Transcript Risk management in Indian Life insurance industry

Solvency II –Lessons for
India
Dr. R. Kannan
Member (Actuary)
IRDA
Udaipur- 08.01.2011
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Timing of Solvency II process
2001
Solvency I
Decision to
Solvency II
2011
Solvency II Directive
European Commission
Decisio
n
Europea
n
Council
&
Parliam
ent
Imple
menta
tion
Mem
ber
states
Answers to Calls for Advice
CEIOPS
QISI
QIS2
QIS3
More QISI
Various consultation papers
Preparation of solvency II, participation to QIS
Respond to consultation papers
Insurance industry
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Changing role of Risk management ?
The insurance industry has undergone a process of de-regulation which enabled
them to take more risk and explore competitive edges of the market.
The drive for competitive forces led to fall in premiums which had to be compensated
by taking on investment risk. In the life segment unit linked products becoming more
popular.
Capital markets have become more volatile. Part could be attributed more efficient
and linkage to globalized markets.
Investment strategies have become a more important source of income. This places
additional importance on investment strategy as a source of risk.
In late 1990s and early 2000s the number of insurers becoming insolvent grew
significant world over especially in Europe.
The difference between bank and an insurance company and hence the risk
management principles have to recognize the nature of insurance business:
– Cash on hand
– Liability estimation
– Duration of assets and liabilities
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Background for Sol II
Their novelty compared with the current best practices.
The strategic nature of the problems.
Huge level of investment likely to be required to comply with the
coming Solvency II framework.
The European Commission asked CEIOPS to launch a wide
consultation process with the industry players. The result:
A first wave of 12 consultation papers was published on 26 March
2009.
A second wave of 24 CPs was published on 2 July 2009.
A third wave of 17 CPs was published on 2 November 2009.
The outcomes from these consultations assisted CEIOPS in issuing
final advices to the Commission.
The European Commission published QIS5 technical specifications
on 6 July 2010.
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Three pillar approach
Pillar - I
Pillar - II
Pillar - III
Financial
Requirem
ent
Superviso
ry review
process
Disclosur
e&
Market
discipline
Valuation of
technical provisions
and solvency
requirements (SCR
/ MCR)
Supervisory powers
governance
guidelines
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Disclosure
requirements and
supervisory
reporting
5
Risk Categories
Risk
Investment risk
Market risk
(Incl. ALM)
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Credit Risk
Underwriting
Risk
Life
Risk
NonLife
Risk
Non- financial
risk
Operational
Risk
Business
Risk
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Basic forms of Risk Management
Risk Management
Risk control
Safety
Control,
prevention
measures
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Risk financing
Risk reduction
Risk retention
Withdrawal
Risk Transfer
Diversification
Hedging
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Role of capital
Why capital is required?
– Capital is required to absorb extreme unexpected
losses caused by various risks.
– Capital guarantees long term continuity. Without
continuity the insurer could not obtain future profits.
– When rating established by the rating agencies they
also look at financial aspects of the insurer and the
amount of capital.
– When their capital falls below certain limits it could
have negative consequences for rating.
– Capital is also required to protect policyholders’
interest and thus protect the stability of the economic
system.
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Guiding Principles
The guide is based on six main themes:
Economic balance sheet
Data management
Standard formula (SCR solo and SCR
group)
Internal model
Risk governance and supervisory review
Disclosure
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Economic Balance Sheet
In addition to the methods of valuation of the different
components of the balance sheet, it is important to
highlight an important principle reinforced in the first
wave of consultation:
– Convergence of the regulatory environment: CEIOPS has
chosen a pragmatic approach by defining the economic
valuation of the different components of the Solvency II balance
sheet according to the IFRS principles.
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Economic Balance Sheet
Although Solvency II and IFRS Phase II contain similar
principles, there are a number of important differences in
the technical provisions and other elements of insurance
company balance sheets.
– Predominance of the balance sheet approach in IFRS, Solvency
II focuses on defining the valuation principles of assets and
liabilities.
– the balance sheet approach will ultimately lead insurance
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Issues on Economic Capital
Wide variation between statutory liability and
economic liability
Various risk parameters--standardization
Diversification effect
Concentration effect
Issues on estimating operational risk
The link between EC and Embedded value
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Technical provisions
The Solvency II framework directive will lead to major changes in the
valuation of the balance sheet items compared to the current local
GAAP and, in particular, in the valuation of insurance liabilities
which will need to be undertaken on a market-consistent basis.
Technical provisions will typically be estimated on a proxy to a
market value, i.e., a best-estimate basis allowing for the time value
of money supplemented by a risk margin. It will now become
important that companies focus on the projection of future cash
flows. In projecting cash flows, companies need to bear in mind that:
Cash flows should be estimated taking into account gross amounts
recoverable from reinsurance contracts.
Cash flows should account for the full lifetime of existing insurance
contracts and reflect policyholder behavior and management
actions.
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Technical Provisions
CEIOPS has retained a cost-of-capital approach for the
estimation of the risk margin with a rate of at least 6%.
It is important to note that in QIS5, the risk margin is
calculated at an undertaking level and not at a line-ofbusiness level. This means that undertakings will enjoy
the diversification benefits between lines of business
within the risk margin.
Should an undertaking decide to transfer a line of
business, the contribution of each line of business to the
risk margin can be allocated separately
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Internal Models
The analysis of all measures relating to internal models
(or models used for the parameterization of the standard
formula) is a central element of the path towards
Solvency II. Features of internal model include :
–
–
–
–
–
–
Assumptions for future management actions
Process to be followed for the approval of an internal model
Tests and standards for internal model approval
Partial internal models
Treatment of future premiums
Segmentation for the calculations
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Main challenges for internal models
The need to have the internal model approved before being
allowed to use it for regulatory solvency requirements is a major
development for the teams working on capital models
Use test
Statistical quality
Calibration
The need to show
that
the
internal
model
is
clearly
relevant
and
integrated into daily
risk management and
decision-making
process
The settings of the
internal
model
(data, assumptions,
methods,
tools)
must be accurate
and credible
The internal model
must be consistent
with SCR framework
(i.e., at least a 99.5%
confidence level over
a
one-year
time
horizon)
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Steps to follow for the completion of an
approval application
Based on the experience of developing actuarial
models, the documentation for the approval process
needs to be produced along with the development
and the validation of the model. The documentation
would also include information gathered during
discussions with the supervisor in the context of the
pre-application process.
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Governance and supervisory
review
Adequate and operational structure
Clear allocation of tasks and responsibilities
Transparency of the organization
Efficient information systems on all business activities.
Internal control and internal audit are largely defined and
required in the current regulatory environment in a
similar way to that set out in the Solvency II directive.
Risk management and actuarial functions already exist
but are not properly defined; hence there should be
some significant changes with Solvency II.
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Governance and supervisory
review
The main changes within the Solvency II
directive in terms of governance are:
Requirement of formal governance in order to
implement efficiently policies decided by the
management body.
Requirement of a full system of governance
ensuring:
– Identification, assessment and management of risks
– Efficient communication of information
– Reporting of a consolidated view of the risks.
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Risk management and actuarial
functions - ambiguous roles
For the risk management function, CEIOPS prescribes (for
large companies) the creation of a chief risk officer (CRO)
who will be responsible for:
Leading the risk management function
Reporting the risk exposure to the administration and
business operation
Maintaining a consolidated view of the risks through the
ORSA (own risk and solvency assessment)
CEIOPS recommends that the risk management function
has leadership of the internal model in terms of conception,
maintenance and management of results. The actuarial
function contributes to the implementation of the internal
model.
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Risk management and actuarial
functions - ambiguous roles
These recommendations do not remove the ambiguities and
difficulties of implementation:
CEIOPS defines the actuarial function as the role of controlling and
reporting technical provisions by means of an actuarial report:
Coordination and control of the technical provisions valuation
Statement of opinion regarding underwriting and reinsurance
policies –the actuarial function should express an opinion
independently from any other administration or business operation
department.
This is another point where there are ambiguities in the roles of the
risk management function and the actuarial function, in particular for
the leadership on the best estimate reserves computation in the
SCR calculation:
The ownership of the model and the consolidated vision of the risks
would mean that the calculation of the SCR (and hence of the best
estimate reserves under Solvency II) should be the responsibility of
the CRO. This would appear to restrict the role of the actuarial
function.
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Own risk and solvency assessment
(ORSA) principles
The overall solvency needs taking into account the
specific risk profile, approved risk tolerance limits and
the business strategy of the undertaking.
The compliance with the capital requirements and with
the requirements regarding technical provisions.
The extent to which the risk profile of the undertaking
deviates significantly from the assumptions underlying
the SCR, calculated with the standard formula or with
its partial or full internal model.
The ORSA principles should be applied in a
proportionate manner having due regard to the nature,
scale and complexity of the activities of the
undertaking concerned.
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Lessons from Solvency II exercise for
India
Solvency II is unquestionably the most significant regulatory change
for the insurance industry that is happening right now and continues
to be widely reported in the industry press. We have started the
process of estimating economic capital and yet a long way to go for
risk mapping and risk reporting.
One benefit of moving the effective start date to 1 Jan 2013 would
be to align the rules to the effective financial reporting year for most
European insurers. This would make life a bit easier for most firms
but the reality remains that firms must be fully compliant from day
one and implementation should already have started in all firms. We
are working on IFRS and this issue need to be addressed in future.
Solvency II is needed to strengthen the regulatory framework for
insurers in Europe and enable both supervisors and firms to move
on from the confines of an outdated European regime that stands in
the way of the adoption of modern methods and the spread of best
practice. Our solvency regime is robust but there is no complacency
in examining the alignment with accounting disclosure.
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Lessons from Solvency II exercise
for India
Solvency II will fundamentally transform the capital adequacy and
risk management regime for the European insurance industry. The
requirements for delivering and demonstrating the standards of risk
management and governance will be challenging, and especially so
for groups that operate in multiple countries. We have already
initiated this exercise.
It will require greater disclosure and transparency, together with
additional and more frequent reporting. We have already initiated
disclosures and this will be strengthened in the light of our
experience
it puts robust risk management firmly at the centre of the new
regime; insurers will be required to focus on the early identification,
quantification and management of the risks that they face, or will
face in the future, through the forward-looking Own Risk and
Solvency Assessment. We have already developed “early warning
system” for life and this needs to be strengthened. Shortly we will
be finalizing the guidelines for non-life industry also.
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Lessons from Solvency II exercise
for India
One consequence of the market consistent approach to the
valuation of liabilities is that there will be no arbitrary prudence in
technical provisions. This needs a closer examination.
Solvency II is also very clear that the responsibility for the running of
the firm rests firmly on the shoulders of senior management. This
means that senior management and the Board must be able to
demonstrate they are fully in control of their firm and that they fully
understand the risks that the firm is running, or might face in the
future. We have already positioned “corporate governance
principles” and they need to be strengthened.
Another big shift in the regulatory landscape as a result of Solvency
II means that there will be an increased focus on groups and the
joint supervision of groups. The supervisory colleges will play an
increased role and this will mean an adjustment of the mindsets for
supervisors under Solvency II. This is not a pressing issue now,
however we are addressing this.
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Lessons from Solvency II exercise
for India
Insurers will also need to report more information, more
frequently to their supervisors. For example, under the new
regime, it is likely that firms will need to report all their
individual asset exposures to their supervisor every quarter.
This is a big change and the bigger the firm, and the more
complex the investment strategy, the more work there will be
to get this up and running. We have already moved on this.
It is a fundamental precondition for the proper understanding
of risks that they are measured on an objective and consistent
basis. It will be a big step forward for Europe to move to a
common valuation basis. It is absolutely necessary that the
solvency capital requirement (SCR) and the minimum capital
requirement (MCR), or internal models – will be based on the
Solvency II balance sheet. We have to initiate our own work
on internal models.
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Thank you
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