Capital and Solvency Reform in the Insurance Sector

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1 Capital and Solvency Reform in the Insurance Sector Craig Thorburn Senior Insurance Specialist, The World Bank Policy Advisory Consultant, CGAP or Skype: craig_thorburn

2 Some thoughts 1. Introductory remarks 2. Process as a critical success factor 3. Risk based capital pillars 4. Shape of minimum capital rules 5. Absolute minimum capital approaches

3 INTRODUCTORY REMARKS

4 Introductory Remarks Experience drawn from Reform projects as a supervisor Chair of IAIS Solvency World Bank / FIRST Initiative engagement 7 countries ranging from less to more developed Projects that provide technical capacity to develop and implement the approach. and many more in the pipeline

5 Observations Solvency II Providing a strong catalyst for change The Case for Change (Sharma Report) Served the market well but in need of modernisation Not adequately risk based to observe the IAIS Core Principles; Many jurisdictions outside the EU have a Solvency I framework. Do the same issues have a relevance in these markets? Key elements are attractive Particularly for some jurisdictions seeking equivalence considerations.

6 Solvency II: Not just a minimum capital rule Pillar 1: Quantitative Requirements Balance sheet evaluation (including asset and liability valuation and accounting) Solvency Capital Requirements calibrated to a 1 in 200 year / 99.5% one year time horizon type basis. Can be either a standard formula or approved internal model based calculation. Minimum Capital Requirement is lower and is the basis for regulatory withdrawal of authority to operate. Pillar 2: Qualitative Requirements, Governance, Policies, Risk Management and Internal Controls, ORSA Note the key linkage of this to supporting risk based supervisory oversight and a proportionate approach. Pillar 3: Market Discipline / Disclosure Some of the detail reflects the EU situation (multiple supervisors, multiple jurisdictions, broad geographic coverage, home and host domiciles of internationally active insurers etc) All need to be implemented consistent with local market circumstances For example, material capacity for market discipline will work within an EU regime but will be different where shareholders are more distant, listed firms are less predominant, etc.

7 Intentions of a Solvency II Approach The system should provide supervisors with the appropriate tools to assess the overall solvency of an insurance undertaking. This means that the system should not only consist of a number of quantitative ratios and indicators, but also cover qualitative aspects that influence the risk-standing of an undertaking (management, internal risk control, competitive situation etc.) Adapted Basel-type three pillar structure, highlighting the importance of the supervisory process in pillar II. Encourage and give incentive to insurers to measure and manage their risks. Recognizes a risk-oriented approach that would lead to the recognition of internal models (either partial or full) provided that these improve the undertaking s risk management and better reflect its true risk provide than a standard formula. 2003, Design of a future prudential supervisory system in the EU, MARKT/2509/03

8 PROCESS AS A CRITICAL SUCCESS FACTOR

9 Not just a rule Need to bring everyone into the new paradigm; Start What will the new capital level be? We do not need to change. What we really need is to relax the approval rules. End I think this risk has a different profile. Nobody talks about the approval rules anymore. I love our new capital regime!!!

10 Process is critical to success Step 1: Review the Market Step 2: Qualitative Report Step 3: Quantitative Report Step 4: Implementing Documentation Reforms require an iterative process of consultation and refinement to: Ensure development is orderly and well structured; Makes relevant decisions at relevant times rather than prematurely jumping to the answer ; Ensure, as far as is practical, that all stakeholders have the same opportunity to contribute to the process. The least sophisticated insurers and the most busy managers who are running their day to day business have to be able to implement it. Governance aspects cannot work if people misunderstand and are focused on the compliance replacing one rule based regime with another more complex rule based minimum capital rule. Questions that come from misunderstanding should not dominate the consultative process.

11 Consultation is Learning the consultant s report Adequate time should be allowed for consultation even if it is not considered to be controversial. The first consultation round might seem unduly long but it is useful that it be similar to later rounds to demonstrate a procedural fairness. Time during consultation will also be taken up by sector stakeholders in their own discussions. Insurers and supervisors are both learning through these processes. Objective is more than a new rule it is a new approach to thinking about risk. From Managing Rules to Managing Risks

12 RISK BASED CAPITAL PILLARS

13 Taxonomy of Risks Business strategy risk Excessive business growth Liability / Technical Risk Reinsurance (operational, asset, liability) Catastrophic Risks Credit Risk Related party assets Liquidity Risk Asset Liability Matching Concentration risks (and diversification)

14 Pillar I Minimum capital standard rule Absolute minimum capital requirement Rules for the valuation of technical provisions Assets and their valuation Eligible capital Pillar II Governance of risk Adequate policies and procedures Capital, reinsurance, investment Adequate risk monitoring and control Supervisory Review Pillar III Market Discipline Disclosure

15 Preferences Identifying risk metrics Balance sheet measures and claims ratio variation Scenario or stress testing as a risk metric. Minimizing compliance costs and transitional complications by looking to use current classes and categories and valuations. Governance always comes up Design system to encourage supervisors and management to put decisions in the company hands;

16 THE SHAPE OF THE MINIMUM CAPITAL RULE

17 Option 1 Minimum Re quirement x + + i Ai y jl j = zkck Asset based factors: Risk index is the balance sheet asset value; Factors consider asset based risks such as credit, market, liquidity, custody, concentration, etc Liability based factors: Risk index is balance sheet technical provisions; factors reflect technical risk particularly with respect to variation in outcomes as liability values should reflect expected outcomes; Other factors using alternative risk index measures: Depending on materiality,

18 Option 2 Minimum Re quirement = ( x A ) 2 + y L + i i j j z k C k Correlations and diversification approach, more popular in countries with North American trained actuaries.

19 ABSOLUTE MINIMUM CAPITAL APPROACHES

20 Guidance The nominal minimum should be set at a level that means the more risk based solvency rule is relevant for the insurance market. It should not be that the absolute minimum, even if applicable to most insurers, is the expected long term figure for most insurers as this would imply the regime is not risk based as per the ICPs. consider issues of competition and concentration. This can be informed by benchmarking and observations of practices of new entrants, mergers and acquisitions, and exits. consider issues related to the policy for access to insurance markets for the underserved. Benchmarking database has been useful.

21 END

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