalGreater market discipline through increased

public disclosureMore information on firms to allow supervisors

to have a total view of the business modelMuch stronger emphasis on risk management

and forward-looking risk governance leading to a stronger risk culture in firms

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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

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