Tag Archives: comframe

What Should Future of Regulation Be?

It is of course much easier to look back and second-guess regulatory actions. It is far more difficult to propose a way forward and to do so in light of the emerging hot-button issues, including data and the digitization of the industry, insurtech (and regtech), emerging and growing risks, cyber, the Internet of Things (IoT), natural catastrophes, longevity and growing protectionism. The way forward requires consideration of the primary goals of insurance regulation and raises critical questions regarding how regulators prioritize their work and how they interact with one another, with the global industry and with consumers.

We offer below some thoughts and suggestions on these important questions and on how regulation might best move forward over the next 10 years.

Establish a reasonable construct for regulatory relationships.

Relationships matter, and it is imperative for there to be careful consideration of how regulators organize their interactions and reliance on each other. We have some examples in the form of the Solvency II equivalence assessment process, the NAIC’s Qualified Jurisdiction assessment process (under the U.S. credit for reinsurance laws), the NAIC’s accreditation process for the states of the U.S., the U.S.-E.U. Covered Agreement, ComFrame, the IAIS and NAIC’s memorandum of ynderstanding and the IMF financial sector assessment program (FSAP). Each of these provide varying degrees of assessment and regulatory cooperation/reliance.

These processes and protocols, however, have largely emerged on an ad hoc, unilateral basis and in some cases have had a whiff of imperial judgment about them that may not be justified – and certainly is off-putting to counterparties. We would urge regulators to give careful consideration to the goals, guiding principles and the process for achieving greater levels of cooperation and reliance among global regulators.

We hope these efforts would include an appreciation that different approaches/systems can achieve similar results that no jurisdiction has a monopoly on good solvency regulation. There must also be respect for and recognition of local laws and a recognition that regulatory cooperation and accommodation will benefit regulators, the industry and consumers. Most importantly, regulators need to work together to develop confidence and trust in one another.

The IAIS first coined the phrase “supervisory recognition” in 2009. In March of that year, the IAIS released an “issues paper on group-wide solvency assessment and supervision.” That paper stated that:

“To the extent there is not convergence of supervisory standards and practices, supervisors can pursue processes of ‘supervisory recognition’ in an effort to enhance the effectiveness and efficiency of supervision. Supervisory recognition refers to supervisors choosing to recognize and rely on the work of other supervisors, based on an assessment of the counterpart jurisdiction’s regulatory regime.”

See also: Global Trend Map No. 14: Regulation  

The paper noted the tremendous benefits that can flow from choosing such a path:

“An effective system of supervisory recognition could reduce duplication of effort by the supervisors involved, thereby reducing compliance costs for the insurance industry and enhancing market efficiency. It would also facilitate information sharing and cooperation among those supervisors.”

This is powerful. We urge global insurance regulators to take a step back and consider how they can enhance regulatory effectiveness and efficiency by taking reasonable and prudential steps to recognize effective regulatory regimens − even where these systems are based on different (perhaps significantly different) rules and principles, but which have a demonstrated track record of effectiveness.

As noted above, we have seen some efforts at supervisory recognition. These include Solvency II’s equivalence assessment process, the NAIC’s accreditation process for other U.S. states, the NAIC “Qualified Jurisdictions” provisions for identifying jurisdictions that U.S. regulators will rely on for purposes of lowering collateral requirements on foreign reinsurers, the E.U.-U.S. Covered Agreement and the IAIS’s Memorandum on Mutual Understanding. Some of these processes are more prescriptive than others and have the danger of demanding that regulatory standards be virtually identical to be recognized. This should be avoided.

One size for all is not the way to go.

The alternative approach to recognition of different, but equally effective systems is the pursuit of a harmonized, single set of regulatory standards for global insurers. This approach is much in vogue among some regulators, who assert the “need for a common language” or for “a level playing field” or to avoid “regulatory arbitrage.” Some regulators also argue that common standards will lead to regulatory nirvana, where one set of rules will apply to all global insurers, which will then be able to trade seamlessly throughout all markets.

There are, however, a variety of solvency and capital systems that have proven their effectiveness. These systems are not identical, and indeed they have some profoundly different regulatory structures, accounting rules and other standards such as the systems deployed in the E.U. (even pre-Solvency II), the U.S., Canada, Japan, Bermuda, Australia, Switzerland and others. Attempting to assert a signal system or standard ignores commercial, regulatory, legal, cultural and political realities.

Moreover, we question some of the rationale for pursuing uniform standards, including the need for a common language. We suggest that what is really needed is for regulators to continue to work together, to discuss their respective regulatory regimes and to develop a deep, sophisticated knowledge of how their regimes work. From this, trust will develop, and from that a more effective and efficient system of regulation is possible. The engagement and trust building can happen within supervisory colleges. We have seen it emerge in the context of the E.U.-U.S. regulatory dialogue. We saw it in the context of the E.U.-U.S. Covered Agreement. No one, however, has made a compelling case for why one regulatory language is necessary to establish a close, effective working relationship among regulators.

Similarly, the call for a level playing field sounds good, but it is an amorphous, ambiguous term that is rarely, if ever, defined. Does the “playing field” include just regulatory capital requirements? If so, how about tax, employment rules, social charges? How about 50 subnational regulators versus one national regulator? Guarantee funds? Seeking a level playing field can also be code for, “My system of regulation is heavier, more expensive than yours, so I need to put a regulatory thumb on the scales to make sure you have equally burdensome regulations.” This argument was made for decades in the debate surrounding the U.S. reinsurance collateral rules. We hear it now regarding the burdens of Solvency II. It must be asked, however, whether it is the responsibility of prudential regulators to be leveling playing fields, or should their focus be solely on prudent regulatory standards for their markets.

Finally, the dark specter of regulatory arbitrage is often asserted as a reason to pursue a single regulatory standard, such as the development of the ICS by the IAIS. But one must ask if there is really a danger of regulatory arbitrage today among global, internationally active insures? Yes, a vigilant eye needs to kept for a weak link in the regulatory system, something the IMF FSAP system has sought to do, supervisory colleges can do and the IAIS is well-equipped to do. But using regulatory arbitrage as an argument to drive the establishment of the same standards for all insurers does not seem compelling.

Proportionality is required.

Often, regulators roll out new regulatory initiatives with the phrase that the new rules will be “proportionate” to the targeted insurers. Too often, it seems there is just lip service to this principle. Rarely is it defined – but it is tossed out in an attempt to say, “Do not worry, the new rules will not be excessive.” Greater debate and greater commitment to this principle is needed. Clearly a key component of it must be a careful cost/benefit analysis of any proposed new standard, with a clear articulation of the perceived danger to be addressed – including the likelihoods and severity of impact and then a credible calculation of the attendant costs – economic and otherwise to industry and to regulators. In October 2017, the U.K. Treasury Select Committee published a report criticizing the PRA for its excessively strict interpretation of Solvency II and its negative effect on the competitiveness of U.K. insurers. The report concluded that the PRA had enhanced policyholder protection at the expense of increasing the cost of capital for U.K. insurers, which hurt their ability to provide long-term investments and annuities. Although the PRA emphasized its mandate of prudential regulation and policy holder protection, the Treasury Committee reiterated its concern with how the PRA interpreted the principle of proportionality.

Simplicity rather than complexity.

Over the past 10 years, there has been a staggering increase in proposed and enacted regulatory requirements, many of which are catalogued above. There is a danger, however, that increasingly complex regulatory tools can create their own regulatory blind spots and that overly complex regulations can create a regulatory “fog of war.”

Andrew Haldane, executive director at the Bank of England, in August 2012 delivered a paper at a Federal Reserve Bank of Kansas City’s economic policy symposium, titled “The Dog and the Frisbee.” He graphically laid out when less is really more by talking about two ways of catching a Frisbee: One can “weigh a complex array of physical and atmospheric factors, among them wind speed and Frisbee rotation” − or one can simply catch the Frisbee, the way a dog does. Complex rules, Haldane said, may cause people to manage to the rules for fear of falling in conflict with them. The complexity of the rules may induce people to act defensively and focus on the small print at the expense of the bigger picture.

Focusing on the complexity of the banking world, Haldane compared the 20 pages of the Glass-Steagall Act to the 848 pages of Dodd-Frank together with its 30,000 pages of rulemaking, and compared the 18 pages of Basel 1 to the more than 1,000 pages of Basel III. The fundamental question is whether that additional detail and complexity really adds greater safety to the financial system or has just the opposite effect and significantly increases the cost. Haldane’s analysis provides compelling evidence that increasing the complexity of financial regulation is a recipe for continuing crisis. Accordingly, Haldane calls for a different direction for supervisors with “…fewer (perhaps far fewer), and more (ideally much more) experienced supervisors, operating to a smaller, less detailed rule book.”

Although Haldane’s analysis and discussion focuses on the banking system, his assessment and recommendations should be considered carefully by global insurance regulators. The sheer volume and complexity of rules, models and reports that flood into regulatory bodies raise the real question of who reviews this information, who really understands it and, worst of all, does a mountain of detailed information create a false confidence that regulators have good visibility into the risks – particular the emerging risks – that insurers are facing? A real danger exists of not seeing the forest for the trees.

See also: To Predict the Future, Try Creating It  

Regulation should promote competitiveness rather than protectionism.

At a time when competition has been growing not only from within the established companies but also more importantly from outside the traditional companies, protectionism will only inhibit growth and stifle better understanding of risk in a rapidly changing business environment. The goal must be to make the industry more competitive and to encourage transfer of innovation and create better ways to address risk, distribution of products and climate changes. Protectionism will only limit the potential of growth of the industry and is both short-sighted and self-defeating.

Recognition of the importance of positive disruption through insurtech, fintech and innovation.

The consensus is that the insurance industry is ripe for disruption because it has been slow (but is now working hard) to modernize in view of an array of innovative and technological advancements. Equally, regulators are trying to catch up with the rapid changes and are trying to understand the impacts through sandbox experiments and running separate regulatory models. The pace is fast and presents challenges for the regulators. Solvency and policyholder protection remain paramount, but cybersecurity, data protection, artificial intelligence and the digital revolution make advancements every day. Where this will lead is not clear. But changes are happening and regulators must work to understand the impact and need to calibrate regulatory rules to keep up with the industry and encourage innovation.

Regulation must be transparent.

Too often, regulation is drafted in times of crisis or behind closed doors by regulators believing they know better how to protect policy holders and how to prevent abuse of the system. As we have said, getting it right matters. A strong and healthy industry is the best way to protect consumers and policy holders. Industry engagement is essential and acknowledging and actually incorporating industry’s views is critical. This is particularly true given the dramatic changes in the insurance sector and the need to adopt regulation to new economics, business practices and consumer needs and expectations

This is an excerpt from a report, the full text of which is available here.

10 Questions on Capital Standards

PwC U.S. risk and capital management leader Henry Essert and PwC global insurance regulatory director Ed Barron recently sat down to discuss the proposed International Capital Standards (ICS) for insurers. They addressed at length what the ICS is and what it could mean to insurers. Here are their thoughts on the standard, as well as some background information on capital management and related issues in the insurance industry.

1. Why have an ICS?

The ICS is about creating a consistent capital measure across globally active insurers and is being promoted as a solution for group-wide supervisors to better manage capital allocation around an international business.

Insurers generally have developed their own capital standards, and what they have developed applies globally across groups. However, regulators need a capital measure to oversee insurers, and most of the regulatory measures are at the legal-entity level. During the last financial crisis, problems arose when parts of a troubled financial institution fell through a regulatory crack.

Even before that, many insurance regulators were concerned that they did not have a good picture of companies as a whole because capital is measured differently in different jurisdictions. This makes it hard for a supervisory college to identify where there may be shortfalls in capital.

2. Who wants it?

Primarily regulators and, by extension, policymakers and politicians/elected representatives. At the end of the 2008 crisis, many of them were concerned about avoiding or better handling any subsequent crises. This prompted politicians (via the Financial Stability Board) to direct regulators to improve the regulatory system for all of financial services, particularly as it relates to capital standards. And, while the banking industry has received the most attention, the insurance industry is part of a wider move for change in financial services; in fact, the FSB is now firmly focusing on the sector.

However, many elected officials in the U.S. are now concerned about adopting a “foreign” calculation that differs from what regulators in their jurisdiction have used. To run their business and generate a good return on capital, multinational and other groups need to have some way to measure how much capital they need in total on a consistent basis. They have devised their own ways of doing this calculation using a combination of current regulatory calculations and their own capital models (which are sometimes called economic capital models). They tend to do these calculations on their own without outside prompting and have concerns that the ICS calculation could conflict with what they are already doing. There has been extensive regulatory change in recent years, and the ICS is yet another initiative that insurers have to address – and in a very aggressive timeframe.

3. Does it reflect current practices or does it break from them?

Practices differ by country, so there is no single current practice standard to compare with, and the ICS is intended to be a truly global group measure. The current ICS proposal is not the same as any practice in any jurisdiction currently, but most people would say it is closer to European Solvency II approach than to the current U.S. practice. Accordingly, ICS (as it currently stands) would be a considerable change to the U.S. market. This is why the Federal Insurance Office (FIO) is leading a workstream on setting up a GAAP+ concept that will be more closely aligned to U.S. practice.

4. Who’s going to enforce compliance?

The International Association of Insurance Supervisors (IAIS) does not have any executive powers; its role is strictly to develop regulatory guidelines and best practices for national supervisors to adopt, either in whole or part. Application of the ICS is up to individual supervisors, and the question remains if they will act in many major jurisdictions. In theory, the ICS will apply (via ComFrame) to only internationally active insurance groups (IAIGs), of which there are roughly 50 worldwide. However, many observers expect that when the ICS becomes an industry standard, other companies also will use it to calculate and report their capital adequacy.

Several jurisdictions do not have an IAIG. Therefore, we assume they would not be pressured into introducing an ICS concept. However, because most jurisdictions readily adopt many IAIS principles, we would not be surprised to see some of the principles within ComFrame and the ICS “trickle down” to smaller markets, especially where there is not necessarily global activity but a high concentration of regional activity (e.g., Asia).

The reason countries tend to adopt IAIS guidelines is because, when the IMF/World Bank conducts its Financial Sector Assessment Program (FSAP) reviews, it uses IAIS principles as the benchmark for assessing the insurance sector. Therefore, it is in many people’s interest to adopt IAIS standards to achieve strong FSAP results (which feed into sovereign rating, etc.).

5. Who at insurers will be most affected?

If the calculation is similar to others already in use, then primarily risk, actuarial, financial and compliance will be affected. If, on the other hand, the calculation is very different, then just about all functional areas could be affected because of a knock-on effect on product portfolio, pricing, investment strategy and so on. In either case, boards will need to demonstrate they understand the numbers and what they mean, particularly as they relate to
strategic decisions.

Taking a look at the bigger picture, the ICS is only part of a larger regulatory package for IAIGs called Comframe. Other aspects of Comframe, like governance, risk management policies and Own Risk and Solvency Assessment (ORSA) also will have an effect on many areas, regardless of where the ICS ends up.

6. How much investment/effort would implementation and compliance require?

This depends on the nature of both the calculation that is adopted and its enforcement. It is almost certain that the calculation will be complex. But, if the calculation is similar to what groups are already using, either because it is similar to the main regulatory calculation groups use or is similar to their own internal, economic capital calculation, then the investment/effort will be less significant.

More importantly, if it winds up being similar to current calculations, then the new ICS would not have a major impact on how the company’s business profitability is measured. However, if the calculation is different, implementation/compliance and business impact will be significant.

Investment and effort may not necessarily be limited to basic compliance. Insurers can look to their experience with Solvency II, which entailed more than just change to capital standards, and required significant investment in new technology, as well as potential changes to organizational structures.

7. Will product offerings change? Are there certain products that may disappear?

If calculations are different than those now in use, then, yes, there would likely be impacts on premiums for some products, and some may even become nonviable. Many life companies are concerned that if certain types of calculations (notably, market-consistent calculations) are used, then long-term savings products may be too costly to remain viable. At the least, if certain products do not disappear, then their design may need to change (which would change the balance of insurers’ product portfolios).

8. What’s been the reaction of ratings agencies and analysts?

Ratings agencies typically have their own capital calculation formula and, for the most part, at the group level. It is not clear if they will replace their own with ICS but could do so if they think the latter is a comparable or better formula.

Equity analysts typically are concerned with the ability to pay dividends or buy back stock, which happens at the parent company level. Accordingly, they typically do their analysis at the group level. They have not been a vocal part of this discussion but probably would find an ICS helpful.

In fact, most stakeholders are likely to support the concept of a global capital standard for the insurance industry, but there almost certainly will be differences of opinion about what one should look like as details are hashed out about how the standard will actually work.

9. With all this in mind, is a true ICS likely?

It’s too early to say for certain one way or the other, but even the regulators who question the necessity of an ICS seem reconciled to the notion that one should be developed. The debate now is what the one true ICS should look like, and how the calculation should be done is the main area of disagreement between and among geographies. For other aspects of the Comframe regulatory package, like governance, risk management policies and ORSA, there is significantly less disagreement.

10. What should insurers be doing now?

Building the ICS calculation formula and finalizing the rest of Comframe probably will take several years. The following are likely to be key steps in the journey:

  • In the early stages, companies will want to understand how the different, proposed ICS options may affect them, to determine which option they favor.
  • As regulators further develop the different options’ details, they will want to study how different factors in the proposed formulas will affect companies. They will ask insurers to conduct studies of these different factors for their business (i.e., field testing).
  • Once the nature of the ICS becomes clear, companies will need to implement the formula (and eventually, the rest of Comframe).
  • All stakeholders should remain aware of ICS developments to assess where there is consensus and disagreement. If there continues to be significant divergence in how required capital is calculated across regimes, and if ICS adds complexity rather than reducing it, then most insurers will need to factor these developments into how they are modernizing or plan to modernize their risk, actuarial, financial and technology platforms to operate effectively and efficiently in the new environment.
  • Insurers may need to redesign and reprice their products, as well as potentially rethink their business strategies. It is possible that they will need to divest certain businesses and add others.

What are current capitalization requirements?

Current capital requirements in the U.S. are set at a legal-entity level. There are no global requirements for a company that operates in more than one country, and calculation formulas for capital requirements typically vary in each jurisdiction. Solvency II gets close to mandating a group standard. However, it uses the concept of “equivalence” to deal with differing capital regimes between the EU and the rest of the world, rather than enforcing Solvency II capital standards on a third country. In other words, if a country outside of the EU is deemed equivalent, then the group headquartered in the EU can use the capital standard of the operation outside the EU within its group calculation on the grounds that EU regulators are comfortable with the system in that
third country.

Are those requirements adequate if there’s another market shock like 2008 or a series of catastrophic events?

During the 2008 shock, some significant companies did not have enough capital, and governments intervened. In many cases, the formulas that set the capital requirements that proved insufficient are still in use.

However, that doesn’t necessarily mean current requirements would be inadequate for future shocks. There’d need to be a model to test if current requirements are adequate for a defined market shock like 2008, but we would need to define exactly what “a series of catastrophic events” means before modeling its impact.

What results in undercapitalization?

The more risky the business, the theory is that insurers will need to hold more regulatory capital against the risk. To be undercapitalized is normally a reflection of poor reserving or liquidity management.

More specifically, companies hold assets to defease their liabilities, which are calculated based on a more or less average level of claims. Additional assets are set aside (not available to pay shareholder or policyholder dividends) to pay for claims should they be higher than the average. This amount of additional assets is the regulatory required capital. If these assets set aside prove insufficient during a crisis, then undercapitalization results.

What is an adequate level of capital reserves (and, if the level varies by sector, what is the appropriate level for each)?

Figuring out the answer to this question is what the whole ICS global and country level debate is all about.

Which sector (reinsurance, P&C, life) has the biggest challenges remaining adequately capitalized?

There is no perception that this is a bigger issue for one sector compared with another. Problems have occurred in all sectors. Some future crisis events will affect all sectors, like credit risk events; others are more harmful for PC (wind storms) or life (pandemics).

Do different sectors have different standards? In other words, does life have a lower standard than P&C?

No, the same formula is used across the sectors. The formula will cover risks that are common across sectors with the same calculation. Different types of risk are covered by having different factors assigned to different exposures. Some of these will apply only to business/exposures written by life companies or PC companies.

Which are better capitalized, groups or subsidiaries (or does it vary)?

Each subsidiary typically has an amount of actual and required capital it holds on its own balance sheet. The group actual and required capital is the sum of these. Many companies hold actual capital in the subsidiaries just sufficient to cover the regulatory requirement in that subsidiary. They would hold any significant excess at the parent company. So for these types of companies, that would mean the group is better capitalized than the subsidiaries. But that is not always the case.

A group parent company typically can send capital to subsidiaries, subject to meeting its own capital requirements if it is an insurance company. However, the normal capital flow is from subsidiaries to the parent, but the flow is constrained by the subsidiaries’ own capital requirements. (Laws differ from country to country about how readily a company can move capital from one entity to another when it has a group capital position.)

Are there certain insurance lines that are difficult to adequately capitalize?

There are certain coverages for which the level of required capital is too high to make premiums affordable. Where this occurs, some form of government intervention typically occurs (e.g., flood insurance in certain areas). This is unlikely to change with or without an ICS.

However, when the objective is policyholder protection, capital is not the only tool. Better risk management is also key, with tools such as the ORSA and governance protocols being paramount. If it is hard to quantify a certain risk type, then strong risk management principles should augment the degree of policyholder protection.

The Case for Modernizing Insurance

Several drivers of change are compelling insurance companies to re-evaluate and modernize all aspects of their business model and operations. These drivers include new and rigorous expectations from regulators and standards, increasing demands for more relevant and useful information, improvements in analytics and the need for operational transformation.

The modernization creates considerable expectations for finance, risk and actuarial functions, and potentially significant impacts to business strategy, investor education, internal controls, valuation models and the processes and systems underlying each – as well as other fundamental aspects of the insurance business. Accordingly, insurers need more sophisticated financial reporting, risk management and actuarial analysis to address complex measurement and disclosure changes, regulatory requirements and market expectations.

Three key areas to look at:

Regulation and reporting

Changes in regulatory and reporting requirements will place greater demands on finance, risk and actuarial functions. Issues include:

  • Changing global and federal regulation (e.g., Federal Insurance Office, Federal Reserve oversight)
  • ComFrame, a common framework for international supervision.
  • Principle-based reserving
  • Own Risk and Solvency Assessment (ORSA), the Solvency II initiative that defines a set of processes for decision-making and strategic analysis
  • Solvency reporting measures
  • Insurance contract accounting

Information and analytics

Stakeholders are demanding more information, and boards and the C-suite need new and more relevant metrics to manage their businesses. Issues include:

  • Economic capital
  • Embedded value
  • Customer analysis and behavioral simulation
  • New product and changing underwriting parameters

Operational transformation

Those in charge of governance are demanding that the data they use to manage risk and make decisions be more reliable and economical. Issues include:

  • Updated target operating models
  • Centers of excellence
  • Enterprise risk management (ERM), model risk management and governance
  • New framework from the Committee of Sponsoring Organizations (COSO), a joint initiative of five private-sector organizations that provides thought leadership on ERM, internal controls and fraud deterrence
  • Optimization of controls, and efficiency studies

These drivers of change, which affect every facet of the business — from processes, systems and controls to employees and investor relations — have significant overlaps, and insurers cannot deal with them in isolation. To meet emerging challenges and requirements, simply adding processes or making one-off, isolated changes will not work.

Systems, data and modeling will have to improve, and the finance, actuarial and risk functions will need to work together more closely and effectively than they ever have before to meet new demands both individually and as a whole.

Moreover, all of this change is imminent: Over the next five years, leading companies will separate themselves from their competitors by fully developing and implementing consistent data, process, technology and human resource strategies that enable them to meet these new requirements and better adapt to changing market conditions.

The insurers that wind up ahead of the game will excel at creating timely, relevant and reliable management information that will provide them a strategic advantage. Legacy processes and systems will not be sufficient to address pending regulatory and reporting changes or respond to market opportunities, competitive threats, economic pressures and stakeholder expectations. Companies that do not respond effectively will struggle with sub-par operating models, higher capital costs, compliance challenges and an overall lack of competitiveness.

In subsequent articles, we will take a closer look at those leaders/business units that need to modernize.

 Eric Trowbridge, a senior manager, contributed to this article.