Risk Based Supervision Lessons from other markets

Overview of contents of Solvency II 18 Balance sheet valuation & capital requirement s Harmonised standards for the valuation of assets and liabilities and the calculation of capital

Teus Mourik, actuary Kampala, 25 February 20 16

Risk Based Supervision of

Insurance Companies

- Experiences from Developed Markets

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1 Introduction

2 Definition of Risk Based Supervision

3 Old solvency requirements in Europe: ‘Solvency I’

4 Solvency II (‘SII’) development process

5 Overview of contents of SII

6 Consequences of SII for the European insurance industry

7 Risk Based Supervision of Ugandan insurers

+ Room for questions and discussion Please feel free!

1 Introduction

Who am I?

- Teus Mourik, Life actuary from The Netherlands

- Working experience:

1983-1991: Dutch Central Bank (researcher econometrics)

1991-2003: Mercer (actuarial consultant) 2003-2007: KPMG (actuarial consultant) 2007-2013: EY (actuarial consultant) 2013-2015: AEGON Holding (senior actuary)

Feb 2016 - Feb 2018: actuary at the IRA of Uganda

2 Definition of Risk Based Supervision

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Risk Based Supervision is a supervisory

approach that is designed to identify activities and practices of greater risk to the soundness

of financial institutions and accordingly

deploying supervisory resources towards the assessment of how those risks are being

managed

3 Old solvency requirements in Europe: ‘Solvency I’

- Developed in the beginning of the 1970ties

- Key elements:

1 Assets and liabilities are valued in accordance with financial

accounting principles (local GAAP/IFRS), with some restrictions

on admissable assets → ‘Available Capital’ (= Assets -/-

Liabilities = AC)

2 ‘Required Capital’ (= RC) for

a Life insurers: 1% or 4% of Technical Provision + 0.3% of Sum

at Risk, with a discount of maximum 15% for Reinsurance

b Non-Life insurers (roughly): MAX[18% of premium with a

discount of maximum 50% for the ratio between claims net

and gross of reinsurance, 26% of (average claims in last 3

years + change of Technical Provision over last 3 years) times the same ratio for the reinsurance discount]

Requirement: AC / RC > 100%

4 Solvency II development process (1)

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During the second half of 1990ties increasing awareness of

inadequacy of Solvency I, particulary because

-Financial accounting principles for assets and liabilities are generally inconsistent (→ ACs are disputable) Moreover, a less prudent technical provision for Life and/or more

capitalization of acquisition expenses (DAC) would result in a higher AC!?

-Required capital rules are somehow proportionate to the size

of the portfolio, but they are not ‘risk-based’ Moreover, a less prudent technical provision for Life would result in a lower RC!? -RC formula does not include ‘fair’ discounts for risk mitigation policies, in particular reinsurance.

As a result: introductions of ‘Embedded Value’ concept by the industry and ‘Liability Adequacy Testing’ by the IASB (‘IFRS 4 Phase I’, 2005) and some European insurance supervisiors

(e.g., Dutch supervisor).

4 Solvency II development process (2)

- SII development process started in 2004, also triggered by research reports from KPMG and, particularly, IAA (→ ‘total balance sheet approach’).

- Many parties were involved, in particular

1 Developer: European Insurance and Occupation Pensions Authority (‘EIOPA’)

2 Representatives of the insurance industry: Insurance Europe, CRO Forum

3 Professional bodies: e.g., FEE, EAA (European accountants/actuaries)

4 Final approvers: European Commission and European Parliament (EU).

- 2009 Milestone: Approval of the ‘Solvency II Directive’ (framework)

- 2010-2015: More details and implementation in laws of individual EU

countries.

- In total five Quantitative Impact Studies across Europe!

1 January 2016: Solvency II in force.

5 Overview of contents of Solvency II (1)

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Balance sheet valuation &

capital requirement s

Harmonised standards for the valuation

of assets and liabilities and the

calculation of capital

requirements (SCR and MCR)

Pillar 1

Quantitative Requirements

Pillar 2

Supervisory Review

Pillar 3

Disclosure

Review process

To ensure that insurers have good

monitoring and

management

of risks and adequate capital

Market discipline and

disclosure

Harmonisation

of disclosure requirements, allowing

capital adequacy to

be compared across

institutions

5 Overview of contents of Solvency II (2)

Key elements of SII Pillar 1 (1)

The SII Balance Sheet (ACnew):

- All assets and liabilities need to be valued consistently at ‘fair

value’, i.e only items that have cash flows matter! (therefore DAC

is not allowed under SII)

- The FV of insurance liabilites is defined as the sum of

1 the ‘Best Estimate’ value, discounted at current risk-free interest rates

2 a ‘Risk Margin’ defined by the ‘Cost of Capital’ method (6%), and

3 the fair value of embedded options and guarantees (if applicable)

→ SII Balance Sheet is generally very different from IFRS balance sheet!

- ‘Tiering’ approach for defining admissable elements of resulting

equity (like in Basel II and III for banks) → ACnew

5 Overview of contents of Solvency II (3)

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Key elements of SII Pillar 1 (2)

Required Capital (RCnew):

- Based on shocks on individual types of risk (market risk, credit risk, underwriting risk, operational risk), net of reinsurance

- Supposed to reflect 0.5% worst case scenarios

- Effects on equity in SII BS to be calculated by means of either

a ‘Standard Formula’ or a (possibly only partial) ‘Internal Model’; internal models must have been approved beforehand

by the company’s (lead) supervisor

- Aggregation of effects of shocks allows for correlation between risks

→ RCnew

Requirement: ACnew / RCnew > 100%

5 Overview of contents of Solvency II (4)

Key elements of SII Pillar 2

- Requires clear risk management policies (including

outsourcing)

- Need to establish internal audit, risk management, control and actuarial function, with detailed descriptions of tasks and

responsibilities

- Fit and proper requirements for management

- Requires periodical reporting of approach and outcomes

of the company’s ‘Own Risk and Solvency Assessment’

This ‘ORSA’ must show that the company will be able to meet the future solvency requirements, at least for the next 3-5 years, when the business plan is executed (including new business

assumptions)

5 Overview of contents of Solvency II (5)

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Key elements of SII Pillar 3

Defines reporting requirements, in particular:

1 The contents of the ‘Solvency and Financial Condition Report’ (SFCR, annually).

2 The contents of the Quantitative Reporting Template’ (QRT, quarterly).

6 Consequences of SII for the European insurance industry (1)

Developing SII has cost European insurance companies a lot of money,

particulary because of

1 Pillar 1:

- Major adjustments of IT systems in order to (also) allow for the calculation

of the SII balance sheet (ACnew) and RCnew.

- Larger companies: development of (partial) internal model(s).

2 Pillar 2:

- Organisational changes, in particular because of the requirement to have

a risk management function and actuarial function.

- Defining concrete risk management policies for individual types of risk.

- Much stricter requirements on data quality and substantiation of (best estimate) assumptions.

3 Pillar 3: Preparation of IT systems for Pillar 3 reporting requirements.

Furthermore:

- Mandatory participations in Quantitative Impact Studies (5!).

- Participation in SII working groups of national/European insurers

associations and/or professional bodies (voluntary, in order to influence

6 Consequences of SII for the European insurance

industry (2)

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- During the SII development process, in particular following the

outcomes of the Quantitative Impact studies, it became obvious that

AC / RC.

- For a substantial number of insurers even ACnew / RCnew < 100%!

Consequently, in order to meet the new SII requirements from 2016 onwards, these companies had to

a attract more capital from the capital market (→ ACnew ↑), and/or

b ‘derisk’, e.g by investing more in less risky instruments (bonds

instead of shares) and/or by increasing reinsurance (→ RCnew ↓), and/or,

6 Consequences of SII for the European insurance industry (3)

Several (smaller) insurance companies even decided that meeting the new SII requirements would become too costly/impossible for them They therefore looked for other insurance companies that would be willing to buy them

→ consolidation of the European insurance market

NB: This trend may continue in the upcoming years

Furthermore, many Life insurance companies are now changing their product portfolios In particular, many have stopped offering

(minimum) investment return guarantees (specific savings products like endowments and UL/variable annuities with options/guarantees) and/or products with significant longevity risk (pensions), because the corresponding risks imply significant RCnew under SII

NB: This is of course enforced by the current low market interest

rates and the increased decrease of mortality rates Both

developments could generally be ignored under SI Not anymore

under (risk-based) SII!

7 Risk Based Supervision of Ugandan insurers (1)

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Current solvency requirements for Ugandan insurance

companies

Quantitatively:

- Life companies: Minimum = 3 billion UGX.

- Non-Life companies: Minimum = MAX(4 billion UGX, 15% of net written

premiums).

In addition, minimum premium rates and maximum commission rates.

Qualitatively:

- Restrictions on admissable assets and liabilities.

- Maximum limits on retention percentages (reinsurance); however, without affecting minimum quantitative solvency requirements.

- Fit and proper requirements for management.

Consequently:

- No quantitative requirements regarding the adequacy of technical provisions for Life business.

- Solvency requirements for Life are not proportionate to the size of the liability portfolio.

- In general: quantitative solvency requirements are not ‘risk-based’.

7 Risk Based Supervision of Ugandan insurers (2)

New requirements from 2014 onwards: CARAMELS

- Only qualitatively, in particular

1 companies will be required to have internal audit, risk

management, actuarial and specific control functions, and

2 they also need to define business plans and risk management

policies

These new requirements, that show similarities with SII Pillar 2, will be included in the new Insurance Bill.

- However, CARAMELS also comprises a new risk-based framework for analysing/ assessing the performance of insurance companies that are supervised by the IRA, including quantitative early

warning test ratios

Consequently: So far, Ugandan law will only support some qualitative elements oif risk-based supervision Nevertheless, the IRA will

further elaborate CARAMELS, including quantitative elements

following experience, in order to further improve its

risk-based supervision.

7 Risk Based Supervision of Ugandan insurers

(3)

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Possible future changes in Ugandan law/regulations

regarding risk-based supervision of Ugandan insurance companies

-The IRA fully supports the principles of risk-based supervision

as expressed in, e.g., Solvency II, as these principles improve our understanding of the (risks associated with) insurance

business This is primarily in the interest of our policyholders (Ugandan customers), but also in the interest of shareholders, management and employees in the industry

-Consequently, further elements of risk-based supervision will

be introduced in the future However, the industry will be

consulted regarding contents and timing, as commitment from the industry is key for their success.

7 Risk Based Supervision of Ugandan insurers

(4)

Possible future changes may comprise:

1 introduction of ‘liability adequacy testing’ (of technical provisions)

2 a new reporting template for the regulatory balance sheet (in

which assets and liabilities are valued more consistently) → ACnew

3 eventually, a new approach for calculating solvency requirements (which are proportiate to the size of the portfolio, and, most

importantly, which are risk-based) → RCnew

The IRA therefore wishes to encourage the Ugandan insurance

industry to develop SII similar, i.e more ‘risk-based’ elements in their internal assesments of the performance and solvency

position of their firm(s)

NB: Like for SII relative to SI in Europe, it can not be excluded that ACnew / RCnew < AC / RC

Thank you

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Questions?