It is probably only a matter of time before risk-based insurance regulation becomes the norm in Asia. Companies need not be fearful, however, says Richard Rodriguez of EMB. The process is manageable and has all kinds of business benefits.
Having recently returned from a business trip to several parts of Asia, it is clear that insurers are watching their European counterparts with great interest as they grapple with a new approach to risk management. Senior executives are aware that regulators throughout Asia are considering a similar switch, and they are unsure how it would affect them.
In fact, some Asian countries are likely to get in first, with Singapore among those leading the way. The European Union process, known as Solvency II, is moving at snail’s pace. With more than 25 countries involved, getting consensus on how to proceed is understandably hard. Only in the UK, where the FSA decided it could no longer wait, have the authorities switched fully to risk-based regulation.
Elsewhere, Australia was the first major economy to go down this route and other countries, including South Africa, are also about to do so. It is a fair bet that in ten years time risk-based regulation will be the global norm.
Many insurers you meet view these changes with concern. Most businessmen are instinctively suspicious of anything that involves a different way of doing things, especially one that appears to require more work and administration. In my view, however, this is one reform that will produce benefit all round. Insurers and their customers both stand to gain.
Removing guesswork
The guiding principle behind the Solvency II approach is to measure the risk inherent in a business before deciding how much capital it needs to support it. Under the traditional approach, although regimes vary from country to country, insurers have typically been assessed by their premium income. More volatile lines may demand additional resources but, in essence, the required levels of capital are determined mainly according to the amount of business written.
This old system is rather crude and fails to take into account the true dynamics of any insurance operation. To provide a very simple illustration, consider a motor insurer that reduces its rates to retain business. The strategy has almost certainly increased the possibility of default because each dollar it receives has more risk attached to it than before. Yet, if its overall premium income has gone down, the regulator may actually reduce its capital requirements when it would be more logical to raise them.
The new system is more sophisticated and aligned to the approach long applied towards the banks. It expects the insurer to demonstrate that it understands the risk inherent in the business – and not just the insurance risk. It should include operational risk, group risk, investment risk, credit risk and liquidity risk, among others.
As well as aggregating the capital requirements of all the risks, they should demonstrate an understanding of how they interrelate. The World Trade Centre attack provides a good illustration of why this is needed; many insurers and, above all, reinsurers involved in 9/11 had underestimated this inter-relation of risk. In simple terms, when one aspect of the business goes badly wrong, there is a good chance that the rest will too. For example, many capital providers lost much more money in the stock market falls that followed September 11 than they did in the event itself.
The danger that adverse factors will come together at once needs to be factored into calculations about capital requirements. The main aim of any regulator is to ensure that insurers and reinsurers under their jurisdiction have the funds to pay out under all but the most extreme of conceivable circumstances or combination of circumstances.
The more reliably you can measure the risk involved the easier it is to work out precisely how much capital you should allocate. In that sense, the new system seeks to remove the guesswork from insurance.
A model answer
Much has been made of the fact that, under Solvency II, most insurers and reinsurers are expected to produce financial models of their businesses. These models can be used to test the robustness of any insurance company by simulating thousands of feasible real-life scenarios. It is then possible to assess the financial impact that such scenarios would have and whether or not the insurer would survive.
No regulator can expect an insurer to withstand all possible scenarios. Trying to achieve that utopian state of affairs would consume massive amounts of capital and is, anyhow, impossible. Instead, the authorities must take a view on what is an acceptable risk of default. In the UK, for example, the FSA have decided that insurers should be able to demonstrate at least a 99.5% probability of solvency in any one year.
Creating a financial model is not as difficult as some people imagine. It is a well-tested process, the key being to acquire a detailed knowledge of a company’s exposures and assets. Once you have this data it is relatively simple, using modern software programmes, to do the rest. For the smallest insurers, there are a number of simpler approaches that replicate the process without requiring full-scale models.
The business advantages
The crucial point, though, is that the benefits of financial modelling go well beyond just keeping the regulator happy.
The information you gather, the analysis you do and the overall modelling undertaken can provide an insight into how you manage your capital. Hence the output can underpin the analysis required for many core strategic activities. These include:
• Capital allocation;
• Reinsurance purchase;
• Product and pricing strategy;
• Business expansion;
• Mergers and acquisitions;
• Alternative Risk Transfer mechanisms;
• Relations with ratings agencies.
One common outcome with this type of exercise is that insurers can streamline their reinsurance programmes. Modelling will help to identify holes in coverage, but also areas where current levels of reinsurance may be excessive. Another benefit is the ability to know better and in more detail which lines of insurance are genuinely profitable and which ones are not. Ultimately, this kind of information will help executives to devise strategies that optimise capital, underpin stability and improve returns.
In short, modelling will benefit any insurance or reinsurance business, regardless of whether or not the regulator requires it.
This article appeared in Asia Insurance Review in April 2006
