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ANALYSIS: The new risk-based global insurance capital standard

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The International Association of Insurance Supervisors is developing a risk-based global insurance capital standard that is designed to provide transparency and comparability of insurers across jurisdictions. By Kerry-Anne Forster and Matthew Brinckmann

Over the past four years the wave of regulatory change that has hit the global insurance industry seems to be refusing to break. While insurers are all knee-deep in the implementation of our new local solvency regimes, the International Association of Insurance Supervisors (IAIS) is in the midst of developing a risk-based global insurance capital standard (ICS) to allow for the effective evaluation and comparison of insurers across jurisdictions.

THE ICS: WHAT INSURERS NEED TO KNOW

The announcement by the IAIS of the ICS came in October 2013 and has since been the subject of significant global debate among stakeholders. It is important that insurers are aware of ICS and ComFrame developments although, in the short term at least, the requirements are only likely to apply to the very largest insurers. The ICS will be a component of the common supervision framework (ComFrame) that the IAIS (sponsored by the Financial Stability Board and G-20) is developing for internationally active insurance groups (IAIGs).

ICS reporting for IAIGs begins in 2017. The first field testing on the ICS was run from March to May 2014. A second field test was launched in April 2015 for final reporting by October 2015. Following further analysis, the revised ICS consultation document will be released and a third round of field testing is planned to take place in June 2016. All insurance groups designated as IAIGs will fall within the scope of ComFrame and ICS.

The IAIS defines an IAIG as a large, internationally active group that includes at least one sizeable insurance entity. There are two criteria for an insurance group to be identified as an IAIG:

  • International activity: Premiums are written in not fewer than three jurisdictions, and the percentage of gross premiums written outside the home jurisdiction is not less than 10% of the group’s total gross written premium, and
  • Size: Based on a rolling three-year average, total assets of not less than US$50 billion, or gross written premiums of not less than US$10 billion

The capital standard is not intended to be a legal entity capital requirement. The ICS will apply only at a group consolidated level to designated IAIGs and additional insurers designated by local supervisors, even if not IAIGs per the definition. In the context of development of the ICS, further capital requirements will be defined for global systemically important insurers (G-SIIs) for higher loss absorbency (HLA) to address systemic risk arising from non-traditional and non-insurance activities. Relative to the IAIS’s Insurance Core Principles, the ICS is intended to achieve a greater degree of comparability, providing supervisors with a common base for assessing IAIGs’ capital requirements and capital resources; however, this will be a minimum standard and local supervisors are not precluded from demanding higher standards or higher levels of capital.

The IAIS has agreed to the release of two interim versions of the ICS once the 2016 field testing has been completed. ICS Version 1.0 will be for confidential reporting and based on two identified valuation approaches and a standard method for calculating the capital requirement. IAIGs will be required to report on ICS Version 1.0 annually from 2017. ICS Version 2.0 is for adoption within ComFrame. The goal for Version 2.0 is the delivery of an ICS for implementation by supervisors.  After ICS Version 2.0 is adopted there will be an implementation period while jurisdictions embed the ICS into local regulatory requirements and supervisory practices. Formal adoption of ComFrame, including ICS, is scheduled for 2019 and will replace the basic capital requirement (BCR) that G-SIIs are currently required to confidentially report. The HLA requirements will be subject to confidential reporting during 2016 to 2018 and will then be applied for G-SIIs from 2019 once ComFrame and ICS have been finalised.

ICS, SAM AND SOLVENCY II

While the IAIS have designated certain insurers as IAIGs, supervisors will also be required to consider which groups in their local jurisdiction would be considered to be internationally active or globally systemic for the purpose of ICS reporting. Thus while the IAIS may not have designated a South African insurance group as an IAIG or a G-SII, this does not preclude the Financial Services Board (FSB) from making such a designation and requiring that the group report under the ICS.

In the short term, reporting under SAM and under the current ICS proposals will present challenges. Essentially most designated insurance groups will be required to operate simultaneously under two risk-sensitive regimes. If you think this is a struggle, try three. Insurance groups that operate across the EU are also required to report under Solvency II. Initial feedback from European insurers on the 2015 ICS field-testing exercise highlights concerns around developing and implementing another capital standard, when they already largely have a Solvency II framework in place. While the IAIS proposal uses a market-adjusted valuation approach as the basis to develop the capital standard, it is not consistent in all areas with SAM or Solvency II, with some key divergences, resulting in insurers having to report multiple balance sheets which could include IFRS, Solvency II, SAM, ICS, stress testing and economic capital. It is also debateable whether it is really feasible to expect the ICS to render any improvements over the Solvency II specifications, given the many years of effort that have gone into Solvency II.

For those insurers reporting under Solvency II, there is some light at the end of the tunnel for potential convergence of ICS and Solvency II as the Solvency II directive requires that the calibration be revisited in 2020. This would potentially allow for an opportunity to reflect on the initial period of implementation and to potentially align the requirements of Solvency II with ICS. The question as to whether SAM will follow suit is still unanswered and given that South Africa is not yet operating SAM as a Solvency II equivalent, there is concern that SAM may be, and continue to be, diverged from the ICS. Convergence of regulatory regimes is important for governance and differences in capital and risk management incentives will inevitably arise unless all regimes are identical. In addition, measures on which to base performance incentive schemes may need to be relooked at and different measures of capital will require separate explanations to the market.

Albeit less of a challenge for our local insurers, IAIGs that have made a significant investment in internal models will now need to consider how the ICS will affect such models and the resultant reporting. These internal models are likely to already be embedded into the insurers’ risk management systems at both a group and legal entity level. The difficulty arises in that, under current ICS proposals, no allowance has been made for the use of these internal models. European IAIGs (many of whom are adopting the internal (or partial) internal model approach for Solvency II) have lobbied hard for ICS to have an internal model process so that the group’s ICS results reflect the detail of both the risk profile and group structure. South African life insurers have generally not gone the route of adopting an internal model for SAM reporting, but this could change once SAM is fully embedded into business as usual. Any designated insurer wishing to move to an internal model approach under SAM will have to develop the model with the ICS proposals in mind.

We are all well aware that the South African insurance industry has already made heavy investments and incurred significant costs in SAM implementation. Effects have been even more pronounced for European insurers having to implement Solvency II. With this in mind, current and potential IAIGs should start conducting cost versus benefit analysis on the implementation of the ICS in its potential forms, including the resources required to calculate and report the ICS numbers. This should be developed with current and future regulatory reporting in mind – for example, will reporting staff have capacity to consider the ICS in conjunction with their current and future SAM and Solvency II reporting requirements or will additional, dedicated resources have to be sourced?

Consideration also needs to be given to the cost versus benefit implications of any system re-design.  Any leverage of current SAM or Solvency II system implementation plans will go a long way to reducing ICS implementation costs but if elements of ICS reporting remains significantly out of line with SAM and Solvency II, such leverage will be difficult to achieve and system costs will escalate. The importance of such a cost-benefit analysis cannot be under estimated and any key findings should be lobbied back to the IAIS.  It goes without saying that this should be done sooner rather than later in order to influence the proposals.

WHERE TO FROM HERE?

The increasing number of regulatory standards tests supervisors, insurers and investors alike. Boards have to split their attention between focusing on running the business and operating strategically, while focus is also needed on regulatory compliance and reporting. Over the past years significant effort has gone into the development of local risk-based solvency regimes, and while the industry acknowledges the need for effective cross-border supervision, there is a concern with the rising number of capital requirements in a currently challenging capital environment. This results in the IAIS being under pressure to produce a global standard that is somewhat consistent with domestic ones while at the same time ensuring that the global standard provides a common methodology that achieves comparable outcomes across jurisdictions.

Insurers are going to have to acknowledge the changing role for boards in the overseeing of capital. In addition, the ICS may cause insurers to adjust business models, engage in less innovation or design products that perhaps do not meet the needs of customers, which appears counter-intuitive to the ‘customer-centric’ model that market conduct authorities are pushing for.  IAIGs will now need to report under a number of different regimes and should try to achieve leverage to the highest extent possible. This multiple reporting is clearly challenging from a management perspective, but it also raises issues for communication with stakeholders: the IASB is in the process of re-defining profit reporting for insurers and now the IAIS will define capital standards resulting in different measures that can be misleading to the market. It will be of interest to see how the IAIS are going to respond to this and, more importantly, how the market will respond to analysts’ interpretation of the different measures.

Despite the above challenges, stakeholders agree that a risk-based global insurance capital standard that is transparent and comparable will promote effective risk management and enhance public confidence in the global insurance sector’s capital adequacy. The ICS aims to strike an appropriate balance between risk sensitivity and simplicity and aims to reflect all material risks to which the entity is exposed. We expect discussions between the IAIS and stakeholders to heighten over the next 18 months leading up to ICS implementation. In the interim it is important that current and potential IAIGs consider the above challenges now and produce quality output in the field testing in order to influence the ICS solution more effectively. Participant insurers will therefore need to go through appropriate governance procedures and engage with management to effectively review the submission and to obtain buy-in into the process. The accelerated timeframes under which the IAIS wishes to develop the ICS leaves very limited time for insurers to provide such feedback and influence the final solution.

Author:

Kerry-Anne Forster CA(SA) is an Insurance Associate Director and Matthew Brinckmann is an Actuarial Services Director, both at EY