Author: MAPFRE Economic Research
Summary of the report’s conclusions:
MAPFRE Economic Research
Insurance Solvency Regulation Systems:
An analysis of progress toward riskbased regulations
Madrid, Fundación MAPFRE, January 2018
Progress toward risk-based regulation is an element that can stimulate supply growth and therefore raise the participation of insurance in the economy, in that it allows for a more efficient allocation of capital, and creates incentives for more professional management of insurance companies. As such, it is possible to align the prudential objectives of regulation with incentives for an environment favorable to competition and supported by efficient risk management.
Significantly, in recent years, in particular over the course of the last two decades of the 20th century, financial regulation has been developing and keeping pace with the process of economic and financial globalization. This progress in regulation has been led by the banking regulators who have developed and refined risk measures as an essential factor in the determination of capital risk weights and incorporated additional pillars into quantitative requirements (strengthening the governance and discipline of the market) in order to help in maintaining solvency and integrity in the banking system, in particular because of the latest global crises.
In the case of insurance companies, which represent one of the main institutional investors worldwide, the evolution of prudential regulations has followed a different path to the one taken by credit and securities firms, although in recent years it has had to converge with conceptual elements common to the rest of the financial system. Despite insurance industry regulations having traditionally been limited to domestic markets, they are currently undergoing a regulatory homogenization process (see Chart 1)
Regulatory progress concerning insurance markets comprises three key dimensions. The first consisted of the International Association of Insurance Supervisors (IAIS) which started to prepare the regulation and supervision principles and standards. The second, regionally and in terms of the main markets, was the decision to modernize existing solvency regulation systems. And the third was the definition and establishment of macro-prudential oversight measures to limit the potential systemic effects resulting from insurance activities, thereby contributing to maintaining financial stability worldwide.
However, regulatory evolution in the insurance industry is taking place progressively and asymmetrically by country and region. This is what can be inferred from the analysis of a sample of countries and regions of the world that is considered to be representative.
To measure the state of progress in a regulatory system that is purely based on risks, a specific metric has been employed that achieves this comparison. It is called the “proximity to risk-based regulation index” (I-RBR)). The outcome of the analysis produced the results shown in Chart 2 (refers to the regulatory position in January 2018).
It is important to note that the I-RBR does not seek to rate the effectiveness or quality of market regulation or the effectiveness of supervision tasks, but rather to measure the transition process from regulatory frameworks to risk-based regulations, both for purposes of establishing capital risk weights and to consolidate better management of capital, based on the terms established in the respective regulations.
In 2016, the European Union took a definitive step following the entry into force of Solvency II, one of the most advanced risk-based solvency regulatory capital systems, alongside the Swiss Solvency Test, which seek to adapt capital requirements to the risk profile of each insurance company and its groups. Thus, an efficient allocation of capital is sought, within confidence levels considered adequate for the protection of policyholders.
Worldwide, the International Association of Insurance Supervisors (IAIS) is working on creating harmonized solvency supervision frameworks, both for global systemically important insurers (GSIIs) and internationally active insurance groups (IAIGs) with a view to creating a common supervision framework (known as ComFrame), which includes, as one of its key elements, an international standard for the calculation of regulatory capital based on market-adjusted risks and valuations – the International Capital Standard (ICS).
Analysis by regions
In the United States, the National Association of Insurance Commissioners (NAIC) has, since the 1990s, been developing a standard methodology for calculating the minimum capital considered necessary to underpin insurance companies, depending on their size and risk profile, (called Risk-Based Capital – RBC). This is currently being revised via the Solvency Modernization Initiative (SMI). A characteristic of this system is that it is not a standardized one because regulatory powers are decentralized down to individual States which can incorporate into their respective legal systems the model rules drafted by the NAIC. To date, some States have adopted it with amendments that do not affect the RBC designed by the NAIC. As such, it cannot be said that it is generally applied across the insurance market in the United States.
In Latin America, although some markets like Mexico and Brazil have made significant progress in the regulatory adjustment process, generally speaking, there is still progress to be made at regional level for the implementation of risk-based regulatory solvency capital calculation models, especially with regard to the pillar of quantitative requirements. It is worth noting that in countries with relatively small markets, steps have been taken to implement the governance requirements, dividing functions as part of which the risk function plays a significant role in the management of insurance companies, which in any case, must be looked upon positively.
In the Asia Pacific region, Australia and Japan, two mature and developed insurance markets, have shown a greater degree of progress with their regulations. Of the two, Australia is closer to implementing a risk-based regulatory system. Nonetheless, Japan has taken significant steps in terms of handling insurance and financing risks. At present, Japan’s regulatory and supervisory authorities are in the process of developing aspects that require further improvement, performing field tests to assess the impact of their introduction, with a particular focus on the effects caused by long-term low-interest rates.
Furthermore, the sample of Asia Pacific region markets analyzed includes three emerging markets: the Philippines, Indonesia, and Turkey. The Philippines and Indonesia have made progress in the handling of financial risks and those deriving from insurance obligations, maintaining, nonetheless, limits in terms of assets in which insurers can invest and a strict system concerning the authorization of new products. Finally, Turkey has the system that most closely mirrors Solvency I type systems, although some progress can be seen in relation to the handling of financial risks.
Global vision of regulatory progress
Regulatory progress can greatly contribute to the goal of developing the market, when it is carried out gradually and in parallel to the development of technical capacities of both the industry and regulators, as well as to the creation of the necessary market infrastructure for its proper implementation. Therefore, particularly in terms of emerging markets, the first phase for implementing risk-based regulations entails the development of these institutional and market conditions, which involves coordination work in the medium-term between financial authorities and the insurance industry.
Concerning quantitative requirements, insurance companies must firstly have statistical information that makes it possible to model the risks that quantitative requirements entail. Risk measurements employ intensive statistical techniques (stochastic modeling) in terms of the use of information. The same occurs with qualitative requirements, as part of which appropriate risk management by insurance companies is supported by the ability to employ this type of quantitative analysis technique. As a result, a first indispensable precondition for the application of a risk-based regulatory system consists of there being (in the form of a public good available to all market participants) sufficient, reliable, appropriate and homogeneous information concerning insurance operations, which makes it possible to model inherent financial and technical (underwriting) risks. Furthermore, this information must comprise a sufficiently far-reaching and detailed series and be generated from continuous bases.
Secondly, trained, knowledgeable and skilled professionals must be available to undertake risk modeling work (actuaries, mathematicians and, in general, professionals with skills in the field of quantitative techniques). These professional profiles will be required both by the supervisory body and the insurance industry and demand for them may increase insofar as, first, these types of measurements are performed internally as part of institutional operations and additionally, in line with market growth and development. Furthermore, the market itself may require this type of professional profile to perform parallel functions (external auditing, consultancy, external analysis, etc.).
Thirdly, efficient financial markets are required, the development of which makes it possible to undertake efficient asset-liability management (ALM), which represents one of the essential activities in the risk management process. This process consists of matching terms, duration, interest rate and the currency comprising the obligations deriving from insurance policies and the investments of insurance companies with an appropriate approach to credit risk management. To this end, having adequate knowledge of the characteristics of the company’s technical liabilities is insufficient; efficient financial markets are also required, markets in which the level of development makes it possible to retain investment instruments that provide for an efficient ALM process.
Fourthly, and linked to the preceding precondition, it is essential that the guidelines framework does not establish limits (other than rationale of insurance activity regulations) relating to the acquisition of financial assets available on financial markets (for example, financial assets in foreign currency). The presence of this type of limitation in specific markets would impede or significantly hinder the ALM process and, as a result, the adequate implementation of risk-based regulations.
And finally, legal barriers to reinsurance operations must be removed, as applicable, in such a way that it is possible to adequately disperse and mitigate technical risks so that, by pooling other risks on the international stage, their potential impact on the insurance company that directly assumed them can be mitigated.
In terms of governance requirements, progress made implementing this type of regulatory model requires the development of an organizational and business culture to a certain extent, insofar as governing bodies are able to formally and genuinely act as a driving force in the management of companies, structured around an appropriate risk management strategy.
Therefore, the adaptation process is by no means a quick process; rather, it involves, in most cases, an organizational adaptation and maturity that makes it possible to internalize regulatory standards. This process must be based on solid bases in the medium-term, as demonstrated by the mature regulatory systems developed in this regard.
As far as products and competition go, the absence of legal limitations (the logical limitations of a prudent approach to solvency management aside) is an essential prerequisite so that companies can launch and adjust the pricing of their products, first in terms of essential tools that protect the financial position and solvency of companies in the event that specific financing and underwriting risks materialize and, in addition, facilitate a reaction in the light of competition on the market.
The complete analysis can be found in the report Insurance Solvency Regulation Systems, prepared by MAPFRE Economic Research, available at the following link: