Solvency Assessment and Management. Summary of Roadmap Responses

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1 Solvency Assessment and Management Summary of Roadmap Responses AUGUST

2 C O N T A C T D E T A I L S Physical Address: Riverwalk Office Park, Block B 41 Matroosberg Road (Corner Garsfontein and Matroosberg Roads) Ashlea Gardens Extension 6 Menlo Park Pretoria South Africa 0081 Postal Address: P.O. Box Menlo Park 0102 Switchboard: Facsimile: (for general queries) (for SAM Roadmap related queries) Website: 2

3 Introduction During November 2010 the Financial Services Board (FSB) published a SAM Roadmap. The purpose of the Roadmap was to serve as a concise guide to the new risk-based solvency regime and to assist in preparing for SAM. The Roadmap included 27 questions which were interspersed throughout the document at key junctures to elicit essential information from. The purpose of this document is to provide a summary of the responses to the questions included in the SAM Roadmap. Completion of the questionnaire was voluntary. 81 responses were received from the 191 registered long- and short-term insurance companies 1. Summary of responses Category Number of Responses Total in Industry 1 Percentage Responded Long-Term % Short-Term % Reinsurer % Total % 1 As at 30 November Including Lloyd s Methodology In reporting the responses, where a consolidated response was received for that form part of the same group of companies the same response was allocated to each of the relevant in the group. Respondents were divided into the following categories for reporting the results: Long-term Short-term Re (short-term and long-term re combined) The questions were divided into quantitative and qualitative categories. The quantitative questions are those that required a Yes or No answer (Questions 1-6). The questionnaire allowed for more details to be added, which were generally disregarded if an explicit Yes or No was given. If no explicit Yes or No was given, a judgment call was made whether the response was closer to a Yes or closer to a No, and allocated accordingly. 1 Throughout this document both and re are referred to collectively as or insurance companies unless a specific distinction is drawn in reporting the responses. 3

4 The qualitative questions are the open-ended questions. (Question 2b, 7-27). For these a summary of responses based on the categories mentioned above are provided. Specific thoughts from the FSB have also been included in the document for each of the qualitative questions. For the quantitative responses, the FSB has provided a consolidated commentary at the end of the feedback from participants. Quantitative Responses Question 1: Have you begun planning for SAM implementation? Category Percentage responded Yes Long-Term 87% Short-Term 95% Reinsurer 100% Question 2a: Have you set an internal deadline to perform a gap analysis to determine the transition requirements to SAM? Category Percentage responded Yes Long-Term 74% Short-Term 72% Reinsurer 100% Question 2b: If so, by when? Category Average Response of those responding Yes Long-Term June 2011 Short-Term July 2011 Reinsurer May 2011 Note: a period of 12 months was awarded if an insurer appeared noncompliant or unprepared. 4

5 Question 3: Have you allowed in your planning of SAM implementation the necessary resources and time to complete the South African Quantitative Impact Studies? It appears that the majority of respondents planned to have completed their SAM gap analysis by mid Category Percentage responded Yes Long-Term 58% Short-Term 70% Reinsurer 57% Question 4: Do you intend applying to use an internal model? Category Percentage responded Yes Long-Term 39% Short-Term 74% Reinsurer 57% Question 5: Have you nominated a champion to drive SAM implementation? Category Percentage responded Yes Long-Term 97% Short-Term 88% Reinsurer 86% Note: It was observed that particularly the smaller companies, and those that were less prepared, tended to nominate their CEO as the SAM driver. 5

6 Question 6: Which of the issues: governance arrangements, capital adequacy, use and approval of internal models do you expect to generate significant additional costs and how do you intend to quantify these costs? Category Long- Term Short- Term Governance Arrangements Percentage responded Yes Capital Adequacy Internal Models 45% 26% 45% 33% 26% 53% Reinsurer 29% 0% 14% Note: One small company mentioned tax as an anticipated additional expense. Other responses regarding additional costs related to Human Resources. In terms of quantifying the costs, many respondents indicated that it was too early to obtain a true estimate of the costs. Some respondents have already incurred costs in early development work, but many have indicated that they are awaiting the outcomes of their gap analyses to assist in quantifying costs. Most respondents who have done some level of quantification have utilised third party providers to do so, while the rest have attempted to estimate required resources and time needed. We are pleased to see the progress that the industry is making towards implementation of SAM, specifically to see the high percentage of respondents who have nominated a SAM champion and have begun the planning journey for SAM. Those that have not completed a SAM gap analysis to date are in danger of falling behind the curve in terms of SAM implementation. A relatively high proportion of respondents have indicated that they may be applying for an internal model. Given the onerous nature of the application process and stringent requirements around the model, the FSB expects that some of those intending to apply may not be in a position to do so immediately, but may end up applying at a later stage. 6

7 Qualitative Responses Long-term Question 7: Where these issues are likely to add to your current regulatory commitments, what do you think the benefits are to and their customers? All were positive about the benefits of SAM to themselves and to their customers. There were no significant differences between the responses of long-term, short-term and re. According to the respondents, SAM will lead to better governance and enhanced risk and capital management by, including optimising the return on capital through better capital allocation. As businesses will be managed within a defined risk appetite, with the insurer holding an adequate level and quality of capital for its particular risk profile, the expectation is that this will lead to enhanced policyholder protection. This will lead to increased levels of confidence amongst investors, policyholders and shareholders leading in turn to improved confidence in the industry. There is a view that SAM could lead to increased overall profitability through better pricing of products. There is also a view that premiums could potentially decrease due to a lower cost of capital. A uniform approach to statutory requirements is valued, as well as the fact that the proposed regime will have international recognition. Third country equivalence will be beneficial for forming part of an internationally active insurance group. The SAM regime should also contribute to increased stability in the financial sector. Transparency through new reporting requirements was also valued. However, some respondents raised some potential disadvantages. These related mainly to concerns about the increased cost of regulation and potential increased levels of capital. In contrast to the majority view, some are of the opinion that the new regime will lead to increased premiums and a reduction in earnings. The proposed framework will add to regulatory commitments and reporting and will lead to significant additional work. One respondent was of the view that the new requirements can result in reporting delays and that the SAM framework will have very little, if any, benefit to consumers. A comment emanating from some long-term specifically was that the proposed regime may not be suitable for underwriting pure linked business. 7

8 SAM will bring definite benefits to both the as well as policyholders, as has been acknowledged by the majority of participants. One implication of SAM is that less risky and/or lines of business will require less capital, and hence will generate greater returns on capital and/or result in lower premiums. The converse is true where business is more risky than in the past - it is certainly anticipated that SAM will result in higher regulatory capital requirements for riskier types of insurance business. Regarding concerns raised with respect to the suitability of the regime to pure linked long-term business, the question of whether or not a specific SAM dispensation is required is being actively considered within the SAM project structures. Long-term Short-term Re Question 8: What steps are you taking to develop the appropriate valuation systems to calculate technical provisions under SAM? How is this work linked to the implementation of IFRS Phase 2 standards? Most long-term indicated that they do not anticipate the need to develop a new valuation system and that no big changes are expected. Some are of the opinion that the debates and flux regarding boundary conditions, transitional arrangements and insurance vs. investment allocation has meant that the SAM and IFRS4 Phase 2 projects are being run separately and that there is no link between the two streams. Insurers are concerned that, in certain aspects, Solvency II and IFRS Phase 2 are not currently aligned and are more than likely to remain as such. Most commented that the implications of IFRS4 Phase 2 have not yet been considered. It is too early to judge how the work can be linked since IFRS4 Phase 2 is still in progress and the detail still needs to be finalised. Most short-term indicated that they are spending time on development work as well as efforts to improve the quality and availability of data used to calculate technical provisions. Some short-term indicated that they do not foresee IFRS4 Phase 2 having a material impact on the valuation of their liabilities due to the shortterm nature of the insurance contracts. Re have been developing robust and flexible cash flow models as both valuation bases (SAM technical provisions and IFRS) use best estimate cash flow projections as a starting point. For some re the calculation of technical provisions is centralised at the group level. 8

9 The ability to calculate technical provisions in accordance with the SAM criteria is one of the foundations of Pillar I, and as such those which have not as yet started updating or developing their valuation systems to produce the required provisions will need to do so as soon as possible in order to ensure readiness for the regime as well as to facilitate their participation in future Quantitative Impact Studies (QIS). Long-term Short-term Re Question 9: What steps have you taken to consider whether you have the right quality of capital to meet the capital requirements? Long-term indicated that the majority of solvency capital is in the form of shareholder equity which is classified as Tier 1 capital (i.e. the highest rated form of capital under Solvency II). Some intend to develop capabilities to accurately identify and rank their sources of capital. Another potential step is to perform a gap analysis to identify shortcomings. The majority of short-term have a conservative investment strategy where most of the investment assets are allocated to cash or near cash instruments. As a result they have predominantly Tier 1 capital and no major changes are envisaged. Similar to short-term, the re portfolios are invested conservatively, predominantly in money market instruments and government bonds. Some are closely following the issue of grandfathering of hybrid debt in the European Union. The introduction of capital resource standards is part of the move towards a more risk-based approach to capital. Based on the responses, it seems that most are holding Tier I capital, and these participants will have to ensure that this investment strategy is maintained in order to ensure adequate capital quality. Those with assets falling into Tier II and/or Tier III will have to ensure that their capital strategy provides appropriate coverage of their capital requirements. It is important for to keep up-to-date with developments regarding the classification of different types of capital instruments in the calculation of overall capital resources. 9

10 All Question 10: How do you think could best demonstrate compliance with the Pillar 1 requirements on a continuous basis? There were no significant differences between the responses of long-term, short-term and re to this question. Comments were received that the expression "continuous" needs to be interpreted in a sensible and pragmatic manner. In reality it is not practical to expect that any insurer calculate continuous "real-time" updates to the solvency position - the technological capability (and in particular the data) required is not available. A practical "continuous" monitoring of solvency can be achieved by requiring regular updates on the solvency position at a practical and realistic frequency (e.g. quarterly) and employing approximate techniques (e.g. curve fitting, replicating portfolios) to perform the updates. In general it was felt that compliance would be achieved through processes in all pillars: Compliance can be demonstrated through calculating the MCR plus a suitable margin on a quarterly basis, and the SCR on an annual basis. It was felt that this should be sufficient, unless there is a significant change to the risk profile of the business. There should be detailed commentary on the movements between quarters as well as details of modeling improvements over the period. The insurer then needs to show that the output of the models used to calculate the MCR and SCR are also used for the management and running of the business (i.e. through the use test). The Pillar 1 requirements must be used as the basis for the ORSA process that should take place frequently. In line with the principle of proportionality, an insurer s reporting requirements, aimed at demonstrating compliance with the Pillar 1 (and other) requirements, should be commensurate to the nature, scale and complexity of its risks. The auditors and statutory actuaries should certify compliance with Pillar 1 requirements at regular intervals. The ability to calculate risk-based capital requirements is not only useful for demonstrating compliance, but also in terms of ensuring that management decisions utilise up-to-date risk information. Proportionality is an important concept within the SAM framework, and will aid smaller, lower risk in complying. The role of the statutory actuary is under discussion at the FSB. Question 11: Do you already have a process similar to the ORSA in place? If not, what progress are you making in preparing to develop an ORSA? Insurers submitted a variety of answers. In most cases there has been some progress on various levels towards an ORSA. Most indicated some 10

11 Long-term Short-term Re type of risk management process was taking place, with the intention of formalising the risk management process in order to meet the ORSA requirements. Some long-term, who are part of a banking group, indicated that they had been involved in a process similar to ORSA through their banking group which was helping their preparation for ORSA. The larger long-term insurance groups were generally better prepared for the ORSA than the smaller long-term. For long-term that do not currently have a process similar to ORSA in place, their comments regarding their progress in developing one included performing a gap analysis; formalising, refining and expanding current processes; waiting for further guidance on how the principle of proportionality will be applied to the ORSA and developing an explicit risk strategy and risk appetite limits. Most short-term indicated that they do have an extensive risk matrix in place that is similar to the ORSA, but that this needed to be either developed further or documented better to bring it in line with ORSA. For short-term that do not currently have a process similar to ORSA in place, their comments regarding their progress in developing one included that it will be done as part of the development of their internal model. One shortterm insurer believes the ORSA is much more applicable to third party than to first party. Most re have a number of different processes employed at present which taken together resemble the requirements of the Pillar 2 ORSA. They intend building on what has already been developed and envisage refinements and deepening of their current processes. For re that do not currently have a process similar to ORSA in place, their comments regarding their progress in developing one included that it is still under consideration and that the ORSA requirements are being assessed and will be implemented at the Group level as part of the group Solvency II project. The ORSA, if performed as a collaborative process within an insurer involving senior management and relevant middle management and/or experts, can provide key insights to executives as to the current risks materialising within the business. As such, the ORSA is not only a regulatory requirement, but also provides a useful tool in managing the business in a risk-sensitive manner. All, including those who do not intend to apply for an internal model, should already be taking active steps to develop an ORSA process. 11

12 All Question 12: How do you consider supervisors should respond to a breach of targeted economic capital requirements? There were no significant differences between the responses of long-term, short-term and re on this question. However, this question was interpreted inconsistently as some referred to a breach of the SCR whilst others refer to a breach of the targeted economic capital requirements. Generally, respondents felt that supervisors should engage with the management of an insurer in order to gain a better understanding of the problem and to gain an insight as to how the insurer plans to remedy the situation. The extent, nature and reason for the breach (whether the cause is a once-off event or whether a significant risk of continued deterioration exists) should be considered. The insurer must be able to submit a plan of action on how they intend to rectify the position. Additional reporting requirements should be required until such time that the supervisor is satisfied that the insurer can meet its capital requirement. Most agreed with the Ladder of intervention that was put forward in the SAM roadmap. However, the ladder of intervention should only start at the SCR and the breach of internal economic capital targets should not trigger supervisory intervention, but should simply be observed and monitored. One insurer felt that the FSB should not intervene too frequently or unnecessarily in the affairs of the insurer and that the actions of the FSB should not be of such a nature that they begin to drive company policy and behavior. Definitions of Economic Capital (EC) vary in different organisations, however most definitions relate the capital in some way to the insurer s own assessment of the risks, at the insurer s own defined confidence level. One widely-used definition is that EC is the capital required by a insurer to maintain a targeted credit rating. The FSB would as such take an interest in breaching their EC levels as part of our overall risk-based supervisory process. Question 13: In the event you answered yes to question 4, please indicate both your current level of progress in developing the model and whether you are prepared to make your development work available to the FSB. All respondents indicated that they are generally happy and willing to engage with the FSB to ensure that the ongoing model development reaches the 12

13 Long-term Short-term Re required stage of maturity required before an application is made for approval, provided that the work is not publicly disclosed. For long-term, the various elements of development work underway with respect to components of an internal model are at different stages of maturity. It ranges from that have not yet started with the process to that anticipate shortly carrying out the first dry run of "using" their internal model. Some have done ground work in terms of understanding the risks and have identified the major risks to be modeled. Most of the work done relates to calculations required for PGN104 and PGN110. Although some models are at the starting phase, in general good progress is being made in the short-term industry and some plan to take part in the early pre-application processes. Work needs to be conducted in achieving the desired minimum requirements around data governance, documentation and related business processes. Some models have been in use for some time and have been reviewed by external consultants. Re responses were varied. Whilst some aim to be ready for the preapplication phase and implementation in 2014 others have not progressed very far and intend to draw on work done by their parent companies. The local work is anticipated to largely entail modifying these models to fit their specific market and balance sheet. The development and embedment of an internal model is a significant undertaking, which will take significant time and resources to complete. This is especially true for an internal model to reach the standard required for approval by the FSB for the calculation of regulatory capital. It is important to note the requirement of an independent review as part of the application process 2. Sharing the development work with the FSB, and indeed the information provided along with the early stages of the IMAP (PAQC), will not impact the FSB s level of review of the model, nor should it have an impact on the independent review process. 2 Please refer to the Contents of Application on the SAM site (click here to open) 13

14 All Question 14: To what extent does this description reflect current and planned future internal models? 3 Most indicated that this is an accurate and appropriate description of what they understand an internal model to be and how they would envisage employing it in their business. The future state of internal models is likely to be similar in structure but with further refinements/enhancements to ensure greater compliance with the relevant guidance and directives. The description reflects the fact that an internal model is not just a technical exercise, but a tool to manage risk. Internal models would be preferable for those risks where the standard formula is unlikely to reflect the insurer s specific risk profile. Internal models give flexibility to accurately model their unique risks in situations where the standard formula may give only a high-level view. It is comforting that respondents recognise that an internal model is far from purely a model, but is, as per the definition, a risk management system. All Question 15: SAM is likely to require clear and demonstrable integration between capital measurement systems and capital management. How should demonstrate the link between or integration of their internal model and their risk management framework, in particular to the ORSA? There were no significant differences between the responses of long-term, short-term and re to this question. To demonstrate the link between the capital model and the risk management framework, need to show how the model is embedded in the day-today running of the business (i.e. through the use test). Insurers could demonstrate this link by providing the following to the FSB: documentation, proof that the link has been communicated and practical examples of how the model and the risk management framework have been integrated. The integration of these components allows the supervisor to assess the 3 This question was included in the SAM Roadmap section dealing with Internal Model Development. The description of internal model referred to in the question is the definition used by the International Association of Insurance Supervisors (IAIS), namely: internal model refers to a risk management system developed by an insurer to analyze the overall risk position, to quantify risks and to determine the economic capital required in meeting those risks. An internal model may also be used to determine the insurer s regulatory capital requirements on the basis of the insurer s specific risk profile and the defined level of safety of the solvency regime. 14

15 appropriateness of the model for the risks within the business. ORSA reporting will be the output of this integration process. Insurers must demonstrate how and which decisions were taken using the output of the model. The outputs of the model should contribute towards: the assessment, measurement and management of risks; risk appetite; asset-liability management; capital allocation and optimisation decisions; risk-adjusted pricing and performance measurement; reinsurance strategy; new business strategy; decisions relating to the payment of dividends; target underwriting margins based on allocated capital; and investment strategy. Capital measurement systems should inform the day-to-day management of the entity, to ensure that decision-making takes into account the dynamic risk profile of the organisation. Documentation, communications, and practical examples are all good mechanisms for demonstrating to the FSB how this link has been put into practice. All Long-term Short-term Question 16: Does the use test reflect capital management practice within the industry? If not, how do the use test prescriptions differ from current practice? The general response was that although have capital management processes in place to actively manage their capital, these are not currently formalised and documented as envisaged under the SAM framework. Most long-term felt that although the industry makes efforts to manage its capital, this is not done as rigorously as would be required under the use test. Current practice is less formal, less regular and of a short-term view. Only three indicated that the use test reflects current capital management practice within the industry. The general view was that capital management practices in the short-term insurance industry are not very developed and that there are shortcomings in terms of the inter-linkages between risk management systems and their business decision making. Currently capital is not key to business decision making. The current focus is on profitability rather than capital allocation or return on capital. 15

16 Re Only a few respondents indicated that their internal model is being used extensively with regards to capital management. It was also felt that, as things currently stand, short-term would find it very challenging to demonstrate how capital management practices are integrated into their dayto-day operations. In respect of those re that responded to this question, it was indicated that this issue will be dealt with at group level. The 'Use Test' is a test of whether the model has been incorporated into the day-to-day risk management of the insurer. The principles governing the 'Use Test' are fundamental to the approval of an internal model. Without demonstrating that the model has been used in decision-making, it cannot be approved for quantifying capital needs. The use test furthermore will ensure that risk and capital management practices are more robust, by formalising these processes where they exist. All Long-term Short-term Question 17: What are doing to evaluate and improve data? The insurance industry undertakes continuous reviews on data and it seems that in some cases significant resources have been allocated to improve the quality of data. Many undertook gap analyses to identify information that will be needed in future. Focus areas include data warehousing, data to identify risks and data governance frameworks. Long-term have, in addition to the continuous reviews that are taking place, allocated significant resources to improve the quality of data, with specific focus on automation of processes and improvement of documentation. In some cases the focus is only on data flows as identified within the scope of the internal model. Some of the smaller long-term indicated that additional work on data is not applicable as they do not intend to implement an internal model. For most long-term, regular data quality checks are performed and some have started with gap analyses. Some rely on the statutory actuary to sign-off that the data used is reasonable. One insurer indicated that although they already have good quality data, they are looking to improve data capturing relating to operational risk. Others also indicated that they are redefining reports (and making sure that the necessary data is available to support these reports) and trying to improve data to support effective risk management, albeit not necessarily for the purposes of an internal model. The large short-term are actively addressing data requirements where gaps exist, although it seems that these gaps are not highly prevalent. They are also focusing on data warehousing and data governance frameworks. 16

17 Re Most short-term mentioned that they are constantly refining their data and/or doing regular (e.g. monthly) data reconciliations. There is a drive to perform gap analyses to identify additional information that will be needed in the future. Some mentioned that they are enhancing their systems to store more relevant risk related information. A few small rely on systems implemented in the larger group of companies. In respect of captive and cell captive, respondents reported that analysis is undertaken to ensure that the information received from third parties is valid, accurate and complete. Some are busy implementing either centralised systems or specific requirements regarding the format in which data should be submitted. It is clear that the SAM requirements will raise the expected level of data governance and oversight over third parties responsible for providing data. Although considerable efforts are being made by re, the quantum, quality and availability of data are heavily dependent on other industry players such as brokers, underwriting managers (UMAs) and primary insurance companies. Some are putting processes in place to improve the data they receive, others expect to obtain better data in future (due to the SAM project) whilst others believe that the FSB has a role to play in ensuring the respective practitioners in the industry meet their obligations regarding the provision of quality, accurate data on a timely basis, i.e. requiring specific regulatory provisions to compel the provision of the required data. It is hoped that many of these issues will be addressed through the planned introduction of explicit regulations governing binder agreements. Data quality should be a priority to all, not just those chosing to implement an internal model. Even those that plan to utilise the standard formula will be required to demonstrate that they have adequately identified, measured and managed the risks they are exposed to and understand how this informs an adequate level of capital. They will also need to demonstrate that they have adequately evaluated the extent to which the standard formula is appropriate given their insurer-specific risk profile. In order to do this additional work on data will be necessary. It should be noted that under SAM, sign-off on data quality will become a Board responsibility, informed by the risk management and actuarial control functions. Interestingly, many short-term touched on the issue of ownership of data. The FSB s expectations are that even though certain functions are outsourced, the insurer should always own the data relating to the business that has been underwritten. Many small short-term are dependent on external providers (such as brokers, underwriting managers and administrators) to supply them with data, which adds an additional layer of 17

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