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Preconditions for a new insurance regulatory regime

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<strong>Preconditions</strong> <strong>for</strong> a<br />

<strong>new</strong> <strong>insurance</strong><br />

<strong>regulatory</strong> <strong>regime</strong><br />

OCTOBER 29, 2020<br />

Bernhard Mayr<br />

INTERNATIONAL MONETARY FUND 1


Content<br />

• Experience with Solvency II development<br />

• The supervisor<br />

• Staffing and resource allocation<br />

• Supervisory process<br />

• Supervisory cooperation<br />

• The insurer<br />

• Balance sheet impacts<br />

• Risk management<br />

• Governance<br />

• Reporting<br />

• Other stakeholders<br />

• Markets<br />

• Policyholders<br />

• Conclusions<br />

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The three Pillars of Solvency II<br />

Pillar 1<br />

Pillar 2<br />

Pillar 3<br />

Technical provisions<br />

Own risk and solvency<br />

assessment (ORSA)<br />

Disclosure<br />

Own funds<br />

Risk management<br />

Solvency and financial<br />

condition report<br />

Capital requirements<br />

Governance<br />

Supervisory reporting<br />

Internal models<br />

Supervisory review<br />

Market discipline<br />

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Experience with Solvency II development<br />

Several implicit and explicit objectives were pursued with the development of Solvency<br />

II:<br />

• Establish a consistent approach to <strong>insurance</strong> regulation/supervision in the EU/EEA:<br />

In contrast to Solvency I, Solvency II is a maximum harmonisation Directive.<br />

Considerable differences in Solvency I implementation existed across member<br />

states.<br />

• Solvency II established a risk based approach to regulation/supervision. Solvency I<br />

was essentially size based (premiums)<br />

• The increase of capital requirements was not an objective<br />

• Introduction of a “realistic balance sheet” and move away from historic cost<br />

accounting<br />

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Experience with Solvency II development II<br />

• Different development stages of <strong>insurance</strong> business and <strong>insurance</strong> regulation across<br />

EU member states.<br />

• Different philosophies regarding technical provisions and capital requirements and<br />

respective prudence<br />

• Weaknesses were sometimes hidden in the conservative assumptions <strong>for</strong> technical<br />

provisions and the accounting approach and now surface with the application of<br />

Solvency II (in a low interest rate environment)<br />

• Different legal systems (rules based versus principles-based)<br />

• Different discounting approaches<br />

• Existence of actuarial function<br />

• Application of diversification assumptions to aggregate risks across company / group<br />

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Experience with Solvency II development III<br />

• Insurers <strong>for</strong> many years primarily focussed on Pillar 1 and underestimated Pillar 2<br />

and 3 requirements<br />

• Underestimated IT requirements <strong>for</strong> reporting<br />

• Original enthusiasm <strong>for</strong> development of internal models, which declined over time<br />

• Considerable investment by insurers in developing internal model, which<br />

• Contributed to experience and sophistication of insurers, nonetheless<br />

(→investment not a sunk cost)<br />

• Maximum harmonisation limits possible adjustments <strong>for</strong> jurisdictional specificities<br />

but they do exist<br />

• Some consolidation pressure<br />

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Implications <strong>for</strong> the supervisor<br />

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Questions<br />

• Where do you see the main challenges <strong>for</strong> the authority in the implementation of a<br />

<strong>new</strong> <strong>regulatory</strong> <strong>regime</strong>?<br />

• What will be the benefits?<br />

• What – in your opinion – will change (most) relative to the current supervisory<br />

approach?<br />

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Introduction of a risk-based solvency <strong>regime</strong><br />

The introduction of a <strong>new</strong> risk-based <strong>regulatory</strong>/solvency <strong>regime</strong> has significant<br />

implications on how supervisors operate. The long process until the eventual<br />

introduction of Solvency II, provided supervisors the opportunity to partly adapt over<br />

time.<br />

Both supervisors and industry need to develop an inherent risk culture<br />

Move from compliance-based to risk-based <strong>regime</strong>, with consequential changes:<br />

• Resource allocation and staffing<br />

• Supervisory process<br />

• Supervisory cooperation<br />

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Staffing and resource allocation<br />

• High demand <strong>for</strong> actuaries and risk experts<br />

• Competition with industry on a scarce (human) resource with impact on prices<br />

• Investment in staff training<br />

• Increase in importance and thus of size of risk and analysis departments<br />

• Correspondingly, stronger focus on reporting<br />

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Supervisory process<br />

• Increased focus on the consolidated position of the <strong>insurance</strong> group relative to / in<br />

addition to standalone entity (→ supervisory cooperation)<br />

• Increased focus on the asset side of the insurer as part of a total balance sheet<br />

approach; analysis of assets and liabilities in conjunction<br />

• Required capacity to analyse (partial) internal models with adequate approval<br />

process<br />

• Increased focus on risk prevention: market monitoring, stress testing<br />

• Extended supervisory review process<br />

• Strong focus on data reporting and analysis<br />

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Supervisory cooperation<br />

• The introduction of Solvency II – through maximum harmonization - led to a less<br />

fragmented approach to regulation <strong>for</strong> the European <strong>insurance</strong> market.<br />

• Supervisory colleges <strong>for</strong> group supervision, with home and host supervisors<br />

• Competition of local entities with subsidiaries of international groups<br />

• (Third country) Equivalence of other <strong>regulatory</strong> <strong>regime</strong>s:<br />

• Equivalence of re<strong>insurance</strong> supervision (Art. 172)<br />

• Consolidation of non-EU subsidiaries into EU group Solvency II (Art. 227)<br />

• Reliance on group supervision from outside the EU (Art. 260)<br />

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Implications <strong>for</strong> the insurer<br />

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Questions<br />

• Where do you see the main challenges <strong>for</strong> the <strong>insurance</strong> industry with the<br />

introduction of a risk-based supervisory/<strong>regulatory</strong> <strong>regime</strong>?<br />

• What will be the benefits?<br />

• What – in your opinion – will be the main changes relative to the status quo of<br />

<strong>insurance</strong> business operations in your jurisdiction?<br />

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Balance sheet impacts<br />

Business decisions should ideally be risk-based and thus in<strong>for</strong>med by an assessment of<br />

pros and cons in terms of profitability and other considerations. Regulatory requirements<br />

are not necessarily binding constraints in these considerations. Nevertheless, experience<br />

has shown that <strong>regulatory</strong> changes can have implications on how insurers run their<br />

business.<br />

• Be<strong>for</strong>e the introduction of a realistic balance sheet, the provisions of guarantees has<br />

sometimes been insufficiently priced.<br />

→ Change in products provided (in terms of richness and supply)<br />

→ Change in asset allocation, increased hedging<br />

• Lack of market consistent valuation led to late identification of crystalizing risks, e.g.<br />

through<br />

• Insufficient asset liability management<br />

• Inadequate reserving and under-pricing<br />

• Underestimation of reinvestment risk<br />

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Balance sheet impacts<br />

Overall, experience in several European markets showed (e.g):<br />

• A change in the richness of guarantees<br />

• An increase in the duration of assets to be better aligned with liabilities<br />

• Increased hedging activities and risk transfer<br />

• Move towards products where the policyholder bears the (investment) risk.<br />

Not all those changes are the results of Solvency II only. Also, the experience from the<br />

crisis and the prolonged low interest rate environment played a major role. Solvency II,<br />

however, made the challenges of the <strong>insurance</strong> industry more visible.<br />

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Reaction of insurers to changes<br />

• Possible change in investment strategy<br />

• Adjustment of pricing<br />

• Change in product features<br />

• Some insurers engage in development of internal development, <strong>for</strong> capital to better<br />

reflect their risk profile<br />

• Increase in importance of reinsurers and other risk mitigating measures<br />

• Potential push <strong>for</strong> market consolidation<br />

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Risk management<br />

Art. 44 of the Solvency II Directive states:<br />

Insurance and re<strong>insurance</strong> undertakings shall have in place an effective risk<br />

management system comprising strategies, processes and reporting procedures<br />

necessary to identify, measure, monitor, manage and report, on a continuous basis the<br />

risks, at an individual and at an aggregated level, to which they are or could be<br />

exposed, and their interdependencies.<br />

That risk management system shall be effective and well integrated into the<br />

organisational structure and the decision-making processes of the <strong>insurance</strong><br />

undertaking […].<br />

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Risk management<br />

Risk management is an elementary part of Solvency II. Central to it is the requirement<br />

to fully embed it into the organizational structure and decision-making processes.<br />

• Move away from a compliance-based to a risk-based culture.<br />

• Increased focus on the three lines of defense:<br />

• Operative management<br />

• Risk management, compliance and actuarial functions<br />

• Audit function<br />

• Establishment of an Own Risk and Solvency Assessment (ORSA) that combines<br />

those functions<br />

• The ORSA is generally seen as one of the biggest challenges <strong>for</strong> the<br />

implementation of Solvency II.<br />

INTERNATIONAL MONETARY FUND 19


Governance & Reporting<br />

Governance<br />

• Under Solvency II, Board and executive management must show a good<br />

understanding of their firms’ risk appetite and capital implications. → Fit and Proper<br />

requirements.<br />

• The ORSA is a good instrument to show the consistency of the insurer’s indicated<br />

risk culture and its actual operations.<br />

Reporting<br />

• Solvency II removes the multiple bases <strong>for</strong> solvency reporting that are<br />

characteristic of the Solvency I world.<br />

• More stringent and detailed requirements on documentation and data provision<br />

with corresponding resource implications.<br />

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Synthesis<br />

• The impact of the introduction of Solvency II will vary considerably across insurers.<br />

• It will depend on factors, such as:<br />

• Product mix<br />

• Quality of existing risk management<br />

• Use of risk mitigating measures, such as re<strong>insurance</strong><br />

• Existing capital requirement models<br />

• Organizational structure<br />

• It will affect all organizational units, including Board and management<br />

NB: The long development phase until implementation in 2016 of Solvency II provided<br />

considerable time <strong>for</strong> both European regulators and insurers to adapt. In practice,<br />

insurers were prepared to different extent, depending on whether they took a proactive<br />

or reactive approach to those changes.<br />

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Implications <strong>for</strong> other<br />

stakeholders<br />

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Markets<br />

• Analysts, rating agencies and investors will have more in<strong>for</strong>mation available to<br />

assess the insurer<br />

• Extensive disclosure requirements by the insurer in terms of data and reports<br />

(e.g. SFCR)<br />

• Risk-based capital requirements<br />

• Market consistent valuation<br />

• Earlier identification of increase in risks<br />

• Comparability with other markets<br />

Market consistent valuation necessarily leads to a more volatile balance sheets (i.e.<br />

own funds) compared to historic cost accounting. The market needs to learn how to<br />

interpret these changes; particularly with respect to the long term nature of the (life)<br />

<strong>insurance</strong> business.<br />

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Policyholders<br />

• A stronger risk-based focus in regulation (but also business operation) should<br />

strongly contribute to policyholder protection<br />

• Policyholders face a change in products (or product features) as a result of more<br />

realistic product pricing.<br />

• Products, where the policyholder bears the investment risk (unit linked products)<br />

increasingly replace other <strong>insurance</strong> products.<br />

• Policyholders have more in<strong>for</strong>mation available to assess the riskiness of the<br />

insurer. In practice, though, more in<strong>for</strong>mation is more effective at the wholesale<br />

level.<br />

INTERNATIONAL MONETARY FUND 24


Conclusions<br />

• The introduction of a <strong>new</strong> <strong>regulatory</strong> policy <strong>regime</strong>, like Solvency II, will lead to<br />

considerable changes <strong>for</strong> all stakeholders involved.<br />

• Generally, both insurers and supervisors will be faced with increased investments<br />

in risk assessment and management (systems and human resources).<br />

• EU countries had the advantage to adjust over several years during the<br />

development of Solvency II.<br />

• One the other hand, it is now possible to benefit from the experience of Solvency II,<br />

since it has gone live in 2016. First amendments are currently being worked on.<br />

• Quantitative impact assessments are a crucial element of any <strong>new</strong> policy<br />

implementation.<br />

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Thank You<br />

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