Global Perspectives on Insurance Today: A Look at National Interest Versus Globalization

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Copyright material from www.palgraveconnect.com - licensed to ETH Zuerich - PalgraveConnect - 2011-04-01

Global Perspectives on Insurance Today

10.1057/9780230117372 - Global Perspectives on Insurance Today, Edited by Cecelia Kempler, Michel Flamée, Charles Yang and Paul Windels

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Copyright material from www.palgraveconnect.com - licensed to ETH Zuerich - PalgraveConnect - 2011-04-01 10.1057/9780230117372 - Global Perspectives on Insurance Today, Edited by Cecelia Kempler, Michel Flamée, Charles Yang and Paul Windels

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Global Perspectives on Insurance Today A Look at National Interest versus Globalization

Edited by

Cecelia Kempler, Michel Flamée, Charles Yang, and Paul Windels


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GLOBAL PERSPECTIVES ON INSURANCE TODAY

Copyright © Cecelia Kempler, Michel Flamée, Charles Yang, and Paul Windels, 2010. All rights reserved. First published in 2010 by PALGRAVE MACMILLAN® in the United States—a division of St. Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010.


Where this book is distributed in the UK, Europe and the rest of the world, this is by Palgrave Macmillan, a division of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN: 978–0–230–10477–8 Library of Congress Cataloging-in-Publication Data Global perspectives on insurance today : a look at national interest versus globalization / edited by Cecelia Kempler . . . [et al.]. p. cm. Includes bibliographical references. ISBN 978–0–230–10477–8 1. Insurance—Forecasting. 2. Insurance—Marketing. 3. Insurance companies—Management. 4. International business enterprises. 5. Corporate governance. 6. Globalization—Social aspects. I. Kempler, Cecelia. HG8051.G56 2010 368.0068—dc22

2010014362

A catalogue record of the book is available from the British Library. Design by Newgen Imaging Systems (P) Ltd., Chennai, India. First edition: December 2010 10 9 8 7 6 5 4 3 2 1 Printed in the United States of America.


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Foreword

vii

Acknowledgments

ix

Part I

Global Overview of Insurance/Reinsurance Regulations

1

Expansion, Contraction, Consolidation, and Regulation Patricia Guinn

2

The Future of International Insurance Supervision in Light of the Financial Crisis Michel Flamée and Paul Windels

11

Improving Regulatory Capital Requirements: Developments in the United States Therese M. Vaughan

25

3

3

4

Solvency II: A Balancing Act Pamela Schuermans

37

5

Solvency II: A New Regulatory Frontier Paul Sharma and Paolo Cadoni

53

6

The Move to Market Consistent Reporting for Insurers Mark Freedman, Douglas French, Tara Hansen, and Therese Masiello

69

7

Toward a Global Approach to Regulating Insurers and Reinsurers Raj Singh

83

8

Toward Global Reinsurance Regulation Debra J. Hall and Jérôme Berset

91

9

Evolution of Insurance Group Supervision Monica Mächler

10

11

The Role of Financial Conglomerates in the Globalization of Financial Services: Regulatory Complexities and the European Perspective Michel Flamée and Paul Windels The Architecture of Group Supervision John Trowbridge


Contents

107

121 137


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12

13

Contents

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The IAIS Multilateral Memorandum of Understanding: An Important Tool for Cooperation and Information Exchange between Insurance Supervisors Peter Braumüller and Alexander Warzilek Uniform Treatment of Creditors’ Rights: Fundamental to Global Insurance and Reinsurance Regulatory Advances Peter Ivanick and Lynn Roberts

Part II 14

153

161

Industry Governance and Risk Management

Corporate Governance and Risk Management in the Insurance and Reinsurance Industries Cecelia Kempler

171

15

Aggregating Global Risks Arising from Regulatory Disparities Jerry M. de St. Paer and Michael E. Mathisen

189

16

Risk Culture Prakash Shimpi and Heike Klappach

205

17

Incorporating Capital Requirements in Risk Management Stephen P. Lowe

211

18

Securitization and Insurance Marcelo Ramella

229

19

Structuring Catastrophe Bonds: A Functionalist Perspective John Schwolsky and Matthew Stern

245

20

Growth and Diversification of the Captive Insurance Market Peter Neville

261

Part III 21

22

23

Global Insurance Markets

Past, Present, and Future Insurance Markets and Regulations in China Dongmei Chen and Xian Xu

277

Financial Services Firms in India: The Road Ahead and the Challenges Anita Pennathur

291

Insurance Underutilization in Emerging Economies: Causes and Barriers Rodolfo Francisco Wehrhahn

299

Notes on Editors/Contributors

311

Index

317


vi


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he title of this book, Global Perspectives on Insurance Today, reveals its contents. Chapters inform the readers of global complexities in balancing globalization and national interests in the insurance and reinsurance industries (collectively, the industry), and also suggest possible solutions to related challenges. The industry encompasses direct and reinsurance businesses, as well as financial structures that expand capital available to the industry through modern risk transfer vehicles that allow participation by non-industry investors. The contributions are authored by some of the most highly regarded experts from global companies, professional organizations, and supervisory authorities working with the industry and policy makers to enhance the industry’s role in assuring financially sound markets for absorption of routine and complex risk exposures. Each of our contributors agrees on the need for global regulatory coordination to assure realization of this goal. Their recommendations are based on their respective expertise and unique perspectives. Part I (Global Overview of Insurance/Reinsurance Regulations) begins with an overview by a leading actuarial and risk consultant serving companies and regulators throughout the world. Her insights explain how the industry’s landscape is being reshaped by globalization, increased natural catastrophes and new man-made catastrophes, changing demographics, and other factors that are inf luencing the industry expansion, certain contractions, consolidation, and regulatory change (Chapter 1). These insights are followed by a discussion, seen through the eyes of European industry regulatory experts, on the necessity for regulatory adaptations in light of the financial crisis, by shifting from a historic micro focus on regulation—which has proved inadequate in the modern universe of financial services—to a macro regulatory approach to understanding causes and consequences of financial institution failures and actions, to prevent such failures through deployment of appropriate expertise for each task (Chapter 2). A former U.S. Insurance Commissioner, now Chief Executive Officer of the U.S. National Association of Insurance Commissioners (NAIC), explains the current state of the NAIC and of U.S. federal government initiatives to deal with the challenges and complexities of industry globalization, and makes a strong case for the NAIC’s perspective on the importance of rules to set threshold standards for prudential oversight, which could support an overlay of principled prudential industry supervision (Chapter 3). A discussion of the complexities inherent in balancing prudential oversight under


Foreword


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Foreword

Solvency II and its implications for the industry operating under its mandate is presented by an administrator of the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) (Chapter 4). A discussion by two leading U.K. Financial Services Authority supervisors offers a valuable resource on the development of Solvency II and what it has added to fundamental prudential oversight (Chapter 5). Leaders in industry accounting and risk management consulting explain the impact that Solvency II market consistent reporting requirements could have on non-European Union (EU) global industry companies (Chapter 6). The Chief Risk Officer of one of the world’s leading reinsurers addresses how Solvency II advances the need for holistic risk-sensitive regulation, and explains the critical need for the United States to accelerate regulatory modernization, which, in his view, requires material U.S. government involvement because of the global nature of the reinsurance business (Chapter 7). Two U.S. reinsurance experts support the proposition for reinsurance regulatory modernization, offering their views on why U.S. federal legislation that reconciles differences between Solvency II and current state approaches to reinsurance regulation is urgently needed to maintain vibrant reinsurance markets (Chapter 8). The foregoing chapters are followed by three important chapters on financial conglomerate group supervision, which presents core challenges in balancing national interests and global industry regulatory coordination. A leading non-EU member regulator addresses the evolution of group supervision and its relevance in a modern global financial services environment (Chapter 9). The role of financial conglomerates in the globalization of financial services, and their impact on regulation, is also addressed (Chapter 10). A senior Australian supervisor discusses the main difficulties in regulating and supervising insurance groups and offers a proposal for action (Chapter 11). A discussion of memoranda of understandings provided by the chair and an expert of the International Association of Insurance Supervisors (IAIS) illustrates the current means by which regulators can cooperate (Chapter 12). Finally, experts in industry insolvencies and U.S. bankruptcies address why globally uniform treatment of creditors’ rights, an issue not resolved by Solvency II, is critical to the harmonization of global industry regulation (Chapter 13). Part II (Industry Governance and Risk Management) offers the perspectives of legal, consulting, and business experts on corporate governance and enterprise risk management (Chapters 14, 15, 16, and 17). This section also offers excellent summaries from U.S., Bermuda, and European experts on the important industry risk management tool of diversifying and expanding sources of capital through alternative risk transfer mechanisms and captive insurers (Chapter 18, 19, and 20). Part III (Global Insurance Markets) contributors look at the past and, more importantly, the future of the industry and financial services markets in China and India (Chapters 21 and 22). Finally, a senior insurance expert at the World Bank provides an overview of opportunities in emerging economies (Chapter 23). We hope that readers find the book to be a valuable and practical resource.


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irst, we would like to thank our contributing authors who honored their commitments to us, despite enduring one of the most intense periods of volatility in global financial services history, which broadly affected responsibilities of supervisory authorities, the insurance and reinsurance industries, and their consultants. The book’s contributors are leaders in their respective fields in each of the foregoing categories. We are most grateful for the time they have dedicated and the quality of their work. We would like to thank our publisher Palgrave Macmillan for recognizing the value of aggregating the thinking of experts at this most critical juncture in the accelerating pace of global financial services in developing and emerging markets, and in future regulation of the businesses operating in financial services conglomerates. Cecelia Kempler would like to thank Dennis Coates, Dean of the College of Business, Florida Atlantic University, as well as philanthropists Carole and Barry Kaye, without whose support the program of Risk Management at the College of Business would not have existed. In addition, we offer our gratitude to Eileen Schneider and Joan Schlossberg, who provided organizational support despite the fact that this project was outside the scope of their job descriptions. Michel Flamée expresses his gratitude for the support of his assistants Patrick Massin and Ann Devos. He also benefited greatly from inspirational discussions with his colleagues in the global and regional supervisory organizations, the IAIS (represented by its Secretary General Yoshi Kawai) and CEIOPS (represented by its Secretary General Carlos Montalvo).


Acknowledgments


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Global Overview of Insurance/Reinsurance Regulations


PART I


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Expansion, Contraction, Consolidation, and Regulation Patricia Guinn

Introduction The insurance industry is constantly reshaped by rapidly changing business and economic conditions. Natural catastrophes have grown in frequency and severity. Changing demographics have put a premium on both risk management and product development. Man-made disasters have escalated in size and unpredictability. Volatile economic conditions have stressed balance sheets and forced new waves of mergers and acquisitions. Regulators, for their part, feel compelled to act. But how? Should they tighten control, with the inevitable loss of efficiency and innovation? Or should they let the market prevail and find its own solutions? And what of the de facto regulators—the rating agencies? Still smarting from the criticism of their role in the recent financial meltdown, many rating agencies have become overly cautious, demanding that insurers hold more and more capital. Examining the industry at any point in time carries a certain risk because insurers, reinsurers, regulators, and other stakeholders continually adjust to emerging new challenges around risk and capital management. But we can see, at the beginning of a new decade, certain developments and trends that yield insights into how the industry is grappling with these challenges, and the outline of issues that will continue to drive business and regulatory behavior. In examining these patterns, definite themes emerge:


CHAPTER 1

• The pace of change that is facing the insurance industry demands new approaches for managing risk. • Insurers, recognizing this, are turning to increasingly sophisticated forms of risk management, including enterprise risk management (ERM), to manage their risks and their businesses more effectively. However, the industry is sometimes hamstrung by the lack of common global financial reporting standards.


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• Although regulators are adapting to new market realities, the overall regulatory framework is complex, and sometimes out of date.

If the financial crisis has taught us anything, it is that there is a need for more consistent and transparent accounting standards, realistic capital requirements, and effective tools for managing risks. Even before the crisis, insurers and regulators, especially those in Europe, realized that the existing standards had been outgrown and that a new, more comprehensive risk-based framework was needed for solvency monitoring. The European Union has been working on risk-based Solvency II standards with the belief that the new regulatory framework will be robust enough to harmonize insurance regulation not only across Europe but across the globe. Solvency II is designed to provide a risk-based supervisory framework for insurers and reinsurers in which capital requirements and controls are proportionate to the level of risk that is borne. European multinationals that were once subject to an assortment of capital standards and regulations will now have to conform to a single standard. In parallel with Solvency II, the International Accounting Standards Board (IASB) is working to establish a common accounting framework (International Financial Reporting Standards [IFRS] Phase II) that will apply to all insurers outside of the United States. Within the United States, the Financial Accounting Standards Board (FASB) has agreed to harmonize its accounting standards with those of the IASB. Meanwhile, in the United States, work is progressing on the Principles-Based Approach (PBA) for determining life policy reserves and regulatory capital requirements. Unfortunately, PBA is often regarded as only a piecemeal improvement to existing standards and not a complete overhaul of the regulatory system, as Solvency II is in Europe. There are also significant differences between PBA and Solvency II in areas such as methodology, calibration, risk management standards, and disclosure requirements. The lack of a common global financial reporting standard also poses challenges, in particular for life insurers. Outside of the United States, embedded value reporting provides a more meaningful picture of a company’s performance, but there has been a lack of consistency in the approach adopted by different insurers. There are a number of developments toward market consistent approaches for embedded values that ref lect similar aspects of Solvency II proposals. The CFO Forum—a group of finance directors who represent major European insurers—has developed principles for embedded value reporting designed to ensure greater consistency. At the same time, developments under the IFRS Phase II project, and FASB’s efforts to harmonize with these, will bring some convergence in financial reporting. However, the general lack of a consistent reporting standard, driven in part by the complexity of life products, has contributed to a lack of financial transparency. Resolving these differences will be a major challenge to creating a global solvency standard. The National Association of Insurance Commissioners (NAIC)


Global Concord


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in the United States announced in June 2008 that it had circulated a proposal for a solvency modernization work plan that would coordinate the U.S. risk-based solvency system with Solvency II. The complexity of the U.S. regulatory system notwithstanding, this and other recent developments in the United States signal a growing recognition by U.S. regulators that greater consistency among the 50 different state regulators, and with international solvency requirements, could benefit U.S. companies and customers. In addition to Europe and the United States, Bermuda has become one of the world’s top three jurisdictions in the global reinsurance market. The legacy of an English court system, user-friendly taxation policies, and a cooperative regulatory system have proved to be major attractions for insurers and reinsurers. Moreover, in the wake of the capacity shortages of the 1990s and early 2000s, Bermuda became increasingly effective at raising new capital, using such innovative methods as sidecars and collateralized reinsurance structures. Faced with the global movement toward harmonization and cooperation, Bermuda has again demonstrated its capacity to adapt. The Bermuda Monetary Authority (BMA) has for some time been concentrating its efforts on achieving equivalence under Solvency II and the U.S. Reinsurance Modernization Initiative. As for Solvency II, the target date for full implementation remains October 2012. In some countries, such as the UK, regulators have already requested that companies identify an individual from senior management accountable for Solvency II and capable of providing information on implementation. Regulators have also established a process for pre-approval, which companies wishing to take full advantage of the new rules will need to comply with. As the deadline approaches, more and more regulators from other parts of the world are beginning to build consensus around Solvency II. For example, many of the efforts of the International Association of Insurance Supervisors (IAIS) are beginning to ref lect work being undertaken in Solvency II. Thanks to the momentum already generated, Solvency II will become the standard for countries looking to update their regulatory regimes.

Compliance As organizations endeavor to satisfy Solvency II requirements by 2012, many executives anticipate a compliance nightmare. Adopting Solvency II will involve three main challenges: people, systems, and timing. Integrating the new standard will require companies to significantly broaden their risk management expertise. Individuals with strong risk management credentials will find themselves in great demand. In addition, companies will be required to make significant investments to improve the skills of their existing staff. Large investments in systems will also be required. One of the most significant changes instituted by Solvency II is the ability of a company to use its own internal models to calculate capital requirements. For insurers who obtain the necessary internal model approval, this provides the major benefit of allowing them to use a system that has been tailored to their own specific risk profile, rather than a conservative formula laid out by regulators. More often than not, it will mean insurers will be able to make better use of their capital. However, creating these internal models will be expensive and slow-going.


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Timing will also be a challenge. The exact details and requirements of Solvency II are still evolving. It is understandable that insurers may want to wait until the details are more concrete before creating internal systems and processes. However, they do not have that luxury. Even after they are installed, ensuring that the company’s internal models are embedded into the workings of the business—and that they pass the “use test”—may take several years.

From its modern beginnings in Edward Lloyd’s coffee houses or the widows’ and orphans’ funds, managing risk has been at the core of the insurance industry. Until recently, companies took a siloed approach to managing different types of risk. But in today’s increasingly complex, volatile, and interconnected business environment, such an approach is out of sync with market realities. We have seen how risks can interact, aggregate, and inf luence each other in ways never before imagined. Understanding how risks can interact and affect a company as a whole is the focus of an emerging discipline called enterprise risk management. When implemented properly, ERM can help companies anticipate trouble, avoid surprises, and improve decision making. Developing and implementing an ERM program with a holistic view of risk is a fundamental part of the Solvency II process. Unfortunately, many companies are finding it difficult. A survey conducted by Towers Watson1 in 2008 indicated that fewer than half of the respondents feel they are effectively implementing ERM. European companies, because of their movement toward Solvency II, are ahead of their North American counterparts in developing their ERM programs. Likewise, larger companies with more resources are also ahead of medium- and small-sized companies. But only a handful (5%) of the companies surveyed said they had completely integrated ERM as a strategic management initiative. Meanwhile, the increased importance of risk management in general, and ERM in particular, is likely to elevate the standing of the Chief Risk Officer or CRO. Just as the CFO has an enhanced set of responsibilities, resulting from the demands of Sarbanes-Oxley, we may soon see a corresponding increase in the risk-related responsibilities of the CRO. These new responsibilities may require the establishment of enhanced professional standards and higher levels of experience for future CROs. And, as regulators and the financial industry seek ways to prevent past mistakes and avoid future ones, CROs will likely play an increasingly important public policy role.


Enterprise Risk Management (ERM)

Consolidation and the Rise of the Multinationals Over the last 20–25 years, the insurance landscape was transformed by the emergence of large global insurers. These global companies were created primarily by European and North American insurers that saw mergers and acquisitions (M&A) as a way of overcoming limited growth prospects in their home markets. Much of the investment focused in Asia and Latin America, and European insurers also invested in the U.S. market. Going forward, insurance M&A is likely to take on a new look. As a result of the recent financial crisis, some of the large companies are selling parts of their insurance business in order to rebuild their balance sheets. In other


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cases, stronger, better capitalized insurers are looking to consolidate and increase scale at attractive prices. This is not an unprecedented phenomenon; insurers frequently consolidate following periods of market volatility. The point is that a new competitive landscape is emerging. This new landscape will most likely ref lect the increasing importance and inf luence of Asia. Asian insurers may take on multinational or even global aspirations in the wake of demutualizations by Japanese and Korean companies, and as Chinese and Indian companies continue to grow in size and sophistication. This same pattern applies to the large financial services conglomerates that began emerging in the 1990s. Many of these diversified financial companies, based mainly in Europe, are now splitting banking and insurance operations even as Chinese companies appear to be moving toward building a combined banking and insurance franchise. M&A activity is likely to become more commonplace as industry consolidation continues. Given the differences in reporting, regulatory and legal requirements, and the markets for insurance products, companies that are contemplating a crossborder acquisition should establish rigorous due diligence and integration plans. In addition to consolidation among existing players, crises have propelled new start-ups to capitalize on the emerging opportunities. This has been the driving force since the early 1980s for the growth of the market in Bermuda, where a class of start-ups has been launched after each major crisis. Inorganic growth is not without risks for a company that is considering a move into new geographic areas, products, or markets. Despite their advantages of scale and a degree of diversification, the very large players have found that bigger is not always better. Local players are often closer to the market and have better knowledge of customers, risk factors, and pricing considerations. Further, opportunities for leveraging products and systems across geographic boundaries are often limited due to cultural and regulatory differences. For the foreseeable future, there will be a place for local players that can efficiently identify and respond to market needs.

Catastrophes Rewrite the Rule Book for Property/Casualty Companies Although consolidation, product innovation, and globalization have done much to alter the life insurance landscape, catastrophes have been the defining factor for the property/casualty industry in the last several years. The 2004 and 2005 hurricane seasons changed insurers’ views of the potential frequency and severity of hurricane losses. Four major hurricanes struck the state of Florida in 2004, causing close to $23 billion of insured losses. In 2005, Hurricane Katrina proved to be the single most expensive natural catastrophe in history, with insurers paying an estimated $40.6 billion to settle 1.7 million claims. That same season, two additional hurricanes—Rita and Wilma—made landfall in Texas and Florida, causing another $16 billion of insured losses. The combined approximately $80 billion of insured losses from the four major hurricanes in 2004 and 2005 caused many insurers to rethink catastrophe risk-pricing and underwriting. With losses mounting and the likelihood of even more powerful storms in the future, insurers sought to increase rates. Facing significant premium increases, policyholders protested. Nowhere was the problem more acute than in Florida. In response, Florida’s legislature passed HB1A, a bill that would moderate property




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insurance price increases by expanding the size and scope of Florida’s residual market mechanisms. Other coastal states in the United States announced plans to consider similar arrangements, as did national policy makers in Washington. Florida’s legislative strategy illustrates the delicate balance that exists between private market risk-taking and government intervention. In 2007, legislators repositioned state-run insurer Citizens Property Insurance Corporation from “insurerof-last-resort” to a competitive entity. In addition, the state expanded the reach of the Florida Hurricane Catastrophe Fund (FHCF) by creating the Temporary Increase in Coverage Limit (TICL). The TICL expanded the amount of statesponsored catastrophe reinsurance from $16 billion to $28 billion. These policy changes further shifted Florida’s hurricane risk away from pre-funded private market policies to a system composed largely of post-event funding in the form of policyholder assessments. The shifting of risk financing presents some interesting considerations. In theory, Florida legislators believed that a competitive Citizens and the larger FHCF would stabilize rates by forcing homeowners’ insurance prices down and allowing insurers to pass reinsurance cost savings on to their policyholders. In practice, the state-sponsored programs created rate cross-subsidies, with in-land policyholders contributing to the coverage of coastal property losses. In addition, the legislative changes were seen as suppressing risk-pricing across the market and diminishing policyholders’ incentives to mitigate risk. Most importantly, this situation drove a wedge between the insurance industry and policy makers at a time when collaboration was needed most. Critics argue that state-sponsored programs focus too narrowly on, say, insurance pricing and coverage shortages while overlooking deeper and more complex factors, such as increased development in risk-prone areas. Others suggest that government intervention is an effective vehicle to ensure that affordable coverage exists for all homeowners. In 2009, Florida legislators signaled some merit to the former argument by easing prior policy decisions. In 2010, Citizens will increase its property insurance rates and the FHCF will reduce the reinsurance capacity that it makes available to private market insurers. In recent decades, we’ve also experienced the advent of very large man-made catastrophes, including industrial accidents, pollution, and terrorism, which by itself has the potential to disrupt an entire economy. Terrorism risk is extremely difficult to price, so insurers want to exclude it. Yet financial institutions that provide financing on buildings or projects want to know they are covered for terrorism. In response, the Terrorism Risk Insurance Act (TRIA) was created in the aftermath of 9/11. The act was patterned on Pool Re, 2 the terrorism-related insurance cover in the UK that was established in 1993 after a spate of IR A attacks. But with the U.S. government facing huge budget deficits, TRIA has been pared back in recent years and will likely sunset in the coming decade.


8

Meeting the Demand for Guarantees The greater market volatility that has arisen since the financial crisis has reinforced the demand for products with guarantees, while also substantially increasing the cost of providing these guarantees. In an increasingly competitive market, especially in a low interest-rate environment, the industry’s challenges are twofold: first, to


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ensure adequate pricing, and second, to have effective risk management programs in place. Variable annuities are a case in point. Before the financial crisis, variable annuities with guarantees were very popular, and companies that offered generous guarantees at very competitive prices amassed large volumes of business. Unfortunately, traditional reinsurance was largely unavailable for these guarantees. Therefore, companies were forced to retain the guarantee risk and develop sophisticated hedging strategies. The financial crisis and ensuing bear market put these hedging strategies to the test. The risk management challenges were exacerbated by historically high levels of market volatility, frozen credit markets, a significant drop in interest rates, and the falling out of favor of structured products. Hedging programs, which need to strike a balance between effective risk-coverage and cost, were particularly stressed during this time, with substantially increased costs and capital requirements. The impact ranged from minor, for companies that offered guarantees that were not overly generous, to substantial, for many of the major writers. However, without the programs, things would have been much worse. The demand for guarantees will persist as consumers remain financially conservative and focus on security in the wake of the financial crisis. The insurance industry may find significant business opportunities that cater to this demand if it can effectively manage the risks.

Credit Risk In a recent Towers Watson survey of North American life insurance CFOs, respondents predicted that Treasury rates would increase and credit spreads would decrease. No doubt, increasing rates and smaller spreads will likely impact the strategies that life companies are using to address their two primary risks: credit risk and interest-rate risk. The survey found that companies are actively managing these risks by using techniques that have not changed much since the late 1980s and early 1990s. A fresh look may be needed to manage some of these risks, particularly credit risks, in which some companies got badly burned. To manage credit risk, nearly all companies employ investment policy constraints on the percentage or amount of assets held in each credit category. According to the Towers Watson CFO survey,3 credit default swaps—tools which are often more effective because they can target risk to a specific asset—are used by only 11% of respondents. To manage their interest-rate risk, 28% of respondents to a 2008 Towers Watson survey on ERM4 said they use duration mismatch analysis, a newer technique which allows companies to hedge against interest-rate spikes as well as low rates. Most insurers, when asked, will cite credit risk as the largest exposure they faced following the financial crisis—more than double that for equity risk and interestrate risk. Yet, despite the fact that this is their largest exposure, most companies still do not hedge credit risk. Moreover, many life insurers fail to incorporate a credit risk premium into pricing. In effect, they treat credit risk as if it were “free.” Insurers that contemplate more effective management of their credit risk will, in many cases, need to enhance their risk management infrastructures to implement credit exposure monitoring systems. They should regularly measure and report




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large exposures, portfolio diversification, and exposures with deteriorating credit quality, and then assess them against institutionally mandated risk limits. Those who use credit default swaps need to pay particular attention to counterparty risks.

Change invariably brings about risk and, consequently, the demand for new risk management and regulatory approaches. In the immediate wake of the financial crisis, it was commonly noted that insurers generally weathered the crisis better than banks. Although the industry can take some comfort from this, it must remain focused on new and emerging risks and avoid, in military parlance, “fighting the last war.” The same is true for regulators who are challenged to create an efficient, effective regulatory framework that addresses the inevitable trade-off between innovation and market stability.

Notes 1. (Towers Watson 2008). 2. Pool Re was formed with government support in 1983 following a spate of IR A bombings in England. 3. (Towers Watson 2009). 4. (Towers Watson 2008).

Bibliography Towers Watson. “Embedding Erm—A Tough Nut to Crack (Global Insurance Industry ERM Survey Report).” 2008. http://www.towersperrin.com/tp/getwebcachedoc?web c=GBR/2009/200901/2008_Global_ERM_Survey_12809.pdf. ———. “CFO Survey: The Economic Crisis—How Has Hedging Changed?” 2009. http://www.towersperrin.com/tp/getwebcachedoc?webc=USA/2009/200908/CFO_ Survey_23_2009_8–13-09.pdf.


Conclusions


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The Future of International Insurance Supervision in Light of the Financial Crisis Michel Flamée and Paul Windels

Introduction There is no discussion anymore about the nature of the financial crisis, which can be seen as the first economic and financial crisis of globalization.1 What began as a subprime crisis in the U.S. banking sector quickly turned into a full-blown credit meltdown that affected the entire financial sector and, subsequently, the real economy. The evolving crisis developments show a complex, self-reinforcing mechanism through which the different participants in the financial services industry— banking, securities, and insurance—have been affected. The financial “disease” easily spread like wildfire around the world attacking numerous institutions and jurisdictions, most of them ill-prepared for such a calamity. The multifaceted and global nature of the crisis made it more difficult to address and more intractable. After the enormous ravage in the financial sector, it quickly became clear that the real economy at large would not escape this crisis either. As the crisis progressed through different phases, many large economies across the globe fell into deep recession. Few imagined that things would spiral out of control in this way. The tremendous impact of the crisis is unprecedented and has confronted the insurance sector and its system of financial regulation with their limits. The worldwide recession has revealed several weaknesses and gaps in insurance regulation, both at the national and supranational level, as well as challenges to financial supervision that recently have drawn the attention of policy makers, regulators, and industry participants. Several examples are the fragmented supervision of internationally active insurance groups, the extent of contagion risk between the different financial sectors, a complete underestimation and underpricing of risk (in particular liquidity risk), an overreliance on mathematical risk models and credit ratings, procyclicality effects of regulatory and accounting treatments, inappropriate


CHAPTER 2


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Michel Flamée and Paul Windels

incentive and risk management structures, and poor arrangements for cross-border crisis management. Many of these shortcomings and challenges have been well documented. Others are quite new and illustrate the significant changes in the financial landscape. Regulators and policy makers have responded with a spectrum of policy measures and action plans to address the rapidly evolving situation. A number of reports have been published that analyze the causes of the crisis and propose recommendations for improvement (e.g., the Final Report of the IIF [Institute of International Finance]; 2 the Group of Thirty Report;3 the IMF [International Monetary Fund] Lessons paper;4 the de Larosière Report;5 the Turner Review; 6 and the Geneva Report).7 These reports advocate profound changes in the regulation and supervision of financial services, which ultimately should lead to the creation of a new financial architecture. This chapter builds further on these insights, raises some issues, and attempts to identify possible directions in which progress could be made.

General Principles for Future Action The analysis presented in this chapter departs from one of the core objectives of financial sector supervision: the maintenance of financial stability. As a result of the crisis, global financial stability has been put in danger. Massive governmental and central bank interventions have been required to address the adverse market conditions. Banking and insurance supervisors have taken extraordinary measures to deal with the fallout. The crisis has shown that a strongly modified approach to supervisory action is required. In our view, the maintenance of financial stability should become a global objective transcending national borders. This chapter sets out five principles for future action: an integrated prudential model, a forwardlooking approach, regulatory convergence, cross-border cooperation, and industry involvement.

Integrated Prudential Model There is broad agreement from insiders and observers as to the combination of factors that caused this crisis. 8 One of the main origins relates to the interplay between macroeconomic policies implemented around the world since the tech bubble burst and the microbehavior of financial intermediaries. At the turn of the twenty-first century large capital inf lows in the main deficit countries brought down interest rates to very low levels. This encouraged investors and financial services companies to seek out risk through product innovation and leverage mechanisms, making risk less transparent. Liquidity and investment risk became seriously underpriced, and huge profits could be locked in through carry trades and excessive wholesale funding. Macroeconomic strategies of central banks formed the impetus for risky behavior of financial intermediaries, Global macroeconomic imbalances were the major underlying cause of the crisis.9 Since the dismantling of the Bretton Woods system in 1971 and the liberalization of credit creation, many experts have called for the establishment of a sound framework for controlling free trade and capital f lows. Those seeking a new Bretton Woods have been strong proponents of improving the consistency of macroeconomic strategies.10 Against the backdrop of globalization, however, little


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initiative has been undertaken with respect to the modernization of multilateralism and markets for a changing world economy.11 One could argue that this does not really relate to the domain of financial supervisors. Generally, opinions on these matters have changed drastically in the wake of this crisis. A stabilization of international finance in the twenty-first century will require a more comprehensive approach to financial sector assessment. This would involve a more straightforward dialogue and stronger forms of collaboration between oversight institutions, and between oversight and microprudential supervisors. In order to anticipate future crises, prudential policies would have to focus more explicitly on the interactions of macroeconomic policies and microbehavior of financial institutions.12 The aggregation of complementary analyses from different angles, for instance with a focus on financial sector growth and its interactions with the wider economy, should allow regulators to anticipate and act swiftly on potential problems. Financial regulation should thus evolve toward a system where bottom-up supervision of individual institutions is complemented by top-down analyses of systemwide risks. Broader macroeconomic and sector-specific risks need to be incorporated into microprudential assessments and vice versa. Macroeconomic policies also need to be supported by appropriate microprudential measures, when necessary. For instance, the bank rate has been recognized as an effective tool for targeting inf lation, but it has its limitations with respect to financial stability risks, such as asset inf lation, credit booms, and excessive leverage.13 Central banks could adopt a broader macroprudential view integrating financial stability concerns in their analyses.14 Regulators and supervisors should be well aware of the central bank strategies, the underlying analyses, and related risks. The buildup of systemic risk should be tackled on the microprudential level. In this regard, insurance supervisors have an important role to take up and careful consideration is required, for instance, when adopting countercyclical capital requirements. Collective action in relation to macroeconomic policies including systemic risk management requires an appropriate platform for coordination. Both in the EU (European Union) and the United States, decisions have been made on the creation of a systemic risk authority to enhance a macroprudential approach to financial regulation and supervision.15 Detailed work is needed to f lesh out the core responsibilities of these authorities. This can include the setting-up of a financial stability early warning system with a core information responsibility and a more direct role in the targeting of financial stability objectives by supervisors and policy makers. Either way, systemic risk authorities would become a “bridge” to align macroeconomic policies with microprudential measures. Such a new modus operandi will have important ramifications for insurance supervisors. The particularities of insurance activity, which strongly differ from banking activity, will need to be adequately factored into the sector analyses and specific action plans. Microprudential information on the insurance sector will need to f low to the systemic risk authorities in a consistent manner. In turn, insurance supervisors will need to correctly assess the received top-down analyses in their concrete action plans toward the institutions. In this regard, the validity of supranational analyses forming the basis for local action poses a real challenge. For instance, ref lections could be made on the establishment of a granular system for the implementation of higher-level recommendations. In these developments, due consideration should be given to maintenance of a level playing field between financial


International Insurance Supervision


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institutions and the risk of gold-plating macroprudential recommendations at the national level.

Different social and economic factors such as the liberalization and internationalization of the financial markets, rapid advances in information technology, and ongoing innovation in risk management have profoundly altered the behavior of insurance companies. The speed and impact of these developments have created new challenges for the regulation and supervision of these activities. In many jurisdictions, this has resulted in a profound restructuring of the prudential framework. The traditional rules-based approach to insurance supervision based on volume of business and claims has gradually been replaced with a principles-based approach based on risk. The objective today should be to push the envelope toward a more proactive and integrated form of risk-based supervision. This requires not a return to a rules-based approach but a tailored, company approach based on a further elaboration of clear principles that have to come to full maturity. Risk-based capital frameworks, such as the Solvency II model in the EU and the Swiss Solvency Test, provide a sound basis for such a new direction. A risk-based approach implies that supervisory action should be anchored by comprehensive risk assessments and directly responsive to changing risks. Supervisors and regulators need to pay more attention to the internal developments within the organizations to get a grip on the real situation. Through discussions with company management on important evolutions or key decisions, they need to appraise the inherent and emerging risks. This requires a thorough audit approach and a close monitoring of the implementation of the organizational strategy. Supervisors also need to “feel” what’s going on in each company and develop appropriate skills for this. For instance, their analyses should focus on intangible events that could evolve into risks and have a significant impact on the condition of the undertaking. In the institutions under supervision, major progress could be expected in the processes and methodologies for enterprise risk management, including the development of a mature risk management function. The same holds true, for instance, for the organization of asset management and reinsurance departments where a comparable high level of professionalization could be expected as in the underwriting of insurance risks. Prudential expectations should target these key risk areas while applying the principle of proportionality. Regulatory requirements should become forward-looking, in line with the evolving business models and risks on a company basis and aggregated level. A fundamental problem with the present supervisory perspective is the dependence and systematic use of backward-looking information. Solvency and liability coverage ratios are point-in-time figures published after a company’s period ends. They are considered a poor lead indicator for insurer failure.16 Historic capital adequacy gives no information on a company’s current status nor on its future performance prospects, which strongly impedes a proactive risk assessment. Risk-based solvency reporting will certainly improve market transparency, but powerful complementary information is needed. A comprehensive analysis on capital adequacy should use both quantitative and qualitative information elements, which together provide a longer time horizon for analysis. Next to solvency, key areas such as a company’s


Forward-Looking Approach


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management, operating performance, ERM (enterprise risk management), asset-liability management, investment strategy, and liquidity position have to be considered. A multipillar approach, as presented in modern capital models, incorporates these different aspects and forms a comprehensive basis for supervisory action. Integrated risk-based supervision assesses the business of an insurance company, its risk profile, and the macroeconomic context. This requires a forward-looking approach based on a complete picture of an insurer’s financial and operational positions in the key business areas. For instance, prudential requirements with respect to profit-sharing should not be based on accounting or static considerations such as positive technical or financial results, as this may foster risky investment behavior. Instead, profit-sharing requirements should focus on the intrinsic soundness of insurance activities in order to stimulate its self-financing over time. Due consideration should be given to the present situation of each organization and the evolving macroeconomic context. Another example relates to a dynamic approach to asset-liability management. Here, a more direct link could be made between the extent of a financial buffer and emerging risks in life and non-life activities resulting from asset-liability mismatches. The regulatory framework should include a mechanism of additional capital requirements in view of these emerging risks.

Regulatory Convergence In the wake of the crisis, the expansion of the cross-institutional and cross-border scope for regulation has been gaining worldwide acceptance. An increasing group of insurance and reinsurance companies operates in a multijurisdictional environment and is confronted with different regulatory requirements. Despite the progress made by international standard setters in promoting best practices, further work is needed to improve cross-border and cross-sector regulation. A consensus has been growing that the existing regulatory frameworks for insurance supervision, in particular for large cross-border groups, need to become aligned.17 The regulation of global or domestic firms should also be improved by making the minimization of systemic risk the main mission of insurance supervisors.18 This explicit focus on systemic risk assessment should lead insurance supervisors to ensure full coordination with their counterparts in the other financial sectors. In order to avoid regulatory arbitrage, a consistent, cross-border, and harmonized approach is needed in the regulation of similar instruments and of institutions performing similar activities.19 An effective framework of solo and consolidated prudential supervision of insurance companies is required, given the systemic repercussions that have resulted from problems in the insurance sector. The systemic importance of particular insurance activities, such as the monoline insurance business, on global financial markets was seriously underestimated. Similarly, regulation did not consider sufficiently the systemic risks posed by the interaction between regulated and unregulated institutions, activities, and markets. A deficient regulation of complex group structures in relation to intragroup transactions and demands for capital support, for instance by means of large securities lending operations, sometimes endangered the solvency position of contributing subsidiaries. A limited scope of regulation may have allowed for financial innovation, such as in securitization and financial guarantee activities, but with an unexpectedly high cost when the risks emerged.




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Regulatory reforms should thus focus on more effective forms of counterparty risk management and market discipline to take adequate account of institutions’ exposure to unregulated entities and, indirectly, those entities’ leverage and risk. 20 Adequate supervision of cross-sectoral activity should focus on emerging complexities, such as the creation of bridges between regulated and less regulated institutions for the transfer of risks and the adoption of business techniques that may endanger macroeconomic stability. For instance, strengthened capital requirements of the Basel II Capital Framework for banking institutions together with higher liquidity risk requirements and countercyclical provisions may inf luence the risk appetite of other group entities, such as insurers, subjected to less stringent requirements. Although incentives for banks to take excessive risks may be reduced, these institutions can be significantly affected through cross-sectoral transfer of risks from related parties in crisis situations. This risk should not be minimized in large, complex groups where, for instance, securities lending operations can be used for the transfer of risky products toward banks that may have access to central bank liquidity facilities. In this way, a credit event can rapidly evolve into a liquidity event necessitating central banks’ intervention and their acceptance of lowerquality collateral. Intragroup transfer of risks between cross-border institutions entails particular risks for smaller jurisdictions, which may be unable to cope with the related consequences of crisis support. Therefore, more-detailed arrangements should be developed than those established by the Joint Forum for the acceptance of risk transfer including its various mechanisms. The development of a coherent set of international principles and standards for the supervision of large internationally active insurance groups has become a key priority of the International Association of Insurance Supervisors (IAIS). This is challenging work as a regulatory framework for consolidated supervision does not exist, and any far-reaching harmonization of prudential regulations on a solo level does not seem feasible in the short term. However, restricted convergence of company-level regulations would not be problematic if these rules were supplemented with a harmonized approach to supervision of cross-border groups. Through a group supervision framework, which looks beyond the pursuit of company-level regulations, supervisors would obtain a groupwide perspective to examine key elements such as group solvency, group risk management, and intragroup risk exposures. Despite the general consensus on the importance of groupwide supervision, views still differ on the modalities for implementing such a framework. This could be, for instance, supported on a generalized basis by an international accord (such as the Basel Capital Accord in the banking sector) or through the use of an opt-in mechanism next to solo supervisory requirements. Although a further harmonization of standards and regulations remains important, this may not become a precondition for further cross-border cooperation. Different areas have been suggested for improving cross-border and cross-sector regulation. 21 In particular, insurance legislation by home and host countries could be aligned with respect to early corrective actions, including criteria of resolution and bankruptcy procedures of a global firm. Common resolution tools should allow a quick and coordinated response by the relevant authorities across jurisdictions. Another point relates to a stronger convergence of depositor and investor protection schemes, which could ensure that clients are covered by the prevailing scheme in each jurisdiction regardless of whether the entity is a branch or a subsidiary.


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Regulatory attention could also be devoted to the free exchange of information between local supervisors and their foreign counterparts as a lack of coordination often occurs owing to imprecise legislation. In a similar vein, a lack of loss-sharing arrangements forms an important legal impediment to better cross-border cooperation. Supervisory authorities have a natural tendency to focus principally on the protection of local depositors and customers, which results in a ring-fencing of national financial systems in stress situations. Loss-sharing agreements should prevent such detrimental actions and provide a fair framework for the contribution of each jurisdiction to the resolution of a firm. The most feasible approach to oversee cross-border insurers and reinsurers is likely based on a minimum set of compatible supervisory principles and practices. These principles and standards would provide a firmer base for supervisory cooperation, as well as a framework for achieving greater harmonization of MoUs (the IAIS Memorandum of Understanding). 22 Consideration could be given to establish harmonized, firmwide requirements on supervisory reporting to improve groupwide risk assessments while reducing the administrative burden for groups. The arrangements for the supervision of cross-border groups could be enhanced with respect to the functioning of the supervisory colleges, including modalities for ongoing coordinated supervision of the group and procedures and responsibilities of supervisors for cooperation in crisis situations. 23 Supervisory colleges should have the explicit responsibility to translate financial stability concerns into concrete supervisory measures with regard to the group. The colleges should conduct periodic risk assessments on the group as a whole and implement common action plans based on these assessments. At the European level, a structured approach for regulatory convergence has been formulated. 24 In a first stage, a single set of harmonized rules of national supervisory authorities would be achieved (a single EU rule book). In a second stage, the European Supervisory Authorities would take up a number of specific tasks in relation to supervisory convergence and cooperation (the European System of Financial Supervision). For instance, the authorities would investigate and adopt recommendations toward national regulators in case of manifest divergences from Community legislation and binding harmonized technical standards. A key initiative for regulatory convergence has been introduced with the Solvency II Framework Directive 25 harmonizing solvency regulation and other aspects such as the supervisory review process, companies’ own risk and solvency assessment, and the disclosure of financial information. The initial provisions on group supervision and group support were abandoned in the final version of the Framework Directive, but new proposals would be considered after an implementation period of three years. The purpose would be to integrate the role and experience of each local supervisor within a coherent groupwide approach to avoid a duplication or divergence of action. 26



Cross-Border Cooperation The supervision of cross-border insurance groups and their different components forms a considerable challenge for supervisors used to operating on a strictly national basis. The well-known risks and deficits of merely voluntary forms of supervisory cooperation have become painfully clear during the recent crisis.


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Cross-border cooperation has not worked in emergency situations and purely protectionist measures on a national basis have prevailed. One could refer to differences in legal environments, coordination problems, inappropriate crisis resolution mechanisms, and so on, to explain in part the encountered difficulties. The lack of a sound framework for the supervision of cross-border institutions has meant that nothing was done. Groupwide supervision including cross-border cooperation needs to become formalized and structured against the economic reality of the entities under supervision. Effective groupwide supervision, however, requires trust among supervisors, which ultimately should lead to strong forms of cooperation. This requires a sensible approach that will entail an evolutionary rather than radical process of change. Different mechanisms are being developed to improve communication among supervisors and to facilitate cooperation and exchange of information on a groupwide basis. At the international level, the IAIS has embarked on the development of a broad framework within which groupwide supervision can be undertaken in an effective and efficient manner. It has been decided not to establish a detailed supervisory regime for groupwide supervision but a coherent set of standards and guidance papers. The Insurance Core Principles of the IAIS acknowledge that there may be different approaches to group-wide supervision that may contribute to the protection of policyholders and to overall financial market stability. For instance, the establishment of a groupwide supervisor, supervisory colleges, and protocols between jurisdictions may facilitate cooperation and exchange of information on a groupwide basis. Group supervision would be most effective where all involved supervisors acted with a common understanding and commitment to cooperation and appropriate information exchange based on generally accepted and agreed supervisory principles and practices. In the recommendations of the Financial Stability Forum 27 and the statements of the G20, 28 particular reference was made to the role of supervisory colleges in enhancing cross-border cooperation for internationally active insurers and reinsurers and as a mechanism for crisis management. As a response to these demands, the IAIS has published a guidance paper on the role and responsibilities of a groupwide supervisor and a paper on the use of supervisory colleges in groupwide supervision. This work considers factors in the establishment and implementation of a supervisory college structure, including its form and membership and the relationship between the supervisory college and the designated groupwide supervisor. As a supervisory college has no legal or binding authority as a decision-making body, the standards and guidance must promote a common understanding and agreement on supervisory activities in relation to groupwide issues. For instance, a proper f low of periodic high-quality information should be guaranteed between the participating authorities in a college. Present developments of the IAIS also relate to a further establishment of a common assessment framework for group supervision. Comparable developments at different regional levels provide valuable input for this work. One could, however, question if principles and protocols without legally binding agreements can provide a sufficient basis for real cooperation. 29 At a global level, there are no laws or regulations on confidential information providing a basis for supervisory cooperation. Thus, bilateral or multilateral memoranda of understanding are used to ensure that information can be shared in a secure environment.


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These protocols are supplemented with principles and standards, the effectiveness of which strongly depends on the level of acceptance by the individual authorities. The limits of voluntary and poorly harmonized information-sharing agreements are not theoretical and necessitate a profound ref lection. For instance, uncertainty about the quality of supervision and the level of compliance with adopted standards forms an important threat for cross-border cooperation. As a response, the Financial Stability Board (FSB)30 and the IAIS envisage further progress in monitoring the adoption of principles and standards through the establishment of a peer review framework. Through country-by-country reviews and disclosure of individual country reports, trust between jurisdictions would be enhanced. A strong convergence of regulations and practices eventually may lead to a mutual recognition of the equivalence of supervisory regimes. At the European level, work is being made on a new microprudential supervisory framework centered around the European System of Financial Supervision (ESFS).31 In this structure, national supervisors will have to work in tandem with the European Supervisory Authorities to safeguard the financial soundness of the financial institutions. These supervisory networks, which will operate in the form of supervisory colleges for large cross-border institutions, will build on shared and mutually reinforcing responsibilities, combining nationally based supervision with centralization of tasks at the European level. Cooperation will be based on principles of partnership, f lexibility, and subsidiary to enhance trust between home and host supervisors in setting policies. Decisions will be made on a collegial basis, but there will be a possibility to challenge individual decisions. The new European Supervisory Authorities, which will replace the 3L3 Committees of Supervisors, receive legal powers and greater authority in developing binding technical standards and nonbinding guidelines and recommendations. They will play a strong coordinating role among supervisors in crisis situations by ensuring a balanced f low of information and providing binding decisions and mediation in case of disagreements. They will also promote a common supervisory culture and convergence of practices, by conducting peer reviews with national authorities, which remain responsible for the supervision of domestic authorities. With the establishment of the ESFS, a legal framework for supervisory cooperation would be enacted in Community legislation. This, however, promises to be a difficult job and the devil will be in the details. Although many of these arrangements and powers still need to be defined, it is clear that national supervisors are entering a complex framework of multiple principles and numerous agents. For instance, potential weaknesses in supervisors’ governance arrangements may hamper cooperation in supervisory matters because they could undermine national supervisors’ trust in each other’s information-gathering capacities, intervention powers, and supervisory actions.32 The effectiveness of the multilayered framework for microprudential supervision, including the cooperation with macroprudential supervisors, remains to be seen. The translation from macroprudential considerations into microprudential actions will depend on the specific mandates given to the European Supervisory Authorities. It is not unlikely that interagency coordination issues may necessitate additional changes at the European or national level to have incentive-compatible structures conducive for information sharing and cooperation. A more profound restructuring of the European architecture for financial supervision should not be excluded.




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The crisis has also illustrated the need for establishing particular arrangements concerning cross-border supervisory cooperation in crisis situations. This involves the development of a crisis management framework with clear guidelines for crisis contingency planning, supervisory cooperation, and crisis resolution. The FSB has started with the development of cross-border crisis management arrangements for systemically important groups. These arrangements cover practical and strategic ex-ante preparations and define expectations for how authorities will relate to one another in crisis. For all systemically important cross-border groups, contingency and resolution plans that involve key participants of the supervisory colleges and company management need to be prepared.33 At the European level, increased attention is paid to the improvement of government intervention and coordination mechanisms between different public authorities in crisis situations. This includes the establishment of appropriate burden-sharing agreements between governments for crisis resolution.34 Further work on crisis management would also focus on particular aspects of company and insolvency laws, such as bankruptcy, winding-up, and transferability of assets.35

Industry Involvement There are many lessons to be learned, and these can be valuable only if an integrated approach is proposed and is supported not only by regulators and policy makers, but also by the insurance industry and its stakeholders. The crisis has shown that supervisors and the industry share compatible objectives, for instance, in relation to an optimal functioning of the business and a reduction of the cost for customers. Both parties also have considerable expertise to share, which can be incorporated into business practices and regulations. Industry involvement in regulatory developments can lead to better regulation and greater levels of acceptance and preparedness by the participating institutions. Through public consultations and active discussions in seminars, the interests and goals of different stakeholders can be secured in the regulatory process. In this regard, the IAIS has introduced observer hearings at its triennial meetings to discuss regulatory approaches and proposals from the industry. The FSB has recently established a Standing Committee for Supervisory and Regulatory Cooperation to foment a dialogue among the different sectors of the financial services industry. In Europe, regulatory development is backed up by a strong tradition of consultation and dialogue with all related stakeholders. At different national, regional, and international levels, regulatory frameworks are evolving toward a multipillar type of approach driven mainly by (technical) standards, principles, and guidelines that combine quantitative and qualitative requirements. In this perspective, regulatory requirements increasingly focus on industry-best practices, which necessitate stronger forms of cooperation between regulators and the industry. If these new requirements are meant to be effective, they should be based on economic reality, common sense, and a real dialogue. As illustrated by the ongoing QIS (Quantitative Impact Study) exercises of the Solvency II project, industry involvement in the development of new regulations can offer important benefits for all stakeholders. Next to the development of riskbased solvency capital requirements (pillar 1), industry involvement is also required for the establishment of an own risk and solvency self-assessment process (pillar 2) and for sound disclosure practices (pillar 3). In this regard, insurance and


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reinsurance companies’ own processes and practices become increasingly important for the supervisory review process and the definition of industry-best practices. In line with the ongoing regulatory developments at regional and international levels, the role and functioning of insurance supervisors has profoundly changed. The times are gone when supervisors could be seen as traditional lawmen who monitored the implementation of strict regulations without much consideration for the economic reality. The prudential policy of insurance supervision has become heavily determined by supranational regulations and standards, which have to be transposed and adopted at the national level. As a result, national supervisors and local entities under supervision are confronted with a complex framework of prudential requirements that seem to be in a constant evolution. In the same vein, prudential supervision “in the field” requires a more comprehensive approach. Insights from the front line of the business and key stakeholders have become important elements for the determination of supervisory actions. The monitoring of prudential requirements increasingly requires dialogue between company representatives and supervisors. In order to guarantee a level playing field, appropriate judgments often need to be made in areas such as solvency, corporate governance, accounting, and reinsurance. The industry’s view on systematic vulnerabilities and cyclical risks could supplement macroprudential analysis and the development of international strategies.36 Through a structured dialogue on emerging problems, macroprudential strategies could be developed and implemented into microprudential activities and the dayto-day operation of supervisory colleges. Macroeconomic considerations may force supervisors to more frequently take corrective actions, such as imposing countercyclical capital requirements in good times and extraordinary measures—with the latent risk of procyclicality—in bad times. The logic of these decisions could sometimes be questioned but should always be transparent. At the European level, an industry platform has been established, representing the large European banking groups to help coordinate college-based supervision of these groups. A similar platform could be established, for instance, for multinational insurance and reinsurance companies, for which supervisory colleges are in place. Such a platform could interact directly with the responsible European Supervisory Authority, or with the FSB, to provide feedback on the microprudential operation of global colleges. Ultimately, increased cooperation among supervisors, regulators, and other stakeholders from the industry—such as auditors, actuaries, and credit rating agencies—should lead to a better controlled environment for the institutions. Through information sharing on the executed work, expertise-sharing, and an open view for discussion, common problems could be tackled and a sound relationship built. Areas of common interest where further improvement is needed relate, for instance, to the functioning of market discipline, which seems to have been rather ineffective over the past years, and to the legal framework for consumer protection. A strong alignment of regulation and supervision with financial and economic developments is conditio sine qua non if the risk of financial instability is to be minimized.



Conclusions Largely in response to the globalization and increasing integration of the financial markets, governments have been reviewing the structure of financial supervision. The financial crisis has shown that there is a need for a more comprehensive


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regulation of the global financial system. An important part of these emerging needs has been taken up by the FSB, which, together with the IMF, have been analyzing the causes of the crisis and making recommendations for action. For instance, a process of multilateral surveillance of global imbalances has been agreed upon and put in place by the IMF, while a clear analysis of the origins of the imbalances and the necessary policy responses have been formulated.37 Through the establishment of new economic policies, large global imbalances and excessive risk taking in the financial markets need to be prevented. An environment that is conducive to sustainable growth of the global economy in the long run should to be developed. International standard setters and regulators have actively contributed to this work and to related cross-sector work conducted by the Joint Forum. A number of pressure points and policy issues have been identified for the regulation and supervision of insurance and reinsurance companies. In the analyses, for instance, attention is paid to investment portfolio risks, underwriting risks, liquidity risk, securities lending, securitized structures, supervisory cooperation, and group supervision. An area of high priority includes, for instance, the establishment of stronger forms of collaboration between oversight institutions and microprudential supervisors. At different national and international levels, regulators and central banks are working together in constructive ways to solve this problem. Another key challenge relates to the supervision of internationally active insurance groups and financial conglomerates, including the establishment of crisis management arrangements. Supervisory colleges have been established and now need to perform effectively. This would mean recognizing the legitimate interests of all the involved jurisdictions and understanding the economic realities for the large groups in their jurisdictions. In addition, by taking advantage of the proximity and knowledge of the local supervisors, it should be possible to put in place a transparent supervisory process that fosters a centralized approach in the relations with and decisions regarding these groups. Such an approach should be based on principles of collegiality and democracy and may follow the example of what has already been introduced in some regions, including, for instance, within the Euro-system.

Notes The views expressed in this chapter are those of the authors and not necessarily those of the Banking, Finance and Insurance Commission (CBFA). 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14.

(Kessler 2008). (IIF 2008). (Group of Thirty 2009). (IMF 2009b). (The de Larosière Group 2009). (FSA 2009). (Brunnermeier et al. 2009). (Bernanke 2009), (King 2009), (Mohan 2009). (Portes 2009). (Wolf 2008), (Boughton 2009). (Zoellick 2008). (King 2009). (Issing 2009). (de Gregorio 2008).


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15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37.

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(EC 2009a), (Bernanke 2009). (Jones and Pallac 2009). (G20 2009a), (Group of Thirty 2009), (IIF 2008). (IMF 2009a). (G20 2009a). (IMF 2009a). (IMF 2009a). (IMF 2009a). (EFC 2009). (The de Larosière Group 2009). For further details please refer to the Solvency II Directive of the (European Commission 2009). (CRO Forum 2009). (FSF 2008). (G20 2008), (G20 2009b). (IMF 2009a). The successor to the Financial Stability Forum (FSF). (EC 2009a), (Bernanke 2009). (Masciandaro, Nieto, and Quintyn 2009). (G20 2009c). (EFC 2009). (The de Larosière Group 2009). (IIF 2009). (Trichet 2009), (G20 2009c).

Bibliography Bernanke, Ben S. “The Crisis and the Policy Response.” Speech presented at the Stamp Lecture at London School of Economics, London, U.K., January 13, 2009. Boughton, James M. “A New Bretton Woods?” Finance & Development 36, no. 1, 44–46 (2009). Brunnermeier, Markus, Andrew Crocket, Charles Goodhart, Avinash D. Persaud, and Hyun Shin. “The Fundamental Principles of Financial Regulation (Geneva Report).” Paper presented at a conference, Geneva, Switzerland, January 24, 2009. CRO Forum. “Insurance Risk Management Response to the Financial Crisis.” April 2009. de Gregorio, Jose. “Price Stability and Financial Stability—Some Thoughts on the Current Global Financial Crisis.” Speech presented at the meeting Pensando Chile 2009, Santiago, Chile, November 3, 2008. Economic and Financial Committee (EFC). “Lessons from the Financial Crisis for European Financial Stability Arrangements.” July 8, 2009. European Commission (EC). “European Financial Supervision.” Communication from the Commission, May 27, 2009a. ———. “Amended Proposal for a Directive of the European Parliament and of the Council on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II).” April 22, 2009b. http://ec.europa.eu/internal_market/insurance/solvency/index_en.htm. Financial Services Authority (FSA). “The Turner Review: A Regulatory Response to the Global Banking Crisis.” March 2009. Financial Stability Forum (FSF). “Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience.” April 7, 2008.




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Group of Thirty. “Financial Reform: A Framework for Financial Stability.” January 15, 2009. Group of Twenty (G20). “Declaration from the Leaders of the Group of Twenty.” Speech presented at the Summit on Financial Markets and the World Economy, Washington D.C., U.S.A., November 15, 2008. ———. “Final Report from the Working Group on Enhancing Sound Regulation and Strengthening Transparency.” March 27, 2009a. ———. “G20 Declaration on Strengthening the Financial System.” Speech presented at the G20 Summit, London, U.K., April 2, 2009b. ———. “G20 Leaders’ Statement.” Speech presented at the G20 Summit, Pittsburgh, U.S.A., September 24–25, 2009c. Institute of International Finance (IIF). “Final Report of the IIF Committee on Market Best Practices: Principles of Conduct and Best Practice Recommendations, Financial Services Industry Response to the Market Turmoil of 2007–2008.” July 17, 2008. ———. “Restoring Confidence, Creating Resilience: An Industry Perspective on the Future of International Financial Regulation and the Search for Stability.” July 23, 2009. International Monetary Fund (IMF). “Lessons of the Financial Crisis for Future Regulation of Financial Institutions and Markets and for Liquidity Management.” February 4, 2009a. ———. “Initial Lessons of the Crisis.” February 6, 2009b. Issing, Otmar. “In Search of Monetary Stability: The Evolution of Monetary Policy.” BIS Working Papers, no. 273 (March 2009). http://www.bis.org/publ/work273.pdf. Jones, Rob, and Yann Le Pallac. “Credit FAQ: Interpreting Insurer Financial Strength Ratings In Light Of Improving Insurer Supervision.” Standard & Poor’s Ratings Direct, March 20, 2009. Kessler, Dennis. “A Severe Financial Crisis That Calls for New Policies.” Speech provided at the 35th General Assembly of The Geneva Association, Hamilton, Bermuda, May 28–31, 2008. King, Mervyn. “Finance—A Return from Risk.” Speech presented to the Worshipful Company of International Bankers, London, U.K., March 17, 2009. Masciandaro, Donato, Maria J. Nieto, and Marc Quintyn. “Will They Sing the Same Tune? Measuring Convergence in the New European System of Financial Supervisors.” Centre for Economic Policy Research Policy Insight, no. 37 (August 2009). http://www. cepr.org/pubs/PolicyInsights/PolicyInsight37.pdf. Mohan, Rakesh. “Global Financial Crisis—Causes, Impact, Policy Responses and Lessons.” Speech presented at the 7th Annual India Business Forum Conference, London Business School, London, U.K., April 23, 2009. Portes, Richard. “Global Imbalances.” In Macroeconomic Stability and Financial Regulation: Key Issues for the G20, edited by Mathias Dewatripont, Xavier Freixas, and Richard Portes. London: Centre for Economic Policy Research, 2009. The de Larosière Group. “Report of the High Level Group on Financial Supervision in the EU.” February 25, 2009. Trichet, Jean-Claude. “The Global Dimension of the Crisis.” Speech presented at the Foreign Correspondents’ Club of Japan, Tokyo, Japan, April 18, 2009. Wolf, Martin “Why Agreeing a New Bretton Woods Is Vital and So Hard,” Financial Times, November 4, 2008. http://us.ft.com/ftgateway/superpage.ft? news_ id=fto110420081450480144 Zoellick, Robert B. “Modernizing Multilateralism and Market.” Speech presented at the Peterson Institute for International Economics, Washington D.C., U.S.A., October 6, 2008.


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Improving Regulatory Capital Requirements: Developments in the United States Therese M. Vaughan

Introduction During the past decade, supervisors around the world have given significant attention to their systems of financial supervision, including capital requirements. Even prior to the recent financial crisis, regulators were rethinking the purpose of regulatory capital requirements and how they should be structured. The financial turmoil has increased regulatory cooperation in this area and increased the importance of international standards. The current U.S. system of solvency regulation was largely framed in the aftermath of a series of insolvencies that occurred in the late 1980s and early 1990s. In 1989, the National Association of Insurance Commissioners (NAIC) unveiled its Solvency Policing Agenda, a series of reforms and innovations in solvency regulation that were designed to strengthen both the underlying requirements and the level of cooperation among states. Today, the U.S. system has evolved to include wide-ranging elements aimed at the promotion of insurer solvency, the identification of potentially troubled insurers, and the enforcement of regulatory action when a troubled insurer is identified. It is generally believed that the U.S. system of insurance regulation performed well in the recent financial turmoil, although the case of AIG highlighted the need for a better U.S. regulatory structure for complex financial institutions that engage in significant noninsurance activities.1 In light of the emerging international developments and the passage of time since the Solvency Policing Agenda was developed, U.S. regulators decided in 2008 that it was time for another comprehensive review of the system of solvency regulation. The NAIC’s Solvency Modernization Initiative (SMI), announced in June 2008, is a critical self-examination of the United States’ insurance solvency regulation framework.


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The remainder of this chapter proceeds as follows. In the next part, elements of the current U.S. system of regulation are described. Third, the SMI is described, including the issues that are expected to be addressed by the initiative, and its general workplan. Fourth, the chapter focuses, in particular, on regulatory capital requirements. Finally, the chapter concludes with closing comments.

The U.S. solvency framework developed over a series of decades into the system we have today. As part of the SMI, U.S. regulators summarized the financial regulatory system in a cohesive framework with underlying core principles. 2 The mission of U.S. regulators is to protect policyholders/claimants/beneficiaries first and foremost, while also facilitating an effective and efficient marketplace for insurance products. Ultimate regulatory responsibility for insurer insolvency rests with each state insurance department and the State Insurance Commissioner (sometimes also known as the Administrator, Director, or Superintendent of Insurance). A unique characteristic of the U.S. system is that it relies on an extensive system of peer review, as well as communication and collaboration among states, that produces checks and balances in regulatory oversight. This multistate system also leads to a diversity of perspectives in establishing policy and regulatory action. Through a process of consensus building and compromise, regulators are driven toward centrist solutions, avoiding dramatic swings in regulatory policy as the political or economic environment changes. Peer pressure encourages states to take appropriate regulatory action, limiting the effects of regulatory capture and forbearance, and redundancy in regulatory processes (multiple sets of eyes) makes it less likely for problems to be missed. The evolution of best practices across the states can be shared to facilitate improvement in all states (i.e., “the laboratory of the states”). This multistate structure, coupled with a risk-focused approach to regulation, form the foundation for the current U.S. solvency regulatory system—a national system of state-based regulation. The NAIC serves as the central structure through which the necessary coordination and joint policy development can occur.3 Financial solvency core principles underlie the active regulation that exists today. Seven core principles encompass the U.S. insurance solvency regulatory system. The core principles are implemented throughout the states primarily through state adoption of the NAIC model laws and regulations, many of which are embodied in the NAIC’s Financial Regulatory Standards Accreditation Program (“the Accreditation Program”). Under the NAIC’s Accreditation Program, states that meet a wide range of legal, financial, functional, and organizational standards are certified or “accredited” by the NAIC. This ensures that states meet minimum baseline standards of solvency regulation, particularly with respect to regulation of multistate insurers. These certified baseline standards promote coordination of regulatory oversight among the various state regulators and also provide efficiencies of process to the national system of state-based regulation. All fifty states and the District of Columbia are currently accredited. The seven core principles that have been identified include:


The Current U.S. Solvency Framework

1. Regulatory Reporting, Disclosure, and Transparency. Insurers are required to file detailed financial statements on an annual and quarterly basis. These


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financial statements are captured electronically in the NAIC’s centralized financial database and used by regulators and the market to evaluate the risk profile of insurers. The extensive data includes, among other things, detailed information on premiums written for each line of business and state, reinsurance arrangements, and investments owned, bought, and sold. 2. Off-Site Monitoring and Analysis. Off-site monitoring is used to assess on an ongoing basis the financial condition of the insurer. The detailed financial information that is collected by the NAIC makes it possible to conduct extensive analyses of trends at the company and market level on a quarterly basis. A single insurer can be compared against a peer group to identify areas in which the insurer’s performance or risk profile is an outlier. These types of analyses are provided to the state insurance regulators through many offsite monitoring tools maintained by the NAIC and are used in conjunction with a state’s own analysis tools and processes. In addition to the independent analysis conducted by state insurance regulators, the NAIC maintains a central staff to perform ongoing monitoring of nationally significant insurers, and it refers potentially troubled insurers and insurance groups to the Financial Analysis Working Group (FAWG), a group of seasoned financial regulators from 16 states that provides peer review of the domestic regulator’s actions. The FAWG, with the support of the NAIC staff, also monitors industry trends in various risk areas and provides guidance for state regulators, including recommended responses to risks that have been identified. Risk areas could include, for example, capital market changes, credit crunch issues, catastrophic events, international events, anomalies with lines-of-business writings, reinsurance activities, investment strategies, and leverage. 3. On-Site Risk-Focused Examinations. U.S. regulators carry out risk-focused on-site examinations in which the insurer’s corporate governance, management oversight, and financial strength are evaluated, as are the processes for risk identification and mitigation. As a new accreditation requirement in 2010, U.S. regulators will utilize a revised risk-focused examination approach.4 This approach incorporates an enhanced risk assessment process with increased consideration of an insurer’s prospective risks, risk management, and corporate governance. Among other things, the examination provides for increased supervisory reliance on the work of the internal and external auditors and on documentation related to the U.S. Sarbanes-Oxley requirements. It also emphasizes consideration of the impact of insurer management. 4. Reserves, Capital Adequacy, and Solvency. Insurers are required to maintain reserves and capital and surplus to provide an adequate margin of safety. The U.S. risk-based capital (RBC) system establishes regulatory capital requirements and creates a ladder of intervention—a set of increasingly strong regulatory actions to be taken as capital levels fall. Though RBC serves an important function in insurance regulation, regulatory action has typically occurred well before the company breaches the RBC action triggers, as a result of the off-site monitoring system of analysis and examination. Where monitoring results trigger regulatory attention before RBC results do, the Hazardous Financial Condition Model Regulation (described below)


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provides the authority for regulatory action. RBC is primarily a factor-based approach. However, internal models are used for certain targeted risks where a factor-based approach has been determined to be inadequate. 5. Regulatory Control of Significant, Broad-based, Risk-Related Transactions and Activities. Certain significant transactions and activities that affect policyholders’ interests must receive regulatory approval. These include licensing a company to transact business, the change of control over the company, the payment of material dividends, and transactions with affiliates (including affiliated reinsurance). 6. Preventive and Corrective Measures, Including Enforcement. When risks are identified as a result of on-site or off-site monitoring, the regulator will take preventive and corrective measures that are timely, suitable, and necessary to reduce their impact on the company, thereby protecting policyholders. It is for this reason that solvency regulation is considered one of the most important consumer protection functions of state insurance regulation. The NAIC’s Hazardous Financial Condition Model Regulation—a required element of the NAIC Accreditation Program—provides the regulatory authority to address risky behaviors and characteristics exhibited by insurers. The regulation identifies a number of general factors that may indicate the need to take action, and it provides the regulator with the authority to intervene in a variety of ways, including requiring the insurer to hold additional capital. The FAWG, mentioned earlier, often serves as a forum for collaboration and problem-solving with respect to potentially troubled insurers and groups. Once the NAIC staff, or another regulator, identify an insurer or group in need of attention, the FAWG will review the available facts, ask questions of the domiciliary or the lead regulator(s), and often invite that regulator in to discuss the situation and their supervisory plan. Those discussions may lead to further requests for information, to additional discussions through regular meetings or calls, and even to recommended regulatory actions.5 The FAWG process, which has existed for over 15 years, is a model of a multijurisdictional peer review process. By engaging a variety of regulatory perspectives to assist and encourage a domestic regulator who is dealing with a troubled insurer, the FAWG promotes effective and timely regulatory intervention. 7. Exiting the Market and Receivership. The legal and regulatory framework defines a range of options for the orderly exit of insurers from the marketplace, including a receivership scheme that prioritizes the payment of policyholder obligations.


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The regulatory tools and activities embedded in these core principles create a robust regulatory system. Each state regulator is ultimately responsible for the solvency of insurers in its state. Insurers provide detailed information to regulators on an ongoing basis, which is supplemented by other market data to permit ongoing monitoring of individual companies and insurance markets. Financial analysis tools, which are developed and maintained by individual states and by the NAIC centrally, facilitate analysis of this detailed information. Periodic on-site examinations of insurers complement the ongoing financial analysis. Accounting and capital requirements establish triggers for required company and regulatory action,


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although in most cases, off-site monitoring has triggered action under the Hazardous Financial Condition Model Regulation. Regulatory control of significant transactions and activities provides explicit oversight of targeted company activities, and a developed process exists for rehabilitating or winding down insurers. The NAIC Accreditation Program articulates the requirements for individual states to be accredited and evaluates each state’s ability to meet those requirements. Underlying all of these elements are the robust peer review processes, including, for example, the Accreditation Program and FAWG, in which there is multistate review of the regulatory and supervisory processes in a given state. The NAIC provides central support for multistate policy making and the multistate review processes.

The Solvency Modernization Initiative (SMI) The NAIC’s SMI is a critical self-examination of the United States’ insurance solvency regulation framework. As part of this effort, the NAIC is reviewing international developments regarding insurance supervision, banking supervision, and international accounting standards, and the organization is evaluating their potential use in U.S. insurance regulation. U.S. solvency regulation is updated on a continual basis, but the SMI is an attempt to take a comprehensive and fresh look at the current system in the United States.6 The SMI will focus on a number of key solvency areas: capital requirements, financial analysis, international accounting, insurance valuation, reinsurance, corporate governance, risk management, and group regulatory issues. Other areas may be identified as the project proceeds. The basic outline of the SMI workplan includes: • Articulation of the U.S. solvency framework and principles. This item has been completed and was discussed in the previous section. • Study of other sectors’ and other countries’ solvency and accounting initiatives, and of the tools that are used and proposed. Particular areas of focus are: the Basel II international framework for banks and its implementation in the United States; solvency work of the International Association of Insurance Supervisors (IAIS); solvency proposals in place or under development in other jurisdictions, including Australia, Bermuda, Canada, Switzerland, and the European Union (EU); and accounting standards being developed by the International Accounting Standards Board (IASB) as part of the convergence project between the Financial Accounting Standards Board (FASB) and the IASB. • As appropriate, development of improvements to the U.S. solvency regulatory system. To undertake this work, the NAIC has created a high-level task force known as the Solvency Modernization Initiative Task Force. The mission of the SMI Task Force is to coordinate all NAIC efforts to successfully accomplish the SMI. This will involve developing an SMI Roadmap, including proposed assignments for other NAIC committees, task forces, and working groups, with deadlines for completion. There are a number of working groups reporting to the Task Force, including the Corporate Governance Working Group, Group Solvency Issues Working Group, International Solvency




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In December 2009, the NAIC released two consultation papers: (1) Consultation Paper on Regulatory Capital Requirements and Overarching Accounting/Valuation Issues for the Solvency Modernization Initiative and (2) Consultation Paper on Corporate Governance and Risk Management. An interim meeting was held in March 2010 to discuss the responses and plan the next steps.

Regulatory Capital Requirements and SMI Current U.S. Regulatory Capital Requirements. The NAIC’s RBC regime began in the early 1990s as an early warning system for U.S. insurance regulators. It is structured as an extensive factor-based approach that applies to risks on both the asset and liability sides of a conservative solvency-focused balance sheet.7 Separate formulas were developed for life insurers, property-casualty insurers, and health insurers. For life insurers, the factors are intended to capture risks related to assets, asset/liability mismatch, underwriting (or insurance), credit risk, and some aspects of business risk. The property-casualty formula includes factors intended to address asset risk, underwriting and reserving risk, credit risk, and some aspects of business risk. The specific factors have evolved over time. The RBC formulas apply a fairly simplistic covariance calculation to the multiple risk areas (essentially assuming a covariance of either zero or one). The RBC-implementing legislation creates four intervention levels, which authorize four stages of regulator or company action, eventually leading to mandatory regulatory control of the company. 8 Under the implementing legislation, an insurer that breaches the Company Action Level must produce an action plan to restore its RBC levels. This could include adding capital, purchasing reinsurance, reducing the amount of insurance it writes, or pursuing a merger or acquisition. In the late 1990s, the NAIC began to introduce internal models-based components to its RBC system for life insurers. The first phase, known as C-3 Phase 1, specifically targeted interest rate risk for fixed annuities and was implemented December 31, 2000. On December 31, 2005, the NAIC implemented C-3 Phase 2, which introduced a new capital requirement for variable annuities. This change was motivated in large part by the recognition that insurers were developing products with increasingly complex guarantees, and that the risks embedded in these guarantees were not captured by the central factor-based capital requirements. The extended and deep equity downturn in the early part of the first decade of the twenty-first century heightened the regulatory awareness of these risks and led to the decision to superimpose an internal-models based approach on the factor-based capital requirements.9 Work is underway to develop a new RBC requirement for life products (C-3 Phase 3). Intricately intertwined with the introduction of models-based capital requirements for life insurers are efforts aimed at modernizing the determination of


Working Group, International Accounting Standards Working Group, Principles-Based Reserving Working Group, and Statutory Accounting and Financial Reporting Subgroup. Detailed information on the activities of the various working groups and the SMI Task Force can be found at http://www. naic.org/index_smi.htm.


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reserves (i.e., technical provisions). While the determination of loss reserves for property-casualty insurance is already principles-based, life insurance reserves have not been. Traditionally, the U.S. insurance regulatory system has required that U.S. life insurance reserves be determined using conservative mortality and interest rate assumptions. Risks other than mortality and interest rate risk were not explicitly recognized. Over the past 30 years, however, the industry has developed new products with a variety of guarantees, and the portion of its business that is tied to asset accumulation, rather than traditional life insurance, has increased. The old rules failed to properly account for the risks in the new products, and the traditional rules-based approach to calculating reserves had to be modified for each new product. After attempting to modify the rules with each product evolution, the regulators concluded that a more comprehensive change was needed. Principles-based reserving is the proposed solution. A key feature of the evolution toward internal models in life insurance in the United States—in contrast to the approach in the EU—is that it has been incremental. Internal models-based capital requirements are intended to capture risks that the factor-based capital requirements failed to capture, and the new requirements often supplement, rather than replace, existing factor-based requirements. A second feature of the U.S. system is the inclusion of significant safeguards that have accompanied the introduction of internal models. A healthy skepticism of internal models by some states resulted in the NAIC incorporating a standard scenario into its capital requirement and reserving standards for variable annuities. The standard scenario is a single scenario with specified assumptions, independent of a particular company’s experience. That is, while the insurer is permitted to calculate its required capital and reserves by using internal models with its own inputs, it must also calculate them using a standard deterministic scenario provided by the regulators. This scenario serves as the f loor for the reserves and required capital. According to the NAIC’s Life and Health Actuarial Task Force, the standard scenario assumptions are not intended to produce requirements that would be adequate most of the time. Rather, they are to ensure that the requirements are not unreasonably low, particularly given the lack of experience in applying internal models in this context. Regulators see the standard scenario as providing reasonable constraints to the f lexibility given to actuarial judgment when doing stochastic modeling. A third aspect of the U.S. system that merits mention in today’s environment is the element of countercyclicality built into U.S. financial reporting requirements. In the United States, life insurance companies are required to establish an Asset Valuation Reserve (AVR), a liability that is intended to absorb market value and credit-related realized and unrealized gains and losses. Gains increase the reserve up to the maximum required reserve; realized losses decrease the reserve. The end result is that the impact of gains and losses on the surplus of the company is dampened (at least until the reserve is completely depleted). The maximum AVR is determined by a factor-based formula, similar in nature to the life RBC asset risk calculation.10



The Impact of SMI. The NAIC’s Consultation Paper on Regulatory Capital Requirements and Overarching Accounting/Valuation Issues for the Solvency Modernization Initiative, released in December 2009, concentrated on the capital


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The comments and discussions that occurred during the interim meeting highlighted an important feature of the U.S. regulatory system. Risk-based capital is considered to be only one of a panoply of weapons in the regulatory arsenal. Several regulators opined that the NAIC’s Hazardous Financial Condition Model Regulation was more likely to be the weapon of choice in dealing with a company engaged in risky activities. Risky behaviors were typically identified well before the company triggered company or regulatory action levels in the RBC system. For many regulators, RBC’s importance was to provide a clear, undebatable threshold for regulators to take action or to assume control of the firm. The objective nature of the RBC thresholds, and the limited need to engage in debate with a company over whether a threshold was triggered, was held by many regulators to be a critical feature of the system. Many commenters and regulators also drew a clear distinction between a firm’s economic capital calculations and its regulatory capital requirements. Economic capital was viewed by many to be a tool for managing the firm, while RBC was intended to be a basis for triggering regulatory intervention. Well-run firms have an incentive to develop economic capital measures that promote effective risk management. While regulatory capital requirements in the United States should not discourage effective risk management, their purpose is primarily not to duplicate the incentives embodied in economic capital measures. In fact, many U.S. regulators seemed comfortable with the idea that regulatory capital would typically be well below economic capital and would not interfere with it. This reaction likely ref lects regulatory satisfaction with the strength of off-site monitoring and on-site examinations in detecting risky behaviors, and with the ability to use the Hazardous Financial Condition Model Regulation to take action. In the United States, efforts to strengthen the detection of risky behaviors are more likely to focus on gathering and analyzing information targeted at those risks, rather than on internal measures of the capital required to hold the risk. While this issue clearly requires additional discussion, a possible direction for SMI seems to be emerging. In some parts of the world, supervisors view a focus on internal models as a way to identify excessive risk taking relative to the amount of capital held, or, alternatively, to force firms to hold “adequate” capital. In this perspective, internal models are used to target capital at the right level, and the focus of regulatory intervention is on whether those capital levels are breached. Understanding the way the firm looks at risk, comprehending their economic capital systems, and basing regulatory capital requirements on their own internal capital management systems (“the use test”) are the primary means of analyzing the risk profile of the firm. In some sense, regulatory capital requirements and risk monitoring become synonymous. In the United States, where robust off-site monitoring systems exist, regulators are considering the relative advantages and disadvantages of moving to that model. The disadvantages include: (1) losing the clarity of the action thresholds that exist in a factor-based system, (2) subjectivity and lack of transparency in


requirements focus area of SMI. Because of the interconnectivity of capital requirements with accounting and valuation, some overarching accounting/valuation issues were also explored. Thirteen comment letters were received, and a 1½ -day public meeting was held in March 2010 to discuss the comments.


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the way regulatory capital requirements are determined from firm to firm, and (3) the likelihood that regulators will be outgunned by the “rocket scientists” at the regulated firms. The advantages are less clear. To the extent that the use of economic capital measures to set regulatory capital requirements are framed as a way to better understand the risk profile of the firm in order to take appropriate action, many U.S. regulators would respond that their robust financial analysis and monitoring systems already do that. Where additional understanding is needed, further information can be gathered, including the firm’s own internal risk measures. What additional value is gained by basing regulatory capital requirements on those measures?11 To some extent, this is a question of where regulatory capital measures are calibrated. If regulatory capital requirements are intended to incent firms to engage in effective risk management, they must be calibrated at a constraining level, and the sensitivity of the requirements to different levels of risk becomes more important. Regulatory capital requirements must be “precise” to avoid creating inefficient incentives in the market. Here, regulatory capital requirements serve a function more akin to rating agency capital requirements. On the other hand, where capital requirements are a f loor, blunter measures can be used, and regulatory capital requirements are less likely to inf luence firm behavior at the margin.12 In this case, regulatory capital requirements are crucial as a trigger for resolution (or certain specified actions before that), and other mechanisms for triggering regulatory action are more important. It is this second model that more appropriately characterizes the U.S. system, with its well-developed systems of financial reporting, analysis and monitoring, examination, and peer review, providing the tools and incentives to encourage appropriate regulatory action. Clearly, the question of what the role of regulatory capital is needs to be answered. The answer to this question will drive much of the direction of the SMI work related to regulatory capital requirements. Regardless of the answer to this question, it seems clear that work will be undertaken in modernizing the NAIC’s system of regulatory capital. U.S. regulators recognize that internal models are useful for certain risks, as indicated by the NAIC embracing the use of internal models for certain elements of the life risk-based capital formula. There is considerable interest in expanding the use of internal models to certain catastrophe risks (e.g., hurricanes, earthquakes). The current factors in the models will likely be studied to determine whether they should be recalibrated, and the overall calibration of the RBC formulas will be studied. The current 1–6 rating of assets may be made more granular. Following the implementation of RBC C-3 Phase 2, regulators have identified some issues with the recognition of hedging arrangements, and that will be revisited. Consideration will be given to more formally incorporating stress tests into the regulatory framework and to requiring that firms provide regulators with their Own Risk and Solvency Assessment (ORSA). Other ideas will undoubtedly emerge as the process continues.



Conclusions The last major revision to the U.S. system of solvency regulation was undertaken with the Solvency Policing Agenda of 1989, when U.S. regulators introduced the


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risk-based capital system, the Accreditation Program, and new financial analysis, coordination, and peer review processes. Many improvements have been made over the years, including the codification of statutory accounting principles, the introduction of enhanced risk-focused exams and the Risk-Focused Solvency Framework, the adoption of the Model Audit Rule, and revisions to risk-based capital, including the addition of internal models for certain life insurance products’ risks. The SMI was announced in 2008 and is a critical self-examination of the U.S. solvency regulation framework. While the SMI will undoubtedly result in improvements in the U.S. system of solvency regulation, the most important objective of insurance regulators is to avoid harming the U.S. system of solvency regulation, a system that has a history of success in protecting U.S. policyholders while maintaining strong and vibrant insurance markets.

Notes These are the personal opinions of the author and do not necessarily ref lect the views of the National Association of Insurance Commissioners or its members. 1. See, for example (Polakoff 2009). Although AIG is often described as an insurance group, it is actually a large, complex financial institution with significant insurance operations. Because it owned a thrift, it was subject to holding company supervision by the Office of Thrift Supervision (OTS). The U.S. insurance regulators were the functional regulators of the insurance subsidiaries. The problems at AIG occurred largely in its Financial Products (FP) division, a noninsurance operation based out of London. AIG FP had written credit default swaps for European and U.S. banks. When asset prices fell, those banks made collateral calls, and AIG could not meet them. See, for example(Polakoff 2009) for OTS’ explanation of failures in supervising AIG. A secondary issue involved the securities lending operation of the life insurance company subsidiaries. The insurance regulators had identified the issue prior to AIG’s failure and had been working with the company, with some success, to reduce the securities lending activities and exposure. The FP collateral calls and resulting reputational impact created a run on the securities lending operation that prevented the risk reduction from continuing. While this resulted in some losses at the insurance subsidiaries, the New York State Insurance Department has testified that it would not have rendered them insolvent. In fact, the insurance subsidiaries continue to be valuable assets, and AIG is selling its insurance subsidiaries to repay the financial assistance provided by the U.S. government. For a further discussion of AIG within the context of systemic risk, see (Harrington 2009). 2. See (NAIC 2010). 3. For a more complete description of the role of checks and balances in the U.S. regulatory system, see (Vaughan 2009). 4. The risk-focused examination is part of a broader effort adopted by the NAIC in 2004, known as the Risk-Focused Surveillance Framework. The Risk-Focused Surveillance Framework ties together four functions, most of which had been performed previously, and coordinates them in a more cohesive manner to be applied consistently applied by regulators. These four elements are (1) risk-focused exams, (2) off-site risk-focused financial analysis, (3) examination of internal and external changes in the organization, (4) and an annual supervisory plan for the insurer developed by the domestic regulator. An Insurer Profile Summary is used to “house” summaries of risk-focused examinations, financial analysis, internal/external


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5.

6. 7.

8.

9.

10.

11.

12.

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changes, the Supervisory Plan and other standard information. It provides an Executive Summary of an insurer’s financial condition, risk profile, regulatory actions/plans, and other highlights. The need for enhanced peer review processes has been highlighted by the current financial crisis. According to (McCarthy 2009), the former chairman of the U.K. Financial Services Authority, “(A)t present, national supervisors do not challenge each other’s decisions often or fiercely enough . . . We need a better process of robust challenge, with an enforcement process that involves at least a strong element of naming and shaming.” He has proposed expanding the International Monetary Fund’s Financial Sector Assessment Program process and creating formal peer review processes in the European Union. See also (The de Larosiere Group 2009): “The present processes and practices for challenging the decisions of a national supervisor have proven to be inadequate . . . The Group believes that an effective means of challenging the decisions of the home regulator is needed . . . Equally, the Group believes that an effective mechanism is needed to allow home supervisors to challenge decisions made by host supervisors.” For detailed information on the NAIC’s Solvency Modernization Initiative, see http://www.naic.org/index_smi.htm. The RBC formula uses the data reported in the audited statutory annual statement, which utilizes conservative accounting rules adopted by the NAIC. Analysis of RBC is not complete without also evaluating the conservatism in the underlying inputs to the formula. The four action levels are: Company Action Level, Regulatory Action Level, Authorized Control Level, and Mandatory Control Level. In addition to the RBC calculation extensively based on factors, there are two trend tests that were introduced over the years. These trend tests place an otherwise adequately capitalized insurer into the company action level under certain circumstances. Under the life company formula, an otherwise adequately capitalized life insurer may be placed at the company action level if there has been a specified deterioration in its RBC position over the past year. Under the property/casualty formula, a combined ratio of greater than 120% could cause an otherwise adequately capitalized insurer to be subject to the company action level. C-3 Phase 1 and Phase 2 have been implemented in all states. In most states, the NAIC’s risk-based capital system is specifically referenced in state law, so changes to the NAIC formula are automatically implemented in the state. It is important to note that the AVR does not smooth surplus for risk-based capital purposes, however. When calculating the Total Adjusted Capital for purposes of RBC, the AVR reserve is added back to surplus. For information on the AVR, see http://www.naic.org/documents/svo_avr_imr_blue_book.pdf. His question is particularly relevant given the disappointing results of internal models during the recent financial crisis. A widespread view prior to the financial crisis was that firms had an incentive to properly manage risk and that the validity of the model could be judged, in part, by whether the firm used its output (“the use test”). The results of the financial crisis have raised questions about these basic assumptions. They have also increased regulator and firm appreciation of the significance of model risk. In this model, regulatory requirements are less likely to be the primary motivator for a firm’s risk management activities. They are also less likely to interfere with a firm’s own risk management activities, and the market will expend fewer resources attempting to arbitrage around regulatory capital requirements.




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Harrington, S. “The Financial Crisis, Systemic Risk, and the Future of Insurance Regulation, September.” 2009. www.namic.org/pdf/090908SystemicRiskAndTheF uture.pdf. McCarthy, Callum. “Britain is not a Regulatory Island.” Financial Times, March 31, 2009. ———. “The United State Insurance Solvency Framework.” 2010. http://www.naic. org/documents/committees_e_us_solvency_framework.pdf. Polakoff, S. Testimony Before the U.S. Senate Committee on Banking, Housing, and Urban Affairs: “American International Group: Examining what went wrong, government intervention, and implications for future regulation.” March 5, 2009. http:// banking.senate.gov/public/index.cfm?FuseAction=Hearings.Testimony&Hearing_ ID=1655fd01–154e- 48de-9fd8 –2832a68f04d6&Witness_ID=ad4b84ae-b2cd46eb-b4f4–4aa20a2f8d1a. The de Larosière Group. “Report of the High Level Group on Financial Supervision in the EU.” February 2009. http://ec.europa.eu/internal_market/finances/docs/de_ larosiere_report_en.pdf. Vaughan, T. “The Economic Crisis and Lessons For (and From) U.S. Insurance Regulation.” Journal of Insurance Regulation 28, no. 1 (2009): 3–18.


Bibliography


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Solvency II: A Balancing Act Pamela Schuermans

Introduction The financial world is in a regulatory fever. Following decades of heralded deregulation, the industry seems in need of guidance, to remind the actors of the consequences of cumulating ill-advised incentives and inadequate actions in a sector which increasingly shapes our society. Europe has been developing a new regulatory framework for the insurance and reinsurance industry, aimed at reinforcing the risk management of undertakings and promoting risk-sensitive supervision. Since the first discussions took place in early 2000, Solvency II has grown into one of the most ambitious legislative projects currently in the European Union (EU). As the implementation deadline draws nearer, the discussions on the details of the measures that will be imposed on the industry have become more intense. While offering advice on the concrete implementation of the Solvency II principles, the supervisory community is being criticized by the industry for being overly prescriptive and heavy-handed, and thus risking losing the spirit of the innovative regulation. Those involved in developing the new European regulatory framework for the insurance sector today may feel the need to balance the interests of all stakeholders between the competitiveness of the industry and prudential supervision, policyholders’ interests and the industry’s aspirations, and large groups and smalland medium-sized undertakings. But there is also a balance to be kept between the complexity of the regulation and the efficiency of supervision, and between adequate harmonization throughout the EU and safeguarding relevant national specificities. At its inception ten years ago, Solvency II seemed, however, to set the standards for a balanced proposal. Has something gone wrong along the way? Did stakeholders increasingly interpret the framework principles from their individual viewpoints? Did the crisis push supervisors, in their advice, to deviate from a balanced economic regulatory and supervisory approach? This chapter aims to analyze certain aspects of Solvency II by shedding light on some of the debates being held in Europe and on the challenges that supervisors


CHAPTER 4


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and the industry are facing. Paired with the ongoing reorganization of the architecture of financial supervision, Solvency II should set the standards for a new regulatory and supervisory era, provided that all stakeholders manage to balance their ambition with realism.

The Solvency II Directive was adopted by the European Council on November 10, 2009, and the date for the start of enforcement of the new regulation will be January 2013.1 The fundamentals of Solvency II can be gleaned from the discussion papers in which the European Commission (EC) presented, to the European Member States, its ideas about a complete overhaul of the regulatory and supervisory framework for the insurance and reinsurance industry. The general aim of Solvency II is to provide supervisors with the appropriate tools to asses the “overall solvency” of insurance and reinsurance undertakings (hereafter: “undertakings”) through quantitative and qualitative measures that inf luence the understanding and the management of the risks faced by undertakings. 2 At the same time, Solvency II is aiming to improve the undertakings’ overall risk management by means of governance and risk management requirements, as well as through the comprehensive quantitative assessment of their risks. This goal was set in response to the deficiencies of the current regulatory framework, which, due to its simplicity, lack of economic approach, and differences in implementation across the EU, currently prevents the European insurance and reinsurance industry from competing and being supervised in an increasingly complex and global world. When setting out the founding principles that govern the design of the new solvency framework, the EC put forward a three-pillar structure inspired by the Basel II banking rules: quantitative requirements (Pillar I), governance of the undertaking and supervisory activity (Pillar II), and supervisory reporting and public disclosure (Pillar III).

Pillar I Two capital requirements are being introduced in Pillar I to ensure the so-called ladder of intervention for supervisory action: the solvency capital requirement (SCR) and the minimum capital requirement (MCR). The quantitative solvency assessment in Solvency II consists of mainly three elements: assets, liabilities (including technical provisions), and available capital (known in Solvency II as “own funds”). The Directive states that the SCR should deliver a level of capital that enables an undertaking to absorb significant unforeseen losses over a one-year time horizon and to give reasonable assurances to policyholders that payments will be made as they fall due.3 The SCR aims to capture the undertaking’s quantifiable risks. All risks attached to the undertaking’s assets and liabilities need to be taken into account in its solvency assessment. The SCR can be calculated by using the standard formula provided for in the implementing measures, or by an internal model in accordance with Solvency II standards. The choice between a standard formula and an internal model should allow undertakings to develop their risk management according to the needs of


Solvency II Basics


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their business and the complexity of their risks. To safeguard this incentive, it is important to ensure that the standard formula sufficiently represents an “average European undertaking.” Where this balance cannot be achieved, undertakings will have the option to partially or fully apply an internal model or, for certain risks, to use undertaking-specific parameters in the calculation of their capital requirements. The main risk categories which have been identified to date in the modular structure of the SCR standard formula are the life underwriting, non-life underwriting, health underwriting, market, and counterparty default risks. These risk modules include relevant sub-modules and an explicit capital charge for operational risk, in addition to the basic solvency capital requirement. The introduction of two explicit capital requirements underlines the role of supervisory intervention. The prospective calculation of the SCR should allow for an accurate and timely intervention by supervisors, whereas the MCR is intended to provide a safety net, a minimum level of security, to be held at all times by the undertaking, and below which the amount of financial resources should not fall.4 The supervisory ladder of intervention and, herewith, the role of the supervisory review process, are explicit elements of the regulatory approach. While temporary breaches of the SCR might be tolerated—although this does not mean that the SCR is a mere “target capital” level; the supervisor will impose restorative action upon breach of the SCR—a breach of the MCR would lead to the withdrawal of the undertaking’s license. In the case of extraordinary circumstances, such as a deviation from the assumptions underlying the standard formula, which cannot be remedied within a specified time frame, or where the undertaking shows severe deficiencies in its governance, the supervisor may impose additional capital charges, the so-called capital add-ons. The importance of the supervisory ladder, which ultimately defines when the supervisor is allowed to exercise its power, helps with understanding the heated discussions that have been held on the design of the MCR and its relation to the SCR. It was ultimately the EC that decided on the design of the MCR, partially following industry views that the limits of the MCR should be set with reference to the SCR—the MCR cannot exceed a fixed percentage of the SCR (45%) and cannot be lower than another fixed percentage of the SCR (25%). The closer that the level of own funds approaches the minimum capital requirement, the stronger and more rules-based the intervention of the supervisor will be. It can be argued that by introducing this rather limitative link between the two solvency capital requirements, the initial purpose of setting two capital requirements is somewhat undone. In addition, the fact that the reference SCR can be either the standard formula SCR or the SCR calculated with the approved internal model will add to the uncertainty surrounding the level of the MCR, especially in the initial phase of application of Solvency II. It is for this reason that the Directive explicitly provides that in the first two years following the enforcement of Solvency II, Members States can allow their supervisors to require the calculation of the reference SCR based on the standard formula.5 In this area, it is important to balance risk sensitivity of the capital requirement and the need for legal certainty to allow for ultimate supervisory action. The capital requirements will need to be covered by capital of sufficient quality to ensure that losses can be covered on a going-concern basis, as well as in the event


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of winding-up. As a tool for insurance risk management, the function of the own funds under Solvency II is to act as a buffer for unexpected losses on the undertaking’s balance sheet. Any expected commitments, claims, or expenses should be covered by the amount of technical provisions set aside for ensuring payment of insurance liabilities as they fall due. The own funds are classified in different tiers according to their ability to cover losses, and an explicit distinction is made between basic own funds and ancillary own funds (off-balance sheet). 6 It is difficult, but essential, to achieve a balance between the coverage of the capital requirements in good times, in terms of the amount and quality of capital, and the availability of the capital in stressed circumstances. Finally, Solvency II applies a market consistent valuation to assets and liabilities for solvency purposes, which should determine the amount for which they could be exchanged (assets), transferred, or settled (liabilities) between knowledgeable willing parties in an arm’s length transaction. What constitutes a laudable economic principle reveals, in reality, existing gaps between national Generally Accepted Accounting Principles (GA APs), the application of the International Financial Reporting Standards (IFRS), and solvency valuation principles.

Pillar II Solvency II puts great emphasis on the responsibility of the undertakings themselves in managing their risks. Quantitative measures cannot address all risks in an undertaking; therefore, an effective governance system should be at the basis of the undertakings’ risk management. The system of governance under Solvency II includes provisions on risk management, internal audit, and the role of the socalled actuarial function. The undertaking should supplement its risk management with its own regular risk and solvency assessment, while the supervisor will monitor the financial and organizational soundness of the undertakings by means of the supervisory review process.7 The general requirements with regard to the establishment of proper risk management practices need to be balanced according to the nature, scale, and complexity of the risks of the undertaking, which should be useful in finding adequate governance structures without creating unnecessary complexity and organizational costs for the undertaking.

Group Supervision


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Solvency II not only aims to improve risk management and supervision of individual (“solo”) undertakings, but also intends to improve the supervision of insurance groups. The integrated approach to insurance and reinsurance groups, and the increased coordination and exchange of information between supervisors in colleges of supervisors on a cross-border basis, will allow for an adapted (solvency) assessment of group specificities. In this area, a proper balance among the need for cooperation, delegation of tasks, and the cross-border exchange of information has to be weighed against the current and future roles and responsibilities of the national—solo—supervisors.


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One of the fundamental elements which will ultimately allow supervisors to carry out their supervisory review is the supervisory reporting, sided by public disclosure. Not only should disclosure provide interested stakeholders with insight into the risks of the undertakings, but it should also form the basis for the reporting to supervisors, thereby enabling supervisors to carry out an informed supervisory review of the undertakings. By including these requirements explicitly in a riskbased supervisory approach, great emphasis is placed on the timely and accurate delivery of information on the undertakings’ financial and solvency positions. In this area, a proper balance must be achieved between the need to inform supervisors and stakeholders, on the one hand, and the administrative burden on the undertakings, on the other.

The Economic Total Balance Sheet One of the fundamental concepts of Solvency II, which gives a good insight into the new framework by combining many of the aspects mentioned above, is the economic total balance sheet approach. The intricacies of this approach show how sophisticated the Solvency II regulation aims to be, by building a coherent system where all elements are intertwined and driven by developments in the market and the risks of the undertaking. The total balance sheet approach applies basically to the Pillar 1 requirements, and it relies on the appraisal of the whole balance sheet of the insurance and reinsurance undertakings, on an integrated basis, where assets and liabilities should be valued consistently. The following paragraphs highlight some of the implications of this approach, regarding the valuation and the level of own funds under Solvency II.

Market Consistent Valuation The Solvency II Directive requires that the solvency position of an undertaking be based on an economic valuation of the whole balance sheet. 8 At the same time, one of the explicit aims of Solvency II is to make valuation standards for solvency purposes compatible with the international accounting standards.9 The IFRS, as adopted by the EC, are being put forward as the reference framework for the valuation of assets and liabilities (other than technical provisions).10 Even if the IFRS are still a work in progress and are not being applied by all undertakings, Solvency II aims to be consistent with international developments, through an alignment with IFRS principles matching the purpose of the economic valuation put forward by Solvency II. The valuation of technical provisions has to be carried out on a best-estimate basis (an explicit risk margin is being calculated where the liabilities are not hedgeable), which in turn depends on market consistent valuation, which requires that future cash f lows be valued by making use of information provided by the financial markets and generally available data on underwriting risks.11 The increasing alignment between the valuation for accounting and solvency purposes should be welcomed. Moving away from the historical cost approach


Pillar III


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ref lects an increasingly widespread conventional wisdom in the financial markets. In light of the recent financial crisis, one should consider whether this approach may better suit the need for long-term shareholder value on the part of reinsurance and insurance undertakings as well, given the important role they play as institutional investors. It can be argued that encompassing solvency aspects in the valuation of assets and liabilities (including for accounting purposes) would allow for better insight into the financial and economic reality of the undertakings. However, as long as there is no harmonization of European accounting regulations, this proposed alignment may lead to uncertainty and a difficult transition for many undertakings and supervisors, especially in those Member States that do not require the application of IFRS for accounting purposes. The handling of different reference frameworks, as well as the risk of limited auditability of the accounts, will render adaptations necessary and make interpretation of the figures even more challenging. What can be said is that the harmonization of the valuation system for accounting, solvency, and disclosure purposes is a welcome development, but it exceeds the scope of Solvency II. The challenges of the Solvency II valuation approach include the debate on the sustainability of market consistent valuation, also known as fair value. During the financial crisis, one could observe a decrease in the value of assets. Market consistent valuation leads to more frequent movements on the balance sheet and gives rise to valuation problems when no observable data exists, for example, where the market no longer functions “normally.” It will be explained below that under Solvency II, the changes in the value of the assets will not only affect the capital requirements, but also the availability of own funds (due to the net asset value principle, explained hereafter). This may lead to procyclical effects due to the Solvency II capital requirements, but also to increased reliance on modelling on both sides of the balance sheet. Furthermore, the valuation of technical provisions under a best-estimate approach requires taking into account data available on the financial market when determining the transfer value of the insurance liabilities. This increased risk sensitivity, and the possibility to allow for a more rigorous measurement of uncertainty in the valuation of technical provisions, is a welcome development which will certainly promote the understanding of the nature of insurance obligations. However, in doing so, many variables need to be taken into account in an increasingly sophisticated manner.

The Net Asset Value


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A direct consequence of the total balance sheet approach is that the level of own funds to be held by the undertaking is measured by the so-called net asset value. This is the difference between the value of the assets and of the liabilities on the balance sheet of the undertaking. The concept of net asset value highlights the important link between the undertaking’s level of own funds and the appropriate valuation of its assets and liabilities, including technical provisions—valuation differences in assets and liabilities will directly affect the amount of own funds that would be available to cover the capital requirements.


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This presents a further development in the prudential approach to capital requirements in the supervision of insurance and reinsurance undertakings in Europe. In line with the total balance sheet approach, the value of own funds will increasingly be dependent on the risks of the undertaking. As the future development of assets and liabilities is not certain, the future level of own funds will also behave stochastically. The level of own funds is, therefore, described by a probability distribution, which measures the likelihood of all possible scenarios and its impact on the level of own funds. In other words, the supervisors’ ability to determine the level of the available own funds will be limited to assessing whether the given amount of capital (except for ancillary own funds, where the supervisor has the power to approve the amount) is eligible to cover a percentage of the SCR or MCR. This fundamental element of Solvency II should be read together with the assumption stated in the Solvency II Directive that the vast majority of the excess of assets over liabilities should be treated as high-quality capital (recital 48), which further limits supervisors’ power to “de-classify” own fund elements ab initio.12 The supervisory community is striving to ensure the quality of the own funds that will ultimately be eligible to cover the capital requirements.13 Supervisors have witnessed, in times of crisis, the call by firms to be permitted to cover their capital requirements with a lower quality of capital—high quality capital being rare and expensive in those circumstances. This opens the way for the inclusion of different sorts of capital, including hybrid capital, on the border between debt and equity, and for potentially lower loss-absorbing capacity. Solvency II will allow for the inclusion of hybrid instruments to cover the solvency capital requirements, up to a certain level, and provided that these elements fulfill the requirements set in the Directive to ensure their loss-absorbing capacity in times of financial distress. Ultimately, all of the efforts being made in the careful elaboration of risk-based capital requirements may fail if the capital that is used to back up the capital requirements is of poor quality. Paired with the abolition of the notion of covering assets—which, under the current EU regulation, requires assets to be tied to the insurance obligations of the undertaking—and the deletion of quantitative limits on investments and asset eligibility criteria, Solvency II presents a radical change in the assessment of the coverage of the capital requirements. Instead of limiting investment in certain assets and the holding of a number of capital elements, Solvency II will merely require undertakings to have assets of sufficient quality to cover their overall financial requirements, and to manage their investments in accordance with the prudent person principle. The risk of holding specific assets should then be covered by the solvency requirements. Therefore, the calibration of the risk modules is a crucial matter in order to ensure that risks are properly captured. But the role of proper risk management and governance of the undertaking becomes even more important in light of the principles stated above.



Ensuring a Proper Calibration The increasing importance of the capital requirements should not lure supervisors and undertakings into assuming that fulfilling the capital requirements will prevent every misfortune. The sophistication of the calculations also should not


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give a false impression of security, not only because the risk measure chosen under Solvency II (as will be explained below) explicitly foresees a possibility of ruin. Capital requirements will necessitate close monitoring while using increasingly sophisticated methods. One of the areas that has attracted a lot of attention during the development of the Solvency II measures is the calibration of the capital requirements. Solvency II has chosen as a risk measure the 99.5% Value-at-Risk (VaR) over a one-year time horizon. This does not mean that, under Solvency II, insolvency events will occur only once every 200 years, or that, on an annual basis, one in every 200 undertakings will fail. Rather, the new solvency regime should ensure that if such an event occurs, there is a probability of at least 99.5% that the firm will have sufficient capital to cover such an unexpected situation for the next twelve months. The effects of this risk measure will have to be simulated in the capital requirements in a factor- or scenario-based calculation. But how does this translate into reality? What financial, economic, or catastrophic event constitutes a one out of 200 event? What data is available to calibrate this charge? When is the data of sufficient quality? As mentioned before, the calibration of the standard formula should cater to the capital needs of an average European firm. Where are the boundaries for including undertaking-specific elements in the standard capital requirements? What does a standard European insurance undertaking look like? Does this standard European undertaking exist? CEIOPS (Committee of European Insurance and Occupational Pensions Supervisors) has made proposals for the calibration of various risk modules, requiring them to make assumptions and some concessions. It is true to say that, even if the recent crisis did not originate in the insurance industry, the industry has been hit hard in its capital reserves and supervisors have to take into account relevant cross-sector developments, not only in order to prevent future regulatory arbitrage and competitive distortions, but also because there are valuable lessons to be learned from the crisis. To mention just one example with regard to risk mitigation techniques, CEIOPS has provided advice on criteria, which should ensure that, under Solvency II, capital relief would be granted only where sufficient assurance exists as to the effectiveness of the risk transfer.14 The calibration of the capital requirements should not be seen in isolation. Under Solvency II, the balance sheet will show reductions in the level of technical provisions and a wider definition of eligible capital. This shift in the level of prudence requires an overall assessment of the financial soundness of the undertaking in order to decide whether Solvency II will ultimately strengthen the prudential framework, or not. Finally, Solvency II also formally introduces in the standard formula the possibility of benefitting from diversification effects by off-setting risks against one another. As it can be assumed that not all risks represented in the solvency capital requirement occur at the same time, the simple addition of the risks could overstate the appropriate amount of capital. Establishing the correlation between risks in normal times, as well as in times of crisis, is a difficult task and depends on a great deal of expert judgment. Small adjustments in the (non-linear) correlation between the risks have a great impact on the level of the capital requirements. One should not expect to find the Holy Grail in the calibration of the capital requirements. The definition of the risk sensitivity in Solvency II will, in the


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initial stages of implementation, need to maintain a sense of technical analysis and economic reality, and future reviews to correlations and calibrations can be expected based on a holistic assessment of the risk of the insurance and reinsurance activity.

In light of the crisis, the EC has proposed to restructure the architecture of financial supervision by creating the European System of Financial Supervisors (ESFS) and the European Systemic Risk Council (ESRC).15 This initiative is based on the increasing need for supervisory cooperation and coordination, but also on the need for a comprehensive understanding of the nature of the risks at micro- and macroprudential levels. In this respect, the proposals put forward by the group of wise men under the chairmanship of Jacques de Larosière have been instrumental.16 Based on the Commission’s proposal, the European Council recommended the establishment of the ESFS, composed of European Supervisory Authorities (ESAs), and supported the creation of a European Systemic Risk Board (ESRB). Following the Council’s compromise proposal for the regulation establishing the European Insurance and Occupational Pensions Authority (EIOPA),17 the European Parliament has delivered its draft report on the Commission’s proposal.18 Once an agreement has been found, the establishment of the ESAs should happen by the end of 2010, transforming CEIOPS into EIOPA. Before outlining some aspects of the new architecture and its relevance for Solvency II, a few facts on the current framework, and more specifically on the role of CEIOPS, are presented below.

A Short Introduction to CEIOPS CEIOPS was set up by the Commission in November 2003 as a Level 3 committee under the Lamfalussy process, and is composed of high-level representatives from the insurance and occupational pensions supervisory authorities of the European Union Member States.19 Since its creation, CEIOPS has contributed to ensuring a convergent approach to regulation and supervision in the EU. In essence, CEIOPS acts as an independent advisory body to the Commission in the insurance, reinsurance, and occupational pensions fields. The Committee also contributes to the common and uniform day-to-day implementation of European Community legislation and its consistent application by the supervisory authorities. It is in this capacity that CEIOPS has been a key contributor to Solvency II by providing technical advice to the Commission for the development of the high-level principles (ref lected in the Directive), as well as the rules for implementing the Directive (so-called Level 2 implementing measures). 20 In 2009, following the Commission’s review of the Lamfalussy process, a revised decision for the establishment of CEIOPS was published. 21 The revision of the Lamfalussy structure resulted in giving CEIOPS and its sister committees for banking and securities—the Committee of European Banking Supervisors (CEBS)


The New Supervisory Architecture and Solvency II: A Match Made in Heaven?


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and the Committee of European Securities Regulators (CESR)—specific tasks to foster supervisory cooperation and convergence, and to enhance the role of the Level 3 Committees in assessing risks to financial stability. 22

Under the new architecture, the European System of Financial Supervisors should form a network of European Community supervisory authorities, leaving the dayto-day supervision of financial institutions at the national level and giving colleges of supervisors a central role in the supervision of cross-border groups. Greater harmonization and the coherent application of rules for financial institutions and markets across Europe should also be achieved. The new supervisory structure will complement the Solvency II regulations in various ways, not only by providing a stronger institutional framework to ensure the coherent application of the new rules, but also by explicitly providing tools that will allow EIOPA and the national supervisors to develop a global risk-based supervision.

Financial Stability For example, in the current proposals, the European Systemic Risk Board (ESRB) will monitor and assess risks to the stability of the financial system as a whole. The ESRB will be responsible for the macroprudential oversight of the financial system within the EU in order to prevent or mitigate systemic risks, thereby avoiding episodes of widespread financial distress and contributing to a smooth functioning of the internal market. 23 This activity will provide the basis for a form of macroprudential supervision, by providing an early warning of systemic risks that build up, and, where necessary, by making recommendations for action. The crisis that ignited in 2007 showed a lack of appropriate analysis and sharing of information on macroprudential risks throughout the world. Where the necessary information was available, this was not sufficiently considered in the supervision at the microprudential level, which resulted in all stakeholders failing to see the “big picture” or the level of interconnectedness between the sectors and countries. On top of this, no sufficiently powerful corrective measures were taken at the right time. 24 The creation of the ESRB would allow for the central analysis of macroeconomic risks and the issuance of systemic risk warnings, in close cooperation with the microprudential supervisors, in particular through the collection of relevant data by the ESAs. The Solvency II Directive explicitly includes the duty on the part of the European Member States to ensure that, in the exercise of their general duties, supervisory authorities should duly consider the potential impact of their decisions on the stability of the financial systems in the European Economic Area, particularly in emergency situations. In times of exceptional movements in the financial markets, supervisory authorities shall take into account the potential procyclical effects of their actions. 25 This duty was inserted at the final stage of negotiation of the Directive, expressing the growing awareness in the course of 2008 that supervisors would have to be more instrumental in safeguarding financial stability and preventing systemic risks. 26


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Under Solvency II, one of the areas that supervisors have to address includes certain procyclical effects of the risk-based capital requirements. CEIOPS has been providing advice on so-called dampening mechanisms, which should prevent procyclical effects from kicking in. For example, in times of market turmoil, supervisors can monitor temporary breaches of the capital requirements or allow for the equity capital charges to be calculated, taking into account a longer averaging period as a basis for the observation of changes in value. 27 Through the interaction between the ESRB and the ESFS—in other words, between macro- and microprudential supervision—the chances of an ineffective response to a financial crisis would be limited by, for example, detecting the circumstances in which crisis measures are necessary.

Cross-Border Harmony The new regulation establishing EIOPA will include its explicit role to act as a mediator in cross-border disputes between supervisors. This would allow EIOPA to settle disputes, with binding effect, upon the request of the supervisors. The areas in which this binding mediation would be applicable still have to be determined, and the political bodies have yet to agree on the scope of the mediation powers. In this respect, a decision will have to be made whether EIOPA will have the ultimate power to adopt decisions vis-à-vis individual market operators. Whereas the Commission made a rather ambitious proposal, the Council, as of today, is not convinced of the need to provide the authority with such broad powers. In awaiting the outcome of the discussions that are being held in the European Parliament, a balance will once again have to be struck between national and European interests.

Cross-Sectoral Consistency From a cross-sectoral perspective, the new architecture will include a Joint Committee of European Supervisory Authorities. The joint committee should further improve cross-sectoral cooperation between the ESAs. This joint committee will not replace the decision-making powers of the individual authorities, but will ensure that decisions are being made in tandem. Today, the Level 3 Committees are cooperating on a regular, though informal, basis in areas that are of common interest. The process is coordinated by one of the committees on a six-month rotating basis. In addition, CEBS and CEIOPS have already cooperated on the regulation and supervision of financial conglomerates in the existing Joint Committee for Financial Conglomerates.



EIOPA’s Unifying Role The new architecture has the potential, more generally, to foster a harmonized implementation of Solvency II by providing the right political message and the effective tools. After long negotiations, supervisors, regulators, and the industry agreed on the broad principles of Solvency II, ref lected in the Directive, which was ultimately adopted in 2009. Currently, the same interested parties are debating the rules that will implement these principles. Considering the level of complexity of the debate in the current phase of development, and the upcoming challenges with respect to the implementation of this framework in the various Member States, a


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central institution such as EIOPA should help ensure that agreements that have been made in the past are not unwound. This can only be achieved by increasing the visibility and powers of the European authority by, for example, allowing EIOPA to draft technical standards, which will be binding upon the national supervisors or by having EIOPA play a role in the review of the implementation of the regulation by Member States. At the same time, the transparency of the decision-making process by the authorities and the European bodies will be improved through stronger institutional accountability on both sides. The new architecture can also help to realize the goals of Solvency II, with regard to comprehensive group supervision, by explicitly allocating tasks to group supervisors and to solo supervisors. In some areas, the future European authority will act as a facilitator for improving groupwide supervision. Solvency II encapsulates the efforts of the European supervisory community to provide a global and advanced regulatory and supervisory framework for groupwide supervision of (re)insurance undertakings, with regard to the economic reality and prudential risks and benefits of the group. This should be further emphasized in the European System of Financial Supervisors. For example, the Solvency II Directive lists some objective criteria that should allow supervisory authorities to reach a joint decision on the choice of a group supervisor. During their discussions, supervisors may consult CEIOPS (or in the future, EIOPA). 28 In comparison to the nonbinding cooperation between supervisors that has taken place in the past, the new European authority, EIOPA, will play an important role in increasing the cohesion between European regulators and supervisors. This process will continue to gradually ensure that all Members will be on board. The new authority will have to become a unifying and stabilizing actor as it faces the challenges of Solvency II.

Conclusions The Solvency II project aims to reinforce the supervision of reinsurance and insurance undertakings in the EU, which today is characterized by a limited harmonization and a lack of risk sensitivity. To this end, the new regulation strives to achieve a global view of the undertakings’ risks. In order to prevent regulatory gaps, crossborder consistency and cross-sector coordination are needed, where relevant. To ensure the success of Solvency II, all stakeholders must remain committed to finding the right balance in the discussions that will lead to the adoption of the regulatory measures. In doing so, what should ultimately prevail is the fundamental protection of policyholders and the prevention of systemic risks. One should not be lured into complacency by the increasing comprehensiveness and complexity of the upcoming regulation. Solvency II will not be able to regulate all risks of the insurance and reinsurance business, nor should this be the aim of the new regulation. However, Solvency II is the only path forward in order to keep pace with the increased sophistication of risk management and the complexity of our globalized financial system. Together with the new powers and responsibilities of the European Supervisory Architecture on micro- and macroprudential levels, Solvency II is bound to improve the understanding and management of the risks of European insurance and reinsurance undertakings.


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All crucial elements have been put in place for ensuring the robustness of the new regulation. It is up to the industry and supervisors to become the change they want to see in the world.

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28.

(EC 2009a). (EC 2001, 2003, 2006). (EC 2009a), Recital 62. (EC 2009a), Recital 60. (EC 2009a), Article 129(3). (EC 2009a), Recital 47. (CEIOPS 2008). (EC 2009a), Recital 45. (EC 2009a), Recital 46. (EC 2002); (CEIOPS 2009a). (EC 2009a), Article 76. (CEIOPS 2009b). (Summit 2009). (CEIOPS 2009c). (EC 2009b, 2009c, 2009d and 2009g). (The de Larosière Group 2009). (European Council 2009). (European Parliament 2010). (EC 2004). (CEIOPS 2005a, 2005b, 2006). (EC 2007). (EC 2009d). (EC 2009e). (EC 2009f ). (EC 2009a), Article 28. (European Parliament 2008). (CEIOPS 2010). (EC 2009a), Article 247.

Bibliography CEIOPS. “Answers to the European Commission on the First Wave of Calls for Advice in the Framework of the Solvency II Project.” 2005a. http://www.ceiops.eu/media/ files/publications/submissionstotheec/050630.pdf. ———. “Answers to the European Commission on the Second Wave of Calls for Advice in the Framework of the Solvency II Project.” 2005b. http://www.ceiops.eu/media/ files/publications/submissionstotheec/Doc07_05-AnswersEC2ndwaveSII.pdf. ———. “Answers to the European Commission on the Third Wave of Calls for Advice in the Framework of the Solvency II Project.” May 2006. http://www.ceiops.eu/ me d i a /f i le s /pu bl ic a t ion s /s u bm i s s ion s tot he e c /C E IOP S -D O C - 03 – 06Answerstothirdwave.pdf. ———. “Issues Paper on Supervisory Review Process and Undertakings’ Reporting Requirements.” August 2008. http://www.ceiops.eu/media/docman/public_files/


Notes


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consultations/CEIOPS-IGSR R-18 – 08%20Issues%20Paper%20on%20SR P%20 and%20Reporting-final.pdf. CEIOPS. “Advice for Level 2 Implementing Measures on Solvency II on the Valuation of Assets and Other Liabilities.” 2009a. http://www.ceiops.eu/media/files/consultations/consultationpapers/CP35/CEIOPS-L2-Final-Advice-on-Valuation-of-Assetsand-Other-Liabilities.pdf. ———. “Advice for Level 2 Implementing Measures on Solvency II Regarding Classification and Eligibility of Own Funds.” 2009b. http://www.ceiops.eu/media/ files/consultations/consultationpapers/CP46/CEIOPS-L2-Final-Advice-on-OwnFunds-classification-and-eligibility.pdf. ———. “Advice for Level 2 Implementing Measures on Solvency II: SCR Standard Formula—Article 111 f Allowance of Reinsurance Mitigation Techniques.” 2009c. http://www.ceiops.eu/media/files/consultations/consultationpapers/CP52/CEIOPSL2-Final-Advice-on-Standard-Formula-Reinsurance-mitigation.pdf. ———. “Advice for Level 2 Implementing Measures on Solvency II: SCR Standard Formula—Article 111 and 304 Equity Risk Sub-Module.” 2010. http://www.ceiops. eu/media/files/consultations/consultationpapers/CP69/CEIOPS-L2-Advice-Designand-calibration-of-the-equity-risk-sub-module.pdf. European Commission (EC). “Note to the Solvency Subcommittee of the Insurance Committee, Solvency II: Presentation of the Proposed Work.” March 2001. http:// ec.europa.eu/internal_market/insurance/docs/markt-2027/markt-2027–01_en.pdf. ———. “Regulation (EC) No 1606/2002 [ . . . ] of 19 July 2002 on the Application of International Accounting Standards.” September 2002. http://eurlex.europa.eu/ LexUriServ/LexUriServ.do?uri=OJ:L:2002:243:0001:0004:en:PDF. ———. “Design of a Future Prudential Supervisory System in the EU; Recommendations by the Commission Services.” March 2003. http://ec.europa.eu/internal_market/ insurance/docs/markt-2509–03/markt-2509–03_en.pdf. ———. “Decision of 5 November 2003 Establishing the Committee of European Insurance and Occupational Pensions Supervisors.” January 2004. http://www. ceiops.eu/media/files/aboutceiops/decision_2004–6_en.pdf. ———. “Amended Framework for Consultation on Solvency II.” April 2006. http:// ec.europa.eu/internal_market/insurance/docs/markt-2506 – 04/amended-framework_en.pdf. ———. “Review of the Lamfalussy Process—Strengthening Supervisory Convergence.” November 2007. http://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:52 007DC0727:EN:NOT. ———. “Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the Taking-Up and Pursuit of the Business of Insurance and Reinsurance (Solvency II).” 2009a. http://eur-lex.europa.eu/JOIndex.do?year=2009 &serie=L&textfield2=335&Submit=Search&_submit=Search&ihmlang=en. ———. “Driving European Recovery.” 2009b. http://ec.europa.eu/commission_barroso/president/pdf/press_20090304_en.pdf. ———. “European Financial Supervision.” 2009c. http://ec.europa.eu/internal_market/f inances/docs/committees/super vision/communication_may2009/impact_ assessment_fulltext_en.pdf. ———. “Proposal for a regulation [ . . . ] establishing a European Insurance and Occupational Pensions Authority.” 2009d. http://ec.europa.eu/internal_market/ finances/docs/committees/supervision/20090923/com2009_502_en.pdf. CEIOPS. “Decision of 23 January 2009 establishing the Committee of European Insurance and Occupational Pensions Supervisors.” 2009e. http://www.ceiops.eu/ media/files/aboutceiops/EC-Decision-2009–79-EC-establising-CEIOPS.pdf.


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CEIOPS. “Staff Working Document accompanying the proposal for a regulation [ . . . ] establishing a European Insurance and Occupational Pensions Authority, Impact Assessment, Brussels.” 2009f. http://ec.europa.eu/internal_market/finances/docs/ committees/supervision/20090923/20090923_impact_en.pdf. ———. “Staff Working Document accompanying the proposal for a regulation [ . . . ] establishing a European Insurance and Occupational Pensions Authority, Impact Assessment.” 2009g. http://ec.europa.eu/internal_market/finances/docs/committees/supervision/20090923/sec2009_1233_en.pdf. European Council. “Proposal for a regulation of the European parliament and the Council establishing a European Insurance and Occupational Pensions Authority (EIOPA)—Presidency compromise.” December 2009. http://register.consilium. europa.eu/pdf/en/09/st16/st16749-re01.en09.pdf. European Parliament. “Amendments to the Proposal for a Directive (Solvency II).” June 2008. http://www.europarl.europa.eu/meetdocs/2004_2009/documents/ am/735/735864/735864en.pdf. ———. “Draft Report on the proposal for a regulation of the European Parliament and of the Council, establishing a European Insurance and Occupational Pensions Authority .” February 2010. http://www.europarl.europa.eu/sides/getDoc.do? pubR e f= - // E P// NONS G M L + C OM PA R L +PE -3 8 .410 + 01+D O C +WOR D +V0 // EN&language=EN. Summit, P. “Leaders’ Statement.” September 2009. http://www.pittsburghsummit.gov/ mediacenter/129639.htm. The de Larosière Group. “Report of the High-Level Group on Financial Supervision in the EU.” February 2009. http://ec.europa.eu/internal_market/finances/docs/de_ larosiere_report_en.pdf.




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Solvency II: A New Regulatory Frontier Paul Sharma and Paolo Cadoni

Prudential Regulation for Insurers in Europe: Looking Back . . . Current insurance regulations in Europe are detailed and differ between life and nonlife insurance companies. These regulations are the results of a lengthy process that began in the late 1950s.1 The stimulus for harmonized requirements for insurance companies across Europe was provided by the Treaty of Rome, 2 which established the European Economic Community (EEC), now the European Union (EU). Article 2 of the Treaty of Rome laid out the goals for a common market and an economic and monetary union. This process first required the granting of the freedom and right for an establishment to set up an agency or branch in another Member State.3

First Stage: 1973–1979 The first steps toward the establishment of the free market in insurance within the EU began when the First Non-Life 4 and Life Directives5 of the EU were adopted on July 24, 1973, and March 5,1979, respectively. These two Directives • defined the conditions for carrying on insurance business within the EU; • provided for authorization and prudential supervision of an individual (solo); • set out the requirements that the companies within the EU must meet in order to fulfill the solvency assessment.


CHAPTER 5

The main reason for the delay of nearly six years between the First Non-Life and the Life Directive is the disagreement amongst Member States whether an insurance company should be allowed to carry on both life and nonlife business. In fact, with the adoption of the first Life Insurance Directive, the right to grant authorization that allowed undertakings to do “composite business” (both life and nonlife business from the same company) was abolished. Existing companies authorized


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to do composite activities were allowed to continue their business (i.e., “old-style composites”), provided that separate management was adopted in accordance with the coordinated rules laid down in the Directive. These two Directives, which were based on the pioneering work by Cornelis Campagne 6 in the 1950s–1960s, required insurers to carry reserves of liquid capital over and above normal “technical” or “mathematical” reserves (i.e., solvency margins) against unforeseen events such as higher than expected claims levels or unfavorable investment results. These solvency margins were expressed as proportions of premium income and claims expenses, and they were calibrated using data from a period when insurance markets in Europe were typically far less open, competitive, and dynamic.

Second Stage: 1988–1990 The second steps toward the establishment of the free market in insurance within the EU were the adoption of the Second Non-Life7 and Life Insurance Directives 8 on June 22, 1988, and November 8, 1990, respectively. These two Directives set out requirements for the exercise of cross-border life and nonlife insurance business in accordance with Article 59 of the Treaty of Rome.9 The approach followed for the Second Non-Life Insurance Directive aimed to balance the needs of consumer protection and the freedom to provide services. Thresholds were created to determine which risks could be written across national borders. On the one hand, firms that engaged in large risks such as marine, aviation, transport insurance, and credit insurance of professional, industrial, and commercial policyholders enjoyed freer access. On the other hand, those firms that engaged in mass risk required approval from host Member States. Unlike the Non-Life Directive, the Second Life Insurance Directive did not differentiate between mass and large risks.10 However, the Second Life Insurance Directive drew the line between own-initiative business (i.e., passive business) and active business (i.e., companies that actively seek business in other countries). Groups that carried out passive business had only to notify the host country when underwriting a policy, but they did not need approval for rates and conditions.

Third Stage: 1992 The adoption of the Third Life11 and Non-Life12 Directives on November 10, 1992, and June 18, 1992, respectively is the culmination of the final goals of the Treaty of Rome—the eventual creation of a single passport that enables free access to establish offices in any EU country. This was based on the concept of minimum harmonization and mutual recognition. More specifically, insurance companies, on the basis of authorization in any one Member State, are entitled to sell throughout the entire EU without any price control or prior notification of terms and conditions (except for compulsory insurance). Under this “single passport” system, insurance undertakings authorized by prudential authorities in one Member State can sell in another Member State, either directly (e.g., by telephone or the Internet) or by setting up a branch or a subsidiary there. In addition to the features described above, disclosure of information to policyholders is necessary before a contract is initiated as well as during the contract.


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Finally, life insurers can seek authorization to write health and accident insurance as main classes, rather than as an ancillary business, as was done previously.

In 1997, the findings of the “Müller report,”13 —prepared under the aegis of the predecessor of the Committee of European Insurance and Occupational Pension Supervisors (CEIOPS), which is the Conference of the Insurance Supervisory Services of the Member States of the European Union —led to a review of the solvency rules. This review initiated the Solvency I project, which was completed in 2002 with the adoption of two Directives14 that came into force in 2004. Solvency I represents the first stage in a more fundamental review of the prudential regime, and the revised capital requirements were designed as an interim measure. Solvency I introduced some additional parameters in solvency evaluation.15 On the one hand, Solvency I led to a simple system, easy to understand and inexpensive to monitor. However, Solvency I concentrated essentially on only one, albeit important, aspect of the financial position of an insurance undertaking, the solvency margin,16 not paying sufficient attention to the fact that the overall financial position of an insurance undertaking also depends on other factors. These factors include the level of prudence in the valuation of liabilities, the valuation of assets held to cover these liabilities and the matching of assets to liabilities, the strength and nature of the reinsurance arrangements, and the implications of accounting and actuarial policies adopted. As the solvency margin of Solvency I is mainly based on volume, it does not consider risks explicitly; thus, it does not provide incentives for insurers to improve and invest in risk management (e.g., to manage risk properly and allocate capital efficiently). For example, asset risks are not recognized in the capital requirement, and the effects of pooling, diversification, and reinsurance are only recognized to a limited extent. Moreover, although Solvency I recognizes that some lines of business are larger than others in terms of net premium written, it does not take into account the fact that two lines of insurance writing the same amount of business may face very different exposures to unexpected losses. The level of prudence required in technical provisions is undefined. Personal auto and medical malpractice may each comprise 50% of a company’s written premium. However, personal auto is typically a stable line of insurance, and its loss profile can generally be predicted with reasonable accuracy. Medical malpractice, on the other hand, is a notoriously volatile line and often incurs losses that could not have been anticipated, for example, due to changes in legislation. Therefore, the capital cushion provided to the latter line of business should be significantly higher than that reserved for the former. This does not facilitate accurate and timely intervention by supervisors. The current approach of “supplementary supervision” of groups, as set out in the Insurance Groups Directive,17 is based on a model of loose, voluntary cooperation between supervisory authorities, where the main focus remains on the subsidiaries of the group. The gap between the way groups are managed and supervised not only increases costs for insurance groups but also increases the danger that some key group-wide risks may be overlooked. As new financial instruments and risk management techniques have advanced, issues like guarantees, embedded options, and proper matching of assets and


Solvency I


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liabilities were largely neglected in many countries. Lessons learned from insurance company failures and from the years 2002–03, when financial markets fell sharply, increased the scrutiny of both the industry and regulators on the importance of good risk management practice. Solvency I proved to be neither sufficiently risk sensitive, nor capable to cope with the increase in market complexity (e.g., to accurately capture new and emerging risks) and rising consumer protection needs. Over the past few years, these shortcomings have gradually led to large differences between regulatory capital and the economic capital measures used to run an insurance business. Recognizing the weaknesses in the current framework, some EU Member States developed additional requirements that have resulted in widely diverging capital requirements and supervisory practices throughout the EU. Dual systems for capital regulation are in use in some states, including the UK.18 The resulting lack of harmonization has led to a lack of comparability between the amount of capital used and disclosed throughout the EU. This undermines the proper functioning of a single market in insurance services and imposes significant costs on insurance groups operating in more than one Member State. Thus, the European Commission (EC) developed the Solvency II project.

The Future of Prudential Regulation for Insurers in Europe: Towards Solvency II Organization of the Work In May 2001, the EC began a fundamental review of insurance regulation,— the “Solvency II” project. The project was divided into two phases. The first phase (2001–2003) of this project was a learning stage. Member States and the Commission Services carried out a number of studies19 to inform the decision on the general design and outline of the future EU solvency system. In the second phase (2003 onward), further work to elaborate detailed solutions, draft regulatory texts, and conduct field-testing has been carried out. This work is addressing more detailed technical issues and calibrations. In developing and finalizing this work, comprehensive consultations and quantitative impact studies with all market participants are being carried out. The first phase of Solvency II analyzed the current regime and provided an assessment of the building blocks and principles of the future system, as well as specifications of the fundamentals of the future supervisory system. Two important reports were commissioned as part of these initial analyses. The first study, conducted at the EC’s request, is the KPMG study, 20 concluded with recommendations for a three-pillar structure of insurance supervision. This structure was adapted from a three-pillar structure for the banking sector. 21 The second and more focused study was carried out under the aegis of the EU Insurance Supervisory Conference and led to the publication of the inf luential “Sharma report.” 22


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The Sharma Report In May 2001, the Conference of the Insurance Supervisory Services of the Member States of the European Union was asked by the EC to make recommendations for the review of insurance regulation. In formulating its proposals, the EU Insurance


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Supervisory Conference was asked to regard the practical lessons learned from the past (i.e., investigate the risks that threatened the solvency of insurance companies operating in Europe), to highlight emerging trends in the risks faced by insurance companies, and to consider existing supervisory practices in light of these risks. The report analyzed supervisory toolkits and early warning systems, insurance failures, and near misses, with the aim to increase the supervisory understanding of the risks to solvency of insurance firms and how to better monitor firms’ risk management, as well as to evaluate how supervisors might respond to these risks. The analyses of the actual failures and near misses questionnaires revealed that, as risks can interact in complex ways, such events cannot be ascribed to a single cause but to a chain of multiple causes. The study attempted to group the observations according to similarities in the causal chain. It concluded that, irrespective of the grouping, the main drivers of insurance failures and near misses were clustered around the broad theme of management quality and inappropriate risk decisions, rather than inadequate capitalization per se (i.e. management problems are the root cause of most failures/near failures). The report further concluded that, as no amount of capital can substitute for the capacity to understand, measure, and manage risk, and no formula or model can capture every aspect of the risks an insurer faces, a new solvency framework for insurers should not only focus on capital but it should also be geared toward improving and incentivizing firms to use modern risk measurement and management techniques. Thus, the report recommended that the new solvency framework ensured that the assessment of regulatory capital had to be integrated with firms’ wider capital management processes (i.e. the review of solvency needs to encompass governance and risk management).

Solvency II Unveiling the New Framework Finally, on July 10, 2007, the EC published the Solvency II Framework Directive Proposal. 23 After intensive negotiations among the EC, the European Parliament, and the European Council, the three institutions agreed on a final compromise text for the Solvency II Framework Directive, which was adopted by the European Parliament’s plenary session on April 22, 2009. The Economic and Financial Affairs Council (ECOFIN)24 subsequently acknowledged Parliament’s positive vote on May 5, 2009. Structured around the three-pillar architecture of Basel II, Solvency II is a riskbased, forward-looking regulatory regime founded on a “total balance sheet” and a market consistent approach. 25 It aims to establish an innovative, revised set of EU-wide requirements on capital adequacy and risk management for insurers that will replace the current Solvency I requirements, with a view to reducing the likelihood of an insurer failing, and enhancing policyholders’ protection. This would also reduce the possibility of market disruption in insurance (i.e., financial markets stability) and provide insurance supervisors with better information and tools to assess the financial strength and overall solvency of insurance companies. Solvency II will reorganize insurance regulation in Europe by rewriting and consolidating 14 existing directives into a single sourcebook. This will modernize




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EU legislation on life insurance, nonlife insurance, winding-up, and reinsurance. The Solvency II Directive includes a “go live” implementation date of October 31, 2012, and it will apply to all insurance and reinsurance firms with gross premium income exceeding €5 million or gross technical provisions in excess of €25 million. Although a fresh set of regulations is rarely warmly received, the industry has welcomed this as its principles seek to align regulatory requirements with industry good practice. Applying them can bring a range of benefits that will strengthen insurance companies, making them more stable and helping them to make better use of capital. In fact, the strengthened regime will strive to ensure a uniform and enhanced level of policyholder protection across the EU, reducing the likelihood that policyholders lose out if insurers get into difficulties. A more robust system is likely give policyholders greater confidence in the products of insurers. Solvency II is expected to increase competition, especially for mass retail lines of business, such as motor and household insurance, which puts downward pressure on prices. Product innovation will give consumers more choice. Fundamental shifts introduced by the new framework are • its principle-based approach and the new EU legislative process (i.e., the Lamfalussy process); • the emphasis put on the proportionality principle; • its forward-looking and three-pillar structure; • the total balance sheet approach; • the two-level approach to capital requirements, the supervisory ladder of intervention, and the use of internal models; • the introduction of the “prudent person principle”; • the requirements on the system of governance, the own risk and solvency assessment (ORSA), and the supervisory review process (SRP); • the importance given to supervisory reporting and public disclosures.

The Lamfalussy Process and the Principle-Based Approach to Regulation Solvency II is being created in accordance with the Lamfalussy comitology. The Lamfalussy process is an approach to the development of financial service industry legislation that is used by the EU. It is composed of four levels, each focusing on a specific stage of the implementation of legislation. At the first level (Level 1), the European Parliament and Council of the EU adopt a piece of legislation, establishing the core values (i.e., the principles) of a law and building guidelines on its implementation (i.e., the framework), including implementing powers for detailed measures at Level 2. The law then progresses to the second level (Level 2), where sector-specific committees (e.g., CEIOPS for the insurance sector) and regulators advice on technical details that are needed to operationalize the Level 1 framework legislation, then bring it to a vote in front of Member States representatives. At the third level (Level 3), CEIOPS works on joint interpretations, recommendations, consistent guidelines, and common standards. In addition, CEIOPS undertakes peer reviews and compares regulatory practices to ensure consistent implementation and application. The fourth level (Level 4) involves compliance and enforcement of the new rules, regulations, and laws.


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This approach to EU legislation strives to ensure a more transparent process, with better involvement of external stakeholders and enhanced political cooperation among all the institutions (European Commission, Council, and Parliament). This is likely to result in an improvement in the quality of legislation and an acceleration of the legislative process. The implementation of measures and guidance increases f lexibility, making it easier and faster to adapt EU legislation in the future. The process also encourages regulatory and supervisory convergence. Moreover, this approach to regulation means, where possible, moving away from dictating through detailed, prescriptive rules and supervisory actions. Financial markets are constantly changing. It is important for regulation to respond rapidly to the pace of change in markets. Regulation that focuses more on outcomes rather than prescription is more likely to support this development and innovation. Any set of prescriptive rules is unable to address changing market circumstances and practices at all times. In a quickly changing marketplace, principles are far more durable. Finally, a large volume of detailed, prescriptive, and highly complex rules can divert attention toward adhering to the letter, rather than the purpose, of the regulatory standards. As stated above, the Solvency II Framework Directive was unveiled by the EC in July 2007 and was finally adopted in May 2009. The Level 2 and Level 3 measures, however, are currently still under development. Many issues have yet to be finetuned and worked out in the implementing measures.

Solvency II and the Proportionality Principle The Solvency II framework is designed for insurers and reinsurers of all sizes and complexities. Although the same general principles apply to large and small insurers alike, Solvency II is designed to be “proportionate” in the demands placed on insurers. The proportionality principle applies throughout the new solvency framework 26 and is linked to the nature, scale, and complexity of the risks inherent in the business. This implies that the size of an undertaking on its own is not the only relevant criterion. In fact, on the one hand, the new regime takes account of the specificities of the insurance sector and allows for a range of methods to be used to meet those principles, which should be tailored to the nature, scale, and complexity of the risks borne by the insurer. On the other hand, insurance supervision has to be carried out in a proportionate manner. As proportionality is a two-way concept, when assessing what is proportionate, the focus must be on the combination of all three criteria to arrive at a solution that is adequate to the risk that an undertaking is exposed to. This means that simpler and less burdensome ways of meeting requirements for low risk-profile portfolios are allowed. At the same time, for more complex risk portfolios, more sophisticated approaches are likely to be required.



The Three-Pillar Structure Solvency II is structured around the three-pillar architecture of Basel II, with each pillar governing a different but complementary aspect of the regime. The pillars are not discrete and should be considered together.


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• Demonstrating an Adequate System of Governance: including an effective risk management system and prospective risk identification through the own risk and solvency assessment (ORSA) • The Supervisory Review Process: the overall process conducted by the supervisory authority in reviewing insurance and reinsurance undertakings, ensuring compliance with the Directive requirements, and identifying those with financial and/or organizational weaknesses that are susceptible to producing higher risks to policyholders The third pillar completes the framework and deals with supervisory reporting and public disclosures. These requirements aim to foster market discipline and promote a risk dialogue among stakeholders.

Total Balance Sheet Approach Both Solvency I and II use the balance sheet of an insurance company as a starting point for the solvency assessment. But where Solvency I is mainly based on statutory figures reported in the financial statements and focuses on liabilities, Solvency II aims to capture the true economic value of the balance sheet items. This approach is independent of the statutory accounting and considers not just the liabilities but also the asset side of the balance sheet. To achieve this, Solvency II sets out a “Total Balance Sheet Approach” where the determination of an insurer’s capital that is available and needed for solvency purposes is based upon all assets and liabilities, as measured in the regulatory balance sheet of the insurer and the way they interact. Implications of this approach are that • available solvency capital is given as the difference between the market consistent values of assets and liabilities; • solvency capital requirements are calculated based on a comprehensive analysis of risks, taking into account the interaction between assets and liabilities, risk mitigation, and, where applicable, diversification.


The first pillar sets out the quantitative requirements that insurers must satisfy to demonstrate that they have sufficient financial resources. These requirements encompass the valuation of assets and liabilities, the calculation of the Solvency II capital requirements, and the assessment of eligible own funds. The second pillar covers the qualitative requirements and aims to supplement the first pillar. Central elements of the second pillar include the following:

An economic approach has several advantages: • It can be calibrated to provide a better balance between the protection to policyholders and the encouragement of efficient operations of companies. • It is more transparent and limits arbitrage opportunities. • It leads to a closer alignment of regulatory capital requirements with good practice internal risk management processes. • It can better cope with changing market circumstances and practices (e.g., increasingly sophisticated product design and capital markets innovation). • It is likely to limit double counting of risks and capital requirements.


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Under Solvency II, assets and liabilities are to be valued on a market consistent basis. The fair valuation of assets and liabilities is based on the amount for which the asset or liabilities could be exchanged between knowledgeable willing parties in an arm’s length transaction. Wherever possible, the fair value of assets is to be based on a mark-to-market approach, using readily available prices in orderly transactions that are sourced independently. Where this is not possible, mark-to-model procedures should be used. Mark-to-model is defined as any valuation which has to be benchmarked, extrapolated, or otherwise calculated as far as possible from a market input. The application of the mark-to-model approaches will require adequate systems and controls, sufficient enough to give senior management and supervisors the confidence that their valuation estimates are appropriate and reliable. Liabilities are divided into • technical provisions (or insurance liabilities)—obligations relating to policyholders and beneficiaries of insurance contracts; • non-insurance liabilities —other obligations such as amounts payable, tax liabilities (current and deferred), and employee benefits or wholesale funding obligations, including senior and subordinated debt securities or other loan arrangements. Technical provisions will be valued using a “current exit value” approach. The general approach to work out the value of technical provisions requires the calculation of the sum of two components that is the best estimate and a risk margin. Both components should be valued separately. The best estimate is equal to the probability-weighted average of future cash f lows, taking into account the time value of money. The risk margin calculation is based on the cost of holding regulatory capital for risks considered nonhedgeable (“cost-of-capital” methodology). However, where future cash f lows associated with insurance or reinsurance obligations can be replicated reliably (i.e., they are hedgeable) by using financial instruments for which a reliable market value is observable, the value of the technical provisions associated with those future financial cash f lows shall be determined on the basis of the market value of those financial instruments (i.e., calculation of the technical provision as a whole). Solvency II aims to be compatible, where possible, with international accounting developments. However, although consistency will be achieved where possible, the accounting and regulatory approaches may not prove identical.


Valuation of Assets and Liabilities

The Two-Level Approach to Capital Requirements, the Supervisory Ladder of Intervention, and the Use of Internal Models The Solvency II framework sets out two different levels of capital requirements: an upper level, the Solvency Capital Requirement (SCR), and a lower bound, the Minimum Capital Requirement (MCR). The SCR is based on the Value-at-Risk of the basic own funds of an insurer, subject to a confidence level of 99.5% over a one-year period. In other words, the SCR aims to ref lect a level of eligible own funds that enables insurers to absorb


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losses to a confidence level of 99.5% over one year. The SCR evaluation should include all material risks facing the company: underwriting risk (including reserving risk), credit risk, market risk, and operational risk (including legal risk, but not the risks arising from strategic decisions). The evaluation should take into account risk mitigation techniques (allowing for credit risk) and risk diversification across product lines, asset classes, and risk categories. An important innovation introduced by Solvency II is that to calculate the SCR, insurers can use either the European Standard Formula (“standard formula”) or a full or partial “internal model,” as approved by the relevant supervisory authorities. Partial internal models can be used with the standard formula to calculate the SCR for one or more risk modules or sub-modules, and for one or more major business units. Falling below the SCR requires companies to restore their capital (“eligible own funds”) to the SCR level (or to a higher level if deemed more appropriate) or reduce their risk profile (to ensure the own funds are sufficient) within six months. The MCR is designed to correspond to a solvency level, below which policyholders and beneficiaries are exposed to an unacceptable level of risk if the insurer were allowed to continue its operations. In these circumstances, if the insurer were unable to reestablish the amount of eligible basic own funds at the level of the MCR within a short period of time, its authorization is withdrawn. As the breach of the MCR implies extreme supervisory action, this requirement has to be calculated in accordance with a simple formula and based on auditable data. The design of the MCR proved to be one of the most controversial issues of the whole Solvency II process. Several quantitative impact studies (QIS exercises) have tested a number of alternative methods to calculate the MCR. Finally, a compromise led to the calculation of the MCR as a linear function of a subset of the company’s technical provisions, written premiums, capital-at-risk, deferred tax, and administrative expenses. This linear function is calibrated to the Valueat-Risk of the basic own funds of an insurance or reinsurance undertaking, subject to a confidence level of 85% over a one-year period, and to both a f loor and cap (i.e., the corridor) equal to 25% and 45% of the insurer’s SCR, respectively. This corridor aims to establish an adequate ladder of intervention between the MCR and the SCR.

Investment Strategy and the Prudent Person Principle Solvency II is set to remove many of the limits on the nature and extent of admissible assets. The current rules on admissible assets (i.e., the list of qualifying asset types) will be replaced by the “prudent person principle” (i.e., the requirement to invest so as to ensure the security, quality, liquidity, and profitability of the portfolio as a whole), with the requirement that assets covering technical provisions must be invested in “the best interests” of policyholders. This concept has been largely borrowed from the EU Reinsurance Directive, though it applies to all assets, not just those backing technical provisions. The Prudent Person Principle effectively places responsibility on the insurer to act in the best interests of their policyholders by seeking to maintain the security, quality, liquidity, and profitability of their portfolios. The insurer has to decide whether the nature of any investment is appropriate, and it has an obligation to show that it


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has appropriate systems and controls to hold and manage any such investments. In practice, this may require insurers to give their investment managers more detail about the type of investments permitted.

ORSA and SRP

• the requirement for firms to complete an own risk and solvency assessment (ORSA) of overall solvency needs, taking into account their risk profile and approved risk tolerance. The results of the ORSA must be incorporated into the firm’s strategic decision-making and must be disclosed to the regulator; • the supervisory review process (SRP), which could lead to sanctions, including capital add-ons in exceptional cases. The ORSA is an internal risk assessment process that aims to ensure that senior management have conducted their own review of the risks to which they are exposed and that they hold sufficient capital against those risks. The ORSA must ref lect the firm’s own risk appetite. The ORSA is an integral part of managing the business against the company’s chosen strategy, and it should thus be an important tool in assisting strategic decision-making. Demonstration of this activity will be important. The sophistication and extent of the ORSA should be proportionate to the nature, scale, and complexity of the risks within the firm. While there may be firms using the SCR standard formula (for which, owing to the size and complexity of their business, the ORSA process is relatively sophisticated), this will not be the case for all firms. The ORSA will also provide supervisors with an early indicator of the firm’s solvency position, as the insurer may breach its economic capital target level before it breaches its regulatory capital requirement. The ORSA should enable the supervisor to draw conclusions regarding the ability of the insurer to review its own risks.

Supervisory Reporting and Public Disclosures


The Solvency II framework strives to ensure that effective risk management and policyholder protection are embedded into the governance, operations, and decision-making of the business. Mechanisms include

The third pillar covers the supervisory reporting (report to supervisors [RTS]) and public disclosure (solvency and financial conditions report [SFCR]) aspects of the regime. This is the information that undertakings are required to report to the supervisory authority, as well as the information to be publicly disclosed to the market. Supervisory reporting requirements aim to support the risk-oriented approach to insurance supervision, while, on the other hand, public disclosure requirements aim to reinforce market mechanisms and market discipline by acting as a strong incentive to undertakings to conduct their business in a sound and efficient manner, including an incentive to maintain an adequate capital position that can act as a cushion against potential losses that arise from risk exposures.


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Both the RTS and the SFCR should contain a qualitative report, including quantitative data, where necessary, and quantitative reporting templates. Both reports should be designed as stand-alone documents and follow a similar structure. Solvency II requires undertakings to submit, to the supervisory authorities, information:

Solvency II sets out the minimum content of information that undertakings are required to publicly disclose (SFCR) and establishes requirements on the updates to be provided on the disclosed information following major developments. On one hand, for firms using the standard formula, disclosure requirements are preset. On the other hand, as there are various ways that an internal model can be constructed, implemented, and operated, public disclosure requirements on internal models are, to the extent possible, based on principles with regard to harmonization of reporting and comparability issues between undertakings. The RTS should contain all the information necessary for the purposes of supervision. The information should be specifically aimed at the supervisor, including all elements (although at a more granular level) set out in the SFCR. The RTS should follow a preset structure and template to facilitate its review and understanding.

Conclusions This chapter provided an insight of the regulators’ thinking on the new European regulatory regime for insurance and reinsurance companies (i.e. Solvency II), and it shed light on the expected benefits of this new framework. As highlighted in the “The de Larosière Report,” 28 Solvency II is an important step forward in the effort to improve insurance regulation, to foster risk assessments, and to rationalize the management of insurance and reinsurance firms. This reform will provide for a new modern, robust framework for the supervision and regulation of insurance companies by establishing strengthened solvency and risk management requirements for insurance and reinsurance companies. This innovative framework already embeds measures that draw lessons from the recent financial crisis and, and it aims to remedy the present fragmentation of rules in the EU, allowing for a more comprehensive, qualitative, and economic assessment of the overall risks borne by insurance and reinsurance companies. Solvency II would also facilitate the management and supervision of large insurance groups. With colleges of supervisors for all cross-border groups, this framework would strengthen and organize better supervisory cooperation. The industry has welcomed Solvency II as its principles seek to align regulatory requirements with industry good practice. This new framework can bring a range of benefits, which are likely to strengthen insurance companies, helping them to make better use of capital. Finally it is important to stress that complying with the Solvency II standards is not a one-off exercise. Standards have to be met on an ongoing basis and the bar should rise over time to take into account both internal and external developments.


• at predefined periods (regular basis); • upon occurrence of predefined events; • during inquiries regarding the situation of the undertaking. 27


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To this end, an ongoing dialogue between undertakings and regulators is not required, but essential.

Notes

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.

16.

17. 18. 19.

20. 21. 22. 23. 24.

25. 26. 27.

For a good overview of the subject please refer to (Sandström 2006). EEC 1957). For further details please refer to Article 52 of (EEC 1957). For further details please refer to (EEC 1973). For further details please refer to (EEC 1979). For further details please refer to (Campagne, Loo, and Yntema 1948) and (Campagne 1961). For further details please refer to (EEC 1988). For further details please refer to (EEC 1990). For further details please refer to Article 59 of (EEC 1957). For further details please refer to Campbell et al. (2003). For further details please refer to (EEC 1992b) For further details please refer to (EEC 1992a). For further details please refer to (Conference of Insurance Supervisory Services of the Member States of the European Union 1997). For further details please refer to (EEC 2002a) and (EEC 2002b). For example for non-life insurance an additional index over and above the premium and claim index to take care of the long-tailed claims. However, changes to the Life Directives were minimal. The capital requirements are largely based on either premium volumes or the level of claims outstanding calling for a minimum guarantee fund (minimal capital required) of €3 million, and a solvency margin consisting of 16–18% of nonlife premiums together with 4% of the technical provisions for life. For further details please refer to (EEC 1998). For further details please refer to (FSA 2006). For example, about the use of risk-based capital systems, the lessons learned from the Basel II development process, the use of internal models, the links between financial reporting and supervisory accounts, etc. For further details please refer to (KPMG 2002). For further detail please refer to (BCBS 2006). For further details please refer to (Conference of Insurance Supervisory Services of the Member States of the European Union 2002). For further details please refer to EEC (2008). The ECOFIN Council is composed of the Economics and Finance Ministers of the EU Member States. The ECOFIN Council covers EU policy in a number of areas including: economic policy coordination, economic surveillance, monitoring of Member States’ budgetary policies and finances, etc. For further details please refer to CEIOPS (2005, 2006). For further details please refer to (CEIOPS 2008). This may encompass any other information that supervisory authorities might deem necessary during the supervisory review process, using a wide range of meth-


The views expressed in this chapter are those of the authors and not necessarily those of the Financial Services Authority.


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ods and formats (e.g., questionnaires, request for further information on a specific issue, relevant documents during on-site inspections). 28. For further details please refer to (The de Larosière Group 2009).

Basel Committee on Banking Supervision (BCBS). “International Convergence of Capital Measurement and Capital Standards: A Revised Framework—Comprehensive Version.” 2006. http://www.bis.org/publ/bcbs128.pdf?noframes=1. Campagne, C. “Standard minimum de solvabilité applicable aux enterprises d’assurances.” Report of the OECE, March 11, 1961. Reprinted in Het VerzekeringsArchief deel XLVIII, 1971–1974. Campagne, C., van der Loo, and A.J. Yntema. “Contribution to the method of calculating the stabilization reserve in life assurance business” in Gedenboek Verzekeringskamer 1923–1948, Staatsdrukkerij- en uitgeverijbedrijf, Den Haag, 1948. CEIOPS. “Consultation Paper 7: Draft Answers to the Second Waive of Calls for Advice in the Framework of the Solvency II Project.” 2005. http://www.ceiops.eu/ media/files/consultations/consultationpaper/cp_0504.pdf. ———. “Advice to the European Commission on the Principle of Proportionality in the Solvency II Framework Directive Proposal.” 2008. http://www.ceiops.eu/media/ docman/public_files/publications/submissionstotheec/AdviceProportionality.pdf Conference of the Insurance Supervisory Services of the Member States of the European Union (EU). “Solvency of Insurance Undertakings (‘Müller Report’).” 1997. http:// www.ceiops.org/media/files/publications/reports/report_dt_9704.pdf. ———. “Report on Prudential Supervision of Insurance Undertakings (‘Sharma Report’).” December 2002. http://ec.europa.eu/internal_market/insurance/docs/solvency/impactassess/annex-c02_en.pdf. European Economic Community (EEC). The Treaty of Rome. 1957. http://www. eurotreaties.com/rometreaty.pdf. ———. “First Council Directive 73/239/EEC of 24 July 1973 on the coordination of laws, regulations and administrative provisions relating to the taking-up and pursuit of the business of direct insurance other than life assurance.” 1973. http://eur-lex. europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:31973L0239:EN:HTML. ———. “First Council Directive 79/267/EEC of 5 March 1979 on the coordination of laws, regulations and administrative provisions relating to the taking up and pursuit of the business of direct life assurance.” 1979. http://eur-lex.europa.eu/LexUriServ/ LexUriServ.do?uri=CELEX:31979L0267:EN:HTML. ———. “Second Council Directive 88/357/EEC of 22 June 1988 on the coordination of laws, regulations and administrative provisions relating to direct insurance other than life assurance and laying down provisions to facilitate the effective exercise of freedom to provide services and amending Directive 73/239/EEC.” 1988. http://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:31988L0357:EN:HTML. ———. “Council Directive 90/619/EEC of 8 November 1990 on the coordination of laws, regulations and administrative provisions relating to direct life assurance, laying down provisions to facilitate the effective exercise of freedom to provide services and amending Directive 79/267/EEC.” 1990. http://eur-lex.europa.eu/LexUriServ/ LexUriServ.do?uri=CELEX:31990L0619:EN:HTML. CEIOPS. “Third Council Directive 92/49/EEC of 18 June 1992 on the coordination of laws, regulations and administrative provisions relating to direct insurance other


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than life assurance and amending Directives 73/239/EEC and 88/357/EEC.” 1992a. .http://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:31992L0049:EN: HTML. ———. “Council Directive 92/96/EEC of 10 November 1992 on the coordination of laws, regulations and administrative provisions relating to direct life assurance and amending Directives 79/267/EEC and 90/619/EEC (third life assurance Directive).” 1992b. http://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:31992L009 6:EN:HTML. ———. “Directive 98/78/EC of the European Parliament and of the Council of 27 October 1988 on the supplementary supervision of insurance undertakings in an insurance group.” 1998. http://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ: L:1998:330:0001:0012:EN:PDF. ———. “Directive 2002/83/EC of the European Parliament and of the Council of 5 November 2002 concerning life assurance.” 2002a. http://eurlex.europa.eu/ LexUriServ/LexUriServ.do?uri=OJ:L:2002:345:0001:0051:EN:PDF. ———. “Directive 2002/13/EC of the European Parliament and of the Council of 5 March 2002 amending Council Directive 73/239/EEC as regards the solvency margin requirements for non-life insurance undertakings.” 2002b. http://eurlex.europa. eu/LexUriServ/LexUriServ.do?uri=OJ:L:2002:077:0017:0022:EN:PDF. FSA. “Prudential changes for insurers—Feedback on CP06/16. Including Policy Statement for Chapter 7 of CP06/13 ‘Quarterly Consultation (No.9).” 2006, http:// www.fsa.gov.uk/Pages/Library/Policy/CP/2006/06_16.shtml. KPMG. “Study into the methodologies to assess the overall financial position of an insurance undertaking from the perspective of prudential supervision.” 2002. http:// ec.europa.eu/internal_market/insurance/docs/solvency/solvency2-study-kpmg _ en.pdf. The de Larosière Group. “Report of the High Level Group on Financial Supervision inthe EU.” February 25, 2009.




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The Move to Market Consistent Reporting for Insurers Mark Freedman, Douglas French, Tara Hansen, and Therese Masiello

Introduction The global insurance market is in the midst of sweeping changes as companies emerge from the financial crisis of 2008 and move to adopt more market consistent financial reporting, risk measurement, and management frameworks. Developments in International Financial Reporting Standards (IFRS) and Solvency II are laying the groundwork for a more effective framework for insurers to better manage capital, improve strategic decision making and strengthen the critical linkages between key aspects of the financial management cycle— including pricing, capital management, risk management and financial reporting. In Europe, differences in country accounting standards have resulted in the market striving for financial reporting consistency. This led to the rationale for the introduction of IFRS. However, the International Accounting Standards Board (IASB) was not able to develop a comprehensive accounting standard for insurance, acceptable to all constituencies, in time for the European adoption of IFRS in 2005, so the IASB compromised with IFRS 4 Insurance Contracts, which temporarily allowed companies to continue with the same accounting treatment for insurance contract liabilities that they were already using for their local Generally Accepted Accounting Principles (GA AP) financial statements. On the regulatory front, Solvency II has been developing as an updated longterm solvency standard. In the United States, the short-term solution has been evolving as a system of principle-based reserves and capital. The differences in these two systems are discussed later in this chapter. In the longer term, a market consistent standard such as Solvency II may appear in the United States as a result of the difficulty of managing elements of the balance sheet on different bases, requirements of rating agencies, and competitive and risk measurement/management concerns.


CHAPTER 6


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Freedman, French, Hansen, and Masiello

In the meantime, the European temporary solution for communicating results to investors had been for companies to manage themselves (and explain results to analysts) by unwinding regulatory accounting inconsistencies with embedded value reporting. Embedded value reporting is the sum of the value of in-force and the net asset value of the organization. The value of in-force is the present value of future regulatory profits, including the release of required capital, from existing business, and the net asset value is the market value of net assets backing free surplus. Although some companies in the United States have adopted embedded value measures and reporting for use in managing their business, most have believed that U.S. GAAPs were sufficient for the purpose of communicating results to stakeholders. The differences in key embedded value assumptions and disclosures among companies caused discomfort among analysts. This led European companies to develop more consistent approaches and disclosures through the advent of the specified rules and disclosures emanating from the CFO Forum, a European consortium of insurance chief financial officers. Ultimately, these companies evolved their embedded value techniques to market consistent techniques in order to increase transparency and consistency even more. Market consistent techniques have started to be used more in pricing business, as lines between insurers and banks and other financial institutions have started to blur. At the same time, Solvency II, IFRS, and U.S. GA AP appeared to be headed toward a market consistent approach. The United States seems to be committed to convergence between IFRS and U.S. GA AP, and potentially the elimination of U.S. GA AP. Ultimately, if the “rules” of IFRS do not completely address management needs, market consistent embedded value (MCEV) reporting may continue within the marketplace. Companies need to determine the potential impact of the changing rules on patterns of profit emergence, in-force management, capital requirements, and asset/ investment practices. Companies also need to understand and have a plan to deal with the implementation and technology issues that result from these changes. In addition, they need to determine if such significant changes will result in a transformation in how operations are conducted. In the short term, financial transformation must deal with all principle-based systems, and, in the long-term, some of them may disappear. The move in the United States toward a market consistent framework reveals many questions, as insurers recover from the financial crisis of 2008: • Will an IFRS introduction accelerate within the United States or take a back seat, allowing U.S. GA AP to slowly merge with the current IFRS framework? • Will a possible federal regulatory system allow for a new principle-based solvency regime similar to Solvency II? • Will the United States retreat to the status-quo of current U.S. GA AP and statutory reporting? • Will insurers in the United States price products on a market consistent basis? • How will risk management techniques be more integrated in the life insurance companies in the United States?


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The answers to these questions will be covered in this chapter.


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Financial Reporting The United States and Europe are headed toward a market consistent financial reporting regime in both U.S. GA AP and IFRS. In particular, the IASB and Financial Accounting Standards Board (FASB) are working together on an insurance contract project that will alter accounting for insurance for U.S. and global insurers.

U.S. GA AP financial reporting is currently a mixed attribute system in which many assets are reported at market value and most liabilities are reported on a book value type basis. Some fair value treatment has been introduced to the liability side of the balance sheet through Statement of Financial Accounting Standards (“SFAS”) 133, Accounting for Derivative Instruments and Hedging Activities, and SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities.

IFRS Under IFRS, International Accounting Standard (“IAS”) 39, Financial Instruments: Recognition and Measurement, is currently a mixed attribute system similar to U.S. GAAP; however, IAS 39 is in the process of being revised with a replacement standard, IFRS 9. In November 2009, the IASB issued an exposure draft that includes a provision to allow assets to be measured at amortized cost if the asset has basic loan features and is managed on a contractual yield basis. Otherwise, assets must be measured at fair value through profit or loss or Other Comprehensive Income (OCI). Currently, IFRS looks to be moving toward one of two measurement approaches for insurance contracts, which will be discussed in more detail later in the chapter. At a high level, both of these approaches are market consistent, with the exception of non-economic assumptions, which are entity-specific. However, there may be one or more accounting principles that take some of the market consistency out of the financial standard. As of June 2010, it appears that the net effect will likely add conservatism to the balance sheet, from one that is purely market consistent. The developments in IFRS toward a final insurance standard are discussed in more detail in the next section.

Convergence of U.S. GA AP and IFRS


U.S. GA AP

U.S. GA AP is in the process of converging with IFRS. The FASB and IASB (the Boards) are working together on a Phase II insurance contract standard and intend to issue an exposure draft by late summer of 2010. Regardless of whether the SEC adopts IFRS for accounting in the United States, U.S. GA AP will incorporate the IFRS Phase II insurance contracts accounting requirements. This section discusses where the FASB and IASB are as of June 2010.

Measurement Attribute Both the FASB and IASB are moving toward a discounted cash f low approach toward measuring insurance contract liabilities. The FASB is leaning toward an


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attribute that is consistent with the revenue recognition project. The IASB’s preferred attribute is more consistent with IAS 37, Provisions, Contingent Liabilities, and Contingent Assets. The measurement building blocks in each attribute are similar and include

More details about the measurement attributes can be found in the Appendix.

Gains at Issue Neither the FASB nor the IASB plan to permit a gain at issue, and would remove the gain, if any, with a margin. The IASB has tentatively decided to recognize revenue to offset acquisition costs, so the initial measurement of the residual margin would exclude an amount equal to the incremental acquisition costs, resulting in no significant loss at inception from those acquisition costs. The FASB tentatively believes (although this continues to be a topic of significant debate and their view may potentially change) that all acquisition costs should be expensed at issue (i.e., the initial liability would be equal to the premium). This means that there would be a loss equal to the acquisition expenses. This will be a challenge for insurers, especially for products with relatively high acquisition costs relative to premiums, such as life insurance. More details about gains at issue can be found in the Appendix.

Discount Rate Although the Boards have not given explicit guidance on what discount rate should be used, it is generally expected that the base discount rate will be a risk-free rate that may be adjusted. The challenge with this issue is what, if any, items should be added on to the risk-free rates, such as excess of swap rates over risk-free rates, reflection of a company specific own credit spread, illiquidity adjustments, etc. This is an important issue for investment-intensive products in the United States because if all liability cash flows are to be discounted at risk-free rates, there will be a large loss at issue. More details about discount rates can be found in the Appendix.

Margins


• current estimates of expected (i.e., probability weighted) future cash f lows; • incorporation of time value of money; • an explicit margin.

The IASB has tentatively decided that there should be an explicit risk margin, plus a residual margin in order to calibrate the initial liability to the premium less any incremental acquisition costs. In contrast to this, the FASB has tentatively decided that there should be a single composite margin in order to calibrate the initial liability to the premium. Figure 6.1 illustrates this concept. More details about margins can be found in the Appendix.

Policyholder Behavior The Boards have tentatively decided that the measurement of a liability should include the expected (probability-weighted) cash f lows that result from those


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FASB

IASB

Unbiased, probability-weighted average of future cash flows expected to arise as the insurer fulfils the obligation

Unbiased, probability-weighted average of future cash flows expected to arise as the insurer fulfils the obligation

Time value of money (Discount)

Time value of money (Discount) Risk adjustment Residual margin • A risk adjustment for the insurer’s view of the uncertainty (amount and timing) associated with the future cash flows • The residual margin represents an amount that eliminates any gain at inception of the contract minus an amount equal to the incremental acquisition cost

Figure 6.1

contracts, including those cash f lows in which amount or timing depends on whether policyholders exercise options in the contracts. More details about policyholder behavior can be found in the Appendix.

Policyholder Dividends and Excess Interest The Boards have expressed an initial preference for an approach that includes all cash f lows that arise from a participating feature in the measurement of the insurance liability on an expected present value basis. More details about policyholder dividends and excess interest can be found in the Appendix.

Renewal Premiums The question with respect to renewal premiums is whether liability cash f lows related to discretionary renewal premiums can be considered. This will be a challenge for North American-style universal life contracts. If expected renewal premiums cannot be accounted for, there will be a large loss for these contracts at inception. The high first-year commissions in universal life contracts are priced to be amortized, assuming that profits from expected renewal premiums will be received. The Boards have tentatively decided to allow discretionary renewal premiums to the extent that they are part of the existing insurance contract. If the insurer can re-underwrite and re-price the contract each year, any renewal premiums are excluded from the cash f low projections. More details about renewal premiums can be found in the Appendix.


An amount that eliminates any gain at inception of the contract (Composite margin)

Regulatory Accounting Today, the United States is headed toward a principle-based approach in regulatory accounting, while Europe is headed toward a market consistent approach, which


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is broadly similar to the future direction of IFRS. It is unclear when or whether the United States will converge with the European approach of Solvency II, and how convergence, or lack thereof, will impact the level global playing field. We do note, however, that the pace of anticipated change in the United States has quickened recently. The Obama administration released a white paper (which will be discussed in more detail below) in June 2009 that outlines its recommendations for U.S. financial services regulatory reform. In December 2009, draft legislation known as the Federal Insurance Office Act of 2009 was introduced. The bill is an amendment to the Office of Insurance Information legislation introduced in 2008 and largely follows the proposals in the administration’s white paper. The bill proposes the establishment of a Federal Insurance Office (FIO) within the Treasury that would gather information so that the federal government can better determine how policy decisions may affect the insurance market. The FIO will have the authority to represent the United States on international insurance matters and enter into international insurance agreements. The U.S. Senate passed a similar bill in May 2010. Reconciliation of any differences in these bills is expected by July 2010. The National Association of Insurance Commissioners (NAIC) is separately pursuing its Solvency Modernization Initiative, which will be discussed in more detail below.

U.S. Regulatory Accounting The NAIC is moving toward a principle-based reserving and capital standard, and is moving away from the historic formulaic/factor-based system. The progress in moving to a principle-based system varies by product type. Principle-based reserving and capital rules were in place at year-end 2009 for variable annuities. Capital rules are expected to be in place for life insurance contracts by year-end 2011. Reserving standards for fixed annuities are expected to be in place with an integrated rule that covers all annuities, including variable annuities, by year-end 2011. Reserving requirements for life insurance and other contracts will be set after yearend 2011. At the same time, there is impetus for federal regulation. President Obama’s proposal contains six principles, including “strong capital standards” and “an appropriate match between capital allocation and liabilities for all insurance companies.” The white paper focuses primarily on the banking sector, but also has some definitive views on changes required for the insurance industry. An office within the Treasury will be created to monitor the insurance industry such that, at the very least, policy decision makers at the federal level will be cognizant of the impact of their decisions on the insurance industry. There was a general recognition that the federal government needs to better understand the insurance industry, given its size and impact within the economy. The NAIC has also sponsored a solvency modernization initiative. The NAIC has performed comparisons of the current risk-based capital (RBC) framework against Solvency II and seems to be comfortable with the developments being made around capital levels. However, it is doing more work to assess the gaps in the risk assessment framework and is looking at what Europe is doing with Pillar 2 of Solvency II, as an example. The areas of focus of this initiative are capital requirements, reinsurance, group issues, international accounting, and insurance valuation. Although some think that the


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combination of these events could result in a standard in the United States similar to Solvency II, a clear direction is not definite at this time.

The main purpose of Solvency II is to achieve transparency on an insurer’s risk. Solvency II is a three-pillar approach that aligns risk measurement, management, and disclosure requirements. Pillar I contains the quantitative requirements that define a valuation framework that is consistent with how a deep and liquid market would value assets and liabilities. Pillar II contains sound corporate governance and effective risk and capital management requirements that will enhance transparency within an insurance company on both its own value and risk exposure. Pillar III contains explicit disclosure requirements, toward both the public and supervisory authorities, that will enhance transparency. The core of Solvency II is the market consistent balance sheet, which defines available economic solvency capital, and how risks are measured. Assets are valued at the amount for which they could be exchanged between knowledgeable and willing parties in an arm’s length transaction. This concept corresponds to observable market prices for assets that are traded in a deep and liquid market. Liabilities are valued at the amount for which they could be transferred or settled between knowledgeable and willing parties in an arm’s length transaction. More details about the Solvency II liability components can be found in the Appendix. Economic capital computation is generally based on the impact of adverse shocks to the market consistent balance sheet. Examples of shocks that should be tested include the following: • • • • • • • • • • • • • •

currency interest rate equity property credit spread market default operational mortality longevity lapse disability catastrophe expense


Solvency II

Liabilities can be broken down into technical provisions and own funds, as shown in figure 6.2. Technical provisions are the sum of the best estimate of insurance liabilities, the risk margin, and the market value of other liabilities. Own funds are the sum of the solvency capital requirement and free surplus. The solvency capital requirement (SCR) is the value at risk of the change of own funds over a one-year time horizon on a 99.5% confidence level. This requirement is a


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Free Surplus

Minimum Capital Requirement

Market Value Margin

Technical Provisions Best Estimate Reserves

Figure 6.2

buffer for market, credit, operational, nonlife underwriting, and health underwriting risk during the year. The minimum capital requirement (MCR) is calibrated to a level that corresponds to the value at risk, and is calculated on an 80–90% confidence level.

Market Consistent Embedded Value (MCEV) Under MCEV reporting, the balance sheet is very similar to the Solvency II balance sheet. European companies had been fairly far along with MCEV prior to the economic developments in late 2008. However, at year-end 2008, the methodology was shown to have f laws when credit spreads substantially widened. A significant number of companies have chosen to include a liquidity premium as an add-on to the discount rate, which had been the swap rate. At year-end 2008, the methodology for determining this add-on was inconsistent across the industry. Accordingly, the CFO Forum has agreed to perform further work to seek to improve the consistency in the adjustments made for liquidity premiums and volatilities. More details on MCEV can be found in the Appendix.


Solvency Capital Requirement

U.S. and European Convergence The United States is not moving toward the European approach to regulatory accounting as fast as it is moving toward the European approach to financial


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reporting for the investing community. If this trend continues, the resulting disconnect between the two accounting bases used by U.S. insurers will introduce multiple challenges. The first challenge is that companies will have to reconcile between two bases, one that is a principle-based but real world model, and another that is a market consistent model. The second challenge involves two sets of movement analyses being performed each period as management and stakeholders will want to see results under both bases. This dramatic departure from the current financial and regulatory reporting frameworks will test management’s ability to explain key drivers of profitability, the company systems’ ability to produce and maintain the required level of information, and the finance organization’s ability to produce meaningful information in a timely manner. European companies must convert to Solvency II by 2012, but the United States is presently headed down a different track for solvency accounting. However, the United States is currently investigating and debating solvency reform, and it might change its track as a result of either proposed federal regulation or rating agency developments. In Europe, Solvency II conversion can be leveraged to assist in producing IFRS financials under Insurance Contracts Phase II. In the United States, however, implementation of Insurance Contracts Phase II will likely precede any conversion to a Solvency II type solvency requirement. As such, it may be difficult for companies to integrate upcoming solvency developments in the United States with the Insurance Contracts Phase II conversion unless solvency developments become market consistent. Since Solvency II has a similar infrastructure to that expected in the Insurance Contracts Phase II, if the IFRS conversion is done carefully, Solvency II, if and when it is required, could be leveraged off the IFRS conversion.

Impact of Market Consistent Frameworks Market consistent frameworks will impact many other areas of a company. Some of the areas that will be impacted are reinsurance, pricing, and risk management.

Reinsurance Market consistent frameworks will impact a company’s reinsurance transactions in many ways. The Solvency II capital requirement is for a BBB-rated company. Since most groups will voluntarily hold capital at a higher confidence level, they will have the ability to hold lower capital in a subsidiary, as long as the capital level in a subsidiary is larger than the local regulatory standards. When the regulatory capital of a subsidiary is larger than the economic capital, as defined by Solvency II, there will no longer be credit for the excess at the Group level. However, intercompany reinsurance and other possibilities may exist to mitigate this issue. If the idea of equivalent regulators becomes accepted as part of Solvency II, and the U.S. insurance regulator is deemed equivalent, there will be no need for Solvency II calculations to be performed by the following:



• U.S. subsidiaries of European insurers • European subsidiaries of U.S. insurers


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Market consistent frameworks will also impact strategic business decisions and asset and hedging strategies. For example, investment-intensive products may be divested if the discount rate is risk-free because the lower discount rate will result in higher reserves and lower profitability. There will also be a larger demand for mortality-intensive products in order to balance the investment risks assumed by insurance companies as they strive to diversify their risks.

Pricing will be impacted by moving to market consistent regulatory accounting and capital standards. A single-premium immediate annuity (SPIA) new business projection will be discussed in this section. A comparison of the U.S. statutory (using statutory rules in effect as of 2009) and Solvency II distributable earnings emergence for an SPIA product without own credit is shown in figure 6.3. Solvency II distributable earnings (Solvency II earnings less increase in required capital) are much lower in this example than U.S. statutory distributable earnings

Distributable Earnings 1,000,000 500,000 0 (500,000)

$

(1,000,000) (1,500,000) (2,000,000) (2,500,000)

U.S. Statutory Solvency II

(3,000,000) (3,500,000)

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20


Pricing

Policy Year Figure 6.3

Table 6.1 IRR Stat/RBC Solvency II

10.8% 7.1%

PVDE @ 10% (000s) $84 ($664)


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in the first year, but they are greater than the U.S. statutory distributable earnings in future years. In this example, this was caused by higher requirements for reserves plus capital under Solvency II. A comparison of internal rate of return (IRR) and present value of distributable earnings for U.S. statutory and Solvency II is shown in table 6.1. The IRR and present value of distributable earnings are lower for Solvency II due to the higher capital requirement under Solvency II. Products are commonly priced on a target IRR basis. For example, assume a company’s target IRR is 11% and its regulatory accounting basis is U.S. statutory. Its pricing tests show that this IRR will likely be attained, so there is no need to change its premium scale. Then, its regulatory basis changes to Solvency II. Its pricing tests now show an IRR of 7%, which is less than the company’s target. In order to achieve a higher IRR, the company must increase its premiums. This proposed increase is, of course, subject to competitive pressures. Therefore, pricing will be greatly impacted by the market consistent regulatory accounting and capital standards. There may be competitive advantages for European insurers that issue a particular product, as compared to U.S. insurers that report under U.S. statutory capital requirements as a result of Solvency II, if local U.S. regulatory capital requirements are stricter than Solvency II requirements. There may be reinsurance and other structural strategies for European companies with subsidiaries in the United States that may provide competitive disadvantages to U.S.-only companies. However, U.S. companies may be able to get to a similar outcome by reinsuring the business to an affiliated offshore reinsurer under Solvency II. Life insurance companies in the United States must, therefore, focus on currently evolving U.S. regulatory requirements, but should also continue to monitor developments around Solvency II.

Risk Management Companies, especially in Europe, have made some progress in building risk management practices within the market consistent framework. Prior to the financial crisis of 2008, companies had developed enterprise risk management policies, although development of these policies was not completed. Investment and asset/ liability management strategies are now being de-risked by minimizing the asset/ liability mismatches that existed prior to moving to a market consistent framework. Liquidity risk measurement and management have become more important to companies. New products are being designed for product management f lexibility in order to reduce the vulnerability to unmanageable risk. Finally, scenario testing and dynamic capital forecasting are becoming more significant for companies. Many challenges remain as companies shift to a market consistent framework. Insurance companies need to start developing a strong risk management program but are waiting to see the direction that regulators will take. Going forward, regulators and investors are going to place greater importance on the internal dynamics of risk governance. Risk frameworks, therefore, need to adapt and become more forward looking. Boards and senior management will have to view strong risk management practices as a competitive advantage, and not just a regulatory requirement. Financial institutions are going to evolve their systems and




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• capture and integrate the full spectrum of risk faced by the insurer; • learn lessons from the current crisis but also look forward to the next one; • challenge the incentive structure to a model where risk and reward are viewed together as drivers for behaviors and decision making; • report all of this information in a meaningful way to a board of directors that will be much more active, probing, and challenging than it has been historically.

Issues for Companies in the United States Insurance companies in the United States will face many issues as they report on various bases in the near future, since some of these bases will not be market consistent. Companies in the United States will need to manage under four main accounting bases. The first basis is current regulatory accounting and capital requirements. These requirements will ultimately be replaced by principle-based regulatory accounting and capital requirements, and possibly Solvency II. The second basis will be regulatory accounting bases for subsidiaries outside the United States. If the subsidiaries are located in Europe, they will ultimately report under Solvency II. Insurance companies will also need to report under U.S. GA AP, which will ultimately be replaced by an IFRS Insurance Contracts Phase II-type standard. Finally, companies will also have to address rating agency requirements. Even though regulatory requirements in the United States may not be market consistent, there are several common elements among the various bases. There are also similarities with the direction regulations are moving elsewhere, in that • • • •

valuations are prospective, stochastic, and model-based; there will be more volatility in financials than in the past; there will be a need for experience monitoring and assumption governance; there will be a need for attribution and reconciliation analyses.

Insurance companies in the United States should attempt to identify the implications that the changing compliance rules will have on their products in terms of earnings emergence and capital management practices. The financial environment is transforming, so companies will need to begin to prepare for an environment in which they manage and report under several prospective principle-based valuation and capital bases. Companies also need to integrate risk management practices throughout their business processes in a way that is consistent with the way that risk is measured and reported. Pricing, too, should be performed on a basis that is consistent with the way companies measure their performance, in order to ensure that they achieve their overall profitability objectives.


develop—and demonstrate to regulators—integrated approaches to risk management that


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The discount rate should conceptually adjust estimated future cash flows for the time value of money in a way that captures the characteristics of the liability rather than using a discount rate based on expected returns on actual assets backing the liability. The standard should not give detailed guidance on how to determine the discount rate.

The IASB is leaning toward an approach with a separate risk adjustment as well as a residual margin. The IASB decided that the driver selected for releasing the residual margins should result in recognizing those margins in income in a systematic way that best depicts insurer’s performance under the contract. The residual margin should be released over the period during which the insurer is standing ready to accept valid claims (the coverage period). The insurer should not adjust the

Discounting

Margins

Risk margin for the component that cannot be replicated. Risk margin defined as the expected cost for future regulatory capital required to support risks within insurance liabilities that cannot be hedged.

Swap rates. No adjustment for own credit but QIS 5 has included an illiquidity adjustment that will vary by liability. Company’s credit standing cannot be taken into account.

Current Exit Value (CEV)

Solvency II

Continued

Frictional costs are established in lieu of risk margins inherent in Solvency II. Frictional costs are taxation and investment costs on assets backing the required capital over the projection lifetime of underlying risk. An allowance should be made for the Cost of Non-Hedgeable Risk (“CNHR”) not already allowed for in the Time Value of Options and Guarantees or Present Value of Future Profits. These risks are non-financial risks such as mortality, longevity, morbidity, persistency, expense and opera

Swap rates, but at year-end 2008, the methodology was shown to have flaws when credit spreads substantially widened. Some companies have included a liquidity premium, which is determined by reference to the returns expected from the actual asset portfolio held or from that expected from a minimum cost replicating portfolio. The CFO Forum has agreed to do further work to seek to improve the consistency in the adjustments made for liquidity premium and volatilities.

MCEV

Market Consistent Embedded Value


Current Fulfillment Value (CFV) model, consistent with the direction of IAS 37. Another potential CFV is being considered, too. (See section on risk margins.)

IFRS (and FASB) Phase II

A comparison of IFRS (and FASB) Phase II, Solvency II, and MCEV, as they stand as of June 2010

Measurement attribute

Table 6A

Appendix


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Both the IASB and FASB do not want to permit a Allowed gain at issue and would plug up the gain, if any, with a margin. They are leaning toward calibration of initial liability to the premium less any incremental acquisition expenses, implying no significant loss at issue.

Entity specific Entity specific

Profit at issue

Expenses Other noneconomic assumptions


Allowed

Best estimates

Best estimates

tional risks, and non-hedgeable financial risks such as risks due to illiquid or nonexistent markets where the financial assumptions used are not based on sufficiently credible data. Methods that have been used to calculate the CNHR are the cost of capital approach, margin on the discount rate, explicit deduction for asymmetries in risks by stressing assumptions, and assuming a higher locked-in capital base as part of an overall cost of capital calculation to allow for frictional costs as well as CNHR.

Market Consistent Embedded Value



The Boards have expressed an initial preference for Best estimates an approach that includes all cash flows that arise from a participating feature in the measurement of the insurance liability on an expected present value basis.

Policyholder dividends and excess interest

Recently, there has been pushback into companies assuming best estimates and there is a movement to only allow companies to include renewals in flexible premium products to the extent that including them increases the liability.

Solvency II

Based on its project on accounting for leases, the Board is likely to allow some provision for renewal premiums, based on the status of the underlying insurance contract being considered unchanged.

residual margin in subsequent reporting periods for changes in estimates. The risk adjustment is released over risk and is re-measured at each reporting date. The FASB is leaning toward a composite margin, which should be released over time based on the insurer’s exposure to the insurance coverage provided and its exposure from uncertainties related to the future cash flows. These drivers should be implemented using an amortization formula.

IFRS (and FASB) Phase II

Continued

Renewal premiums

Table 6A

Toward a Global Approach to Regulating Insurers and Reinsurers Raj Singh

Introduction One of the key lessons from the recent financial crisis is that regulations need to better reflect the globalization that has occurred in the financial sector in recent decades. The fragmented network of regulatory regimes that currently exists cannot cater to the international character of the large insurance and reinsurance companies that operate today. The insurance and reinsurance industry continues to face tremendous challenges in the years ahead. The ever-changing risk landscape, and regulators’ and shareholders’ demands for greater transparency, will require the industry to set forth its operations in ever more detail. A regulatory framework is required that instills and preserves confidence in the financial health of the industry, while accommodating its unique characteristics and global needs. As this article will explore, steps toward this global approach are underway, even if there is still a considerable distance to go. From a regulatory perspective, the insurance and reinsurance industry faces substantial changes in many of the major markets. In the United States, where insurance supervision is state-based, the industry has been trying hard to modernize the overall regulatory framework. When the U.S. insurance supervisory authorities introduced the risk-based capital (RBC) system in 1994, based on a multi-risk-factor model, it was the most advanced set of regulations in the world. It was considerably more sophisticated than the previous rules and the rather crude solvency margin calculation under Solvency I in the European Union (EU). Most recently in Europe, Solvency II and similar frameworks, like the Swiss Solvency Test (SST), have introduced a more holistic view of all risks. An important difference is that Solvency II will rely on market-consistently valued assets and liabilities, whereas RBC is based on U.S. statutory accounting rules, and thus does not ref lect the true economic reality of a company’s balance sheet. By setting the path toward an economic and risk-based regulation, these regulatory frameworks set a


CHAPTER 7


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new benchmark. Solvency regimes based on economic principles and an all-risk approach point the way forward for how insurance and reinsurance regulations could look in the rest of the world. This can be seen, for example, with Australia’s plans to adapt its regulatory framework along the lines set by Solvency II. There is no doubt that insurance supervision and accounting standards must reach a new level—and on a global scale—in order to better ref lect the economic realities of insurers’ business models. We only need to consider the recent financial crisis for evidence. The regulatory initiatives in Europe and in the United States, as well as the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) joint projects, provide a significant opportunity for greater convergence of views on how to regulate this industry. This article will explore the developments in Europe and the United States before considering post-crisis reform measures and the criteria needed to develop a global approach to regulating the insurance and reinsurance industries.

Solvency II Directive—A New Global Benchmark for Insurance Regulation? The European Council, together with the European Parliament, approved in early 2008 a joint compromise on the Solvency II Framework Directive, paving the way for the new pan-European approach to calculating capital requirements, to come into force by 2013. When fully implemented, insurers and reinsurers in the EU will operate under some of the world’s most progressive insurance and reinsurance regulatory standards. The new regulations are bound to lead to an improved risk culture within insurance and reinsurance companies, stricter requirements for risk management, and greater transparency across the sector. Given the significance of this framework for the industry, it is inevitable that it will have consequences for other regulatory regimes around the world. Supervisory authorities, insurers and reinsurers in Canada, Mexico, South Africa, Bermuda, Japan, as well as other Asian countries, are watching the developments in Europe with great interest. Similarly, the United States is not indifferent to this step forward in European regulation. State regulatory authorities in the United States are assessing the new European regime and embarking on a solvency modernization initiative. But what exactly will change under Solvency II? The new solvency rules, which govern the capital requirements of insurance and reinsurance companies, are intended to establish a more risk-sensitive capital regime. The Solvency II framework is built on three pillars. The first of these pillars sets out the quantitative requirements that an insurance company’s financial resources must fulfill. A key component here is that the use of internal risk models will be permitted to determine the required capital. The second pillar has a qualitative aspect: it establishes the principles for the supervisory review process, as well as for the internal risk management of insurers. The third pillar concerns disclosure and transparency, with the aim of promoting market discipline. In contrast to Basel II, which is the regulatory framework for banks, Solvency II is based on an economic view and takes into account the company’s total balance sheet. Available capital is calculated as the economic net worth of a company plus additional liabilities that have loss-absorption characteristics. The solvency capital requirement (SCR) is determined by taking into account all the risks


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facing insurance or reinsurance companies’ balance sheets in an integrated way. Furthermore, under the directive, the company’s whole balance sheet should be calculated based on the market consistent valuation of assets and liabilities. The Solvency II system also foresees a new approach to the supervision of groups, introducing an effective group supervision system under the lead of a group supervisor. The main difference between Solvency II and the old Solvency I system is that the new approach will assess accumulation potential and explicitly recognize diversification benefits. Diversification is a fundamental principle of the insurance and, in particular, the reinsurance business and can vary across organizations. Under Solvency II, insurance companies will be required to check whether their available capital is sufficient to pay even for rare, large-scale claims, taking into account correlations between risk factors; that is to say, their accumulation potential. For instance, a hurricane can trigger claims in several lines of business at the same time; not just in property insurance, but also in liability and life business. A pandemic would impact life insurance business, but it could also cause losses in the company’s investment portfolio. Conversely, Solvency II will recognize diversification benefits when no correlation exists between risks. Because a hurricane in Florida is not correlated with an earthquake in Japan, broad diversification reduces the cost of taking on risk and improves the efficiency of the capital deployed. The new regulations will lead to more effective risk mitigation, because risk mitigating instruments will be adequately recognized in the calculation of the capital requirements. Different instruments will be treated in a consistent manner, whether they are reinsurance, hedging, or securitization products. As a prerequisite, the insurer must quantify the actual contribution to risk reduction. Solvency II is therefore expected to spur the development of new risk-hedging and risk-transfer tools that provide a true economic benefit, such as insurance-linked securities. Solvency II is scheduled for implementation in EU Member States by 2013, and already many insurance and reinsurance companies are well on their way toward adapting their practices to the new requirements. Many leading European insurers and reinsurers have created the position of Chief Risk Officer (CRO), separating risk management from product design, pricing, and underwriting. Solvency II introduces strong incentives for professional risk and capital management, as well as for an improved risk culture.

U.S. Reinsurance Reform—Towards a Common Reinsurance Regulatory Framework


Toward a Global Approach

The existing U.S. regulatory system has served the U.S. insurance and reinsurance industry well over the years, but it needs to better ref lect the economic reality of an industry that has become increasingly globalized. The U.S. insurance and reinsurance regulatory regime currently comprises 50 states, the District of Columbia and five U.S. territories. The reinsurance market is necessarily global in scope, yet each U.S. jurisdiction adopts and implements its own local reinsurance laws, regulations, and related mandates. Consequently, the U.S. reinsurance regulatory regime requires modernization. Differing requirements among the U.S. states and between the United States and other jurisdictions interfere with reinsurers’ abilities to deploy capital and to serve client companies most efficiently inside the United States and globally. These


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differences affect the extent to which client companies can ref lect the benefits of reinsurance in their financial statements, and they also affect the extent to which reinsurers can ref lect the benefits of intragroup retrocessions in their financial statements. Even before the financial crisis, the National Association of Insurance Commissioners (NAIC) proposed the modernization of U.S. state-based reinsurance regulation. The NAIC proposed to establish a new regulatory framework based on the concepts of mutual recognition, single-state licensure of U.S. reinsurers, and single-state certification of non-U.S. reinsurers from approved jurisdictions. An approach such as this would complement the globalized nature of the reinsurance industry and promote market efficiency. Ultimately, however, the U.S. federal government must assume a key role in the regulation of the global reinsurance industry. A single national regulator for the reinsurance industry in the United States could ensure that suitable, principles-based financial and risk disclosure requirements are implemented. Likewise, solvency monitoring and supervision could be performed using economic and risk-based assessment measures that bring regulatory capital in line with economic capital and give recognition for internal risk models. A total balance sheet view should be introduced when supervising insurance groups. Furthermore, communication and coordination with regulatory counterparts around the world would become easier and more effective, especially because a federal regulator would have the authority to represent the United States in negotiations with other countries.

After the Crisis—The Need for a Global Approach to Regulation During the financial crisis, the lack of coordination among financial services regulators became particularly apparent. In a globalized economy, this limited viewpoint poses a danger. Large financial institutions, whether banks or insurers, should be subjected to group supervision and considered in their entirety across state or national borders. In order to achieve this, there needs to be greater coordination and cooperation between regulators and supervisors around the world. The concept of a lead regulator, as proposed by Solvency II, represents a significant step forward. To be most effective, group supervision needs to be based on a set of formal agreements in which the roles and responsibilities of the various home and host supervisors are defined. As an example, the Swiss supervisor and the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) signed a memorandum of understanding in 2006, which was an essential part of establishing a formal basis for cooperation and information exchange between Swiss and EU supervisors. The International Association of Insurance Supervisors (IAIS) has also developed a Multilateral Memorandum of Understanding (MMoU), which is currently being signed by the relevant nations. The group supervision concept can be further enhanced with the mechanism of the College of Supervisors, as developed by the IAIS and already implemented in Europe. Such colleges encourage the home country supervisor of insurance or reinsurance groups to provide a global view and share comprehensive information on the groups’ risk assessment, governance, and financial situations with supervisors from other jurisdictions where the group operates. Colleges are important


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platforms in crisis management of international and cross-border financial institutions. They also play a key role in building greater mutual understanding and confidence between regulators, ultimately paving the way for mutual recognition of supervisory regimes. However, they should not just be forums for the exchange of information; a decision-making process must be introduced, with a clear role for the group supervisor, giving colleges responsibility to take decisions. The IAIS is also taking important steps in developing a common assessment framework for (re)insurance group supervision. In strengthening the international framework of group supervision, the IAIS should: develop a comprehensive, shared framework for risk and solvency assessment; establish regulatory incentives for sound risk and capital management; address macrosupervisory regimes to ensure adequate representation and recognition of (re)insurance specificities; and establish a legal framework to strengthen cooperation and convergence. In order to accelerate regulatory convergence across countries and to ensure that the view of (re)insurance is adequately considered by governments and international institutions, the IAIS should engage supervisors to agree on implementing a common framework for international (re)insurance group supervision. Politicians, central bankers, regulators, and financial institutions generally agree that given the complexity and global reach of modern financial firms, and the magnitude of the crisis that the world has experienced, there needs to be a macroprudential approach to supervision. Both the EU and the United States have proposed the introduction of a new layer of supervision, with a systemic risk regime to identify emerging risks and to make recommendations on their mitigation. On the whole, the insurance industry withstood the financial crisis well. Insurers were impacted mainly on the asset side of their balance sheets. While the insurance industry supports the introduction of a macrosupervisory regime, (re)insurers are concerned with excessive regulatory reaction, inappropriate spill-over of banking requirements, or discriminatory rules that create an uneven playing field among financial institutions, as well as harmful inefficiencies. The EU recently introduced a draft regulation that proposes a European Systemic Risk Board (ESRB), which would oversee the entire financial services sector and help to identify the kinds of risks that led to the recent crisis. A similar system is being considered in the United States. This so-called macroprudential approach to supervision would be supported in Europe by a microprudential supervision, where national supervisors who look at individual financial institutions would work together with three new European Supervisory Authorities (ESA) who will develop common, binding standards for financial regulation throughout the EU. The U.S. Obama administration recently introduced a regulatory reform report that proposes four significant changes: addressing systemic risk, protecting consumers and investors, eliminating regulatory gaps and arbitrage, and fostering international coordination. The plan outlines few direct federal regulatory changes for the insurance sector, but leaves open the possibility for Congress to address regulation for the insurance and reinsurance industries more specifically. It also proposes the creation of a Federal Insurance Office, with a mandate to promote national and international coordination of insurance supervision. It is important to note that insurers and reinsurers were not affected by the financial crisis in the same way as the banking industry. While banks can be deemed a systemic risk in that their individual failure could spark a widespread




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Accounting Standards—Toward an Economic-Based, Worldwide Standard An additional element that needs to be addressed alongside the globalization of the regulatory framework for insurers and reinsurers is the move toward an international standard accounting method for the industry that truly ref lects the business model of the sector. If the insurance industry is to increasingly present a truly economic view of the risks that they are facing, there needs to be a process of standardization and harmonization of accounts. The key objectives of a process of standardization should be to provide transparent, comparable data on a company’s balance sheet and the risks they are running. Giving clear information about an insurer’s financial position means that shareholders and investors alike are able to get an optimal understanding of the situation, and are better equipped to compare the performance of a particular company against its peers. With this in mind, the EU has requested that the International Accounting Standards Board (IASB) develop International Financial Reporting Standards, or IFRS, for insurance accounting. The first phase of this project resulted in an interim set of standards that allows for a wide variety of different approaches for accounting of insurance contracts. Under the second phase of the project, the IASB plans to develop a permanent standard that will replace the interim solution and which should become the basis for the consistent accounting for insurance contracts in the longer term. Final standards are expected to be published in 2011. The U.S.-based Financial Accounting Standards Board (FASB) is collaborating with the IASB on joint projects, with the goal of converging international financial reporting standards. Beyond this alignment of accounting standards, there also needs to be a commitment to the economic valuation of assets and liabilities in the insurance industry. The valuation of assets and liabilities is the foundation of any measurement of a company. However, in the case of illiquidity, as was witnessed during the financial crisis when certain markets froze up and the market closed down for certain assets, it becomes increasingly difficult to come to an accurate valuation. For insurance liabilities, which are usually not traded in liquid financial markets, this is all the more difficult. As a result, many insurers and reinsurers already base their risk frameworks on market consistent valuation. Market consistent valuation means that components of the insurance liabilities that can be replicated in liquid financial markets are priced at market values, and the components that cannot are marked to model. As interest rates, volatility, or risk premiums rise or fall, then the valuation of the liabilities is adjusted


crisis, insurers and reinsurers, due to their different business models, are less likely to pose such a threat; insurers and reinsurers are less exposed to liquidity risk than banks, less connected with the financial services industry, and do not play a role in the monetary system or in payment systems. Reinsurers, by providing capital relief to primary insurers in times of crisis, act as shock absorbers. They are thus part of the solution to the crisis, rather than part of the problem. Consequently, the insurance and reinsurance industry should neither be the primary focus of macrosupervisory regimes, nor should it be treated in the same way as other financial institutions.


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dynamically. The same approach can be applied to value assets. In illiquid markets, a mark-to-model approach could be used. Through its combination of f lexibility and robustness, the market consistent approach has proven to be a valuable tool. Properly applied, market consistent valuation should not aggravate procyclicality. However, it does require rigorous controls and clear risk governance structure in order to be effective and successful.

Global insurers and reinsurers seek to manage their capital and risk on a global basis in order to provide their clients the full benefits of diversification. In doing so, they can ensure that the capital they hold is commensurate with the worldwide risks on their balance sheet, and they can make sure that the funds they need to support their clients are accessible when and where they are most needed. To provide this necessary capital efficiency, while at the same time providing strong financial support to policyholders, there are various elements that need to be in place. Solvency II offers many of these elements, which include: group supervision measures, with a group supervisor and clear roles and responsibilities for the various players; market consistent valuation of both assets and liabilities, making this the principle that underpins financial information and prudential oversight in insurance; incentives for stronger risk management and empowerment for risk managers to act in a decisive and preemptive way; and the use of internal models for developing business and gauging capital adequacy. The financial crisis has emphasized the need for international cooperation among regulators and made clear the importance of preemptive and independent risk management. Now is the time to move resolutely toward establishing global standards for regulating the insurance and reinsurance sectors, recognizing the equivalence of different systems in various parts of the world and incorporating this within a wider framework of appropriate macroprudential supervision. As a result, the industry will emerge stronger, and it will be well-equipped to fulfill its essential economic function of risk transfer, and thus, as an enabler of economic growth.


Conclusions


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Toward Global Reinsurance Regulation Debra J. Hall and Jérôme Berset

Introduction Significant progress and enhancements have been made in the reinsurance regulatory landscape during the past decade. This is illustrated by the introduction of the Reinsurance Directive in Europe and in North America with the recent NAIC (National Association of Insurance Commissioners) adoption of a longcontroversial proposal for a new reinsurance regulatory framework. Historically, the manner and quality of reinsurance regulation has varied significantly among jurisdictions1—some jurisdictions regulate reinsurers directly, 2 others apply a form of indirect regulation through the reinsurance transaction,3 and still others do not regulate reinsurance or reinsurers at all.4 However, the trend today is to strengthen regulatory requirements and to supervise reinsurers directly, not just through their counterparties. This evolution is a result of a number of factors, including the increased activity of the International Association of Insurance Supervisors (IAIS), the advent of Solvency II, the increased complexity and globalization of the (re)insurance industry, as well as the development of more sophisticated risk management techniques. In this generally more robust regulatory environment, regulators5 are attempting to better balance their roles and responsibility with that of company management, depending on the type of regulatory framework chosen in a particular jurisdiction. Supervisors internationally have taken steps to better account for the idiosyncrasies of the reinsurance business, while company management typically seeks to reduce the regulatory burden by increasing operational efficiencies, simplifying legal entity structures, eliminating redundancies around centralized functions supported with internal/external outsourcing, and urging regulators to focus on the quality instead of the quantity of regulation. Among the reform measures important to reinsurers are: (1) the full recognition of the risk mitigating effect of reinsurance, (2) the reliance on financial strength of the reinsurer and the effectiveness of home country supervision, (3) the increased focus on risk-based principles and integrated risk assessment, and (4) avoiding the


CHAPTER 8


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addition of prudential safeguards by way of indirect supervision (at the ceding company level) when a reinsurer is subject to robust risk-based direct supervision that is in line with IAIS standards. While these reforms were being debated and implemented, the financial crisis intervened, causing supervisors to question the direction in which regulatory reform was headed. This chapter will examine the continued need for reform and what lessons we should learn from the crisis.

Established in 1994, the IAIS is an association of insurance regulators and supervisors from over 190 jurisdictions in nearly 140 countries. According to the IAIS website, these regulators and supervisors constitute 97% of the world’s insurance premiums. Originally established to focus on the development of regulation in emerging markets, the IAIS has, not surprisingly, turned into the standard- setting entity for global insurance and reinsurance regulation. Through its adoption of principles, standards, and guidance papers, the IAIS addresses issues such as: insurance core principles and methodology; capital adequacy and solvency; supervision of reinsurers (both direct and indirect); exchange of information among regulatory jurisdictions; derivatives; use of internal models for regulatory capital purposes; risk transfer, disclosure, and analysis of finite reinsurance; mutual recognition; and group supervision. There exist tensions between individual jurisdictions or regions that seek to retain their authority to regulate (re)insurers 6 in the manner and to the extent that they see fit, and the interests of the IAIS to establish standards that are, or should be, applicable across jurisdictions. The IAIS recognizes that its membership is a wide and diverse one, covering most jurisdictions in the world.7 Likewise, it acknowledges that some insurance lines are offered on a global basis, just as some insurance groups serve a global client base while other insurance products are more locally oriented (ref lecting local market conditions) and offered by locally operating insurers. This tension plays out not only at the global level but between regions (e.g., the European Union and the United States) and within regions (e.g., the various states in the United States).

The IAIS and Reinsurance Supervision The IAIS has adopted several papers that address reinsurance supervision, from the cedent (or transaction) perspective as well as the reinsurer (or entity) perspective. 8 These papers recognize the differences among supervisory practices, but the IAIS endeavors not to favor one approach over another. One approach that has ignited years of controversy at the IAIS and other forums is the practice of certain jurisdictions (e.g., the United States, Canada, Thailand, Portugal, and Brazil) to require that nonlicensed reinsurers provide collateral for their assumed reinsurance liabilities, while reinsurers licensed in the jurisdiction are treated differently. The issue of collateral is discussed more fully below. Also, in recognition of the global scope of reinsurance, the IAIS publishes on a yearly basis a Global Reinsurance Market Report.9 The dedicated group that prepares the report includes representatives of supervisory authorities and delegates of


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reinsurance groups, and it offers focused analyses that address specific reinsurance issues in addition to a range of valuable statistics, which contribute to increasing the understanding of reinsurance business and its specificities within the regulatory community, as well as with a broader audience.

In 2008 the IAIS adopted a guidance paper on the issue of mutual recognition.10 The purpose of the IAIS paper is to provide guidance to supervisors when making judgments as to whether or not to recognize the method and extent of supervision of reinsurers in other jurisdictions, as well as to strengthen cooperation and trust among regulators. Although the IAIS used the term “mutual recognition,” it acknowledges that supervisory recognition might be achieved through various methods, including the following: • Unilateral recognition— refers to a situation where a supervisor recognizes the supervision of another jurisdiction but does not require that the other jurisdiction recognize its supervision; • Bilateral recognition— refers to a situation where two supervisory jurisdictions recognize one another’s supervision; • Multilateral recognition— refers to the situation where several supervisors (three or more) recognize one another’s supervision.11 In theory, supervisory recognition of another jurisdiction’s method and extent of regulation would alleviate the need for the requirement of collateral or other additional requirements for reinsurers that are not licensed in the recognizing regulator’s jurisdiction. It would establish trust among the regulators that would permit them to treat reinsurers that are regulated by the recognized jurisdiction as if they were licensed in the recognizing jurisdiction. However, the reference to “theory” is an important one because not all regulators agree even on this characterization.

Reinsurance Regulation in the United States “Credit for reinsurance laws” have historically been a critical factor in regulating reinsurance in the United States. These laws determine the conditions under which a ceding insurer domiciled or licensed in a state can take financial statement credit for its ceded reinsurance. As such, credit for reinsurance laws contain a powerful incentive for compliance, since there are few situations in which a ceding insurer would be willing to pay out premiums to a reinsurer without being able to ref lect a corresponding increase in assets or reduction in liabilities as a result of the cession. In summary, ceding insurers may take financial credit for reinsurance ceded to reinsurers licensed or accredited in the cedent’s state of domicile, to reinsurers considered to be domiciled in states employing substantially similar credit for reinsurance laws as the cedent’s domiciliary state, or to reinsurers that collateralize their obligations. Collateral may be provided on a multi- or single-beneficiary basis. Some states apply their laws on an extraterritorial basis, meaning that they impose


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their credit for reinsurance laws not only to cedents domiciled in their state, but to cedents simply licensed there, creating significant conf licts between the cedent’s domiciliary state and these extraterritorial jurisdictions. For years, non-U.S. reinsurers have advocated that the U.S. system of reinsurance regulation should recognize their financial strength and relieve them of at least a portion of their collateral obligations. This effort has been opposed by U.S. ceding insurers that object to giving up the collateral they currently maintain or the leverage that the U.S. laws provide in their ability to obtain it in the future. Often, cedents claim that they have confidence in their own reinsurance purchasing decisions but they lack confidence in their competitors, meaning that imprudent decisions on their competitors’ part will ultimately result in increased guaranty fund costs on them, should their competitors become insolvent. Non-U.S. reinsurers often argue that U.S. collateral requirements serve as an inappropriate proxy for the credit worthiness of unauthorized reinsurers. They claim that credit worthiness in the current sophisticated financial services environment is no longer elusive but subject to reasonable and sound determination. The current system, they argue, fails to differentiate among reinsurers with varying degrees of financial strength, though it should, and the means exist to do so. Meanwhile, U.S. reinsurers maintain that any effort to focus on the narrow issue of collateral rather than comprehensive reform is misplaced. Doing so creates winners and losers: non-U.S. reinsurers, which are perceived as “winning” reduced collateral obligations; ceding insurers, which are perceived as “losing” the security currently afforded them; and U.S. reinsurers that continue to be burdened by a system of regulation with 51 jurisdictions (50 states and Washington, D.C.). The latter group argue that, in the end, a comprehensive effort to modernize U.S. reinsurance regulation is the only resolution that will benefit all stakeholders.

Attempts to Reform Reinsurance Regulation in the United States Credit for Reinsurance Recognizing the advances taking place in other jurisdictions like the European Union (EU) (as discussed below)—and as a result of familiarity with other regulatory systems gained by U.S. regulators’ participation in activities of the IAIS, and not immune to political pressures emanating from Washington, D.C., and around the globe—U.S. regulators engaged in an effort in the last few years to reform the nation’s credit for reinsurance laws. In 2008, the NAIC adopted a Reinsurance Regulatory Modernization Framework Proposal (NAIC Proposal), which would allow for a single state regulator of those who opt for and qualify as National Reinsurers.12 Under this system, a licensed U.S. reinsurer, or a “certified” non-U.S. reinsurer (called a Port of Entry Reinsurer, or “POE Reinsurer”), could choose a particular state as its home state (or port of entry) regulator, enabling it to assume reinsurance in every other U.S. host state. Non-U.S. reinsurers could not be certified unless their domiciliary regulatory requirements met certain standards, as established by the NAIC Reinsurance Supervision Review Department (RSRD). The RSRD would assess non-U.S. regulatory regimes for equivalency purposes and facilitate the evaluation of states that wish to become home state or port of entry supervisors. Other factors would be considered in evaluating the domiciliary


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jurisdiction of the non-U.S. reinsurer, including the extent and speed with which that jurisdiction enforces U.S. judgments and arbitration awards. Efforts by the NAIC to garner interest for this regime in Congress have thus far been unsuccessful. However, the currently pending federal legislation aimed at financial regulatory reform will have an impact on these regulatory issues.

The NAIC has also undertaken, since June 2008, its Solvency Modernization Initiative (SMI). The initiative encompasses projects already underway at the NAIC, as well as a study of other financial supervisory modernization initiatives and solvency proposals in place or under development in other jurisdictions, including Australia, Canada, Switzerland, and the European Union. The initiative focuses on five key areas: capital requirements, international accounting, insurance valuation, reinsurance, and group supervision. In examining capital requirements, regulators are considering whether the action and control levels in the NAIC risk-based capital (RBC) are established at appropriate levels, and whether to increase the RBC, past its current role of establishing minimum capital levels, to a more expanded use in requiring regulatory reporting of a company’s economic capital level and information about the development of the company’s target capital. Regulators are also discussing whether additional tools, such as internal models, could serve a role within or as a replacement to RBC. Regulators are also considering whether to implement a system of enterprise risk management ERM reporting—a requirement that insurers perform their own risk and solvency assessment, including an assessment of their risk management and evaluation of the potential impact of risks on their solvency position.

Obstacles to Mutual Recognition between the United States and Other Jurisdictions Although the NAIC at one point considered implementation of the NAIC Reinsurance Regulatory Modernization Framework Proposal through adoption at the NAIC and among the various states, some in the industry argued that doing so would violate the U.S. Constitution. States are sovereign governments within the federal system, with their own regulatory regimes, which are subordinate only to superior federal power under the Supremacy Clause.13 The Foreign Affairs doctrine vests exclusive power over foreign policy with the federal government. States cannot negotiate treaties or bilateral trade agreements with foreign governments, because the U.S. Constitution confers treaty-making power and responsibility for conducting foreign affairs on the President and the Executive Branch. Similarly, the Foreign Commerce clause vests Congress with the power to “regulate Commerce with foreign nations.”14 The Constitution specifically provides that “[n]o State shall enter any Treaty, Alliance, or Confederation,”15 and further provides that “[n]o State shall, without the Consent of Congress, enter into any Agreement or Compact . . . with a foreign Power.”16 Some in the industry argued that the NAIC Proposal violated the Compact Clause because it purported to give the NAIC and the states the power to enter into an agreement with


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Federal Regulatory Initiatives For decades, the U.S. (re)insurance industry has flirted with the idea of federal regulation. Different coalitions have existed at different points in time. However, today the lines of demarcation are typically as follows: those who favor federal regulation (or the option of it) are reinsurers, large/global insurers, and business coalitions; those who oppose it are state regulators and small/regional insurers. Many other constituencies come into play, but describing them goes beyond the purpose of this article. Legislation has been introduced during the past decade that would either create an optional federal charter or, more recently, establish a federal insurance information office that has limited authority. This latter legislation, known as the Insurance Information Act of 2009 (H.R. 2609) was passed on December 2, 2009, by unanimous vote in the House Financial Services Committee. H.R. 2609 would establish, within the Department of Treasury, the Office of Insurance Information. Most importantly, this federal office would be responsible for coordinating federal efforts and establishing federal policy on international insurance matters. The Office of Insurance Information would be authorized to work with the IAIS and enter into bilateral and multilateral recognition agreements with non-U.S. jurisdictions. It would have the power to preempt state law that was inconsistent with federal policy, as entered into pursuant to such recognition agreements. The office would also have the authority to promulgate rules and regulations to carry out its responsibilities. This is an important step for the reinsurance industry, both domestic and foreign. Reinsurance is a global business and it deserves global coordination. That coordination among jurisdictions cannot meaningfully move forward in a state system of regulation. While H.R. 2609 does nothing to immediately create a federal regulator for reinsurers, it properly places the responsibility for U.S. federal policy and regulatory recognition agreements at the appropriate level of government. If we were to design a system of global policy and coordination today, starting from scratch, few would suggest that we would design it in the context of a 51-state system. It is time that the United States moves forward from historical roots that have little to do with the world in which we now live.


foreign sovereigns, without any statutory authority or other indication of consent by Congress to grant such power. Faced with these constitutional obstacles, the NAIC adopted and proposed in Washington, D.C., the introduction of legislation referred to as the Reinsurance Regulatory Modernization Act of 2009 (NAIC Legislation). The NAIC Legislation sought to establish the RSRD (denominated in the legislation as the Reinsurance Supervision Review Department and bestow upon it certain authority that was normally reserved for the federal government. Thus far, there has been little interest in Congress to pursue the NAIC’s agenda.

Solvency II: An Integrated Approach to Reinsurance Regulation for Europe Europe is on its way toward implementing Solvency II, effective November 1, 2012.17 Formally launched in May 2001, observers would probably agree that this ambitious project to create a common supervisory framework for all Members of


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the European Economic Area (EEA) found its roots in the Report on the Prudential Supervision of Insurance Undertakings that was released in December 2002, better known as the Sharma Report. The launch of the Solvency II project took place in the difficult context of the financial crisis that hit the insurance industry in 2001 and 2002. This crisis saw the explosion of the new economy stock market bubble in 2001, aggravated by the claims following the attack of September 11. On the life side, historically low levels of interest rates put an additional strain on investment results and weakened insurers’ balance sheets, leading a number of well-established companies close to bankruptcy. A few cases in countries including Germany, Switzerland, and the United Kingdom were well publicized near-misses. Under these conditions, Solvency II could have taken a very different path, resulting in the implementation of only quick fixes to the existing regime. Fortunately, this was not the case. Rather, the Sharma Report recommended a complete overhaul of prudential supervision in Europe, and it recognized the need to integrate governance and risk management in the solvency requirements that were, until then, mainly driven by the Solvency I quantitative capital requirements based on a set of statutory accounts. It also recognized the need for supervisors to adapt to changing market conditions, with a need to “maintain a balance between market forces and regulatory prevention and control to protect the welfare of an insurance company’s customers and other stakeholders.”18 This also implied the need to reinforce supervisory coordination to more effectively address the challenges of supervising groups that had expanded their activities on a global scale. Back in early 2000, Solvency II began a long-haul journey to develop an integrated and harmonized supervisory framework for Europe. In 2009, recommendations and objectives of introducing an economic risk-based framework, balanced with strong qualitative risk management requirements and reinforced by public risk disclosure principles, found their way into a Framework Directive that was adopted by the European Parliament and, subsequently, by the European Council (ECOFIN).19 In advance of the implementation of the Solvency II Framework, the European Union introduced in 2005 the Reinsurance Directive (RID). This directive opened the door to a single market in Europe for reinsurance by establishing a licensing system that provided reinsurers the freedom to access every EU market with a similar passport system that was already available to primary insurers. As a fast-track directive, the RID introduced a minimum level of harmonization in the supervision of the reinsurance industry, requiring that EU-based pure reinsurers hold a solvency margin, as well as additional capital requirements, in accordance with the Insurance Group Directive. In short, rather than constituting a specific prudential regime for reinsurance, the RID brings regulation a few steps closer to existing insurance regulation. With the implementation of Solvency II, reinsurance regulation will be completely integrated into the framework that regulates the insurance industry’s financial condition and solvency.



Solvency II in a Nutshell In January 2010, J.P. Morgan characterized Solvency II as a “potential game changer.” 20 The new framework does indeed represent a fundamental shift in


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measuring capital requirements and otherwise assessing the financial condition of (re)insurers active in the EEA, as compared to the current simplistic requirements of Solvency I. Though not a complete picture of Solvency II, 21 the following elements are the ones that may truly redefine the “game” for the (re)insurance industry. The first and most important element is commonly referred to as economic valuation. Solvency II will consider the total balance sheet of insurance companies, which includes, among others, the valuation of all off-balance-sheet options and guarantees. This balance sheet will be economic, which means fully based on market observations where available. It will serve for the calculation of solvency capital requirements that will consider the impact of risks and related shocks on both sides of the balance sheet, ref lecting possible accumulations as well as offsetting effects. (For example, an interest rate shock—assume an increase in interest rate level— will lead to a reduction in the market value of the bond holdings on the asset side as well as a reduction of the value of the best estimates on the liability side through higher yields used to discount the liability cash-f lows.) In the absence of accounting standards that set similar economic principles, companies will have to develop a separate set of accounts for Solvency II. Considering the size of the technical provisions on the insurers’ balance sheets that need to be revalued on a market consistent basis, it is reasonable to say that this element of the new framework will have significant implications on the level of “own funds” eligible for solvency22 and the corresponding coverage ratio. 23 Economic valuation will also increase the volatility of the solvency measures, but it will have the benefit of enhancing transparency. Nonetheless, in the absence of consistent valuation principles, the economic view of Solvency II and the accounting perspective (as established, for example, by the IFRS or U.S. GA AP standards 24) may continue to create tensions for capital and risk management steering purposes. The increased focus on the coverage ratio and its volatility is expected to be accompanied by increased scrutiny, both on the riskiness of single investments as well as on the capital consumption of insurance products. The latter may have a significant impact on product development via price adjustments and/or a new definition of risk transfer conditions, due to the combined effect of the new valuation principles and the risk-based capital requirements. Under Solvency II, capital requirements may be calculated with a standard approach or a validated internal model (or partial internal model). The element of the capital requirements that will no doubt have the most important impact on the industry is the calibration of the standard approach. The Solvency II Directive requires entities to hold a level of capital that allows them to withstand an adverse shock with a level of confidence of 99.5%25 Setting the calibration of each risk module in a way that it ref lects the regulators’ risk appetite has turned into one of the key challenges that will determine the real success of Solvency II. Capital requirements have been tested on four occasions with dedicated Quantitative Impact Studies (QIS) and will be tested probably one final time in summer/fall 2010. While the industry overall demonstrated solid levels of capitalization under the last study in 2009 despite the financial crisis, factoring in the latest proposals of the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) could dramatically darken the same picture. With that sword of Damocles over their head, a number of insurers may have to find solutions to


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de-risk their balance sheet on the asset side by, for example, shifting asset allocation away from stock holdings into bond investments. De-risking the liability side of an insurer is generally less immediate. It can be achieved by adjusting one’s business mix with less capital-intensive products, or placing part of the business in run-off, or selling portfolios. Under the new framework, the fastest way to decrease the level of risk will be to buy reinsurance from strongly capitalized reinsurers. Consequently, reinsurers may be among the potential winners of Solvency II, as demand for capital relief solutions may surge, primarily from smaller insurers. Not only will these valuation and capital requirements increase pressure on the industry, the new public disclosure requirements will play an important role in enhancing transparency on the companies’ financial strength and risk-adjusted performance. Each company subject to Solvency II will be required to prepare and publicly disclose a detailed report on its solvency and financial condition. Intended to improve market discipline, this provision may also contribute to increasing the already high competition for scarce capital resources. The fourth and fundamentally new element in European supervision is that each insurer, independent of size, will have to implement a solid governance and risk management framework as well as its own solvency and risk assessment (ORSA). For (re)insurance groups, both have to be embedded into the legal entity structure. Fulfilling this requirement presents a number of challenges, starting with the need for companies to clearly define roles and responsibilities within their organization, particularly at the executive management and Board of Directors level (at group as well as legal entity level). Solvency II will therefore not only impact risk functions, but it will lead companies to establish clear distinctions among risk owners, risk takers, and risk controllers. Another challenge may come from the operational side—including implementation of systems and processes that will produce the data required for the calculation of capital requirements, as well as financial reporting purposes. Understanding the effects of Solvency II also requires a focus on the requirements that are specific to (re)insurance groups. Supplementary group supervision was first introduced in Europe in 1998. With Solvency II, group supervision is not only anticipated but underscored, with most of the requirements applying to single entities mirrored at the group level. Because the current provisions fail to fully recognize group diversification benefits, this may have an impact on the legal structure of groups, which are likely to increasingly make use of the passport option to simplify their legal entity structure and aggregate their risks in a single carrier (e.g., Swiss Re has centralized its structure in Luxemburg and continues to operates locally with a branch network). With its comprehensive approach to solvency supervision, Solvency II has the potential to become a real game changer for the European insurance industry. It is therefore crucial for regulators to strike the right balance in their requirements in order to avoid negative consequences on the industry, and, through its significant contribution to the GDP, the economies of European countries.



The Regulatory Treatment of Reinsurance under Solvency II Solvency II strengthens the harmonization process introduced by the RID. Indeed, the new framework foresees a single supervisory regime with the same provisions applicable


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to all types of (re)insurance entities, as soon as they reach the minimum size threshold prescribed in article 4 of the Framework Directive. The difference between the supervision of a large and complex reinsurance group, like Munich Re, and a small reinsurance captive entity in Malta lies in the application of the principle of proportionality, which requires that appropriate supervisory approaches be provided to reflect not the size, but the nature, scale, and complexity of an entity’s business. In fact, Switzerland’s experience with the Swiss Solvency Test (SST), introduced in 2006 and generally observed as comparable to the future Solvency II framework, tends to demonstrate that supervisory scrutiny may significantly increase for insurance groups and reinsurers due to the complex nature of their business. While the use of an internal model is optional for every undertaking under Solvency II, the SST actually goes one step further, mandating the use of a validated internal model for groups and reinsurers. Solvency II aims to capture the true economics of insurance business. The effect of reinsurance is, therefore, factored into both the valuation of the technical provisions, as well as the calculation of capital requirements. While a few European jurisdictions may still today require some form of collateral requirements, Solvency II will replace these with risk-based capital charges on the primary insurance’s balance sheet, capturing the risk of counterparty default by combining the probability of default and the losses-given-default (LGD) as a measure of the exposure. 26 The probabilities of default of the exposure will be denoted with the ranking of a credit rating agency, whenever available. As a logical result, carriers with a solid financial strength rating , being traditional reinsurers or other rated carriers that provide reinsurance coverage, will become more attractive for primary insurers. While the difference in capital charge may not become a deal breaker for ratings above A, less strong and unrated companies will become expensive with capital requirements that could reach close to 15% of the LGD for a BBB-rated counterparty (over 10 times more than the charge for a A A A-rated counterparty). For counterparties with a rating lower than BB, the capital charge in percent of the LGD could be 100% in the worst situation. 27 For primary insurers, this has different consequences: • Cedents will place a greater focus on the financial strength of the counterparty, and also on its stability over the longer term. Also, they will have an incentive to diversify their reinsurance coverage with several reinsurers to avoid any concentration penalty, which will increase operational complexity, particularly for smaller companies that are used to working with one single counterparty. • Reinsurers unable to demonstrate their financial strength and stability will be under increased pressure to offer some form of guarantees of the stability of their rating. This could include downgrade clauses that provide increased collateralization to compensate the ceding company for the increased capital requirements it may incur (in particular, in the event that the rating deterioration drives the capital charge for the cedent to material levels). • For these companies, a possible downgrade would induce some additional liquidity risk that would need to be appropriately considered in the solvency assessment. • Finally, for cedents entering into reinsurance agreements with unrated carriers (as is often the case for captive structures or internal reinsurance), the CEIOPS expresses a preference for the use of a fixed capital charge 28 over solutions that include deriving the probability of default from the solvency


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In order to appropriately capture reinsurance, Solvency II also needs to find solutions to model the economic impact or benefit of the risk transfer. The new framework develops five key principles that should allow for considering all forms of risk mitigation techniques. These include the principle of an effective risk transfer, the recognition of the economic effect over the legal form or the accounting treatment, as well as the condition for legal certainty, effectiveness, and enforceability. While the modeling of proportional reinsurance is fairly straightforward as to its impact on reserving and measuring capital requirements, assessing the benefit of non-proportional reinsurance is more complex. Appropriately capturing this effect is also of capital importance for cedents using non-proportional transactions to manage peak risks in their portfolio, exactly the risks that will attract high capital charges under Solvency II. Past quantitative tests have shown that catastrophe risks will typically belong to the key risk drivers for Solvency II capital requirements, along with financial market risks (for life insurance), and charges on lines of business with long tails, including third party liabilities. At the time of writing, discussions are ongoing, with the industry proposing to test a simple and rather conservative solution to capture the effect on nonproportional reinsurance during the upcoming Quantitative Impact Study. In summary, Solvency II, independent of how it will finally be implemented, can be expected to give cedents the following incentives: • Smaller companies will likely seek increased protection through reinsurance for capital-intensive lines of business. • As capital requirements are dependent on the counterparty’s financial strength, large strongly capitalized reinsurers that offer traditional reinsurance may benefit first from the increased demand for reinsurance. However, insurers looking to cede business will also have to consider concentration of risks with a single (of few) reinsurance counterparty that will attract specific capital charges. • To better capture the benefit of their reinsurance program, cedents will have a stronger interest in developing partial internal models to calculate their capital requirements. Under Solvency II, the use of partial internal models enhances the industry’s risk management capacity and is a step toward moving to full internal modeling.


ratio of the counterparty. In reality, the absence of a rating does not necessarily correspond to financial weakness. The relatively conservative approach proposed by the CEIOPS could lower the incentives for companies to enter into intragroup reinsurance agreements or seek other forms of efficient risk transfer structures such as securitizations. Recognizing internal ratings used by cedents in their reinsurance decisions, or overlooking the shortcomings of using ratings implied by the Solvency II ratio, remain interesting avenues to maintain a risk-based assessment for unrated entities.

More open are the consequences for alternative risk transfer instruments (ART ), particularly securitizations. Protection from ARTs will be treated similar to traditional reinsurance, based on the effective risk relief they provide on the cedent’s balance sheet. Cost factors will remain as a central element that influences the development


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of such structures going forward. In the mean time, ARTs may remain interesting tools to provide capacities where traditional reinsurance cover falls short.

Reinsurance has long been a global business, and yet regulatory structures continue today to focus at local or, at best, regional levels for some good and other not-sogood reasons. This has led to situations, as discussed above, where third country reinsurance is provided less than equivalent treatment. To address third country-related issues in a more efficient way, Solvency II formalizes the concept of equivalence. For reinsurance, the most important provisions can be found in Articles 134, 172, and 173 of the Framework Directive. Where equivalence is determined to exist, EEA Member States are required to treat reinsurance contracts with reinsurers located in a third country in the same manner as they would treat local reinsurance contracts. Specifically, Member States will not be allowed to require any form of pledging of assets, and shall not require the localization of assets held to cover technical provisions or assets representing reinsurance recoverables within the EEA. From a process perspective, the European Commission (EC), upon advice by the CEIOPS, retains the jurisdiction to unilaterally recognize the equivalence of a third country regime. The decision of the EC will then be binding for all EEA Member States. Alternatively, and only in absence of a decision by the EC, single Member States may also recognize the equivalence of a third country regime. Their decision, however, will be enforceable only locally. In a Consultation Paper released in December 2009, the CEIOPS developed a number of criteria to assess the equivalence of third country solvency regimes and address important issues related to the solvency assessment of international insurance and reinsurance groups. Early in the discussion, the key issue that emerged was the need to find the right balance in establishing equivalence criteria in order to maintain a level playing field for all market players. To achieve this, the following pitfalls should be avoided: • While assessing the third country regime, supervisors need to bear in mind that equivalent does not mean identical or equal. • Assessment has to be contextual and pragmatic. It needs to account for the specificities of the third country solvency regime, in its broad definition (e.g., including relevant elements of the legal framework, like winding-up provisions, arbitration practices, etc.); • Equivalence testing needs to recognize that solvency regimes are evolving, which creates the need for grandfathering provisions and appropriate transitional measures.


Addressing Issues with Third Country Reinsurers: The Case for Equivalence under Article 172 of the Framework Directive

The Way Forward for Global Reinsurance Regulation: What We Can Learn from the Financial Crisis Although beyond the scope of this chapter, careful attention needs to be paid to the lessons we can learn from the recent financial crisis and how these lessons can


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• Efficient reinsurance regulation requires full recognition of all financial resources available to the group on a going-concern basis, supported with mechanisms that facilitate transferability of capital. The concepts of liquidity, fungibility, and transferability of own funds and financial resources are too often confused and, accordingly, addressed with biased regulatory means. We need to demonstrate the importance of a competitive framework to attract reinsurance in a very concentrated and highly competitive market where capital is scarce and competition for it is fierce. We also need to recognize that reinsurance capital is highly mobile; therefore, we need to provide for concrete mechanisms that make capital transferable, and avoid capital that stays idle in some jurisdictions. • Coordination of regulation at the regional level is not sufficient—reinsurance is a global business and the regulation of it must be a global effort. Appropriate regulatory structures that ref lect the geographical reach of global reinsurance are crucial. We need these structures to fully recognize the specificities of the (re-)insurance business. We also need to refrain from blindly applying the same regulatory “remedies” that other sectors of the financial industry impose. In this respect, the IAIS has gained valuable experience, establishing itself as the most appropriate regulatory platform to launch convergence initiatives that would facilitate supervision of groups. To further facilitate global regulatory coordination, developing simple and comparable quantitative minimum requirements, in line with the existing regulatory context in each jurisdiction (e.g., building on statutory technical provisions/reserves combined with a corresponding additional capital buffer), would be a concrete contribution that the newly established IAIS ComFrame Project should seek to achieve. • Regulation needs to embrace and demand stronger risk management. We need to recognize and foster best practices ERM and internal models embedded in business activities. Collateral requirements should be replaced with adequate risk-based capital requirements that foster better risk management practices, in terms of actively managing one’s risk portfolio and determining risk transfer policy and strategy (including criteria for the choice of reinsurers). Financially stronger reinsurers should not be treated in the same manner as those who are not. Primary insurers should bear the responsibility of their choice of reinsurers. • Finally, the economic impact of risk transfer should prevail over the legal form or other nonrelevant elements of the reinsurance transaction. In particular, regulatory capital relief for risk transfer should not discriminate between traditional reinsurance and other forms of risk transfer.


be applied to bolster reinsurance regulation going forward. We can begin with the following:

Notes 1. EC (2002). 2. Examples of countries employing “equal or nearly equal treatment” of reinsurers and direct primary insurers, according to the Framework Study, include Denmark, the


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3. 4. 5. 6.

7. 8. 9. 10. 11. 12.

13.

14. 15. 16. 17.

18. 19. 20. 21.

22.

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United Kingdom, Finland, and Portugal. Countries employing direct supervision through a “reduced regime,” according to the same source, include Austria, Italy, Spain, and Sweden. The United States has, for several decades, regulated both reinsurance transactions (indirect regulation) as well as reinsurers as entities (direct regulation). In the United States, reinsurers are subject to essentially the same direct regulation as primary insurers with the exception of the rates they charge and the terms of their reinsurance contracts. The Framework Study noted that Germany, France, and the Netherlands combined some elements of direct supervision with indirect supervision. (EC 2002). (EC 2002). Jurisdictions vary in their use of the term “regulator” or “supervisor.” The terms are used interchangeably throughout this chapter. In this chapter, reference to “insurer” and “reinsurer” are intended to apply to those segments of the industry. Reference to “(re)insurer” is specifically intended to apply to both insurers and reinsurers. (IAIS 2007). (IAIS 2002a, 2002b, 2003). (IAIS 2009). (IAIS 2008). (IAIS 2008). Although National Reinsurer status would purport to provide those reinsurers with one state regulation, thereby relieving them of the various burdens of multiple state regulation, many reinsurers believe that the NAIC Proposal confers a greater benefit on ceding insurers than it does on reinsurers. The NAIC Proposal expressly reserves to the host states the question of whether risk has been transferred and it requires certain contract clauses that can be and routinely are subject to significant interpretation. Therefore, a cedent need only be concerned about the contractual clause requirements demanded by its state of domicile, while the reinsurer is not only subject to that state’s contractual clause requirements but also to the requirements of the various host states where the reinsurer is licensed. The Supremacy Clause states: “This Constitution, and the Laws of the United States which shall be made in Pursuance thereof . . . shall be the supreme Law of the Land . . . any Thing in the Constitution or Laws of any State to the Contrary notwithstanding.” U.S. Const., art. VI, cl. 2. U.S. Const., art. I, Sec. 8, cl. 3. U.S. Const., art. I, Sec. 10, cl. 1. U.S. Const., art. I, Sec. 10, cl. 3 (also known as the “Compact Clause”). Art. 309 of the Solvency II Framework Directive requires the transposition of the Solvency II provisions for October 31, 2012. It is however expected that the Solvency II requirements will become binding by January 1, 2013. (EU 2002). The European Council (ECOFIN) is the codecision legislative body, that is composed of the Ministers of Finance (or equivalent) of the 27 Member States. (J.P. Morgan 2010). The three pillars of Solvency II include the following: Pillar 1 (quantitative solvency requirements), Pillar 2 (qualitative risk management requirements and supervisory review), and Pillar 3 (public disclosure requirements). Solvency II defines the basic own funds eligible to cover the solvency requirements as the difference between the market value of the assets and the market consistent value of the liabilities.


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23. Eligible Own Funds over Solvency Capital Requirements. 24. The International Financial Reporting Standards (IFRS) are prepared and adopted by the International Accounting Standards Board (IASB). They are in use in a majority of jurisdictions around the world. In North America, they have recently been introduced in Canada. In Europe, IFRS are the standards for financial reporting at group level. For single entities, local Generally Accepted Accounting Principles (GA AP) still prevail. The U.S. GAAP are prepared and adopted by the Financial Accounting Standards Board (FASB), the U.S. counterpart to the IASB. Both Standards Setters have recently started a convergence project. 25. Art. 101 of the Framework Directive states that capital requirements shall correspond to the Value-at-Risk of the basic own funds of an insurance or reinsurance undertaking subject to a confidence level of 99.5% over a one-year period (also expressed as an adverse scenario with a probability of 1 in 200 years). 26. The LGD is conceptually defined to be the loss of basic own funds, which the insurer would incur if the counterparty defaulted. Starting point for the determination of the loss is the current value of the exposure, namely the best estimate recoverables in the case of reinsurance. 27. (CEIOPS 2009). 28. (CEIOPS 2009).

Bibliography Committee of European Insurance and Occupational Pension Supervisors (CEIOPS). “Advice to the European Commission on the Counterparty Default Risk Module for the Scr Standard Formula.” 2009. http://www.ceiops.eu. European Commission (EC). “Study into the Methodologies for Prudential Supervision of Reinsurance with a View to the Possible Establishment of an Eu Framework.” 2002. http://ec.europa.eu/internal_market/insurance/docs/reinsurance/reins-sup_en.pdf. European Union. “Report On Prudential Supervision Of Insurance Undertakings.” 2002. http://ec.europa.eu/internal_market/insurance/docs/solvency/solvency2- conferencereport. International Association of Insurance Supervisors (IAIS). “Principles on Minimum Requirements for Supervision of Reinsurers.” 2002a. http://www.iaisweb.org. ———. “Supervisory Standard on the Evaluation of the Reinsurance Cover of Primary Insurers and the Security of Their Reinsurers.” 2002b. http://www.iaisweb.Org. ———. 2003. “Standard on Supervision of Reinsurers.” http://www.iaisweb.org. ———. “Towards a Common Structure and Common Standards for the Assessment of Insurer Solvency: Cornerstones for the Formulation of Regulatory Financial Requirements.” 2007. http://www.iaisweb.org/__temp/cornerstones_for_the_ formulation_of_regulatory_financial_requierements.pdf. ———. “Guidance Paper On The Mutual Recognition Of Reinsurance Supervision.” 2008. http://www.iaisweb.org. ———. “Global Reinsurance Market Report.” 2009. http://www.iaisweb.org. Morgan, J.P. “European Insurance—Solvency II: a Potential Game Changer.” Europe Equity Research, January 19, 2010.




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Evolution of Insurance Group Supervision Monica Mächler

Introduction Insurance groups play an important role in today’s insurance markets. All the enterprises in the DJ (Dow Jones) Sector Titans Insurance Index operate as groups of companies.1 And these tend to be the largest groups. Other insurance groups of smaller size are also active in many markets around the world. Many factors have contributed to the formation of insurance groups. Insurance regulation has not been an insignificant factor. National restrictions to market access and local licensing and related requirements have tended to favor, and, in many instances even required, the creation of separate local legal entities. Another factor relates to the strategy of some market participants. From a corporate organization perspective, forming a group and managing all of the entities in such a group more and more centrally has been one means for large enterprises to overcome national boundaries and achieve synergies and economies of scale, sometimes also generating adverse effects such as contagion or the pursuit of regulatory arbitrage. 2 As the above has been taking place, both groups and regulators have taken note of challenges that emerge from such arrangements. Multilocal and multientity insurance groups show a variety of interlinkages that reach considerable complexity, going well beyond mere shareholding intricacies. Those inter-linkages include: group-internal decisions on business and structure; intragroup transactions of various sorts, including financing arrangements (such as guarantees and letters of support) between parents and subsidiaries or among siblings; intragroup charges for the use of intellectual property and for central services; groupwide investment policies; groupwide governance and risk management standards and decision making; groupwide reach of auditing practices; and many other groupwide processes. The regulatory responses to these developments have varied considerably, sometimes being disjointed and sometimes complementing other regulatory and supervisory


CHAPTER 9


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measures. Thus, a central question is how best to address the now numerous multilocal and multientity insurance groups in terms of regulation and supervision.3 This chapter is divided into three parts. The first part categorizes and examines the currently existing or planned conceptual approaches to group regulation and supervision. The second part is dedicated to outlining areas where further developments in group supervision are needed, and to establishing which approaches are most apt to address these matters. In this context, lessons learned from the crises of 2001–2002 and 2007 onward are also taken into account. Based on these insights, conclusions are drawn and possible ways forward are suggested. For the purposes of this chapter the term “insurance group” refers to a group of companies that is based on shareholding or contractual links providing for control or substantive inf luence on decision making, and where the activities of the group—or at least a part thereof—center around insurance. As used here, the term “group supervision” refers to the act of supervising or regulating the group as a group of companies (including related parties under certain circumstances). In this context, it is important to note that few jurisdictions are home to internationally active groups. Many more jurisdictions host subsidiaries of internationally active insurance groups.4 There is also some overlap, inasmuch as some countries are home and, simultaneously, host countries. In addition, many groups are primarily national in nature and thus may have little cross-border activity.

Existing and Planned Approaches to Insurance Group Supervision The main approaches today to group supervision in place or planned may be categorized into five types, recognizing that there may exist overlaps or nuances in between these types. They range from having no specific regulations for insurance groups (which is the traditional approach that focuses on the supervision of individual or solo insurance companies), to an approach that gives full attention to the group as a whole. Traditionally, regulatory regimes did not address insurance groups. With insurance regulation dating back to the nineteenth and early twentieth centuries in some jurisdictions, the drafters of insurance regulation could not have anticipated the phenomenon of insurance groups developing so widely. However, as insurance groups began emerging, a few individual jurisdictions began adjusting their regulations to cover them in some way. Subsequently, countries of some regions sought a common set of rules for insurance group supervision. Based on a recent initiative from the International Association of Insurance Supervisors (IAIS), which will be discussed later, an even larger number of countries could be expected to commit to apply common methodologies to insurance group supervision. The five main approaches are: (1) no group supervision, (2) shareholding-centric group supervision, (3) unilateral holistic group supervision, (4) regional holistic group supervision, and (5) multilateral holistic group supervision.


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No Group Supervision In numerous countries insurance group supervision is still not ref lected in regulation, or is ref lected only narrowly. The thrust of insurance supervision in these countries is based on the traditional approach directed at legal entities domiciled


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within the same jurisdiction, sometimes including branches of foreign insurers. Group aspects are, in general, not formally taken into account, although the fact that a local entity is the subsidiary of an international insurance group is likely to be known to the local regulator and may lead to it taking a keen interest in such an entity. Links to the rest of the group may be formally taken into consideration only when the parent or other group companies enter into commitments for the benefit of the local company or vice versa. Such commitments may include reinsurance agreements, guarantees, and the like. Outf lows from the local company, in the form of dividends or other distributions, often attract attention and, under certain circumstances, may require local approval. Furthermore, the outsourcing of local activities to other group companies (or insourcing by the local entity of services from the parent or a sister company) may be examined, and shareholders and members of corporate bodies may have to qualify under local requirements. In addition, it is possible that the local regulator may review the foreign activities of a local insurance company. In all the above examples, the local regulator takes only a limited interest in or action on matters regarding the parts of the group venturing outside of its borders. The preponderance of the regulator’s focus and concern remains the local company. The risk associated with this solo supervisory approach is certain disconnect with the company’s reality. The local company may be driven by dependencies and by forces coming from elsewhere in the group, which are in effect artificially excluded by the regulator’s review, which is focused on the local legal entity. Under these circumstances, there is little expectation that the local regulator will gain a view on the totality of the group, or will regularly seek information from or interaction with foreign regulators overseeing other parts of the group. Whether such a local regulator would fully cooperate with information requests from foreign regulators, or whether local laws facilitate such cooperation, is also less likely.

Shareholding-Centric Group Supervision In some countries, the approach to insurance group supervision focuses primarily on the shareholding relationships of the supervised legal entity. This includes the relationship to its direct (and sometimes indirect) parent, to direct (and sometimes indirect) subsidiaries, and, less frequently, to sister companies. Other affiliates or related parties may also be taken into account under specific circumstances. This approach tends to focus on financial outf lows and transactions that provide linkages upstream to the parent, cross-stream to or from sister companies or affiliates, and downstream to subsidiaries. Compared to these financial interlinkages, groupwide policies and decision-making processes receive less consideration. With the main focus on shareholding relationships, the local regulator often requires approval or preapproval of these relationships and of financial outf lows and inf lows, including transactions, that relate to them. The shareholding-centric approach is valuable in creating a foundation for supervisory review. But, by focusing on shareholding lines, it excludes the financial and managerial interrelationships that go across groups. Perhaps because of this limitation, the U.S. Model Holding Company Act and its implementation in the states’ laws and practices is being enriched with a number of quantitative and qualitative elements.5 Those insurance related provisions did, however, not suffice to address


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the challenges that resulted from the complexity of a group such as AIG (American International Group Inc.) with considerable non-insurance business. In the context of shareholding-centric approaches to group supervision, the local regulator may seek information from foreign regulators overseeing other entities of the group, with respect primarily to intragroup transactions, and may be prepared to answer information requests from foreign rtegulators in this regard. However, other matters regarding the group would be less likely to be captured by the local supervisory radar.

In a few countries such as Australia, Bermuda, Canada, and Switzerland, the approach to group supervision has already moved in recent years, or is moving now in the direction, of focusing more on the totality of an insurance group or insurance conglomerate. This involves overseeing the group from the top company of the group domiciled in the respective country. 6 A holistic group supervision approach looks at a group as a whole and focuses on how the group and its members operate. Thus, it looks at group structure and management lines, intragroup transactions, group governance and risk management, group auditing, and group reporting, among other things. A holistic group supervision approach also seeks to regulate and supervise the solvency of the group as a whole. This is of major importance, as it touches on the capital lifeline of a group and can have an effect on the immediate and long-term economic health of the group and its member companies. With respect to solvency, two different assessment methodologies can be witnessed. Either the member companies are assessed individually, including their links to the other group members (unconsolidated or granular approach), or the group is considered as one economic entity and the consolidated accounts form the basis of the assessment (consolidated approach).7 Under the consolidated approach, the links to the rest of the group are formally taken into account when the parent or other group companies enter into commitments for the benefit of local companies, or vice versa, such as reinsurance agreements, guarantees, or the like. The risk associated with this approach is that there may result a disconnect between the aspiration of a home supervisor viewing the group holistically and its ability to implement it as a result of a lack of powers going beyond its borders. This may be a particular risk when a smaller jurisdiction is the home supervisor to a large, internationally active group and fails to secure the cooperation of other regulators supervising parts of the group. Under these circumstances, it is to be expected that the local regulator will seek information from regulators overseeing other parts of the group, or respond to information requests from regulators of subsidiaries. Cooperation among regulators under this approach is indispensable. To launch and respond to information requests, the use of memoranda of understanding to govern the sharing of information and cooperation among regulators is common practice. Such cooperation often is structured through supervisory colleges chaired by the groupwide supervisor, and involving the regulators of the more important subsidiary companies. 8 Under this approach, of course, the differences in regulatory and supervisory regimes among the various countries involved remain. While it would not be common to have formal equivalence testing processes for insurance supervisory regimes of other countries, there may exist general principles that are applied for this purpose.


Unilateral Holistic Group Supervision


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In countries linked by common constitutional or other frameworks, such as the European Union (EU), a system of holistic group supervision has been evolving in two stages over recent years. In the EU, the first stage includes Directive 98/78/EC of the European Parliament and of the Council of October 27, 1998, on the supplementary supervision of insurance undertakings in an insurance group, and Directive 2002/87/EC of the European Parliament and of the Council of December 16, 2002, on the supplementary supervision of credit institutions, insurance undertakings, and investment firms in a financial conglomerate. The second stage in EU group supervision is triggered by Directive 2009/138/EC of the European Parliament and of the Council on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II). The regime under the Solvency II Directive9 puts considerable emphasis on supervising insurance groups as groups. Insurance conglomerates remain subject to the Conglomerates Directive; however, this directive is expected to be revised.10 According to the Solvency II Directive, group supervision focuses on financial solvency, group governance, risk management, internal controls, actuarial and other processes, as well as reporting. The assessment of solvency is primarily based on a consolidated approach (similar to the Basel II approach for banking supervision), with a fallback being a deduction and aggregation method.11 Commitments for the benefit of local companies, such as reinsurance agreements, individual explicit guarantees, or the like, are formally taken into account. Within this context, the regulators of the EU Member States are expected to operate under a defined regime of cooperation that includes information sharing, consultation, and cooperation. A foundation for these purposes is to be the college of supervisors.12 The Committee of European Insurance and Occupational Pension Supervisors (CEIOPS) plays an important functional role, one which, as a result of the de Larosière recommendations in the aftermath of the recent financial crisis,13 will be strengthened even more as the committee is transformed into a separate functional agency with a wider remit. Regarding relations to non-EU countries, the Solvency II Directive provides for three elements of predefined equivalence testing of third country regimes. One of these elements addresses, in particular, insurance group supervision.14 Thus, there is a harmonization within the region being achieved, and the limits at the external borders of the region are being addressed by providing mechanisms of testing compatibility with other regimes. In the absence of such compatibility, the external borders of the region would limit the EU’s ability to pursue a comprehensive approach, something that it would particularly need for the effective supervision of large multiregionally active insurance groups.


Regional Holistic Group Supervision

Multilateral Holistic Group Supervision While, as described above, a multilateral approach to group supervision exists at certain regional levels, nothing comparable is yet found in practice on a multiregional or global basis. However, principles for such approaches are emerging and will be discussed later.15 The benefits of a multilateral approach are clear. Such an approach overcomes the fragmentation that results from national or regional


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regimes. It also helps avoid regulatory arbitrage or forum shopping. A multilateral approach is consistent with the notion of “rebalanced multilateralism,” as set out in a World Economic Forum Report of 2009.16 Beyond the ability to cover intragroup issues, this approach also allows more possibilities to consider the risks that relate to the business structure and business mix of a group. The need for a nonnational and transregional approach became more evident during the recent financial crisis, including in the context of the fate that befell AIG, ING, Aegon, KBC, and Dexia. Taking these lessons into account, the International Association of Insurance Supervisors (IAIS) took an important step forward in January 2010 when it approved a plan to develop a common approach to group supervision, which, when finally issued, would provide an available framework for the numerous member countries of the IAIS to use. Known as the “Common Framework for the Supervision of Internationally Active Insurance Groups” or the “IAIS ComFrame,” this framework does not rest on the creation of any separate supervisory body. Rather, it is intended to be operated by the local regulatory authorities in coordination with each other. The IAIS ComFrame is planned to be built over three years, and be available in 2013. At such time, calibration tests are to be conducted; following this, the IAIS ComFrame will come into operation. While the IAIS ComFrame focuses on supervision of insurance groups, it will also address interfaces with other sectors in the context of conglomerates. Areas which are planned to be addressed include shareholding and management structures, intragroup transactions; business mix and business development, contingency planning for crisis situations, and situations of failure or bankruptcy. The IAIS ComFrame foresees both quantitative and qualitative requirements. The quantitative requirements relate to reserving, investments, valuation, economic solvency assessment, and liquidity. The qualitative requirements relate to corporate governance, risk management, actuarial, internal controls, internal and external audit, and other processes. Other important elements of the IAIS ComFrame are: (1) a focus on principles with adequate specificity, rather than on detailed rules, and (2) the furthering of cooperation among regulators. The latter is to be pursued by using predefined roles that include information exchange and the utilization of supervisory colleges. For each of these, IAIS ComFrame foresees leveraging on the already existing Multilateral Memorandum of Understanding of the IAIS to ensure appropriate protection of confidential information.17

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While the approaches to insurance group supervision continue to differ, the interest in considering a more common approach is growing. At the IAIS alone, various initiatives to look into and improve group supervision preceded the IAIS ComFrame project.18 One could expect further activity in this area, particularly as important individual elements that relate to groups are examined further by regulators and international standard setters. For example, in its work reviewing the differentiated nature of regulation, as between primarily the insurance and the banking sectors, the Joint Forum recently identified group regulation and supervision and the use of supervisory colleges as high potential areas for a more common approach.


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Complexity of Groups The complexity of international groups has in general been increasing over recent years. The causes of this complexity are many. Some may result from the corporate structure that a group chooses, and its use of legal entities and intragroup transactions and linkages. Other complexities may result from the nature of the business and the business mix pursued by the group. The risks emanating from these complexities warrant regulatory attention. Group Structure. Groups are practically never an assembly of self-contained legal entities without any links other than shareholding. Groups with insurance activities use a wide spectrum of structures that often feature numerous legal entities. Some of these entities may be the result of careful planning, while others may ref lect more accidental accretion. Even originally well justified legal entities may lose their justification over time. Mergers and acquisitions, where, in buying a target, the acquiring company inherits all of the target’s legal entities, also often add uninvited complexity. With the rush of business, some insurers do not always find the time to review the resulting structure and make necessary cleanups. The subject of corporate structures becomes more than a housekeeping exercise when one considers that they may have considerable impact on the financing options of a group and on dividend and liquidity streams (or they may represent dividend and liquidity traps). The question of whether clusters of companies with similar activities are grouped together, or whether they are dispersed, can also affect the potential for disposing of such activities or entities without unreasonable effort or time delay. Corporate complexity can also be compounded where there exist considerable differences between the legal and management structures. The larger these differences are, the greater the risk that a legal entity’s requirements are not attended to with as much attention as would be needed. In addition, the blurring of legal obligations can occur when the same persons assume corporate roles in several legal entities. The structure that a group uses may also have a considerable impact on how effectively it can implement enterprise-wide policies, and how well it can manage and govern the group. If too many legal entities exist, some may be forgotten or not properly managed. If the group structure is too complex or subject to the blurring described above, obstacles of legal, tax, organizational, or those of a different nature could arise that diminish the group’s ability to manage itself and its risks. This, of course, would be of great concern to the various supervisors overseeing the diverse parts of the group.


The increased recognition of the need to better supervise groups can be traced to many sources. Clearly, the challenges that the insurance sector and the insurance supervisors experienced in the crisis of 2001–2002, and in the more recent financial crisis, is one source. Another source is the concern with the growing complexity of groups, as well as their impact and interplay with the economies of different nations. Yet another source is the increasing awareness that, as groups are multinational, purely national approaches are insufficient. As a result, there is recognition of the need to improve regulatory cooperation in group supervision on a national, regional, or multilateral level.


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Structures may also lay the foundation for the need of intragroup transactions and the complexities related thereto. While a structure is mainly based on shareholding, contractual arrangements that are designed to allow for management or even control can also play an important role. Interlinkages between group members may relate to financial arrangements such as guarantees from parents or other affiliates. In addition, interlinkages may be established through the setting up of groupwide standards and processes; for example, regarding reserving, investments, or risk management. As a result, any regulatory or supervisory approach to groups has to cope with these realities. Group structure and interlinkages are addressed, one way or another, by all active approaches to group supervision. Only the solo-focus approach normally pays no attention to structure or interlinkages. The shareholding-centric approach looks at interlinkages mainly to the extent they follow the shareholding lines. The unilateral holistic group supervisory approach seeks a comprehensive view, but may be limited from attaining this view and from implementing it by national boundaries. Such limits are overcome with the regional holistic approach with respect to countries in that region, but continue to exist vis-à-vis third countries. These limitations can only be overcome by a multilateral approach, whereby interlinkages to all jurisdictions involved can be addressed. The multilateral approach works only, however, if the individual jurisdictions that are adhering to the multilateral approach have corresponding powers and use them to implement the multilateral framework. In considering these aspects, it becomes clearer why a multilateral approach is better suited for assessing the risks associated with the challenges that arise from a group’s structural complexities. The multilateral approach permits capturing more ramifications of group structures. At the same time, the multilateral approach is ineffective on its own. It clearly needs to be backed up by the necessary powers of the individual jurisdictions. Given the fact that a multilateral approach is today still under development, holistic approaches that result from unilateral or regional sources remain, for the time being, the most effective tools. The shareholdingcentric approach may also be helpful to the extent it is enriched with elements that reach beyond shareholding lines and financial interlinkages. Nature of the Group’s Business and Business Mix. In some cases, groups remain focused on insurance and ancillary activities, but in others, they expand to other regulated and nonregulated activities. Insurance groups may, in particular, evolve into asset management, securities, capital markets, retail, and investment banking businesses. There also exist combinations with other services or industrial businesses. Certain business mixes may lead to a considerable span of different business models that are being pursued, entailing potentially conf licting liquidity patterns and needs with regard to capital, risk management, and other processes. While a combination of businesses may bring an element of diversification, it may also create risks that would not be found in a more traditional insurance portfolio. These risks become most evident in times of market turmoil, as was seen during the recent financial crisis, where a number of financial conglomerates were severely impacted. The specific mix of business activities at a given moment in time can put a conglomerate under major stress in crisis situations. In many instances, liquidity needs, combined with a down-grading of the company by the rating agencies, trigger a down-spiral that is difficult to control. During the recent crisis, several groups were split up as a result of such tensions.


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The risks described above may be addressed by regulators directly or indirectly. An example of a direct regulatory measure is the prohibition that insurers combine life and nonlife insurance business in the same legal entity. This is a rule that is followed in many jurisdictions. As a group would have multiple legal entities, this prohibition would not affect the group. Other direct measures are conceivable but are likely to be relatively intrusive. Indirect measures could include imposing risk management and internal control requirements or capital add-ons when a group pursues a mix of business that raises the group’s risk profile. Such direct or indirect supervisory measures would need far more consideration before being used, as they could also have other unintended effects. A unilateral holistic group supervision approach might lend itself to addressing some of the risks related to the mix of business by a group, but it faces the limits alluded to earlier with regard to enforcement beyond a jurisdiction’s own borders. The situation may be considerably improved in a regional holistic group supervisory approach, and even more so in a future multilateral holistic group supervision approach.

Economic Impact of Insurance Groups Larger insurance groups, in particular, touch the economies of many nations. They do so in many ways, including by providing or withholding insurance capacity to cover a wide array of risks. In addition, they may pursue related business activities that impact the economic environment. Among other important activities, they are also acting as important investors and sometimes employers. The policyholders and the governments of multiple nations have a genuine interest to safeguard the stability of insurance groups, whether or not they qualify as systemically relevant institutions.19 Even insurance groups themselves recognize the benefits of a comprehensive, integrated, and principle-based supervision. 20 Having sound processes for supervising groups would serve to both protect policyholders and to safeguard the functioning and stability of markets. Improperly supervised groups and destabilized groups can expose the economies in which they are active to a certain level of economic stress, even if their failure should not be excluded at any cost. It is, however, challenging to determine the appropriate quantitative and qualitative standards around the operations of groups, either in situations of the normal course of business or in stress situations. Quantitative elements may concern reserving, investing, valuing, and setting adequate capital and liquidity standards. In the qualitative area, requirements include corporate governance, risk management, internal controls, or internal and external auditing, and these may also help prevent or reduce adverse effects. No degree of group supervision, whether quantitative or qualitative, can fully address all the risks and impacts of a company that belongs to a group. Group supervision cannot replace the focused review of a local company done through a solo supervisory approach. The efforts of each local supervisor reviewing a local company, and of the lead supervisor of a group reviewing the entire group, can together help ensure that all aspects of a group and its member companies are properly covered. These efforts require each supervisor to take into account, as well, the interest of creating and maintaining a stable international financial environment, and not simply the local interests.




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The Need for Regulatory Cooperation on a National, Regional, and Multilateral Level While regulators often speak of the need for cooperation, it is not always easy to achieve. In stress situations, regulators are often under public and political pressure locally. With decision making already difficult at the local level, the local regulator may find it challenging to complicate matters by also involving foreign regulators in the decision-making process. As a result, international cooperation and information exchanges with fellow foreign regulators can come to a stop or be very superficial. With respect to the recent crisis, some evidence suggests that either no meaningful or incomplete cooperation and information exchange was taking place in the period preceding the crisis. Group supervision has the potential to have a preventive effect. Cooperation and information exchange, including through supervisory colleges, takes place in the normal course of business, without a crisis to require it. The roles of regulators, such as lead regulator (even in a cross-sectoral context) and local regulators, can be spelled out in advance. Routine cooperation and exchange of information among regulators deepens the relationship and trust among them, something that can be of significant value, both when identifying earlier signs of crisis and when dealing with a crisis, should it materialize. Besides regulator-to-regulator relations, this approach enhances interaction of multinational groups with the regulators involved. This can also bring efficiencies to all the parties concerned. Of all the approaches for group supervision, the multilateral approach is best placed to help advance this vision. The roles of the various insurance regulators, particularly from a home and host perspective, are spelled out, creating an agreed basis for cooperation. A useful instrument in this regard is the IAIS Multilateral Memorandum of Understanding, as it creates a stable basis for protecting the confidentiality of information exchanged. As this instrument is already in existence, it can be put to use to promote cooperation and information exchange between signatory countries. However, alone, this memorandum of understanding does not provide the needed framework for group supervision. This is what the proposed IAIS ComFrame aims to do by establishing rules of the road for the interaction between home and host supervisors. Once enough countries have the necessary powers in place and they cooperate according to the same rules, the IAIS ComFrame will facilitate addressing home and host perspectives more seamlessly. Until the IAIS ComFrame comes into effect, the needs for enhanced regulatory cooperation are best addressed in the regional holistic group supervision approach, where the roles of supervisors are set out for home countries and host countries within the same region. Unilateral holistic approaches are also helpful, since countries can establish


The approach best suited for permitting this type of complementary work to cover all elements of a group is the holistic approach. Since, to be effective, quantitative parameters in particular need to be closely linked with enforcement powers, the multilateral holistic approach provides the link to securing enforcement power through the various jurisdictions involved. Until such multilateral holistic approach is in place, national and regional holistic approaches will continue to provide the most solid, though not complete, basis for addressing these needs.


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bilateral cooperation protocols or memoranda of understanding regarding cooperation and information exchange.

From the above discussion, it is clear that with the growing complexity of insurance groups, and with recognition of their impact on the economies in the various countries in which they are active, the need for a proactive and comprehensive regulatory approach to group supervision is becoming stronger. This need is not sufficiently addressed through approaches that focus on solo supervision or on shareholding lines. Neither is it sufficiently addressed by unilateral or regional holistic approaches. A sounder and more comprehensive outcome can be reached through a multilateral holistic approach. However, this approach is dependent on the enforcement powers of the local regulators under local law and regulations, and on their will to use such powers in the context of international cooperation. Until the multilateral approach is in place, enhanced shareholding-centric approaches, as well as unilateral and regional holistic approaches, can be useful platforms. The regional holistic approach spells out the roles and responsibilities of the various member regulators, something that is also required in the multilateral approach. National and regional regimes also offer the critical element of enforcement, including in the context of quantitative and qualitative measures. Thus, these approaches are already preparing a basis upon which a multilateral approach can further build. Effective group supervision necessarily involves interplay among the national, regional, and multilateral levels. In the long run, the multilateral holistic approach to group supervision that is adhered to by as many countries as possible will be the most productive way to assure the right interplay of these factors and to address both home and host country needs. However a multilateral framework is configured, it will need to address a range of key issues. This includes defining what a group is, which risks resulting from its structure and business mix should be addressed, what are the appropriate quantitative and qualitative tools for supervising a group, and which mechanisms should be used for regulatory and supervisory cooperation. It is proposed that the framework ref lected in the IAIS ComFrame project contains these essential elements. It is f lexible and can be expanded when new insights are available. Hopefully, it earns the support of regulators and the industry. If properly developed, the IAIS ComFrame can become the international foundation for efficient and effective supervision of internationally active insurance groups, which will contribute to the stability of these groups and help reduce and mitigate their potential disruptions to local economies and to the economic environment. If it succeeds in combining the needs of the home and host countries and remaining f lexible enough to also capture new risks as these emerge, the IAIS ComFrame will represent a significant step toward modernizing the way to regulate and supervise the very important players in the insurance world, which internationally active insurance groups represent.


Conclusion and Way Forward

Notes This chapter is based on a presentation of the author at the Annual Conference 2008 of the International Association of Insurance Supervisors (IAIS) held in Budapest. It also


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1. 2. 3. 4. 5.

6.

7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

http://www.djindexes.com/titans/. (Darlap and Mayr 2006). (Davies and Green 2008). Among the home jurisdictions to the largest groups are Australia, Canada, Germany, France, Italy, Switzerland, the United Kingdom, and the United States. The U.S. Model Holding Company Act shows many features of a shareholding centric approach, but is being complemented with elements that are usually found in a unilateral holistic group supervisory approach (Gross 2009). In the absence of effective group supervision in the foreign domicile of the top company exercised by the local regulator, the Swiss regulator may establish a regime of group or conglomerate supervision, provided the links to Switzerland are close enough, cf. Art. 65 al. 2 of the Swiss Insurance Supervisory Act. (IAIS 2009b). (IAIS 2008b, 2009a). (EC 2009). (CEIOPS 2009b). (EC 2009). (EC 2009). (The de Larosiere Group 2009). (CEIOPS 2009a). (IAIS 2008a). (WEF 2009). (IAIS 2007). (IAIS 2008a). (Geneva Association 2010). (Geneva Association 2010).

Bibliography CEIOPS. “Draft CEIOPS’ Advice for Level 2 Implementing Measures on Solvency II. Technical Criteria for Assessing 3rd Country Equivalence in Relation to Art. 172, 227 and 260.” 2009a. http://www.ceiops.eu/media/files/consultations/consultationpapers/CP78/CEIOPS-CP-78 – 09-L2-Advice-Equivalence-for-reinsurance-andgroup-supervision.pdf. ———. “The review of the Financial Conglomerates Directive.” 2009b. http://www. ceiops.eu/media /f iles/consu ltations/consu ltationpapers/FCD-Review/JCFC Consultation-Paper-on-FCD-Review.pdf. Darlap, P., and B. Mayr. “Group Aspects of Regulatory Reform in the Insurance Sector.” The Geneva Papers 31 (2006): 96–123. Davies, H., and D. Green. “Global Financial Regulation, The Essential Guide.” Cambridge, U.K.: Polity Press, 2008.


draws on findings of the IAIS Task Force on Common Framework on the Supervision of Internationally Active Groups. The author is grateful for the fruitful and inspiring discussions within the ambit of IAIS on developing such a framework, and thanks Gabe Shawn Varges of the Swiss Financial Market Supervisory Authority (FINMA) for his review and suggestions regarding this chapter. The views expressed in this chapter are the author’s own and do not necessarily ref lect the views of the FINMA or of the IAIS.


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European Commission (EC). “Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the Taking-Up and Pursuit of the Business of Insurance and Reinsurance (Solvency II).” 2009. http://eur-lex.europa.eu/JOIndex. do? yea r=20 09& serie=L &text f ield 2=335& Submit= Sea rch& _ submit=Search&ihmlang=en Geneva Association. “Systemic Risk in Insurance—An Analysis of Insurance and Financial Stability.” Special Report of The Geneva Association Systemic Risk Working Group, Geneva. February 2010. http://www.genevaassociation.org/PDF/ BookandMonographs/Geneva_Association_Systemic_Risk_in_Insurance_Report_ March2010.pdf. Gross A. W. “Group Wide Regulation and Supervisory Cooperation—Current Approaches to Group Supervision in a Globalizing World.” The Geneva Association. August 2009. http://www.genevaassociation.org/PDF/Working_paper_series/ GA_E&D_352.09_GROSS_Regulation&Supervision,ERM,Systemic_risk.pdf. IAIS. “IAIS Multilateral Memorandum of Understanding on Cooperation and Information Exchange (MMoU). Basel, Switzerland: International Association of Insurance Supervisors.” 2007. http://www.iaisweb.org/__temp/IAIS_MMoU.pdf. ———. “Principles No. 3.4 on Group-Wide Supervision. Basel, Switzerland: International Association of Insurance Supervisors.” 2008a. http://iaisweb.org/__ temp/7__Principles_No__3_4_on_Group-Wide_Supervision.pdf. ———. “Guidance Paper No. 3.7 on the Role and Responsibilities of a Group-Wide Supervisor. Basel, Switzerland: International Association of Insurance Supervisors.” 2008b. http://iaisweb.org/__temp/18__Guidance_Paper_No__3_7_on_the_role_ and_responsibilities_of_a_group-wide_supervisor.pdf. ———. “Guidance Paper 3.9 on the Use of Supervisory Colleges in Group-Wide Supervision. Basel, Switzerland: International Association of Insurance Supervisors.” 2009a. http://iaisweb.org/__temp/Guidance_paper_No__3_8_on_the_use_of_ supervisory_colleges_in_group-wide_supervision.pdf. ———. “Issues Paper on Group-Wide Solvency Assessment and Supervision. Basel, Switzerland: International Association of Insurance Supervisors.” 2009b. http:// iaisweb.org/view/element_href.cfm?src=1/6639.pdf. The de Larosière Group. “Report of the High Level Group on Financial Supervision in the EU.” February 25, 2009. World Economic Forum (WEF). “The Future of the Global Financial System, A NearTerm Outlook and Long-Term Scenarios, A World Economic Forum Report in Collaboration with Oliver Wyman.” 2009. http://www.weforum.org/pdf/scenarios/ TheFutureoftheGlobalFinancialSystem.pdf ).




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The Role of Financial Conglomerates in the Globalization of Financial Services: Regulatory Complexities and the European Perspective Michel Flamée and Paul Windels

Introduction The industry seems naturally to converge on an organizational structure that combines as many benefits and opportunities as possible. This is most clearly the case with the structure of a financial conglomerate1 where, for instance, banking or investment activities are combined with insurance activities, usually spread over different jurisdictions around the globe. Financial conglomerates have emerged through the wave of mergers and acquisitions in the 1990s, and the trend has been picked up again in the aftermath of the equity market decline at the turn of the twenty-first century. The highly fragmented nature of the European insurance market—coupled with improved economic conditions and low interest rates—has formed the main drivers for such a development. 2 The financial crisis could have changed the prospects of financial conglomerates, in view of the problems and reorganizations encountered with some of those institutions (e.g., Fortis, Erste Bank). However, many conglomerates have weathered the financial crisis relatively well and are already preparing for a strong revival. Based on an analysis of the 30 largest financial conglomerates in the European Economic Area (EEA), the following characteristics can be summarized for the year 2008.3 The primary activity of financial conglomerates is banking, which accounts for more than 85% of total assets in 23 out of 30 groups. Five financial conglomerates have a predominant insurance activity, and two groups have a relatively significant activity in both sectors (weight of the smallest sector is above 20%). Total assets of the 30 largest financial conglomerates account for 35% of total assets in the EEA banking and insurance sector (i.e., €18 225 billion). In particular,


CHAPTER 10


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The Bancassurance Model in Europe In Europe, the increasing linkages between banks and insurance companies are most clearly present in the bancassurance model. At least three key drivers can be distinguished for the adoption of this model. First, banking and insurance services are offered through the same distribution network, allowing for cross-selling opportunities and synergies in asset management. For instance, many financial institutions, predominantly banks, have capitalized on their heavy commercial networks and optimized their workforce, reducing the risk of social turmoil. Second, banks and insurers can profit from operational synergies, for instance, through integration of their administrative processes, optimal diffusion of their competencies and know-how for product development, and realization of tax advantages in relation to product and distribution choices. Third, this model supports the development of efficient capital allocation strategies in view of both economic objectives and prudential requirements. The resulting cost-revenue synergies and diversification benefits provide positive cost effects for consumers, who also profit from a broader and appropriate choice of financial products, as the risk of misselling has decreased. In response to consumer needs, and often inspired by developments in society, new products have been created that combine different financial elements from banking, as well as from insurance. For instance, the aging problem has fostered the need to combine purely financial elements (such as interest bearing or investment products) and insurance elements (such as insurance for infirmary or elderly assistance). In view of the recent difficulties encountered with some large groups, the structure of a financial conglomerate has been called into question. Despite potential cost/revenue synergies and diversification benefits, a conglomerate structure can create risks that ought to be taken seriously. These risks include a contagion effect, moral hazard, regulatory arbitrage, and a lack of transparency.4 The globalization of mixed groups poses particular challenges for both their managers and their supervisors.5 The nature and scale of their business is often so vast that a robust and comprehensive risk assessment is difficult to conduct. Problems encountered in some parts of the group, or in its wider environment, tend to easily affect the viability of the group, due to asymmetries in the risk/return relationship; for instance, between a financial institution and its affiliated special purpose entities. 6 In cases of severe problems, many institutions may be considered too big to fail, due to their potential cost to society, thus posing the problem of moral hazard. Recent events in smaller jurisdictions have shown that some of these institutions can also be too big to save, in view of the required rescue measures.


conglomerates’ insurance sector assets account for 36% of total assets in the insurance sector (i.e., €2 454 billion), and their banking sector assets account for 35% of total assets in the banking sector (i.e., €15 771 billion). Financial conglomerates thus have significant activities in both the banking and insurance sectors, with each financial sector being of comparable importance. However, insurance sector activity is far more concentrated in a limited number of firms. Industry-wide groups such as Allianz, Generali, Axa, and ING, which are active in both the banking and the insurance sectors, have become among the largest players in terms of market share in life and nonlife insurance markets.


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Several considerations can be advanced, however, in relation to recent events. The crisis has not shown any negative spill-over effects from the insurance sector to the banking sector. On the contrary, in most cases, the insurance activities contributed to the maintenance of a certain value of groups with mixed activities. Moreover, in normal times, banking and insurance activities are not necessarily related to synchronized cycles. This fosters the stability of mixed groups while also reducing their cyclical sensitivity. In stressed times, conglomerates comprising different legal entities can be subjected to a profound restructuring. For instance, certain groups could evolve from a bancassurance model toward an assurfinance model (in which insurance activities predominate), due to new regulatory restrictions on banking activities as a result of the crisis. Generally, the activities conducted by the different entities of the group are subject to specific regulations for each financial sector, and the client protection systems also differ per sector. Although this may involve complex legal proceedings, in a worst-case scenario, large financial institutions should prepare themselves to be broken up relatively easily into component parts. To this end, consistent firm-specific contingency and resolution plans should be developed which not only provide clear insights into the complex structure of the group, but also allow for the development of organizational streamlining and a clear ring-fencing of individual company assets for the sake of customer protection.7 Against the backdrop of recent events, it is prudent to conclude that most conglomerates that span banking, insurance, and other financial services have entered the field rather successfully, and are thus here to stay. Undoubtedly, new opportunities for consolidation will emerge, as will new risks, 8 in view of ongoing regulatory change; the crisis has reset the strategic positions in the financial sector, given that mergers and acquisitions are expected to pick up over the next few years. This may lead to a further increase in the number of so-called large complex financial institutions, which are active in many different business segments and operate in numerous jurisdictions across the globe. In this light, the development of a coherent regulatory structure for supervising financial conglomerates, including the creation of a level playing field among the different financial sectors, has become one of the main challenges for supervisors.

The Financial Conglomerates Directive The steady increase of cross-sector mergers within and outside the EU—with a bank acquiring an insurance group or vice versa—has led to the adoption of the Financial Conglomerates Directive (FCD).9 According to the FCD, the supplementary supervision of credit institutions, insurance undertakings, and investment firms in a financial conglomerate should be applied to a conglomerate when the ratio of these entities’ activities to the balance sheet total of the group exceeds 10%, and financial sector entities together exceed 40% of the total assets of the conglomerate. The group can be headed by a regulated banking, insurance, or investment firm, or organized as an unregulated holding company with interests in regulated financial companies. The directive advances specific capital adequacy requirements, organizational requirements relating to risk management and control, and it requires groups to report on significant risk concentrations and intragroup transactions. Regarding the latter, Member States may set their own quantitative limits until further harmonization of legislation.


Role of Financial Conglomerates


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Under the FCD, the exchange of essential information among supervisory authorities is obligatory, as is the appointment of a coordinator responsible for the group supervision and supplementary requirements. The tasks of the coordinator include the coordination and dissemination of information, the assessment of the conglomerate’s financial situation, the internal control system, and the coordination of supervisory actions with relevant authorities. The transposition and implementation of the directive has raised a number of questions and difficulties for supervisory authorities in seeking to apply the underlying sectoral rules to financial conglomerates. Indeed, many rules of the FCD are minimum rules, leaving ample room for national discretion. As a response, further guidance has been prepared with respect to cross-sectoral work on the eligibility of own funds and the assessment of equivalence of financial conglomerates supervision in Switzerland and in the United States. More recently, a review of the directive has been launched to consider the authorities’ practices and the extent to which any differences identified may cause problems. The review is conducted with a particular focus on a precise formulation of the definitions used and an alignment of the scope with the Capital Requirements Directive (CRD),10 the Insurance Groups Directive,11 the Reinsurance Directive,12 and the work underway for insurance supervision with Solvency II.13 Attention is paid to the harmonization of internal control requirements, in particular with regard to the definition of significant risk concentration and significant intragroup transactions, and the introduction of quantitative limits and qualitative requirements for this purpose. The review also focuses on the supervision at the level of the holding company, where the combination of current provisions in FCD, CRD, and Insurance Directives may be confusing. Consideration is given to current restrictions in the use of supervisory tools, the inclusion of participating interests, and the incorporation of asset management companies within the definition of conglomerates and in the directive’s scope, as well as to the supervisory treatment of these participating interests. Discussions on further amendments to the FCD are underway in order to include not only asset management companies but also other related undertakings such as special purpose entities, in the scope of supplementary supervision of the group risks of large complex financial institutions. Consideration will be given to the Capital Advice prepared by the Joint Committee on Financial Conglomerates (JCFC), which points to differences in eligible capital across sectors, as well as to potential distortions caused by using different capital calculation methods, as advanced by the industry. After all technical issues identified have been addressed, the European Commission (EC) intends to assess the impact of the potential changes and launch a proposal for a revised FCD in early 2010. A more fundamental debate on supervisory scope and capital-related issues will be prepared afterward.


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Regulatory Complexities An extended set of regulatory complexities in the supervision of financial conglomerates may be identified. In what follows, we present a limited and nonexhaustive list of challenges that supervisors and industry professionals are confronted with today. For this purpose, the presentation draws heavily on related cross-sectoral work by


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the Joint Forum,14 a working group established by the International Association of Insurance Supervisors (IAIS), the Basel Committee on Banking Supervision (BCBS), and the International Organization of Securities Commissions (IOSCO), as well as on the work of the JCFC at the EU level.

Financial services integration and the development of new risk transfer mechanisms have encouraged cross-sectoral risk transfer between different financial sectors. Entities seeking to transfer risks, which they may have taken on as part of their core business activities, will consider a number of factors such as the cost of transferring or hedging the risk relative to the cost of retaining the risk on their own balance sheet. Next to legal considerations, differences in tax treatment, accounting conventions, and the regulatory capital treatment of risk can inf luence the cost of retaining risk. For financial conglomerates that are subject to different legal frameworks, it is natural to conduct an analysis of the costs and benefits of transferring risks among various legal entities. For instance, the potential for different regulatory capital treatment may create incentives to transfer risks in one entity over another. In particular, if the regulatory capital cost is above what the conglomerate believes to be the appropriate amount of regulatory capital to hold against the risks, the incentive to transfer risks may increase. While firms may react to differences in regulatory treatment, this should not necessarily give rise to significant regulatory concern. Supervisors need to be concerned about the establishment of appropriate risk management techniques and controls to support the system of cross-sectoral risk transfer. They should also be satisfied that all parties involved hold sufficient capital to support the risks. Institutions need to take a sufficiently prudent view of the relevant risks and make a correct measurement of the accepted, transferred, or transformed risks in their internal assessments. For instance, insurance companies that purchase securitized products or provide credit protection through credit derivatives should be able to justify these decisions within their risk management approach. They should demonstrate that they have appropriate risk management and monitoring systems in place to conduct these activities, and hold sufficient capital to support the related risks. The risk of contagion between the different financial sectors, including banks, insurers, investment companies and special purpose vehicles should be carefully estimated. Differences in supervisory frameworks should thus not be problematic if the main supervisory concerns are being addressed in an equally valid way.15


Cross-Sectoral Risk Transfer

Capital Requirements While a certain degree of convergence has occurred within the financial industry (e.g., through the impressive growth of cross-sectoral risk transfer, cross-sectoral investments, and financial conglomerates), there remain significant differences among the business activities of different financial sectors. These differences have justified a continued approach of sectoral capital regulations in order to adequately address the changing needs of each sector. Despite the merits of the evolving sectoral frameworks, little attention has been paid to the potential implications of


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differing sectoral regulations, for instance, on firms’ decision-making and capital allocation strategies. This, however, should not mean that the need for increased regulatory convergence has diminished in importance. Different capital requirements across the financial sectors can be an invitation to regulatory arbitrage. In view of the vast increase in cross-sector activity, greater convergence in capital frameworks should allow a more coherent and transparent evaluation of the risk profiles of the institutions that are subject to these frameworks. There are several trends that are likely to inf luence the progression toward a more convergent approach to capital regulation.16 One trend relates to the developments in information technology and financial innovation, which are unlikely to stop in view of the growing opportunities for business and retail customers. For instance, through product developments, insurance companies have broadened their activities beyond the classical scope of insurance, sometimes offering products with more attractive risk/return, relationships while combining elements from other financial sectors. A second trend relates to the ongoing development of risk management methodologies that enhance the potential of risk measurement and the diversification of the existing risk portfolio. For instance, improvements in the calculation of risk measures that span multiple categories of risk and the aggregation of these risks on a consolidated level may support enhanced cross-sectoral activity. A third trend relates to current progression in the capital regulations within the individual sectors—particularly the Basel II Accord17 in the banking sector and the Solvency II Directive18 in the insurance sector—offering clear avenues for greater convergence in risk management and capital requirements. The trend to base capital regulations on firms’ own measures of risk, for instance, through the use of internal models or a standardized approach, and to strengthen the supervisory focus on the companies’ risk management practices, seems predominant in the financial sector. In the long run, a more harmonized approach to capital regulation across banking and insurance companies could be established in the EU, based on the common principle of “same business, same rules” which may be refined as meaning “same business, same most appropriate rules.” This principle proposes that regulatory capital requirements be calculated on the most appropriate basis for each set of risks, for all related activities, and for all financial institutions under supervision, regardless of their official supervisory status. According to this view, insurance regulations will be of prime importance for underwriting risk, just as credit risk is covered mainly by banking regulations. Such an approach would, by its very nature, limit operations of regulatory arbitrage and allow different actors to interact in an environment characterized by healthy competition.


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Risk Concentrations As the move toward risk-based supervision is gaining momentum, supervisors of financial conglomerates attach a growing importance to the management of risk concentrations. Definitions or metrics for measuring concentrations have traditionally been defined by risk factor, and they tend to vary between the financial sectors.19 However, the scope and treatment of risk concentrations has widened, including not only separate exposures to a single counterparty, product, region, or industry, but also to multiple exposures of different entities of a same group. The management of risk concentrations has gradually broadened from the asset


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side of the balance sheet to the liability side, and now includes off-balance sheet and wider intragroup exposures as well. For instance, whereas the current EU solvency requirements concentrate mainly on the liabilities side (i.e., insurance risks), Solvency II will also pay attention to the asset-side risks. The new regime will be a total balance sheet type regime where all the risks and their interactions are considered. A challenge remains in aggregating risks on an enterprise-wide basis, across risk types and sectors, together with the establishment of a harmonized framework for groupwide risk management. Current developments in risk aggregation are strongly supported by the industry in view of the calculation of diversification benefits. 20 However, the supervisory tools and treatment of cross-sectoral risk concentrations also need to be further improved in order to correctly appreciate risk concentrations that might emerge across different business lines or member companies of a financial conglomerate. Through the introduction of the group support system, the initial Solvency II Framework proposal included the potential allowance of diversification benefits between the entities of a group. Cross-border companies would then calculate a single capital requirement for the group as a whole, thereby lowering the capital level for the aggregated risks. However, that option has not been retained in the final Framework Directive. A review clause that mentions the group support regime will enable the EC to come back to the issue when progress has been made in a number of other areas, particularly on cross-border cooperation between group and local supervisors. A recent analysis of the Joint Forum 21 shows that the measurement and management of risk concentrations across risk categories is limited, with some higher integration levels for insurance-led groups. Important impediments for integrated risk management are the lack of a common IT platform across business units, the absence of a groupwide database, and poor uniformity in collected data. The aggregation of risk concentrations is also challenged by a silo-line risk culture at the company level and the use of different measurement methods for particular risk categories. Some conglomerates do not hold a groupwide view of risk concentration to be important, which necessitates a further strengthening of the strategic management of risk practices. Supervisors have thus required several financial conglomerates to review their governance structure, with the aim of establishing a comprehensive and independent risk management system. As a result, many organizations have assigned the chief risk officer a seat at its highest level of executive management, with direct access to the board, and have installed a periodic reporting system to a board-level group risk committee.



Risk Modeling Spurred by technical progression and practical experience, internal risk modeling in the different sectors is undergoing rapid change. Supervisors are following these developments closely in order to incorporate the improvements into their respective capital frameworks. The growing acceptance of internal models in regulatory approaches is an iterative process, stimulating further model development and the acceptance of new elements in the regulatory frameworks over time. 22 Supervisory interest has resulted in adjustments to the capital requirements in the banking, insurance, and securities sectors in order to incorporate elements


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of companies’ internal models (e.g., Basel II, Solvency II, capital requirements in the U.S. securities sector). Cross-sectoral interest in internal risk models has been driven to a large extent by financial conglomerates and specialized financial institutions, which have taken a lead in the development processes. As models of the different financial sectors are based on similar techniques and are being developed by the same professionals, there could be room for further convergence in market practice. Greater cross-sector convergence could also be achieved in the regulatory approaches on the acceptance of internal models. The principle-based nature of regulatory capital frameworks, such as Basel II, Solvency II, and the Swiss Solvency Test, offer a basis for the formulation of common high-level principles and harmonized qualitative and quantitative requirements. For instance, qualitative requirements—with respect to the validation process, public disclosure, prudential reporting, responsibilities, definition of outputs, and the use of the internal models for internal decision making—could be aligned to receive equal importance in each regulatory framework. A stronger harmonization of qualitative requirements is likely to enhance not only companies’ internal management processes and industry compliance, but market transparency and the supervisory review process as well. This may be particularly relevant for the supervision of financial conglomerates, where different models used by subsidiary companies feed into the model at the conglomerate level. Through the use of equivalent model requirements, crosssector supervisory cooperation could be strengthened when analyzing the risk management and internal models of a financial conglomerate.

Stress Testing Economic capital models, scenario analysis, and stress testing are the most commonly used tools to aggregate risk exposures across risks and sectors, and to understand conglomerate-wide risks on an integrated basis. A recent study of the Joint Forum 23 has advanced a number of limitations and considerations regarding the use of each of these instruments. While economic capital models allow for the aggregation of risks across businesses and risk categories, such aggregation is often exposed to a high level of subjectivity, making comparisons between firms difficult. For instance, the correlation matrices of these models may not capture the dependencies among the different risk factors in a varying macroeconomic context or crisis situation. Second-order effects, such a decline in market liquidity during a downturn period, or hidden risks which only emerge in stressed situations may not be taken into account appropriately. Hence, additional measures for risk concentrations are necessary through more traditional metrics, such as exposure limits and stress testing. The f lexibility and forward-looking feature of stress testing allow for a more dynamic risk management of financial conglomerates. By using extreme but plausible events, risks across risk categories and business units can be measured as a supplement to economic capital models. While periodic stress-testing exercises may provide a significant added value for management decision-making, they are rarely executed on a systematic basis and used for that purpose. Generally, stress testing is used to examine the event-driven nature of exposures, such as catastrophic industry events or company-specific events. The incorporation of business management


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actions or second-order effects in stress testing remains a challenge. Liquidity stress tests tend to be generated on a company basis rather than in relation to other risk disciplines or market events, such as a liquidity squeeze in short-term funding markets. Likewise, the measurement of operational risk is challenged by the restricted availability of data on operational risk events and losses. Another important area where further progress can be made relates to the stress testing of systemic events. Until recently, testing systemic shocks was considered unnecessary because of their extremely low probability of occurrence and the potentially severe implications. Recent events, however, have shown the potential implications of systemic events on the risk concentrations of a financial conglomerate. The interrelatedness of the financial markets and the globalization of the industry may also have altered views among risk managers on the probability of the occurrence of systemic shocks. The need for an integrated risk management goes hand in hand with the development of more comprehensive scenarios, based on both historical and extreme hypothetical situations. The integration of these exercises on a periodic basis in the risk management processes should allow for faster identification of potential risk concentrations.

Risk Mitigation Several instruments are used to directly reduce the quantity of risk, while allowing for an efficient reallocation of capital. Common examples include the use of collateral, netting agreements, reinsurance and co-insurance, inf lation-linked bonds, securitizations, and hedges with derivate instruments. In particular, the importance of secondary markets as a source of risk transfer has grown significantly over the past years. This has lead to the adoption of similar techniques across the financial sectors, such as collateral management, but also to a strong increase in risk transfer, for instance, through the use of credit derivatives. Risk mitigation efforts are recognized in risk exposure calculations, which are reported on a net basis to supervisors. Strict criteria have been defined for the recognition of risk reduction measures in sectoral capital rules. Generally, acceptance is granted where risk mitigation provides an equivalent protection as capital. 24 One of the key concerns of supervisors relates to the effects of risk mitigation measures under stressful conditions. As seen recently, the interrelatedness of the different sectors through risk transfer markets may invoke contagion risks and other second-order effects, which are not explicitly dealt with in most measures. For instance, particular instruments that are used as collateral may become illiquid under particular stress situations. In this regard, a silo-based approach to risk management is regarded as insufficient, since potential concentrations across risk categories may be not captured. At the conglomerate level, intragroup risk mitigation may not really lead to a reduction of the net quantity of risk when risks are not transferred outside the group. This could lead to a situation where the solvency position at the level of the individual companies seems acceptable, while the conglomerate’s capital adequacy on a consolidated basis is not sufficient. Differences in supervisory treatment of risk mitigation between sectors may result in regulatory arbitrage, aimed at minimizing the available levels of capital within a group structure while complicating risk management practices.




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Special purpose entities (SPEs) are a common risk management tool used by institutions that either originate or aggregate exposures purchased from other market participants. Several large, complex financial institutions have become involved in structured finance activity in order to transfer credit risk, interest rate risk, or market risk to other parties. By using SPEs, these institutions may better manage their risk concentrations, have access to additional sources of funding and liquidity, or reduce funding costs. Sometimes SPEs are used to pool risk exposures, thereby gaining greater access to capital markets. Other motivations for the use of SPEs relate to a different accounting or regulatory treatment for off-balance sheet assets, leading to enhanced capital ratios. In the insurance sector, SPEs are predominantly used to transfer risk exposures to liabilities such as catastrophe risk, but also more traditional insurance risks, in securitized products to investors. Financial guarantee providers have used SPEs that contain credit default swaps to provide the equivalent of guarantee insurance. The transfer to an SPE of an exposure to certain assets or liabilities typically results in an unbundling and redistribution of the risk/return profile of these assets and liabilities among originators, investors, and third parties, such as guarantors and liquidity providers. Strong differences in residual exposure to the assets of the SPE may exist for each of the parties involved, after the process of risk disaggregation. For risk management purposes, all participants should be aware of their explicit and implicit obligations and links to the SPE. In particular, they should be able to conduct an aggregated risk analysis that combines exposures on the balance sheet and risks which have been transferred to the SPE. Such a prudent analysis includes the risk of assets potentially coming back on the balance sheet, and the provisioning of liquidity funds in a stress situation such as, for instance, a rating downgrade of the institution itself or a liquidity squeeze in the short-term money markets. Such an approach is increasingly being adopted by credit rating agencies in their company evaluations, and should be replicated for both supervisory assessment and internal risk management purposes. 25 Due supervisory attention should be devoted by financial conglomerates to their own surveillance of SPE activity in order to assess potential implications for the regulated companies’ risk management of this activity. In this regard, firms’ internal risk reporting processes should be considered, and the information provided to senior management, regarding the volume and nature of the risk transfer activities.26 At all times, senior management should be aware of the overall links and obligations to SPEs and be able to monitor the firms’ risk profiles against the approved risk tolerances. Sound risk management practices and a thorough understanding of the risks of SPE usage in varying market conditions by senior management need to be key considerations from a supervisory perspective. As the degree of risk transfer may change significantly over time, regulatory requirements should take into account this possible volatility in relation to capital adequacy, leverage, and prudential liquidity.27


Special Purpose Entities

Moral Hazard With respect to large complex financial institutions, in particular, financial bailouts of governments, central banks, and other institutions have contributed to


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the risk of moral hazard. So-called too big to fail institutions may be tempted to make riskier loans or investments in the future, if they come to believe that they will not have to carry the full burden of losses if the investments turn out badly. While there is no guarantee to financial institutions that a bailout will occur, several elements point toward the necessity of government rescue measures in an emergency situation. The most important element relates to the creation of systemic risk in the financial sector through the collapse of a major player. The risk of a financial meltdown became apparent after the collapse of Lehman Brothers (which did not benefit from a bailout) and the difficulties encountered by other financial institutions and mortgage companies, such as Citibank and Fortis, whose valuation immediately plunged during the financial crisis. Other concerns relate to the impact on the local and wider economy, and the effects on the labor market, in view of a failure of a number of large financial institutions. In order to prevent cascading damage to the economy, governments have developed an array of rescue and support measures for financial institutions during difficult times. These, however, may not always be sufficient, as the balance sheet of large financial conglomerates sometimes represents a multiple of the gross domestic product of certain jurisdictions. In this view, it has been proposed that all panEuropean institutions of a systemic nature, such as financial conglomerates, be supervised at the EU level. Moving supervisory responsibilities for major crossborder institutions to the EU level would mean including all issues related to crisis support and burden sharing. As this was considered to be unrealistic, the proposal has not been retained. 28 In turn, it has been decided that cross-border institutions will be supervised by colleges of supervisors, with the European Supervisory Authorities 29 having the power to arbitrate if necessary. Due to fiscal responsibilities, the supervision of individual firms remains national, which means that smaller jurisdictions must be able to support their small and large financial institutions whenever necessary. In the EU, the discussion of a possible prohibition of financial conglomerates that span banking, insurance, or other financial services within the same group—as formerly institutionalized in the United States in the form of the Glass-Steagal Act of 1933—seems to have not progressed. Critics argued that such a formal separation of distinct business activities would be merely artificial, as cross-sectoral investments and companies’ interlinkages, for instance through risk transfer markets, would not likely diminish. As a result, financial conglomerates will continue to emerge, while confronting supervisors with even greater regulatory challenges. One of the key challenges in relation to the supervision of large complex financial institutions consists of the development of a sound basis for international supervisory cooperation.



International Supervisory Cooperation The risk of transmission of material problems and the additive nature of concentrations within a financial conglomerate underline the importance of supervisors conducting a groupwide assessment of potential concentrations. The supervisory need for information can be satisfied partly by the conglomerate providing key information on material risk concentrations, including exposures in unregulated entities. However, in order to understand all risk concentrations, supervisors of the


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conglomerate’s regulated entities need to cooperate closely, in an attempt to determine the overall risk profile of the conglomerate. Supervisors also need to ensure that firms in the various sectors are taking a prudent approach to the management of risks that they are taking on. Through the development of monitoring and information sharing practices, they may detect particular vulnerabilities related to emerging risks. Supervisors should thus have sufficient information and authority to monitor material risk concentrations across sectors, and to understand how these risks are managed.30 A deficient regulation of complex financial institutions, for instance, in relation to the changing structure of intragroup transactions can be very disadvantageous to the regulated entities or their customers. For instance, important supervisory concerns may arise when intragroup transactions result in capital or income being inappropriately transferred from a regulated entity while affecting its solvency, liquidity, and profitability.31 A similar concern relates to the resolution of regulated entities within troubled financial conglomerates, as solvency regimes may vary across jurisdictions. As such complex transactions do not lend themselves easily to traditional forms of regulation, supervisors need to have access to other canals and instruments to address their concerns, such as participation in supervisory colleges. Through increased cross-border cooperation, supervisors can develop a strong interest in understanding the evolving risk profile of the conglomerate, including the implications for the regulated entities. In order to address these issues, new forms of groupwide supervision that involve different national regulators in colleges of supervisors have been established for all large complex financial institutions.32 Supervisors also increasingly participate in equivalence exercises to examine whether comparable arrangements are in place for the supervision of cross-border groups, both on a solo and on a consolidated or supplementary basis. Such exercises have also been conducted between EU supervisors and third countries, particularly Switzerland and the United States. For instance, an equivalence exercise regarding supplementary supervision was conducted between the CEIOPS and the NAIC in 2004, with the conclusion that a general statement of equivalence for the NAIC was not possible, as the NAIC is not itself a supervisor.33 In the field of information exchange between EEA and U.S. insurance supervisors, a model memorandum of understanding was agreed between the NAIC and the CEIOPS in 2006, and may be used as a basis for information exchange between U.S. state authorities and EEA supervisory authorities.34

Conclusions


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At the European level, the conglomeratization of the financial industry could be considered a relatively new phenomenon with a remarkable track record. Over the past two decades, a limited number of financial conglomerates have come to be among the largest players in terms of market share in life and nonlife insurance markets. The equivalent could be said about those conglomerates with a predominant focus on the banking side. Despite the inherent risks of intragroup exposures and hidden concentrations, financial conglomerates have generally weathered the financial crisis relatively well, providing further support for the hypothesis of risk diversification between banking and insurance activity. In this view, EU policymakers and regulators have considered it inappropriate to subject financial


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conglomerates to additional restrictions. However, a revision of the FCD is underway, with the aim to provide more detailed quantitative requirements to these type of institutions. Despite the spectrum of benefits that large bancassurance groups may produce for their stakeholders, these groups come with substantial risks, which ought to be taken seriously from a supervisory perspective. These relate, among others, to the cross-sectoral transfer of risks between group entities, regulatory arbitrage for accounting, tax and regulatory capital purposes, risk concentrations, deficient risk management practices, corporate governance arrangements, and the use of special purpose entities. Particular concerns relate to the problem of moral hazard and the emergence of a new, systemic risk in case of the failure of a large group. While financial conglomerates are likely to continue to emerge, others may grow until they are too big and too interconnected to fail. At the same time, some institutions may become too large to rescue for individual jurisdictions, thus requiring a coordinated approach on a regional level and the establishment of internationally consistent firm-specific contingency plans. Effective supervision of financial conglomerates will thus need to go hand in hand with a more integrated and harmonized form of cross-border and cross-sector supervision.

Notes The views expressed in this chapter are those of the authors and not necessarily those of the Banking, Finance and Insurance Commission (CBFA). 1. Financial conglomerate shall mean a group that is predominantly active in the financial services sector and fulfills the criteria of articles 2 and 3 of the Financial Conglomerates Directive (EC 2002). 2. (Van Der Ende, Ayadi and O’Brien 2006). 3. Data are extracted from published financial statements for the year ending 2008. 4. (Dierick 2004). 5. (The de Larosière Group 2009). 6. (The Joint Forum 2009). 7. (G20 2009). 8 These risks will be further discussed in the text in relation to regulatory complexities. 9. (EC 2002). 10. (EC 2006a, 2006b). 11. (EC 1998). 12. (EC 2005). 13. (EC 2009a). 14. (The Joint Forum 1999a, 1999b, 2001, 2006, 2008a, 2008b, 2009). 15. (The Joint Forum 2001). 16. (The Joint Forum 2001, 2006). 17. (BCBS 2004). 18. (EC 2009a) 19. (The Joint Forum 2006). 20. (CEA 2007). 21. (The Joint Forum 2008a). 22. (The Joint Forum 2006). 23. (The Joint Forum 2008a).




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24. 25. 26. 27. 28. 29.

30. 31. 32. 33. 34.

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(The Joint Forum 2006). (The Joint Forum 2009). (The Joint Forum 2008b). (The Joint Forum 2009). (EC 2009b). I.e., the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities & Markets Authority (ESMA). (The Joint Forum 1999a). (The Joint Forum 1999b). (FSF 2008). (EC 2008). (CEIOPS 2006).

Bibliography Basel Committee on Banking Supervision (BCBS). “International Convergence of Capital Measurement and Capital Standards: A Revised Framework.” June 2004. http://www.bis.org/publ/bcbs107.pdf? noframes=1. Comité Européen des Assurances (CEA). “Solvency II: Diversification and Specialisation.” May 2007. http://www.cea.eu. Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS). “EU-US Memorandum of Understanding (MoU).” March 22, 2006. http://www. ceiops.eu/content/view/19/23/. Dierick, Frank. “The Supervision of Mixed Financial Services Groups in Europe.” ECB Occasional Paper Series, No. 20, August 2004. http://www.ecb.int. European Commission (EC). “Directive 98/78/Ec on the Supplementary Supervision of Insurance Undertakings in an Insurance Group.” October 27, 1998. http://ec. europa.eu/internal_market/insurance/legis-inforce_en.htm#conglomerates. ———. “Directive 2002/87/Ec on the Supplementary Supervision of Credit Institutions, Insurance Undertakings and Investment Firms in a Financial Conglomerate.” December 16, 2002. http://ec.europa.eu/internal_market/financial conglomerates/ supervision_en.htm. ———. “Directive 2005/68/Ec on Reinsurance.” December 9, 2005. http://ec.europa. eu/internal_market/insurance/reinsurance_en.htm. ———. “Directive 2006/48/Ec Relating to the Taking up and Pursuit of the Business of Credit Institutions.” June 14, 2006a. http://ec.europa.eu/internal_market/bank/ legislation/index_en.htm. ———. “Directive 2006/49/Ec on the Capital Adequacy of Investment Firms and Credit Institutions.” June 14, 2006b. http://ec.europa.eu/internal_market/bank/regcapital/index_en.htm. ———. “General Guidance from the European Financial Conglomerates Committee to Eu Supervisors: the Extent to Which the Supervisory Regime in the United States of America Is Likely to Meet the Objectives of Supplementary Supervision in Directive 2002/87/Ec.” July 6, 2008. http://ec.europa.eu/internal_market/financialconglomerates/supervision_en.htm. ———. “Amended Proposal for a Directive of the European Parliament and of the Council on the Taking-up and Pursuit of the Business of Insurance and Reinsurance (Solvency Ii).” April 22, 2009a. http://ec.europa.eu/internal_market/insurance/solvency/index_en.htm.


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European Commission (EC). “Financial Supervision - Frequently Asked Questions.” Memo/09/251, May 27, 2009b. Financial Stability Forum (FSF). “Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience.” April 7, 2008. Group of Twenty (G20). “G20 Leaders’ Statement.” Speech presented at the G20 Summit, Pittsburgh, U.S.A., September 24−25, 2009. The de Larosière Group. “Report of the High Level Group on Financial Supervision in the EU.” February 25, 2009. The Joint Forum. “Risk Concentrations Principles.” December 1999a. http://www.bis. org/publ/bcbs63.pdf. ———. “Intra-Group Transactions and Exposures Principles.” December, 1999b. http://www.bis.org/publ/bcbs62.pdf. ———. “Risk Management Practices and Regulatory Capital: Cross-sectoral Comparison.” November 2001. http://www.bis.org/publ/joint04.pdf. ———. “Regulatory and Market Differences: Issues and Observations.” May 2006. http://www.bis.org/publ/joint15.pdf. ———. “Cross-Sectoral Review of Group-Wide Identification and Management of Risk Concentrations.” April 2008a. http://www.bis.org/publ/joint19.htm. ———. “Credit Risk Transfer: Developments from 2005 to 2007.” April 2008b. http:// www.bis.org/publ/joint18.htm. ———. “Report on Special Purpose Entities.” September 2009. http://www.bis.org/ publ/joint23.pdf. Van Der Ende, Johan, Ayadi, Rym, and Christopher O’Brien. “The Insurance Business in Europe” in Van Der Ende et al. (eds) “The Future of Insurance Regulation and Supervision in the EU: New Developments, New Challenges.” Brussels: Centre For European Policy Studies. 2006.




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The Architecture of Group Supervision John Trowbridge

Introduction The effective supervision of financial services groups has become one of the more important regulatory challenges emerging from the global financial crisis (GFC) during the period 2007–2009. Such supervision was not well advanced beforehand, and the GFC has emphasized the gap that it represents in the armory of many prudential supervisors around the world. Although most of the causes and effects of the GFC were within the banking industry, the insurance industry did gain considerable prominence due to the travails of AIG (American International Group, Inc.), the U.S.-based insurer that owned a “rogue,” unregulated subsidiary, AIG Financial Products, an underwriter of credit default swaps. This subsidiary demonstrated the interconnectedness of the insurance industry with the remainder of the financial sector, and it would have brought down the whole AIG group had the U.S. government not intervened.1 This chapter explores the need for effective group supervision, the associated design questions, and some of the issues that arise from efforts to implement group supervision. While it concentrates mainly on insurance, it also refers to the supervision of banking groups and of conglomerate financial groups. Because the author is an Australian prudential supervisor, many of the experiences and examples in this chapter relate to Australia, where HIH Insurance, a major supplier of liability insurance, collapsed in 2001, causing considerable financial, economic, and political disruption at the time. This event had major ramifications for prudential supervision in Australia, as the 2003 HIH Royal Commission report 2 made far-reaching recommendations aimed at strengthening both regulation and supervision of Australian insurance. The recommendations include:


CHAPTER 11

“as a matter of high priority, the Australian Prudential Regulation Authority develop and promulgate a standard for the effective regulation of authorized insurers that operate as part of a corporate group,” and “monitor the financial condition of corporate groups, including those with foreign operations.” 3


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John Trowbridge

As a result, the government legislated to give the Australian Prudential Regulation Authority (APR A) the power to authorize nonoperating holding companies (NOHCs) for general insurers in 2002 and life insurers in 2009. APR A has subsequently responded by introducing a comprehensive approach to the supervision of general insurance groups and, at the time of writing, is in the process of extending the same approach to life insurance groups and cross-sectoral groups.

In the 1970s, both the life and general insurance industries were fragmented in many countries, the fragmentation often characterized by modest market shares for the larger companies. For example, Australia had more than 50 active general insurance companies, and the top five companies had no more than 30% aggregate market share, whereas by 2010, the top five companies wrote more than 90% of most market segments. The life insurance industry has consolidated in similar fashion. Other features of the industry were • many companies had a home base in one country and numerous foreign subsidiaries or branches; • there were many composites (life and general); • there were few countries where banking could exist within a life insurance, general insurance, or composite insurance group; • most companies throughout the world operated through intermediaries rather than selling direct to the customer. As well as being an industry that was fragmented locally and globally, most organizations had simple structures (even if they operated internationally), the scope of regulation was limited and supervisory activities were at a low level, and the range of corporate activities was normally concentrated on underwriting insurance and doing nothing else other than managing an investment portfolio. The life industry was fairly well regulated, based on the previous century’s development in conjunction with the actuarial profession. As a result, life companies were generally reasonably well managed financially, although in many markets there were mutuals that had built up big surpluses in earlier decades and that were, therefore, able to use this surplus to support the cost of new business and still maintain their financial soundness. Many companies wrote participating business, in which all the risks were pooled and shared amongst the policyholders, rather than exposing the shareholders. It was rare to see life insurance companies overreaching themselves, although there were two examples in Australia in the 1980s when aggressive growth and high expenses led to their demise. On the other hand, general insurance companies were often plagued by the difficulties of managing volatile business and, indeed, many of the failures that occurred in the second half of the twentieth century were the result of the mismanagement of long tail business, which often caused governments to make many different arrangements, including moving the statutory or compulsory classes (usually workers compensation or motor liability) between the public sector and private sector, sometimes more than once.


Background: Insurance Industry Evolution (1970–2010)


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There tended to be excessive capital in many companies. Today that would be called “lazy capital” and, in comparison with today, one could probably say that their shareholders were undemanding. However, one mustn’t ignore the prominence of mutuals, especially in the life insurance industry, which tended to have high capital ratios because of their lack of access to new capital. Note that earnings on the excess capital were often used to subsidize, to some extent, the remainder of the business, putting considerable competitive or price pressure on shareholder companies. During the last 40 years, there have been a number of failures, much consolidation within the industry by acquisition and merger, many demutualizations, and an increasing emphasis on shareholder returns and the effective use of capital. Further, there has been an increasing variety of corporate structures and business models, together with some expansion in the range of corporate activities undertaken by insurance companies or insurance groups. In some cases, these activities have been outside the insurance industry—usually, but not always, in the financial sector—in various other forms of business activity. By 2010 we have a relatively small number of insurance institutions that are rather larger than the 1970s variety. They are geographically diverse, but their size also represents a concentration of capital and, in effect, a concentration of risk. Offsetting this concentration, to some extent, is the diversification that occurs when portfolios are more widely spread. The industry is now less fragmented and more concentrated; its structures are more complex, financially and legally; some international companies have large market shares in several jurisdictions and have branches and solo entities in many countries; some companies have a diversity of activities, not only in direct insurance and reinsurance but in distribution ownership and, in some cases, involvement in other financial sector businesses; solo regulation has developed strongly; and supervision is generally more intrusive and more effective. Notwithstanding all these developments, one simplification has occurred: there are fewer insurance organizations writing both life insurance and general insurance. In 1970, many industry participants operated in both industries. While that continues to be the case in reinsurance, in direct insurance there have been many organizations that have withdrawn from either life insurance or general insurance in order to concentrate on just one arm of the industry. In the same time period, the financial services industry has generally been liberalized. In 1970 there were few countries where insurers could engage in banking or banks could engage in insurance. The funds management industry did not really exist as a separate industry, but the proliferation and development of unit linked investment products in the last 30 years or so has spawned a large and relatively new funds management industry. As a result, the life insurance industry in 2010 is only part of the industry that it not just dominated but monopolized in 1970. Regulation and supervision have advanced considerably in the same period. In the 1970s there were simple capital rules, no thought of group supervision, and limited attention was paid to risk management and governance. The fundamental questions, the same today as they were in 1970, are about capital, liability measurement, how to underwrite effectively, and how to manage underwriting risk, investments, pricing, and profitability.


Architecture of Group Supervision


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Nevertheless there were parallel advances for underwriting companies, investors, and supervisors. Generally speaking, underwriters now do better and more technical pricing; are more technical and more professional in reserving for liabilities; make widespread use of actuaries to support pricing, financial management, and risk management; and pay greater attention and give better responses to the interests and needs of both investors and regulators. Investors have become more discerning: they want capital efficiency; they want an emphasis on underwriting, not on gaining extra profits from the investment of policyholder and shareholder funds; and they want to see some stability of earnings and also regular growth in earnings. Supervisors have overseen a maturing of solo supervision and they have also developed capital requirements that are more risk sensitive, introduced substantial risk management and governance requirements, and upgraded the requirements for, and scrutiny of, both reinsurance and investments. In the field of regulation and supervision, life insurance has evolved and strengthened. General insurance has evolved from a relatively low level of regulation compared to life insurance and banking, and, in some cases, from no prudential regulation at all. For example, in Australia there was no general insurance regulation until 1974, and in many European countries, reinsurance was still unregulated by the end of the twentieth century. Nevertheless, in the last 40 years, general insurance has tended to follow the life insurance precedent of introducing actuarial control, particularly over claims liabilities and capital management, and also, increasingly, effective capital standards. It can also be said that solo supervision has matured. Incidentally, one area that has not evolved very much in this period is accounting standards. There are still major differences in balance sheet structure and profit measurement in different jurisdictions.

The Need for Effective Group Supervision During the evolution of the insurance industry, as explained above, there has been a proliferation of corporate structures, business models, and market developments. There are many kinds of group structures and more financial sector businesses that operate within group structures. Contagion risk exists within these corporate structures, and experience is demonstrating that, generally, these risks are not as well understood as they might be, either by company boards and management or by supervisors. There have been some well-publicized examples of life-threatening contagion within financial groups in the last decade, and many less-publicized examples as well. Three cases of interest that illustrate the consequences of such contagion risk are:


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• HIH, an Australian general insurer that grew very quickly in the 1990s by aggressive growth of its portfolios and an ambitious local and international acquisition strategy, collapsed in 2001, and was the country’s largest ever corporate failure. Many policyholders lost part or all of their premiums, and many claimants were not paid when the company failed. • AMP, Australia’s largest life insurer for more than a century, made a commercially successful acquisition of Pearl Assurance in the UK in the early


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1990s. It subsequently demutualized and then made a leveraged acquisition of NPI (National Provident Institution) in the UK, secured in part by the Pearl. The group saw a significant weakening of its capital position as a result of the UK stock market downturn of 2002, which saw NPI and Pearl both trying to call on the same capital. The group maintained the integrity of its Australian business only by divesting its UK businesses. • AIG, was the U.S. insurer with more than 150 insurance subsidiaries (life and general) and a collection of unregulated subsidiaries, including AIG Financial Products. Its losses during the GFC were very great and exceeded the parent’s ability to finance it, partly because the assets of the insurance subsidiaries were quarantined by insurance supervisors around the world in order to protect policyholders. The U.S. government lent AIG large amounts and also injected equity to ensure AIG’s survival, pending divestments, which, at the time of writing, are in the course of execution. These cases illustrate some of the contagion problems which can occur in financial groups and which, in each case, were either not foreseen or not well managed at the time. • HIH: The company, a liability specialist, had consistently engaged in the underreserving of its claims in the 1990s and, as a result, also underpriced its products, thereby generating illusory profits for several years. These profits, the apparently sound balance sheet, and the company’s low prices facilitated rapid growth of existing portfolios and expansion into new markets. When the inevitable crash came, it was bigger than anyone had foreseen because a myriad of intragroup transactions in the 1990s, followed by a range of questionable reinsurance and other transactions in the “death phase” as senior executives “gambled for resurrection,” severely compounded the earlier weaknesses. Poor financial management at all levels, combined with unwise or unsound intragroup transactions, were fatal. • AMP: The Australian parent owned several life companies in the UK, but the fateful transaction was the purchase of NPI in 1999.The transactionas financed by some borrowings and supported by guarantees from Pearl Assurance, which was already owned by AMP and, itself, financially sound. However the leverage on capital, inherent in both the NPI financing and the high allocation of shareholders funds to stock market investments, caused near fatal capital losses when the UK stock market fell 43% in 2001 and 2002.



Adverse market conditions damaged two subsidiaries within the group during an ambitious growth phase and, alongside some gearing and some intragroup guarantees, weakened the capital position of the group, which forced divestitures. • AIG: The credit default swaps business, AIG Financial Products, was an unregulated business that had grown very quickly, and which, when viewed with


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The general conclusions from these cases, which are relevant to the management and the prudential supervision of corporate groups in the financial sector are: contagion risk of various kinds can exist within corporate groups, complex corporate structures and financial arrangements can mask some contagion risks, boards and management of groups need to understand these contagion risks well and manage them effectively, and prudential supervisors need to work out how to maximize the protection of policyholders and depositors against such risks. The AIG case, in particular, has caught the attention of insurance regulators around the world because it has demonstrated two critical features of insurance regulation, as it applies in 2010 in most jurisdictions around the world: • The first feature is the extraordinary strength of solo supervision. For more than 150 AIG subsidiaries in many different countries, not one policyholder was left stranded, notwithstanding the difficulties of the parent company. The explanation is that solo supervision of insurance companies is functioning well, and the evidence is that the assets of the AIG insurance sub • subsidiaries were successfully quarantined by regulators within those subsidiaries, out of reach of the parent. This is to the credit of insurance supervisors in the United States and in many other countries. • The second feature is the absence of effective group supervision (because one subsidiary, an unregulated one, was able to severely damage the group). That is the subject of this paper. Hence solo supervision, that is, supervision of insurers at a solo entity level, does work. The challenge is to maintain the integrity of the solo supervision of insurers while also carrying out effective group supervision that protects the integrity of the group, including all regulated and unregulated subsidiaries. The AIG case demonstrated this need clearly, but at the same time, it and the other cases cited previously demonstrate that the risk attributes or exposure to risk of groups as a whole cannot be ignored. The lessons from AIG should now lead to a range of regulatory initiatives that will, in time, include:


hindsight following the extraordinary conditions of the GFC, was badly undercapitalized and was taking excessive risks. These matters were not visible to insurance supervisors at the time. Adverse market conditions caused losses in an undercapitalized and unregulated subsidiary, which were beyond the capacity of the parent to support. The group’s collapse was prevented only by emergency government funding, pending forced divestitures.

• either more effective supervision of specialist insurance groups and crosssectoral financial groups or restrictions on the scope of activities of specialist insurance groups; and • for financial sector groups, greater emphasis on and scrutiny of intragroup transactions, capital management, governance, and risk management practices.


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The prudential goal of group supervision is to ensure that the group is financially sound and that group activities and interrelationships do not adversely affect the financial soundness of the regulated entities within the group. Expressed another way, the primary prudential aim of group supervision is to minimize contagion risk to regulated entities within a group from other group operations and, thereby, reduce the likelihood of failure of the group’s regulated entities. The supervisor’s position is based around protection for policyholders from contagion risks within the group, and the three main such risks are: • inappropriate capital or ownership arrangements at group level (e.g., debt financing or, as is often the case with venture capital, short term ownership); • unregulated entities in the group that can compromise the solvency of the group; and • intragroup transactions such as loans, guarantees, double leveraging, et cetera. It is also relevant to note that the introduction of group supervision can be seen by financial groups as just another regulatory burden. In addition to improved risk management, however, there are three potential benefits that insurers can gain from group supervision: • mobility of capital; • recognition of diversification benefits; and • reduced or streamlined regulatory requirements. It is useful to describe the current state of play in order to create a reference point for understanding design issues associated with group supervision. What do we have today? Supervisors: • a comprehensive understanding of what needs to be done to protect policyholders in solo entities; • good regulation in most countries for the solo supervision of insurance companies; • regulations that are increasingly principles-based rather than prescriptive; • an increasing number of staff of regulatory agencies who are competent supervisors in dealing with individual companies.


Designing Group Supervision

Industry: • the capability generally to meet regulatory requirements at solo level; • entrepreneurial instincts, which often push the boundaries of existing business models and scope of business activities; • fewer mutuals, because many have demutualized;


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• insurance groups undertaking an increasingly wider range of noninsurance activities; • the existence of some financial conglomerates.

• There is no comparability of balance sheet and profitability measurement and no uniformity of capital requirements for insurers across different jurisdictions • Group supervision is underdeveloped and, in many jurisdictions, there is limited experience and understanding of the full ramifications of group supervision. • In many jurisdictions, there are insufficient legislative powers to undertake effective group supervision. Industry • Without prudential regulations in place, financial groups generally lack the discipline and incentive, and, in some cases, the skills and experience, to introduce high standards of governance, capital management, and risk management at group level.

The “Prudential Hierarchy” Parliament or government promulgates legislation in which the primary role is usually to give supervisors the powers they need to make regulations and to enforce them. Legislation may also prescribe some aspects of the regulations. Regulations are often designed or issued by the supervisor rather than the legislature. They generally have the full force of law but also contain many details that are usually more readily modified than legislation. Supervision is the activity of trying to enforce regulations. Prudential supervision is preventative (before failure) rather than punitive (after failure), the latter approach being more common outside the prudentially regulated sector. The primary conditions for successful prudential supervision, of both solo entities and groups, are appropriate legislative powers, suitable regulations, and effective supervision. So how is group regulation done, what are the legislative preconditions, what is the nature of the regulations needed, how will the groups themselves and their subsidiaries be affected, and what can be achieved by supervisors?


What do we not have today? Supervisors:

Legislative Powers Adequate legislative powers are the starting point for supervisors. Groups that are predominantly insurance groups or conglomerate groups that include one or more


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insurers are not, in most jurisdictions, being successfully supervised as groups. There are several reasons for this situation, but it is a common feature of all too many jurisdictions that the supervisors do not have the legislative powers they need to undertake effective group supervision and, therefore, also lack the necessary supervisory tools. And these problems exist at two levels: in individual jurisdictions and across borders. As is the case for solo entities, the supervisor needs to have the authority or the power to set standards for all aspects of capital, governance, and risk management, and also to enforce adherence to the standards. Incidentally “all aspects” needs to include unfettered access to information and, in relation to capital, the construction of the company’s balance sheet for prudential purposes. The supervisor needs to be able to allow or disallow particular assets or liabilities and to determine their value, sometimes referred to as applying “prudential filters” to the balance sheet. In other words, the supervisor needs to be able to modify the balance sheet in the published accounts, which meet accounting standards, so that each item in the balance sheet is measured appropriately for prudential purposes. This may mean, for example, writing down some or all forms of intangible assets and increasing the value of policyholder and claims liabilities. If our reference point is a supervisor that has all of the legislative powers needed for the successful supervision of solo insurers (and banks), we can also assume that the supervisor has adequate powers to supervise those groups, which have as their parent company a licensed operating insurance company or bank. We make this assumption because, by having the power to set standards for capital, governance, and risk management of the parent—including the power to assess or reassess the values of any assets and liabilities of the parent (which would include in such a case all the subsidiaries, regulated and unregulated, local and foreign)—the supervisor can be expected to have at his disposal all of the requisite prudential tools for group supervision. Hence, the real test for group supervision arises when the group has as its parent a NOHC (nonoperating holding company), or, alternatively, a company that is an operating company but operating in an industry or in a manner that falls outside the power or scope of the prudential supervisor. Where there is a NOHC, the preferred position is that the supervisor has the power to apply to the NOHC the full suite of prudential standards and tools available for solo supervision. This would include the power to obtain through the NOHC any information that the supervisor might wish to have about any subsidiaries in the group. That information access is essential, for there are two kinds of relevant subsidiaries that are unregulated: companies whose business is not the underwriting of insurance policies or the acceptance of bank deposits; and insurers or banks that are regulated in a foreign jurisdiction and which, ipso facto, are not regulated by the group’s home jurisdiction. The actual position for NOHCs is less than ideal in most jurisdictions. For example, in Europe, NOHCs are not regulated but the regulators of solo entities have full access to information from upstream companies, including a parent NOHC. In Switzerland, NOHCs themselves are not regulated, but the supervisor has full information access and also the power to apply capital requirements, risk management, and governance standards to the group as a whole, and, as a




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consequence, is able to enforce group prudential requirements through the individual regulated entities. In many other jurisdictions, the inf luence of supervisors over NOHCs, directly or indirectly, is rather less than in the European Union and in Switzerland. By contrast, in Australia the supervisor has all of the requisite powers, thereby enabling the supervisor to introduce comprehensive group supervision. If the parent is a company that lies outside the reach of the prudential supervisor, there are two possibilities to be considered. One is the case of a local parent company that is an operating company and is unregulated (for example, a funds manager, retailer, building company, etc.). The other is the case of a foreign parent company, usually an insurer (or bank), whether it be an operating or a nonoperating company (note that a foreign parent that is licensed in its home jurisdiction is still an unregulated parent in the local jurisdiction). In both cases a good solution is to require the financial group to insert an NOHC between the group and its parent, which the legislation also needs to permit. This is far more than for the sake of good order, because it allows the financial group to be identified and supervised as an integrated whole that is financially and legally separated from the unregulated parent.

Group Regulation: Insurance Groups If there is legislative power to apply the full suite of prudential standards to NOHCs, regulations relating to groups can be developed that enable supervisors to deal with the potential contagion risks within groups. Supervising insurance groups on a consolidated basis is a viable approach for understanding and minimizing contagion risk within such groups. The capital base of a specialist insurance group (or specialist banking group) can be assessed on the basis that the group is treated as if it were a single consolidated entity. This works because in a single industry, the capital requirements of each insurer (or bank) in the group can be added together to determine the group capital requirement, to be compared with the group capital base derived from the consolidated accounts. In some insurance jurisdictions, a single industry group means only general insurance or only life insurance, so a group that comprises both would be classed as a conglomerate group (see next section below). Consolidation will not always work for conglomerate groups, and it also will not work if the supervisor does not have full regulatory power over a parent NOHC. As with all prudential regulation, there are many aspects to be catered to in standards. Instead of explaining the possibilities abstractly, it is expedient to explain some of the more significant aspects, with reference to the group-specific requirements that APR A has introduced for general insurers licensed in Australia.


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• Definition of a group: An insurance group is defined so as to include all entities in the group that conduct insurance and related business, both locally and internationally. The group contains all insurance subsidiaries (both domestic and international) and any other controlled entities that are integral to its insurance business, including related service entities.


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• Nonconsolidated subsidiaries : Individual subsidiaries that are not associated with the insurance business can be deconsolidated for group supervision purposes. In such cases, the value of their equity exposure is deducted from the group’s capital base. • Capital upgrades: When determining the capital base of the group, individual components of capital that are measured in a subsidiary, regulated or not, must not be upgraded to a higher category of capital when included in the measurement of the group’s capital base (for example, debt in the parent cannot be treated as equity in a subsidiary). • Intragroup capital transactions: Any component of capital that arises from intragroup transactions may be excluded from an insurance group’s capital base if that component is assessed as not contributing to the financial strength of the group. • Unregulated subsidiaries that are undercapitalized: If a subsidiary within the group is undercapitalized, the parent may be required to deduct from its capital base an amount to cover the deficiency. Effective treatment of unregulated subsidiaries is important, as the AIG case has demonstrated. APR A deals with unregulated subsidiaries in two steps: • Information on the subsidiary has to be made available to the supervisor on request. • If APR A believes it is undercapitalized or otherwise a threat to the financial strength of the group, the parent is obliged to hold enough extra capital to offset the undercapitalization.

Group Regulation: Conglomerate Groups Many aspects of the regulation of specialist insurance (or banking) groups and conglomerate groups are the same. The features that are different, however, are so different that full conglomerate supervision has yet to be introduced in any jurisdiction. The jurisdiction that is closest to its introduction is probably Australia, where, at the time of writing, APR A has released a discussion paper with comprehensive proposals.4 Subject to consultation, full conglomerate supervision is expected to be introduced in 2012. The complications of conglomerate groups, relative to specialist insurance groups or banking groups, revolve around matters of capital, including: the inability to consolidate, in relation to both the group’s actual capital and its required capital, consequent upon the different nature of the capital requirements in different industries; the need to identify and deal with unregulated subsidiaries that are material, such that it is not appropriate simply to deconsolidate them or treat them as excised from the group; the complications around quality of capital (Tier 2 capital and hybrid Tier 1 capital) when two different industries are involved; and capital management, which, as a process and as a board responsibility, is more demanding and more complex than for solo entities or specialist groups.




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• in lieu of consolidation , a “building block” or “legal entity aggregation” approach for required capital, and either an aggregation or consolidation approach for actual capital; • for material unregulated subsidiaries, that groups undertake their own assessment of capital adequacy across the group and then subject that assessment to scrutiny by APR A; • to deal with quality of capital, that only equity-equivalent (Tier 1) capital be recognized for group capital purposes, to be compared to a Tier 1 equivalent required capital; and • on capital management, that the board make its own internal assessment of capital adequacy, including target levels of surplus or capital for the group, and also undertake a “transferability assessment” with regard to the disposition of surplus capital within the group.

Limited Legislative and Regulatory Powers In jurisdictions where the ideal set of legislative powers is not granted to the supervisor, or where regulatory requirements are limited by legislative or other factors outside the control of the supervisor, some trade-offs and compromises will be needed, pending improved powers. Group supervision entails more risk for regulators, for not doing it effectively or getting it wrong may be worse than doing nothing at all. So, regulators and legislators need to work out how far they are prepared to go. Do they restrict the activities of the group (for example, to insurance businesses only) in order to facilitate and ensure effective group supervision? Or do they design group regulations to deal with companies with multiple subsidiaries in one or more industries; that is, do they avoid restricting the business activities of companies that engage in insurance, while simultaneously protecting the interests of policyholders? This latter alternative sounds simple and, of course, it supports entrepreneurial and other activities that work in the direction of industry development, whereas the former would constrain the business activities of insurance companies and limit the evolution of insurance groups and other cross-sectoral financial groups. The evolution of financial services, the expectations of most communities, and the ambitions of most governments will lead to the latter direction—regulation of groups with multiple subsidiaries, including noninsurance activities that operate alongside insurance activities. It is, therefore, imperative that regulators find a way to go down this path. The challenge for regulators is to continue to protect the interests of policyholders in regulated insurers, without contamination or contagion from other parts of the group, for as long as it takes to introduce an effective group supervision regime. Note that the matter is complicated by the existence of both branches and subsidiaries within many group structures. Effective regulation of branches that are in a different country from the company’s head office is not a straightforward matter.


Each of these problems is soluble, however, and the Australian approach is illustrative. APR A has proposed:


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One may ask: Why is group supervision so difficult and how different is it from solo entity supervision? The general answer in 2010 is that, in most jurisdictions, there is a lack of experience and a lack of precedent for doing it. So, before looking at some of the details, it is worth revisiting some of the principles for effective prudential supervision or scrutiny. These principles apply equally to solo entities and groups. Once the regulations are in place, scrutiny of a group is not very different from scrutiny of a solo entity, just more demanding. Clearly, scrutiny is also easier to achieve in cases where the group is prudentially supervised by only one agency. In many jurisdictions, there is only one agency and one set of regulations applicable, but some jurisdictions have several. Fragmentation of regulation and supervision is problematical, as demonstrated by the AIG case, where the group supervisor, OTS (Office of Thrift Supervision), was separate from the New York Insurance Commissioner and other state commissioners that were responsible for the U.S. insurance subsidiaries of AIG. Furthermore, where groups have operations in more than one jurisdiction, effective supervision necessarily involves some level of recognition and/or interaction of supervisors across borders. Because of the importance of effective supervision or scrutiny, and the fact that the GFC brought to the surface supervisory limitations in some jurisdictions, it is worth describing here some of the characteristics of effective supervision. One very good source is the HIH Royal Commission, which in 2003 included the following recommendations for APR A:5 • Develop a more sceptical, questioning, and, where necessary, aggressive approach to its prudential supervision of general insurers. Consultation, inquiry and constructive dialogue should be balanced by firmness in its requirements and a preparedness to enforce compliance with applicable standards. • Develop and review processes, guidelines, and training to assist its staff in considering the appropriate approach to take towards supervised entities in different situations. • Develop systems to encourage its staff and management continually to question their assumptions, views and conclusions about the financial viability of supervised entities, particularly on the receipt of new information about an entity. • Develop an internal system for tracking all relevant information concerning regulated entities. • Develop mechanisms for investigating the reinsurance arrangements of authorized general insurers on a random but frequent basis.


Supervision or Scrutiny of Groups

These recommendations give depth to a more abbreviated but consistent principle that is enunciated by the Financial Stability Board in its 2009 “Principles for Sound Compensation Practices” regarding effective supervisory oversight: “Supervisory review . . . must be rigorous and sustained, and deficiencies must be addressed promptly with supervisory action.”


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Note also the importance of the primary governance principle for effective supervision, namely that the supervisor be able to hold the board of a regulated entity (solo or group parent) directly accountable for meeting the supervisor’s standards and requirements. Living up to these standards may not be easy, but failing to live up to them almost certainly increases both institutional and systemic risk, independent of the quality and scope of regulations. The accountability generated by high standards of scrutiny will always be worth more prudentially than the introduction of, for example, higher capital requirements. That is emerging as one of the more important prudential lessons of the GFC.

Some Lessons Learned about Group Supervision Australia has had group regulation of banks since 1999. It has been a relatively simple regime to supervise, however, because until recently, all banking groups have had their major operating company as the parent company within the group. As a result, most of the business of the group was done in the parent company and all the other businesses, whether banking or not, were subsidiaries of the operating company. Nevertheless there is one overriding lesson from the Australian experience with larger banking groups. It is that the measurement of actual capital is a very difficult exercise and nothing can be taken for granted. The Australian experience in introducing group supervision for general insurers in 2009 is instructive. The market is not large, but it has about 130 authorized solo insurers and some 30 groups, including several that are “one on one,” that is, the group comprises one operating insurer that is owned by a nonoperating holding company. APR A decided that every solo insurer that is not owned directly by another insurer would need to be subject to group supervision if there is no upstream entity, meaning in all cases except where the insurer is owned by a listed company (which, by definition, has multiple shareholders and dispersed ownership), or is a mutual (i.e., owned directly by its policyholders), or is owned directly by a foreign parent that is an established insurer. If the insurer is privately owned by a small number of owners, APR A may require the establishment of a NOHC in order to have a clear view of the capital structure. The reasons for this “one-on-one” approach are best explained by the following examples.


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• APR A has discovered that, in some groups, the solo entity was equity funded by a parent that was itself debt funded. This is an unsatisfactory position that needs to be rectified by the parent restructuring its capital. In other words, APR A has rejected the “ring fencing” approach, which, not surprisingly, is widely advocated by the industry but which, in principle, is prudentially unacceptable because it usually means forgoing group supervision in favor of solo supervision only. • Some groups have complicated legal structures with various corporate goals such as debt funding, moving profits, or costs to other entities in the group for tax or other purposes, et cetera. In some such cases, the best solution for


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group supervision is to restructure the group. It is highly desirable that, in this situation, the regulator has the power to oblige the group to restructure. One of the principles here is that capital cannot be upgraded from debt to equity, or, expressed another way, the capital in the insurance business needs to be totally unencumbered so that it is available to absorb losses, with no recourse of any kind being available to the owners. • Some groups sit inside a larger group that undertakes other activities that are linked, perhaps only loosely, to the insurer’s activities. The prudential supervisor is interested in the integrity of the capital position of the insurer and, therefore, in the corporate and financial integrity of the group as a whole. Some insurers have a parent with unregulated subsidiaries that are reliant on the parent for their solvency and are also suppliers of services to the insurer. In these situations, there may be intragroup debts, guarantees, or other transactions which need to be understood. Insurers typically respond in cases like these by proposing a stronger “ring fence” for the insurer. APR A can be expected to reject this argument on the grounds that it wishes to be privy at all times to all material intragroup transactions, present and future, because potential contagion risk within groups needs to be subject to scrutiny. The overall effect of APR A’s introduction of group supervision for general insurance has been a “cleanup” of the corporate and capital structures across the industry, as well as reduced risk across the industry. To summarize the situation, there have been several important lessons from APR A’s experience in introducing full group supervision for general insurance, which commenced only in 2009, which was a year of implementation for both the industry and the supervisor. A surprisingly large number of unforeseen implementation issues arose, with many different possible legal structures exhibiting, in some cases, complexity around capital, difficulties around governance, and increased risk across the group. Noting that all general insurance groups in Australia are now headed by authorized NOHCs, the main observations following the implementation are: 1. The preexisting group structures, both legal and financial, which had not previously been visible to the regulator, showed an astonishing variety. 2. The legal structures of some groups were unsuited to group supervision and needed to be modified; some groups needed a degree of formal restructuring, and for some other groups some serious thinking was needed about governance and capital management. 3. Restructuring of the group can be beneficial for the group as well as for the supervisor: • Restructuring is needed only if it is complexity within the group that creates difficulty or a lack of clarity around one or more of governance, capital structures, financial management, and risk management. • Experience shows that simplifying the legal structure in order to overcome these difficulties and to bring clarity and transparency is often welcomed




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If there is one overarching observation that can be made from the APR A experience, while recognizing that APR A has the benefit of adequate legislative powers to introduce comprehensive group supervision, it is that: Applying carefully a set of principles-based group regulations aimed at protecting policyholders against contagion risk within the group, supported by effective scrutiny by the supervisor, can achieve the goal of applying successful supervision to a wide variety of business models, legal structures, and financial arrangements within groups.

Notes 1. (Baxter 2010). 2. The HIH Royal Commission was established to investigate the 2001 collapse of HIH, which represented the largest corporate failure in Australian history. The commission delivered a three-volume report to the Australian Parliament on April 16, 2003, detailing extensive recommendations for improving regulation and supervision of Australian insurance companies. 3. (HIH Royal Commission 2003). 4. APR A (2010). 5. (HIH Royal Commission 2003).

Bibliography Australian Prudential Regulation Authority (APR A). “Discussion Paper: Supervision of Conglomerate Groups.” 2010. http://www.apra.gov.au/Policy/upload/Discussionpaper-Supervision-of-conglomerate-groups-March-2010.pdf. Baxter, Thomas C. “Factors Affecting Efforts to Limit Payments to AIG Counterparties.” Testimony before the Committee on Government Oversight and Reform, U.S. House of Representatives. January 27, 2010. http://www.newyorkfed.org/newsevents/ speeches/2010/bax100127.html. HIH Royal Commission. The Failure of HIH Insurance. Canberra, Australia: HIH Royal Commission, 2003.


by the board, for it improves the board’s ability to do its job effectively, just as it benefits the supervisor; that is, both the board and the supervisor find that greater transparency and greater simplicity of the legal structure and financial structure reduce risk and increase the ability of the board and the management team to understand and manage the business as a whole. 4. Because of points (2) and (3) above, the very introduction of group supervision sometimes has an immediate risk reduction consequence for the group.


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The IAIS Multilateral Memorandum of Understanding: An Important Tool for Cooperation and Information Exchange between Insurance Supervisors Peter Braumüller and Alexander Warzilek

Introduction The insurance business has become more international in nature over recent decades, with many insurance entities expanding their national activities into international markets—through branches, subsidiaries, joint ventures, cooperation agreements with local insurers, or direct cross-border selling of insurance policies. Furthermore, political changes, trade liberalization, privatization, the establishment of integrated market structures, technological developments, increased need for underwriting capacity for large risks, and demand for reinsurance capacity outside the insurer’s home jurisdiction have created new opportunities. Fiercer competition has also resulted in cross-border mergers of insurance companies. Against this background, there are a significant number of internationally active insurers, as well as insurance groups and financial conglomerates.1 It is crucial that insurance supervisors react in an appropriate way to this reshaped environment. Cross-border supervisory cooperation and coordination are key elements to achieving supervisory objectives. For internationally active insurers and insurance groups, supervision of the domestic business by the local supervisor can only be the starting point. Supervisors need to be informed about business undertaken abroad and about cross-border relationships; detailed and timely information on all of the activities of the supervised entity is a fundamental condition for a state-of-the-art supervisory approach. 2 The information received from the supervised entity has to be examined and analyzed by the competent supervisor and supplemented by information from other supervisors on the cross-border activities of the particular insurer or group, and on the respective markets and their legal, economic, and financial frameworks, and, in particular, the risks involved.3


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As a consequence, the issue of cross-border information exchange and cooperation has become increasingly important in the field of insurance supervision.

A project designed to improve cross-national cooperation is the framework Multilateral Memorandum of Understanding (MMoU), developed by the IAIS (International Association of Insurance Supervisors). It aims to promote the participation of IAIS members to advance cross-border cooperation and information exchange, not only in crisis situations, but also in day-to-day business. Since the G20’s call for better international cooperation and more information exchange during their Pittsburgh Summit, even more importance has been attached to this initiative. As the number of participating IAIS members continues to grow, the IAIS MMoU should be a valuable instrument to foster policyholder protection as well as financial stability on a global level, and it may potentially minimize the impact of future financial crises. In addition, it will further converge by aligning supervisory standards and procedures of the signatories, and thereby strengthen insurance supervisory regimes.4 This will also strongly assure mutual trust and confidence amongst signatories.5

The Launching of the MMoU In 2005 an IAIS working group started to draft the MMoU framework. The attempt to establish such a framework is the logical next step forward after the adoption of the IAIS model Memorandum of Understanding (MoU), which is an archetype for insurance supervisors for the conclusion of bilateral MoUs. In November 2006, the draft of the MMoU framework was sent to IAIS members for consultation. IAIS observers were also invited to comment on the draft. The project was widely well received. Observers were supportive but stressed the importance of having appropriate legal standards of protection for exchanging confidential information. Moreover, they came forward with the proposal to obtain explicit consent from the requested authority as a precondition for the requesting authority to pass on confidential information to third parties. The working group agreed to this suggestion. Another idea from the observers’ side was to give notice of the information exchange between signatory authorities to the relevant regulated entity or entities. The working group dismissed this proposal by pinpointing parallels to already existing bilateral MoUs between insurance supervisors. Regarding these MoUs, notification to regulated entities is not envisaged. From a legal perspective, the reasoning for that is the regulated entity is not part of the bilateral agreement between the insurance supervisors. 6 As a consequence, the entity cannot derive any rights from the MMoU, not even one of information. In addition, such a notification would be an encumbrance to supervisory activities. In many cases it is important that the regulated entity does not know about the investigations initiated by the requesting authority. Ultimately, in February 2007, the Executive Committee of the IAIS approved the MMoU during its triannual meetings in Dubai (after its endorsement by the IAIS Technical Committee, which accounted the recommendations by the IAIS Implementation Committee).7 This was followed by the establishment of the


The Framework Multilateral Memorandum of Understanding


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Accession Process Any insurance supervisor that is an IAIS member10 is eligible to join the IAIS MMoU. The application and the relevant national law must be submitted in English (the official language of the IAIS). The IAIS provides applicants with a standard template for the application, though, its use is not mandatory. The accession process to the MMoU consists of the following steps: • Preliminary screening of the application by the IAIS Secretariat to ascertain whether the applicant fulfills the preconditions for commencing the validation process is completed (basically, checking for any incomplete elements of the application, the signature of the competent representative of the applicant, and the attachment of the relevant laws translated into English).11 • The SWG nominates a validation team, composed of four validators, and designates one of them as lead validator. This team has to be regionally balanced. Validators are members of staff of IAIS members, with sufficient experience in the field of insurance supervision as well as legal processes and procedures. The validation team will scrutinize the information given in the application, check whether the laws of the applicant meet the standards set out in the MMoU, and communicate with the applicant on open or ambiguous issues (most notably, checking the ability of the applicant to obtain and exchange information, as well as the confidentiality standards of the applicant). Following the validators’ thorough and objective appraisal of the application and its annexes (primarily relevant national law), they will prepare a validation report for submission to the SWG.12 • The SWG reviews the validation report and makes a recommendation to the HLC. • The HLC will then finally decide on the application. In most of the cases, this will result in the endorsement of the application. However, if the applicant dissents with the opinion of the validation team, prior to the decision of the HLC, the applicant is entitled to start a mediation process directed by the chair of the Implementation Committee.13


High-Level Committee (HLC), which consists of the chairs of the IAIS Implementation Committee, Technical Committee, and Executive Committee.8 The HLC is responsible for the final and formal endorsement of applications to become a member of the MMoU. At the same time, the MMoU working group was dissolved in order to establish the Interim Signatories Working Group (ISWG), which reports to the IAIS Implementation Committee. In June 2010, the ISWG turned into the Signatories Working Group (SWG), since ten IAIS members have joined the MMoU.9 In April 2008, the validation process of the first applicants to the MMoU began.

Key Principles of the MMoU The MMoU ref lects and formalizes the expectations of the international insurance supervisory community for cross-border cooperation and information exchange.14 All topics relevant for insurance supervisors are covered in the MMoU: licensing of an insurance or reinsurance entity, ongoing supervision, fit and proper criteria,


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supervisory practices, winding-up operations, and group supervision. Issues regarding insurance intermediaries, as well as antimoney laundering and combating the financing of terrorism (in the context of insurance supervision), are also included, provided that the signatories who intend to exchange information are responsible for these issues.15 Generally, information which is available to the public should not be requested through the MMoU. According to Article 4 (6) of the MMoU, requests should be sent first and foremost to the supervisory authority with the greatest measure of regulatory responsibility for the regulated entity.16 Signatories shall set up principal points of contact for cooperation and information exchange through the MMoU. The IAIS Secretariat will create a list of these points of contact, which will be posted and regularly updated on the members-only area of the IAIS website. Unless agreed otherwise, communication based on the MMoU shall be carried out by these points of contact. Confidentiality. Before becoming a signatory, the applicant has to fulfill farreaching confidentiality and professional secrecy requirements. The strict confidentiality regime is central to the MMoU. To ensure the long run integrity and success of and thrust for the MMoU, a high benchmark was chosen deliberately.17 When the goal is a smooth, reliable, and trustworthy f low of information among the signatories, compliance with strict confidentiality rules is an essential prerequisite for the accession to the MMoU. The applicant’s standards of confidentiality have to be at least equivalent to those set out in the MMoU; signatories have to be sure that the others meet the MMoU standards. A proper and accurate validation process safeguards this approach. However, validators accept a certain spectrum of deviation between the MMoU confidentiality benchmarks and the applicant’s confidentiality rules, because a jurisdiction’s law has only to be equivalent to MMoU benchmarks, not necessarily equal. The requesting authority is committed to take all necessary actions to protect confidential information that is received from the requested authority. All persons who have access to such confidential information must be bound by confidentiality requirements, no matter if they are regular staff of the signatory or external parties. It is important that their obligation of confidentiality does not expire when they change jobs or retire. The jurisdiction of the requesting authority has to regard any passing on of information in breach of professional secrecy as unlawful.18 Moreover, the requesting authority has to ensure that access to the information received is restricted to those who need access to the information, when viewed within the context of the stated purpose of the request. Information that is exchanged through the MMoU is treated as confidential unless both of the parties involved themselves declare otherwise.19 The requested authority determines if the requested information has to be qualified as confidential, based on the relevant regulations in its law. Conf lict may arise between the applicant’s ability to share information and the objective to keep information as secret as possible (this objective is promoted through the confidentiality regime of the MMoU). Determining when to disclose or exchange information, and when to keep it confidential, depends very much on the specific facts of each individual case. To deal with this problem adequately, it


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Principle of Prior Explicit Consent for Passing on Information. Principally, information received under the provisions of the MMoU cannot be relayed to any third party as long as the requested authority did not authorize this relay. The authorization by the requested authority has to be given expressly and in written form. When a third party demands information received through the MMoU network, the requesting authority has to notify the requested authority immediately. If the requested authority does not agree to the disclosure of the information, the requesting authority is committed to taking all reasonable measures, including legal, to deny the suit for dissemination to the third party. 21 However, under the following exceptional terms and conditions, consent of the requested authority can be anticipated. First, the requested confidential information shall not be used for purposes other than those declared in the request. Second, the party to which information is passed on is able to guarantee an equivalent level of confidentiality protection. And third, the information which is passed on assists the requesting authority in the fulfillment of its supervisory duties and other domestic bodies of the financial services sector (including banks), law enforcement agencies, and relevant courts in the performance of their duties. These conditions have to be fulfilled cumulatively. Finally, consent from the requested authority to passing on information can be taken for granted as well when the relevant regulated entity to which the information is related to explicitly agreed to the dissemination. In any case, before the information is communicated, the requesting authority has to advise the third party of the confidential character of the information and ensure that confidentiality is maintained adequately. Aside from this, the requesting authority’s use of the information that is received from the requested authority is strictly limited to the purpose originally specified in the request. If a different purpose is intended, the requesting authority must obtain the requested authority’s consent for the change of use. Signatories of the MMoU have to make the necessary internal arrangements to properly fulfill this obligation.


is necessary to weigh the potential benefits and disadvantages. 20 Occasionally, this balancing act can be quite difficult. However, the applicant has to prove that sharing information with another insurance supervisor is usually a legitimate interest of disclosure. In addition, applicants may be bound by their jurisdiction’s law to grant assistance to other domestic authorities; this is another example for an interest of disclosure. Here, applicants have to show in their application that such a duty is compatible with the confidentiality demands of the MMoU.

Enforcement. The requesting authority cannot legally enforce the requested authority to disclose the information that is being sought. The requested authority reserves the right to decide, in response to each inquiry, whether or not to provide the information. In other words, disclosure is exclusively at the discretion of the requested authority. There is no remedy against its decision. However, signatories assure each other the fullest assistance possible, consistent with their supervisory duties and regulatory functions. In principle, signing the MMoU implies the intention to pass over information to a signatory when appropriate. The requested authority should consider a request carefully, and replies should be made without undue delay.


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From a legal point of view, the MMoU is an international nonbinding agreement. It is part of soft law, a type of law which is typically used to regulate international relations. National law is not affected in any way.

Withdrawal of/Exclusion from Participation. A signatory is allowed to withdraw its participation in the MMoU at any time, subject to giving 30 days written notice to the IAIS Secretariat of the intention to do so. Any information that has already been exchanged through the MMoU must still be kept confidential by all parties involved. In exceptional circumstances, a signatory can be excluded from participation, for example, when it is in breach of the strict confidentiality regime. Principle of Valid Purpose and Legitimate Interest. The condition of a valid purpose is met if the requesting authority asks for information in the context of its lawful supervision of an entity, which is subject to the supervision and responsibilities of the requested authority. This means that a request through the MMoU can only be made if it is necessary for the performance of supervisory functions. Furthermore, the requesting authority has to demonstrate its legitimate interest for the request. For the sake of transparency and to avoid any discrepancy at a later stage, the requesting authority has to indicate explicitly in its request the precise purpose for which the information will be used. Making a Request Through the MMoU—Sequence of Events. Any request must be submitted in written form and has to address the following points: • the involved signatories, the field of supervision concerned, and the purpose of the request; • details of the request (e.g., information on the person or the undertaking concerned, description of the facts underlying the request, relevant questions, declaration about the sensitivity of the request); • a statement as to whether information submitted by the requesting authority should be confirmed or verified and, if so, what kind of confirmation or verification is needed; and • a statement on whether, to whom, and for what reason confidential information is likely to be passed on.


Shortened Procedure. For urgent cases, such as in a crisis situation when information is needed immediately, the MMoU allows for a shortened procedure. In this case, a request can be performed orally, but a written confirmation has to follow within ten business days.

As a next step, the requested authority confirms the receipt of the request. If necessary, the requested authority may ask for more specific or further information. As already mentioned, whether and to what extent a request should be fulfilled is left to the full discretion of the requested authority. The requested authority may take into consideration the following points: • whether the request is in line with the MMoU; • whether the fulfillment of the request would be so burdensome as to interfere with the smooth and proper functioning of the requested authority;


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• any infringements against the laws of the requested authority, particularly any law that protects the confidentiality of the information; • whether complying with the request may otherwise be prejudicial to the performance by the requested authority of its functions; and • substantial costs that would arise for the requested authority by fulfilling the request.

It is not obligatory for IAIS members to join the MMoU. 22 However, the IOSCO (International Organization of Securities Commissions) has decided to make the joining of its MMoU a precondition for IOSCO membership. Recently a discussion on this point has begun at the IAIS. 23 The following IAIS Members were first to sign the MMoU during the IAIS Triannual Meetings in Chinese Taipei in June 2009: Bermuda Monetary Authority, Bermuda, Financial Supervisory Commission, Chinese Taipei, Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), Germany. With the signing of these three members, the MMoU came into operation. A further seven members have since successfully completed the validation process: Australian Prudential Regulation Authority (APR A), Australia, Financial Market Authority, Austria, Autorité de Contrôle Prudentiel (ACP), France, Comision Nacional de Seguros y Fianzas, Mexico, De Nederlandsche Bank (DNB), The Netherlands, the Monetary Authority of Singapore (MAS), Singapore, and the Romanian Insurance Supervisory Commission (CSA), Romania, with additional applicants pending. As the number of signatories and applicants continues to grow, the MMoU is well on track. It will have its full positive impact when signatories from different global regions and major insurance markets are properly represented and signatories apply the MMoU adequately in practice. Not only will the MMoU be an important worldwide tool for cooperation and information exchange between insurance supervisors, but it will also foster financial stability as well as convergence among supervisors.

Notes The views expressed in this chapter are only those of the authors. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

(McCarthy 2004), (Vollbrecht 2001). (Savage 1998). (Braumüller 2007). Convergence might also be enhanced through the ongoing revision of the IAIS Insurance Core Principles, aimed to be finalized in 2011. (IAIS 2007a), (Oster and Chatterje 2007). (IAIS 2007b), (Oster and Chatterje 2007). (IAIS 2006). (IAIS 2007c). (IAIS 2006). Insurance supervisors from 190 jurisdictions in over 130 countries are currently members of the IAIS. (IAIS 2007c).


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12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23.

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(IAIS 2007c). (IAIS 2007c). (Oster and Chatterje 2007). (IAIS 2007a), (Oster and Chatterje 2007). When tackling a problem of group supervision, normally the request should be addressed to the home supervisor of the ultimate parent company. (IAIS 2006). The unlawfulness can be based in criminal or in labor law, for example. The request itself is a confidential matter. Regulations to protect confidentiality are normally structured as a general clause, or at least incorporate some generally defined elements. Some applicants to the MMoU ensured the principle of prior consent and its shadings in a specific internal document. (IAIS 2006). Naturally, such a change would require an appropriate amendment to the IAIS by-laws.

Bibliography Braumüller, Peter. “Cross-Border Exchange of Information and Cooperation between Insurance Supervisors.” The Geneva Papers on Risk and Insurance 32 (2007): 201−318. International Association of Insurance Supervisors (IAIS). “Policy Note on Multilateral Memorandum of Understanding.” 2006. www.iaisweb.org. ———. “Annual Report 2006–07.” 2007a. www.iaisweb.org. ———. “Policy Note on Adoption of MMoU Framework and Preparatory Steps for MMoU Implementation.” 2007b. www.iaisweb.org. ———. “Administration and Accession Procedures of the IAIS MMoU.” 2007c. www. iaisweb.org. McCarthy, Callum. “How Should International Financial Companies Be Regulated?” 2004. http://www.fsa.gov.uk/Pages/Library/Communication/Speeches/2004/SP196. shtml. Oster, Axel, and Arup Chatterje. “IAIS Multilateral Memorandum of Understanding (MMoU).” 2007. http://www.iaisweb.org/__temp/IAIS_MMoU.pdf. Savage, Lawrie. “Re-Engineering Insurance Supervision.” 1998. http://www-wds. worldbank.org/servlet/WDSContentServer/WDSP/IB/2000/02/24/000094946_99 031911111146/Rendered/PDF/multi_page.pdf. Vollbrecht, Jörg. “Insurance Regulation and Supervision.” In Policy Issues in Insurance Nr. 3: Insurance Regulation, Liberalisation and Financial Convergence, edited by OECD. Paris: OECD Publications, 2001.


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Uniform Treatment of Creditors’ Rights: Fundamental to Global Insurance and Reinsurance Regulatory Advances Peter Ivanick and Lynn Roberts

Introduction As insurance (and reinsurance) regulators strive to harmonize global insurance regulations, modern initiatives undertaken by the European Commission (EC) on behalf of European Union (EU) members, the National Association of Insurance Commissioners (NAIC) in the United States and the International Association of Insurance Supervisors (IAIS), have not addressed reconciling resolutions of creditors’ rights when insurance companies become financially impaired or insolvent. Unless the EU’s Solvency II and the NAIC Solvency Modernization Initiative (SMI), whose jurisdictions dominate global insurance markets, incorporate equitable treatment of creditors when one or more insurers and/or reinsurers within a holding company enterprise face potential financial or actual failure, it is difficult to imagine that local regulators will not succumb to protectionist measures to preserve local assets under these circumstances. Admirably, the EC, NAIC, and IAIS are focusing on mutual cooperation to assure capital adequacy among insurance companies by emphasizing risk-based and principle-based approaches to insurance regulation, as well as transparently uniform financial reporting, in order to avoid financial failures that could have cascading effects, even when individual companies are doing business regionally, not globally. Imagine if American International Group, Inc. (AIG), which, at the time of the recent financial crisis, controlled noninsurance and insurance enterprises throughout the world, had not been placed on life support by the U.S. government. An AIG insolvency and resolution of its subsidiaries’ creditors’ rights would have been far more complicated than noninsurer financial institution bankruptcies, such as that of Lehman Brothers. The web of AIG transactions within the holding company


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would have implicated U.S. bankruptcy law and state insurance insolvency laws, as well as the laws in non-U.S. jurisdictions where AIG subsidiaries were organized and operated. The complexity of U.S. laws that are applicable to judgments or orders obtained in non-U.S. jurisdictions, even for mere restructurings of non-U.S. insurance companies, much less for proceedings in which such companies are unable to meet financial obligations, suggest that uniform enforcement of decisions emanating from non-U.S. authorities, and uniform treatment of creditor stakeholders of these companies, may not be possible. This chapter will discuss circumstances when both solvent and insolvent non-U.S. insurers could potentially be legally proscribed in the United States from completing reorganizations approved by a non-U.S. authority. The insurance industry will again confront these issues as non-U.S. financial conglomerates, such as ING, and possibly others that have received government support during the financial crisis, pursue restructuring that has been ordered by the EC, based on trade inequities perceived by the EC to have occurred as a result of such support. This chapter identifies those issues that deserve consideration by regulators, in order to provide a clear and transparent path for insurance companies that are undertaking solvent restructurings, and for those which, in the future, confront insolvency proceedings, the definition of which varies among countries. When restructurings involve sales of U.S. subsidiaries or asset/liability transfers to solvent entities that are licensed in the U.S., with no alteration of policyholder obligations in the transactions, state regulatory approvals should occur without the complexities described in this chapter.

Creditors with Interests in Insurance Solvent Restructurings, Impairments, and Insolvencies should be Accorded Uniform Treatment to Complete Cross-Border Regulatory Harmonization All stakeholders (shareholders, creditors, and employees) have an interest in the outcome of the matters identified in this section. However, this chapter limits the discussion to the resolution of creditors’ rights in insurance company solvent and insolvent reorganizations or liquidations. These rights are governed by the law of the state in which the company is organized; that is, one of the 53 U.S. states and territories (collectively referred to as states). State insurance laws define “insolvency” and “delinquency proceedings”1 that govern administration of the estate of the subject entity. In the case of an insolvent nonoperating holding company or a parent company of multiple subsidiaries, the insurance law of each state in which such subsidiary is organized will be controlling. Non-U.S. domiciled insurers must seek recognition and enforcement of their respective applicable authorities’ judgments or orders under federal bankruptcy law. Through a solvent Scheme of Arrangement under section 425 of the U.K. Companies Act, before a company is formally declared insolvent, resolutions of creditors’ rights may occur. There have, however, been no uniform reforms that would bring U.S. insurance in line with these developments. The history of U.S. state laws governing insurance delinquency proceedings suggests that the potential to achieve uniformity in these matters may be circumscribed by the division of powers between state and federal court systems in the United States, and by the U.S. Constitution’s due process requirements.


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Despite the fact that U.S. state laws that relate to insurance financial impairments and insolvencies are considered “uniform” for the purpose of “financial accreditation” by the NAIC, there are sufficient differences among states to create some uncertainty, in addition to the current uncertainty arising under the federal Bankruptcy Code with respect to restructurings approved by a non-U.S. forum. 2

A determination of U.S. policyholder rights in a reorganization ordered in a nonU.S. forum will be effective if U.S. courts with jurisdiction over the matter agree to enforce the foreign forum’s decision. Jurisdiction over such matters in the United States is divided between state and federal courts, and, in either case, courts are limited by due process requirements, as described in the Fifth Amendment to the U.S. Constitution. Thus, state courts can only issue orders that have effect within that state’s borders, and most federal courts are prohibited from granting an injunction to state proceedings in a state court. Exceptions to this rule are limited, with the broadest exception being the extensive authority that is granted to federal bankruptcy courts to issue orders with nationwide effect in connection with bankruptcy and reorganization cases, including foreign proceedings.3 The impact of bankruptcy courts’ nationwide injunctive authority was explained when the U.S. Supreme Court wrote that “. . . Unless all parties in interest, wherever they reside, can be bound by the arrangement which it is sought to have legalized, the scheme may fail.”4 The words remain true: unless all creditors are bound by a restructuring plan regardless of where they are located, the restructuring effort may be doomed. For a non-U.S. parent company with an order restructuring a subsidiary’s or any other entity’s U.S. policy obligations, this means that if an injunction from a U.S. bankruptcy court is not available, the company would be forced to pursue enforcement on a state-by-state basis; this exposes the non-U.S. forum’s decision to uncertainty, as to inconsistent enforcement. Chapter 15 of the current Bankruptcy Code is the only law that authorizes aid in favor of a proceeding in a non-U.S. forum that alters the obligations of a nonU.S. entity. Whether Chapter 15 relief is available to all various forms of available insurance restructuring options is unsettled. Solvent schemes (restructurings), run-off schemes, and, in particular, cut-off schemes and transfers of insurance obligations (such as under Part VII of the United Kingdom’s Financial Services and Markets Act [FSMA]) are currently used by insurers to remediate obligations. And the variety of restructuring and liquidation methods that could be used by foreign forums to resolve obligations of global financial conglomerates presently under orders from the EC is currently unpredictable. The absence of such relief in the United States will certainly hinder, if not derail, the restructuring of any global entity with U.S. policy obligations.


Authority of U.S. Courts to Give Effect to “Foreign Proceedings”

Cases in Point: Solvent Schemes and Part VII Transfers Although the federal Bankruptcy Code now includes Chapter 15 specifically to address recognition and enforcement of “foreign proceedings,” Chapter 15 does not resolve all conf licts between U.S. law and non-U.S. restructuring laws. This is especially true where U.S. policy obligations are implicated. This was demonstrated


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when proponents of restructuring efforts under Part VII of FSMA encountered enforcement obstacles in the United States, and when questions have been posed as to whether solvent schemes should even be enforced in the United States. Solvent schemes of arrangement under laws like the United Kingdom’s Companies Act result in the estimation and payment of claims, which may be then “cut-off ” through a coercive process similar to that used in an insolvency-related case. A scheme accepted by a certain majority of policyholders and claimants can be approved over the objections of others, in order to estimate and accelerate payment (“crystallize”) of claims, and to extinguish the scheme proponent’s future liability based on the crystallized claims. These schemes allow shareholders to maximize and to extract the value of a company in a manner that is, arguably, fair to policyholders and creditors. If the claim submission and estimation process works fairly, policyholders and creditors should be paid at least the discounted value of the claim, to which they would otherwise be entitled in the future, and the company is spared the administrative expense occasioned by a lengthy run-off. Solvent schemes have generally been enforced by U.S. bankruptcy courts, although there is much debate as to whether this trend should continue.5 Part VII of FSMA, which differs from a solvent scheme transfer or restructuring of creditors’ rights, enables multigroup companies to transfer insurance business of one or more affiliates to a single entity within the group, as a matter of law and without the need for policy-by-policy novations; thus, the administrative burden of run-off is eased. Although a transfer of business obligations under Part VII of FSMA alters the contractual relationship between insurer and policyholder, by substituting another insurer as obligor through a coercive process, Part VII is not technically a “bankruptcy” law, because the Part VII plan may not alter the value of distributions of the original insurers’ property to claimants. Rejection by U.S. bankruptcy courts of efforts to enforce these restructurings in the United States will require proponents to seek piecemeal enforcement on a state-by-state basis. This was the dilemma that faced the CGNU (CGNU Plc) companies in the case of in re Rose (discussed below). Enforcement of transfers under Part VII of FSMA has met greater resistance from U.S. courts than have solvent schemes of arrangement. The Part VII Transfer proposed by Lloyds of London to its reinsurer/run-off agent, Equitas, 6 exemplifies the issue of enforcement in the United States of a U.K. High Court Order approving the transfer and subsequent enforcement of any implicated cut-off scheme involving U.S. policy obligations. The U.S. bankruptcy court, in the Rose case, refused to recognize the effects in the United States of a Part VII transfer of 12 Aviva/CGNU insurance subsidiaries to another single CGNU non-U.S. subsidiary. The 12 transferors, who had secured an order of the U.K. High Court authorizing the transfer of their liabilities to another insurer, ended up with no assurance that the U.K. court’s order would prevent U.S. policyholders from seeking judicial relief to enforce pretransfer liabilities. In fact, the bankruptcy court rejected the U.K. court approved plan, leaving Aviva unable to obtain a single order with nationwide scope to prevent U.S. creditor actions that would undermine the substitution (novations) of policy obligations, in accordance with the transfer of policyholder liabilities to the single entity. The administrator of the Part VII transfer could not ever be certain that the transfers completely relieved the 12 transferors of liabilities so that they could eventually be wound down under U.K. law.7


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In another case, involving a solvent scheme proposed by the British Aviation Insurance Company Limited (BAIC), the U.K. High Court questioned whether the estimation of incurred but not reported (IBNR) claims was fair, and whether it resulted in a denial of due process. There, the court’s concern seemed to be that the IBNR claimants should have a voice in determining whether the reserves remaining before distributions to shareholders were adequate to meet future claims. Other cases also lead to the question of how solvent is too solvent for a company to be permitted to use the solvent scheme process. Should shareholders be able to extract or preserve equity by denying policyholders the opportunity to allow their claims to mature, and be paid according to the parties’ original expectations under the terms of their policies? The court case of Hopewell involved shareholders who employed the solvent scheme process to protect their investment, but possible due process issues were never addressed, because the objecting U.S. policyholder never raised the appropriate objection in the foreign court. Since the policyholders participated in the non-U.S. proceeding without objection, the U.S. court recognized and granted effect to that scheme. The questions raised by the BAIC and Hopewell decisions may explain the caution evident in the Rose decision, involving the proposed transfer of Aviva/CGNU owned entities’ policy obligations to a single entity. It was clear from the Rose decision that “too solvent” was a problem for the court. Remarks made from the bench made it clear that the court was concerned that funds set aside to protect the transferor’s U.S. surplus lines (nonlicensed) business (trust funds established in New York pursuant to law to protect policyholders) were going to be raided by the shareholder as part of the Part VII process. 8 The court refused to aid a scheme to maximize shareholder equity, where the companies were not insolvent and were not in need of any adjustment of the economic value of their debts. In contrast to the Part VII transfer process that was the subject of the Rose decision and the Lloyds’ transfers, and in contrast to a solvent scheme of arrangement, an insurance insolvency-related proceeding, as defined under U.S. state laws, typically results in some adjustment, in either amount or timing of payment (or both), of policyholder and creditor claims. Claims are required to be filed by a particular date, and the assets of the insurer are distributed pro rata according to priorities established by law. Regardless of whether the insolvency proceeding is in the nature of liquidation or rehabilitation, the law requires that policyholders and creditors receive at least the distribution that they would receive based on liquidation value of assets, and if those distributions exhaust all available assets, shareholders receive no distribution. If the company distributes its assets fairly, and procedural safeguards are respected, a rehabilitation or liquidation plan can be made effective, even though some creditors or policyholders object to the treatment of their claims. And, a federal bankruptcy court has the authority to recognize orders issued in non-U.S. proceedings as “foreign proceedings,” and grant nationwide injunctive relief that recognizes the foreign reorganization or liquidation scheme in the United States. Given the present formulation of “foreign proceeding” articulated by the Bankruptcy Code, Part VII transfers and solvent schemes, unlike rehabilitation and liquidation proceedings, may be beyond the ambit U.S. bankruptcy courts’ aid. This is true despite the fact that Part VII requires a judicial procedure in which the consent of the creditors whose contracts are transferred is not sought




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individually, and is instead deemed given through their lack of meritorious objection, because their interests are held to be sufficiently protected by the proceeding. Whether undertaken when solvent or insolvent, each of these proceedings alters policyholders’ contractual rights in some manner. The result of a Part VII transfer is not intended to change the economics of the policy, but it does transfer the contractual obligation to a third party, with whom the policyholder did not originally contract. If U.S. courts hold that these results are beyond the scope of Chapter 15 of the Bankruptcy Code, restructuring of non-U.S. insurance global operations that implicate U.S. policyholders’ rights may at times prove impossible. The dilemma is the absence of some degree of certainty as to which type of “solvent” restructuring will be recognized in the United States.

Conclusions This chapter merely highlights the complexities faced by the insurance industry in restructurings that U.S. creditors’ rights, especially those of policyholders. A detailed explanation of relevant federal and state laws is available to readers on the website of Dewey & LeBoeuf, or can be obtained directly from the authors upon request.

Notes 1. Section 104(E) of the Insurance Receivership Model Act (IRMA) promulgated in 2005 by the National Association of Insurance Commissioners (NAIC) defines “Delinquency proceeding” [as] any proceeding instituted against an insurer for the purpose of liquidating, rehabilitating or conserving the insurer, and any summary proceeding under Section 201 [allowing seizure of all or part of the insurer’s business and property without commencement of a formal rehabilitation or liquidation proceeding]. Although not all states have adopted IRMA, the term “delinquency proceeding” has a similar meaning in all U.S. states. 2. (Melnik and Tyrell 2008). 3. Since ratification, the U.S. Constitution has given Congress authority to make uniform laws on the subject of bankruptcies throughout the United States. Congress adopted the Bankruptcy Code pursuant to the authority of Article I, section 8 and specifically gave to District Courts (and, by Order of Reference, to Bankruptcy Courts) power to issue injunctions with nationwide effect. Thus, qualifying foreign reorganizations can be given nationwide effect through a successful petition to a single court—a U.S. Bankruptcy Court—and through no other single court. 4. (The U.S. Supreme Court 1935). 5. (Seife and Vazquez 2008), (Johnston 2007). 6. (Sylvester, Anderson, and Harte-Lovelace 2009). 7. The Rose court held that a Part VII Transfer was NOT a “foreign proceeding,” because the reorganization effected by the Part VII scheme was not for the purpose of discharging or adjusting debts or liquidating the transferor’s businesses. The Rose court’s conclusion, however, requires scrutiny. The court’’s analysis of the term “foreign proceeding” rendered meaningless the phrase “whether or not under bankruptcy law,” which was part of the pre-2005 Bankruptcy Code’s definition (and has now been deleted). Inclusion in the current definition of the alternative “or adjustment of debt,” suggests that even Part VII transfers (and especially solvent schemes


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of arrangement) should be allowed recognition under Chapter 15. Black’s Law Dictionary defines “adjustment” to mean “[t]o arrive at a new agreement with a creditor for the payment of debt.” Part VII effects a transfer of policyholders’ debt obligations against an insurer to a new entity and effects a new agreement with a new obligor for the payment of policyholder and creditor debt. By definition, then, even a Part VII transfer should qualify as a “foreign proceeding.” 8. This concern foreshadowed the carve-out of trust funds from Chapter 15, which prevents U.S. bankruptcy courts from issuing any order that would interfere with trust funds maintained in the United States by a foreign insurer. Regulation of such trust funds is now the province of state regulators and state courts. The fact that Judge Beatty had such a concern may have been an indication that the 2005 Bankruptcy Code amendments were in the court’s mind, although not yet enacted at the time of her decision. More likely, the court’s concern was that the shareholder was going to suck up those funds and leave policyholders with inadequate protection. This would, however, have been an unfounded concern, as the CGNU entity that was transferee of the surplus lines business at issue already maintained trust funds in the United States at levels deemed by regulators to be adequate to support the business that was transferred.

Bibliography Johnston, Susan Power. “Why U.S. Courts Should Deny or Severely Condition Recognition to Schemes of Arrangement For Solvent Insurance Companies.” Norton Journal of Bankruptcy Law & Practice 571 (2007). Melnik, Selinda A., and Vivien Tyrell. “Enforcing Schemes and Part VII Transfers, Runoff & Restructuring.” Spring 2008. http://www.eapdlaw.com/files/News/ a d 5 4 8 9 69 - c 5 e7– 4 612 - 8 2 d b -3 b 6 6757d 2 d 4 c / P r e s e nt a t i on / Ne w s At t ac h ment /22c fc 0bd- c 697– 48e a-ac7f-538ba a4 d5eb1/ E n forci ng %20 Schemes%20and%20Part%20VII.pdf. Seife, Howard, and Francisco Vazquez. “U.S. Courts should Continue to Grant Recognition to Schemes of Arrangement of Solvent Insurance Companies.” 2008. ht t p://w w w.c h a dbou r ne.c om /f i le s/ Publ ic at ion /c 3 c10 f 88 -a f 65 – 4 2 67-bf a7e9e789279343/Presentation/PublicationAttachment/4c8773b3-ece0–4696-a36df 0 f b d 25e9 703/A u g %2 0 0 8%2 0J BL P %2 0 S ei fe%2 0Va z que z %2 0A r t ic le%2 0 08–06-08.pdf. Sylvester, John M., Roberta D. Anderson, and Jane Harte-Lovelace . “Proposed Part VII Transfer of Liability on Lloyd’s Policies: Considerations for Lloyd’s Policyholders.” May 22, 2009. http://www.klgates.com/newsstand/detail.aspx?publication=5660. The U.S. Supreme Court. “Continental Illinois Nat’l Bank & Trust Co. v. Chicago, R.I. & P. Ry. Co. , 294 U.S. 648, 674, 79 L.Ed 1110, 55 S. Ct. 595.” 1935.




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PART II

Industry Governance and Risk Management


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Corporate Governance and Risk Management in the Insurance and Reinsurance Industries Cecelia Kempler

Introduction The insurance and reinsurance industries (collectively referred to as the industry unless otherwise appropriate) share many of the same corporate governance and risk management challenges that all global public companies face, but the industry also confronts challenges that are more specific to its businesses. Among these challenges are: the industry is subject to multiple regulations globally (generally, wherever it conducts business); exposures to regulatory inconsistencies and protectionist government actions in developing and emerging markets; different consumer product preferences and distribution conduits in developed and emerging markets; lack of robust experience data for certain liability exposures in developing and emerging markets; new and emerging risks in developed markets; constraints to growth in developed markets; and competition from other financial institutions. This chapter focuses on: (1) the symbiotic relationship between effective governance and risk management, especially in the context of what the industry independent and nonexecutive directors can do to foster effective risk management (these directors are referred to collectively as independent directors, unless otherwise appropriate); and (2) how the industry might structure approaches for effective risk management through aggregation, control, and management of risks at the parent company after engaging management and enforcing rigorous standards upon subsidiary management, to identify and manage risks locally. In the discussion of each topic, I attempt to keep potential solutions to complex challenges as easy to understand and implement as feasible, and think within the broadest frame of reference possible. The industry is not currently subject to the same degree of heightened corporate governance risk management scrutiny, as is the case with other financial


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institutions; the exceptions being AIG (American International Group, Inc.) and financial guaranty monoline insurers.1 The industry is, however, included in recent initiatives undertaken by global supervisors and related financial institution organizations to develop comprehensive appreciation for material financial institution risk exposures, especially those involving financial conglomerates, and those harboring cross-border consequences in the event of financial impairment or worse. The industry is also drawing constructive lessons from the crisis. An article published in the October 2009 issue of Harvard Business Review, not surprisingly, condemned banking institutions for endemic risk management failures. The article proclaimed, “Of all the management tasks that were bungled in the period leading up to the global recession, none was bungled more egregiously than the management of risk.” 2 The industry was similarly condemned in the mid1980s and early 1990s, when a number of major companies in the property/casualty and life insurance sectors suffered insolvencies or financial impairments, resulting primarily from failures to manage underwriting and investment (real estate and high yield) risks. Regulatory actions taken then may have prevented the industry from being more broadly affected by the recent crisis.3 The risks that the industry confronts today are similar to those of the previous two decades, but are exacerbated as a result of globalization and new risks, such as those identified above and others that may be identified. Many of these risks were recognized in a report produced in 2009 for the European Commission (EC) by The de Larosière Group, which concluded that despite its advances, the European Union (EU) framework is too “fragmented in its rules, supervisory structures and tools to address crises.” The report concedes that supervisors, as well as financial institutions, failed to properly assess risks.4 The entire global regulatory framework for the industry, not just the EU, is too fragmented. Whether this fragmentation can be mitigated depends upon the extent to which nationalism can be balanced with recognition of the need for global regulatory harmonization on key issues. Nationalist inclinations to preserve embedded approaches to regulation will defeat the potential for change for the better. We will simply end up with change.5 “National interests” are ill-served by developed countries that are unwilling to elevate transparency in the industry over the preservation of embedded practices perceived locally as being superior to those of regulatory counterparts in other regions. 6 Organizations and associations such as the Financial Stability Board (FSB) (formed in 2009 from the Financial Stability Forum), the Organization for Economic Cooperation and Development (OECD), the International Association of Insurance Supervisors (IAIS), the National Association of Insurance Commissioners (NAIC), the International Accounting Standards Board (IASB), the Financial Accounting Standards Board (FASB), and others deserve credit for advances made in striving to achieve cross-border harmonization of standards that materially affect the ability to understand and oversee the industry risk exposures globally. However, as long as standards are not harmonized cross-border on all key issues, regulators must address deficiencies produced by global regulatory fragmentation. Post-financial crisis ref lections have centered on corporate governance and risk management failures. Of course, senior executives of the failed institutions are most culpable, but independent directors are also responsible. The fact that independent


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directors seemed to miss emerging calamities has produced a new round of proposals for regulatory, legislative, and principled guidance relating to board service. This attention is deserved, but piling on multiple new principles and rules is not a solution. A few concrete actions, such as those suggested in this chapter might suffice to considerably enhance governance, which will never be perfect so long as human beings are imperfect. A recently published scathing attack on independent and nonexecutive directors of failed companies points out the obvious but useful reminder that some Chief Executive Officers (CEOs) and directors had no shame, were incompetent, or indifferent, and, even worse, they remain on the boards of companies that survived only through government welfare. These individuals also continue to receive new board assignments, despite their participation in one of history’s most awful examples of greed and self-interest in corporate management. These examples of director deficiencies prove that at times the least fit can survive and thrive.7 What is overlooked is that those directors who take their responsibilities very seriously are not recruited by egocentric, obsessively controlling, insecure CEOs. Thus, where the excellent directors are most needed, they are not appointed. I am not sure that even new rules will alter this reality. There are several significant issues in director recruiting and performance which need to be addressed. First, many qualified directors are not properly educated on all of the businesses operating within the enterprise, may not be fully committed to the time required of them, and, therefore, remain ill-equipped to constructively challenge colleagues when circumstances require it. Much has recently been said about educating and certifying directors to improve their appreciation for their governance responsibilities. This issue is about process, but without sufficient education on the company’s businesses, improved governance processes are not likely to produce substantive improvement in director performance, where it is most needed. Therefore, my recommendations will demand even more of independent director time. Proposals for improved oversight and governance in the industry should ref lect the fact that extreme risk failures can generally be attributed to “outliers” in management and on boards. This needs to be kept in mind after crises, which generally spawn a race to overregulate. Ultimately, director and executive performance will be determined by the character, discipline, expertise, and “courage” of the aggregate leadership of the CEO and, where applicable, the lead director or Chairman who set the tone for corporate culture. Rules and principles do not change human behavior, but sometimes they can move it in the right direction. My recommendations are based on confidence that independent directors can make constructive contributions to governance and risk management. Independent director duties are straightforward but can be difficult to perform for a complex global enterprise. Reducing rules and principles to a common denominator, independent director duties should represent shareholders and stakeholders according to applicable laws, principles, and regulations through proactive engagement when risk strategies are being conceived, and, through proactive monitoring. Performance of these duties should also require independent directors assure that strategies for company prosperity are being realized, and if not, to require management to revisit and reset strategies that are falling short of original goals. 8 The processes for discharging these duties include overseeing and monitoring accuracy


Corporate Governance and Risk Management


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Recommendations The chapter advocates that consideration should be given to: (1) mandating more detailed processes to enhance scrutiny and review procedures in recruiting board nominees and evaluating board performance; (2) setting standards for nonpublicly traded industry subsidiary and, to the extent feasible, affiliate boards; and (3) mandating formation of risk committees dedicated to enterprise risk management (ERM).

Corporate Governance and Enterprise Risk Management (ERM) It is not the intent of this chapter to cover governance in any depth. Rather, the discussion of governance is limited to its relevance in considering the roles of independent directors, within the context of the symbiotic relationship between governance and risk management. Business leaders, policymakers, regulators and, other industry experts are taking this relationship more seriously and relinquishing earlier inclinations to treat them as independent compliance functions. Today, governance and risk management are embraced by standard setters as representing independent yet interdependent disciplines, which, when each is nourished by the other, can sustain corporate stability and, hopefully, improve performance.9 ERM, which requires aggregating global enterprise risks, remains an ongoing governance challenge for many industry companies. industry consolidation over the last 20 years produced different corporate cultures and information systems in global enterprises. Putting risks in “silos,” or compartmentalizing by subsidiaries and disciplines, is often the byproduct of these factors, in addition to entrepreneurialism, internecine competitiveness, and legacy systems that survive consolidation. Securing high ERM grades will require balancing entrepreneurial energy and prudent risk management within the enterprise. The definition of corporate governance employed when discussing ERM is one that is practically derived from various articulated government standards, modern literature, and corporate charters, although the term is variously defined within laws and by many experts. Corporate governance is essentially the means by which decisions of corporations are made and strategies are set to enable the enterprise to prosper in the short-, medium-, and long-term for the benefit of shareholders and other stakeholders.10 The IAIS and OECD have adopted this definition in principle, noting also that, included in the concept of governance, are company


in financial reporting, setting executive compensation, recruiting directors, risk management, as well as others presumably well-known to readers of this chapter. Independent directors should not insist upon substituting their business judgment for that of management. A regulator’s duties are more complex than those of independent directors because of disparate pressures imposed by different constituents. Political pressures can especially undermine legitimate regulatory objectives. Numerous other forces inf luence governance and risk management by corporations and supervisory authorities, not the least of which is the profound inf luence of credit rating agencies (CR As), upon which so much reliance was misplaced prior to the recent crisis.


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culture, structures and functions, strategies (which include risk management), and decision-making processes. The IAIS and OECD Joint Issues Paper also states, “Corporate governance is about the allocation and regulation of power and accountabilities within an insurer.”11 Corporate governance laws and principles long preceded formal thinking on risk management. Corporate governance has evolved since it was initially implemented in the 1600s to protect investors, in order to facilitate raising capital for entrepreneurs to support business expansion. Corporate governance has become more comprehensive in response to repeated crises over nearly three centuries. As commerce expanded through capital availability and modern technology, interaction between management and investors became more attenuated. This evolution expanded governance directives. In the 1990s, corporate governance was modernized considerably to ref lect changing investment, economic and sociopolitical dynamics, and after each modern corporate debacle was revised yet again.12 These changes have not prevented massive governance failures. Governance among EU Member States varies somewhat, but EU members generally follow a principles-based approach. EU securities listing exchanges can also drive or follow EU governance standards.13 In the United States, state laws establish governance requirements, since corporations are formed pursuant to state laws, but securities listing exchanges, federal legislation, and regulations control the most significant governance and risk management issues we currently face. However, U.S. states continue to wield considerable powers over director and executive liabilities for alleged malfeasance, through judicial interpretations of corporate laws. It is from these judicial rulings that what is known as the “business judgment rule” has evolved.14

Do Board Structures Influence Independent Director Engagement? Responses to this question are generally based on anecdotal evidence (although some studies have been published on the subject), since board deliberations cannot be directly observed by third parties other than confidential advisors to corporations. It does not appear that one type of structure favors competent diligent board engagement more than another. It is the quality and integrity of service that matters. I do share the belief of many others that separating the CEO from board leadership should positively inf luence more constructive engagement by independent directors in risk management. The two primary board structures in developed countries are unitary and twotier boards. The former is found, for example, in the United States, Canada, and the United Kingdom, and the latter prevails in the Netherlands, Germany, France, and other countries. Unitary boards are comprised of executive, independent, and nonexecutive directors. Home jurisdiction law determines whether the roles of CEO and Board Chairperson should be split, for example, as is favored but not mandatory in the United Kingdom. A modern debate, with respect to unitary boards in the United States, is whether splitting these roles would improve governance. U.S. boards are now moving toward at least appointing a “lead” director, if an independent chairman is not appointed. The two-tier board achieves this separation through its structure of having an executive or management board and a supervisory board.




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The role of Chairman is filled by a member of the supervisory board, which is comprised of nonexecutive and independent directors. The functional responsibilities of each type of board have historically been distinguished by whether the board was unitary or two-tiered. The governance distinctions for each continue to have legal significance, but bright line differences, as a practical matter, have blurred. This is especially relevant to board responsibilities in approving corporate strategy, which encompasses risk management. A significant distinction between U.S. and EU corporate governance standards is that, for the most part, U.S. standards are rules-based, whereas in the EU, the governance standards are generally principles-based, with the latter requiring disclosure and an explanation of noncompliance with a principle. In either case, boards are established to represent shareholders’ and other stakeholder interests. On unitary boards, executive and nonexecutive directors jointly discuss and reach decisions on issues that are presented to the board. Unitary board members are expected to participate in development, review, deliberation, and, ultimately, approval or rejection of strategies, which, in most instances, would have been initiated by management. Experts have observed, however, that independent directors on unitary boards often improperly cede all but approval of proposed strategies to management. This more passive “monitoring” by independent directors had, until recently, been generally accepted because senior management is properly viewed as having primary responsibility for developing, managing, and guiding company strategy. Independent directors on two-tier boards may have also served more often as passive “monitors” in approving management strategies. Passivity is no longer acceptable, regardless of board structure. The two-tier board structure first charges the executive board with discussion and approval of management’s strategy before presenting it to the supervisory board. It is the responsibility of the supervisory board to review that strategy, offer guidance to management, ultimately approve the strategy and its implementation, and monitor its effectiveness. This separation of responsibilities did not spare companies from the disasters experienced by those with unitary boards. Regardless of board structure, it appears that prior to the recent crisis, both monitoring and actual management of risks were seriously deficient in too many cases. Corporate governance laws, principles, as well as regulations applicable to companies listed on major European and U.S. securities listing exchanges and securities regulators, require both unitary and two-tier boards to appoint audit, nominating/governance, and compensation committees. Depending upon the jurisdiction, audit, nominating, and compensation committees must be constituted with only independent directors, and the audit committee chair must have financial reporting credentials (the United States), or the audit committee must include a certain number of independent directors, at least one of whom has relevant financial expertise (the United Kingdom). Depending upon the jurisdiction, the audit committee or full board is responsible for risk management. Although many companies have established risk committees, such committees have not been mandatory. As a result of the financial crisis, a debate has ensued regarding the need for a separate risk committee reporting to the audit committee, given heightened complexities of risk management and time constraints experienced in completing audit committee agendas within times scheduled for meetings. Proposed U.S. legislation would require the formation of a


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risk committee. Engagement by independent directors serving on these committees will be addressed below.

Good governance requires competent, diligent directors imbued with the willingness to challenge management and colleagues, and the discipline to distinguish the roles of executive and director responsibilities. Board productivity will only be as robust as the complement of skills and character being represented on the board. Independent directors can be an asset to the company when they possess relevant skills, dedicate time to understand the company’s businesses, share views based on experience, and willingly ask probative questions when they may be skeptical of management’s approach to specific risk tolerance levels. Directors must be prepared to appreciate how risk governance, risk tolerance, risk exposures, and risk trends are integrally managed, and how risk strategy fits within the overall business strategy. This will be especially important in ongoing assessments of risk strategies and ERM implementation, which are linked to the promise of effective governance. This link and director skill diversity are now universally advocated by standard setters and expressed in various principles, rules, and securities trading exchange listing requirements. The industry boards (including major industry subsidiary and affiliate boards) should include at least one, if not more, independent director(s) with expertise pertinent to specific financial issues and actual businesses of subsidiaries and affiliates of the company. Financial expertise that is pertinent to industry issues requires more than general familiarity with IFRS or GA AP. The industry is in investment (asset) and liability businesses, which present complexities that exceed those faced by other financial institutions. These complexities suggest that at least one independent director should possess sophisticated investment expertise and, if possible, asset liability matching skills. Other valuable skills would include senior executives with experience in services, retail, or manufacturing businesses (including experience in regulated industries and marketing, acquired in any global enterprise), as well as experts from accounting, actuarial, and law firms.15 CEOs and director recruiters often say that lawyers are not favored as independent directors, but lawyers who have served as “advisors” to companies generally develop an understanding of their clients’ businesses and have the benefit of having seen the strengths and weaknesses of company risk management. Recommendation 1: Mandate more specific processes to enhance scrutiny and review procedures in board recruiting and performance.


Assuring Competency in the Industry Board Engagement

Despite jurisdictional disparities in approaches to governance that affect independent directors, perhaps consensus might be reached on a few approaches that are more concrete, than on those currently demanded to enhance standards for director appointments and performance reviews. My recommendations either exceed, or make more specific, current principles and rules that are applicable to independent directors. The recommendations are: 1. Require the nominating committee to scrutinize prior board service of candidates who served on boards when the company experienced some sort of


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crisis during the potential candidate’s tenure; such experience would not itself be a disqualifying factor, but would require the nominating committee to state for the record that it considered the issue and granted the waiver for reasons stated, since certain of these individuals could add tremendous value, based on their experience with a failed company. 2. Require in advance a commitment to a certain number of continuing education hours pertinent to the company’s businesses, and undertake more probative exploration of each candidate’s social relationships with other directors beyond that which is currently expected. 3. Mandate annual independent third party reviews of parent company board performance and triannual reviews for subsidiary boards. Who would impose these standards? My preference would be for self regulatory organizations to promote them, among securities exchange listing organizations. Alternatively, securities regulators in each developed market jurisdiction could adopt them, and hopefully major emerging market regulators would follow their lead. The foregoing measures are consistent with developed market principles and rules, albeit somewhat more stringent. Given recent history, the bar for director service should be raised. I also recognize that these standards will deter some from serving. This outcome is intended; as Kirkpatrick noted, in some instances board service has become “a retirement home for the great and the good,” and for others, the reasons may be even less laudable.16 Nominating committees should not treat the recruiting process as merely confirming compliance with “checklists” for board qualifications. Shareholders deserve the security of knowing that the recruiting process is sufficiently rigorous to assure building and maintaining an outstanding board. Mandatory annual assessments of board performance by third parties are costly but, I believe, important enough to merit the expense. To assure a quality work product, management and board members should provide input for appropriate focus by the assessor during the assessment process. The assessor’s approach and prior experience with similar institutions should be vetted prior to retention. Current standardized questionnaires that are prepared by consulting firms might be a useful part of the process, but they are not sufficient. As to triannual reviews of subsidiary directors, I urge adoption of the procedure, because boards of global companies cannot be as familiar with subsidiary or affiliate operations as much as a qualified subsidiary or affiliate board. Subsidiary failures, as well as those of affiliates, which the parent company is deemed by law to control, can cause substantial damage to the enterprise. Third party board assessments should comprise: evaluations of whether each director is honoring prior time and other commitments to the nominating committee and how each director remains current with global financial and industry developments, time dedicated to board matters, the individual’s self evaluation of his or her specific strengths and weaknesses, and a similar evaluation of other board members that includes the effectiveness of the nonexecutive chairman or board leader. The assessment should also evaluate whether the complement of board expertise suffices for the enterprise. Such assessments add substantive value. A lot can happen in one year to alter the course of an enterprise or engagement of directors. This justifies annual assessments by third parties. In addition, the third


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Recommendation 2

Mandate standards for industry subsidiary boards.

The standards identified in the first recommendation should apply to subsidiary board composition. Subsidiary performance can often determine whether the company can or will meet its strategic goals. This is always the case when the parent company is a nonoperating holding company. In the latter case, the composition of major subsidiary boards is as important as that of the parent company board. In either case, the parent company board should receive periodic input from subsidiary and affiliate directors. Relying exclusively on the parent company’s Chief Risk Officer (CRO), or the equivalent function, or CEO to inform the parent company board about risks, without periodic input from a lead subsidiary or affiliate independent (not a nonexecutive) director, might itself pose risks, especially where the parent relies on one or more major subsidiaries for earnings. To the extent that financially significant subsidiaries engage in higher risk businesses, they should receive similar attention. The importance of subsidiaries to an enterprise is ref lected in the adoption of the principle of employing supervisory colleges for group supervision, as provided by the G20 and the IAIS.17 Some CEOs may not embrace the idea of a coterie of assertive proactive independent directors. They may perceive this to constitute interference with management prerogatives. The best of CEOs focusing on their own global operations know that they can sometimes be myopic on critical strategic issues. Capable independent directors should be able to stimulate and expand management frames of reference at such times, without inappropriately distracting management from its responsibilities or substituting directors’ business judgments for that of management. Recommendation 3

Mandate the formation of risk committees dedicated to ERM.


party’s service should be limited to three years, with the right to return after six years. The more sensitive tasks in performance evaluations should include discussions with the CEO or a retained consultant about individual directors, during which the CEO’s views on contributions that were made during the year by individual directors, and areas where the CEO might value future contributions from a director, would be identified. The entire assessment process offers a check on whether the nominating committee and full board are fulfilling the mission to recruit and maintain an effectively engaged board.

Global companies in complex businesses, such as the industry, require a separate committee dedicated to risk issues. Diverse expertise that is contributed by independent directors on committees responsible for risk oversight working with a CRO and the CEO should add ballast to such oversight, if sufficient time is scheduled for penetrating analysis and dialogue, some of which should occur only with the presence of the CRO, and no other member of management, to create optimal circumstances for getting insight into CRO risk assessments that may conf lict with those of management. To avoid duplicative work, coordination between the audit and risk committees is important in managing governance processes. Time allocated for meetings does not allow for audit committees or full boards to appropriately address the panoply of risk issues that global companies face. An equally important reason may be that the risk committee, especially in executive


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session, can consider and reconcile differences when the CRO’s risk assessments may conf lict with those of management. It is difficult to argue against having a separate risk committee once it is accepted that risk is a core component of governance, and well conceived risk strategies are essential to corporate vitality. In this regard, independent directors of subsidiaries or affiliates could add significant value to risk assessments through periodic interaction with and presentations to the parent company’s full board, audit committee, or risk committee. Although subsidiary and affiliate boards do have responsibility for risk oversight, I do not believe that they receive strong mandates from the parent company, especially where risk management is centralized.18 Regulators, credit rating agencies, policymakers interested in regulatory reform, institutional shareholders, and others are demanding better performance by boards.19 Therefore, it is surprising that some business leaders and boards continue to reject the merits of appointing risk committees with a balanced complement of independent director skills. Ultimately, the modern corporate board in its entirety must have a comprehensive understanding of risks that the company faces, and an appreciation for how management analyzes these risks and proposes to manage them within the context of executing the corporate strategy. These steps are fundamental to enabling a board to fulfill its obligations in approving corporate strategies. 20 This is why principles of governance and securities listing exchanges currently emphasize director commitments to time. 21 Moody’s standards for industry directors of global life insurers, for example, could not be achieved without substantial time commitments. Moody’s states under the heading “Risk Management” that “Management’s and the board’s ability to identify, monitor, manage, and mitigate its risks goes to the heart of a company’s success in minimizing unexpected events and volatility, and in protecting the interests of its policyholders and other stakeholders. Taking strategic risks, whether in underwriting, investments, sales practices, acquisitions, or other areas is a necessary activity for an insurance company.” 22 Addressing these issues in two committees (audit and risk) is difficult enough in normal business environments; leaving the tasks to the audit committee makes them herculean during volatile periods, when dedicated oversight is most critical. There is no doubt in my mind that modern global industry enterprise requires the services of both committees. Modern risk management is the process by which actual or potential risks faced by the company are holistically managed to mitigate exposures to losses, and it is a process by which a company sets risk tolerance that are levels intended to produce value for shareholders and other stakeholders. 23 How can an audit committee handle both financial reporting issues and all risks in a global industry enterprise? It cannot do so effectively, nor can the entire board dedicate the time necessary to analyzing and discussing global risks. Of course, as is the case with all other issues delegated to committees, the entire board must be informed and render decisions on material matters.


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Industry ERM It is understood that the industry survived the crisis relatively well, but there are important lessons to be drawn from the crisis from which the industry did not


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escape unscathed. 24 As financial products and markets continue to converge and increase competitive pressures, the industry will confront many new risks. The IAIS and OECD issued a joint draft, “Issues Paper on Corporate Governance” (the “Governance Paper”) in 2009, which recognizes: “A robust risk management system is an integral element of a sound governance system. The risk management process helps the insurer understand the nature and significance of the risks to which it is or may be exposed and manage them accordingly . . . Risk management systems are made up of strategies, processes and reporting procedures that identify, assess, quantify, control, mitigate and monitor the risks . . . Risk management systems recognize the interdependencies of risks and take into account the nature, scale and complexity of the business of the insurer.” 25 This approach to risk management essentially defines ERM. ERM must be about so much more than quantitative measurements of risk exposures. Quantitative models can obscure important “softer” issues that must be part of ERM for holistic risk management. Those “softer” skills in the industry include sound business judgment and developing an understanding of management strategy, key processes and controls, consumer preferences, the regulatory environment, competitors’ strategies, sociopolitical environments in new markets, anticipating market trends, and other factors. Skepticism for the objectivity of the modeling process had been generally lame until the crisis. Somehow, model users overlooked that models are an approximation of reality and will have inherent limitations, for example, due to the lack of available data. Further, model developers may also have conscious or subconscious preferences for particular outcomes, data selection may result in a defective model, or production of the model could have been inf luenced by pressures from corporate superiors to produce their preferred agendas. Yet, models drove core business strategies without proper consideration for their limitations. 26 Perhaps models were not sufficiently scrutinized because business leaders and independent directors were loath to indicate their inability to understand the models presented to them in support of management’s strategy. One painful yet excellent recent example of this view was the model developed for mortgage-related credit default swaps (CDS), reliance on which was a major cause of the 2007–2008 global systemic financial crisis. We learned when it was too late that the “Gaussian Copula” model, developed by David X. Li for these instruments, was not comprehended by many executives and directors when they supported launching programs based on Li’s model. There was a stampede on Wall Street to develop securitization products that employed Li’s model, despite Li’s warnings, and those of others, about its limitations. 27 Even now, after observing the damage that can be done by overreliance on quantitative models, “quant” adherents continue searching for predictive certainty in finance by seeking to adapt techniques employed in physical science predictive models. 28 To avoid a repeat of history, “quant” experts must explain their models to “nonquants” in layman’s terms. If management does not force the issue, independent directors must do so. One colleague with expertise in these matters has suggested that boards should actually ask management to explain the models upon which they rely, and separately ask the CRO to explain the models. The board can then determine whether the independent recitations are consistent. The outcome




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would be an invaluable indication of whether risk management is embedded in the business strategy. Directors must verify management’s and their own understanding of complex matters contained in models. Mikes, in Spotlight on Risk, expressed the point well: “Models are not decision makers; people are.” 29 If the model and its limitations cannot be explained, it should not be relied upon to measure and manage risk. If independent directors are not armed with a sufficient scope of information that they can understand, their ability to ask the right questions or contribute their unique expertise to the discussion is impeded. Chairman of the Federal Reserve, Ben Bernanke has acknowledged that managing risk effectively requires skepticism of quantitative modeling as an exclusive tool for managing risk.30 The Senior Supervisors Group of global financial services regulators submitted a report to the Chairman of the Financial Stability Forum (now the FSB) on those risk practices that were most and least effective during the financial crisis. The report concluded, “Firms that avoided problems [most effectively were those which] demonstrated a comprehensive approach to viewing firm-wide exposures and risk, sharing quantitative and qualitative information more effectively across the firm and engaging in more effective dialogue across the management team.” The report also noted that “critical judgment exercised by senior executives played an important role in the more successful firms.”31 This discussion by no means advocates eliminating quantitative models from strategic decision making in formulating strategies and ERM structures It simply ref lects the recognition that ERM means capturing the entire important elements of the scene in the strategic snapshot to better understand the environment in which the photograph is taken. Effective governance means effective ERM, which requires attempting to appreciate the full scope of environments within which the business operates. The industry requires models to project future capital and liquidity needs. Capital and liquidity models are fundamental to ERM. They simply should not be allowed to become nearly the sole focus in strategic planning and director deliberations. Once independent directors understand the models, their expertise should add fresh perspectives to strategies.32 The IAIS and OECD appropriately noted that boards should contextualize the “nature, scale and complexity” of the insurer’s business in order to achieve proportionality in ERM. For example, a global, relatively decentralized insurer that is operating multiple legal entities under a holding company structure, or a financial conglomerate offering multiple financial services and possibly even nonfinancial services and products, will have different risk profiles and a more complex ERM program than a regional, centralized insurer. Robust ERM structures, implementation and monitoring embedded in major strategic decisions will not prevent all crises, but should at least circumvent the impact of most.


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Independent Directors and ERM There are certain features unique to the industry that independent directors need to appreciate to add value. Board education on governance matters is now one of the major themes found in protocols for board service. Although governance protocols advocate that independent directors be given educational sessions on the checklist, the industry’s independent directors should receive tutorials on the


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specific businesses of the company, its subsidiaries, and affiliates, which are likely to be more time consuming than is currently expected. The tutorial would include explanations of products, markets, asset liability matching, distribution systems, regulatory approaches, the potential impact of disparate regulations, compensation strategies for distributors, and how risks are transferred through reinsurance and capital markets. Independent directors should also be educated on standards established by rating agencies for grading industry ERM (ratings are a major factor in certain market segments), and on ERM standards articulated by industry regulatory authorities in jurisdictions where the company or its subsidiaries and affiliates operate.33 The industry management must incorporate these elements into strategic planning. Therefore, independent directors need to understand them. If a company does not earn high grades from ratings agencies, the board should receive an explanation and plan for when, if ever, an improved grade will be earned, and the risks inherent in maintaining the status quo or suffering a downgrade. Discussion should be most intense when the company has fallen behind one or more peers. Implementation of the plan for ratings improvement should be monitored by the board. Independent directors should be fully engaged in discussion and awareness of these efforts. “Average” grades, although they may be justifiable, should not be acceptable to directors without receiving satisfactory explanations. An important service provided by independent directors is that they challenge management to achieve excellence. With completion of their education on the foregoing subjects, independent directors will be equipped to participate in overseeing and approving ERM strategies.

Overview of Industry ERM Structures and Practices The ERM toolkit for the industry’s global companies requires: (1) an organizational structure that permits centralized risk management structures that do not tamp entrepreneurial energy essential to corporate prosperity; (2) integrated technology, without which effective ERM in a global industry enterprise is likely to miss objectives and be reactive; and (3) protocols that are efficient, nonbureaucratic, and easily understood throughout the organization in order to achieve the substantive objectives of the ERM program, including a common risk language. It is up to independent directors to confirm that each tool is in the kit. Global industry participants will develop (within the frameworks of legal constraints and rating agencies’ expectations) individualistic approaches to ERM to complement their respective overall risk tolerance, business objectives, and structure. The rest of this section will address how the industry’s independent directors may more specifically help foster adoption of robust ERM structures, and how industry regulators might specifically benefit from similarly robust ERM protocols and substance. We know that past successes and failures are not necessarily predictive of future successes and failures. Yet, understanding them is an important part of the ERM roadmap. One of the more challenging tasks in managing risks is to require management and the board, or a designated committee, to undertake selfcritical analyses when risk management has not succeeded with an adopted strategy. This is difficult for two reasons. The first is that most individuals are not comfortable with such an exercise. The second is that this undertaking presents




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legal sensitivities, which should be addressed with legal counsel. I question whether consultants are any better at forecasting future “unknowns” or “Black Swans” than a competent management team and board, but they can often provoke productive “brainstorming.” Before the process of forward-looking risk identification begins, management is expected to set its own expectations for the undertaking and explain those to the appropriate committee or full board. Next, risk identification should occur at each of the parent company and subsidiary levels, after which the work product of each should be reconciled by the CRO to produce a holistic risk taxonomy. Independent directors need to understand risk exposures and tolerance levels for subsidiaries, in order to better comprehend the overall risk strategy and capital management. Identified risks within each category should be aggregated for the enterprise, and accompanied by a “roadmap” and “ownership” chart that illustrates how and who manages identified risks, completion dates for action items, as well as any recent risk management failures, with descriptions of resolutions for each. Since risk management has emerged as an important corporate discipline, there are considerable literature and technology recommendations on how to build a structure.34 The best of these advocate nonbureaucratic approaches with clear lines of accountability. Independent directors should, without becoming absorbed with tactical decisions of management, ascertain whether these features are embedded in their company’s approach to ERM. If they are not present, independent directors should question management’s approach.

ERM and Subsidiaries Looking at a history of industry insolvencies, disasters can be found in the failure to fully grasp subsidiary operations and risks, for example, where a direct writer entered new, or significantly expanded, existing operations such as reinsurance, brokerage operations, third party administrator, certain product lines, or geographical markets. Directors of industry parent companies cannot possibly address these matters with only the parent company’s risk officer and CEO filtering material issues. Directors at the parent company need to periodically hear from subsidiary and affiliate risk officers, compliance officers, general counsels, and internal auditors for proper checks and balances. Independent directors should have at least an annual nonexecutive session with select subsidiary and affiliate representatives. This outreach affords another check on the robustness of communication between the parent company management and the board. The value that subsidiary board members can add should not be underestimated, since these individuals should have a strong sense of local issues, and must be positioned to provide additional insight into the subsidiary’s operations. This interaction will also enable independent directors of the parent company to evaluate whether subsidiary board independent directors enjoy a sinecure or are properly engaged. Once risks are identified, management and the board must be confident that the ERM structure can be effectively implemented, and monitoring must follow implementation. Industry risks were discussed earlier. In addition to traditional risks, the risk strategy would include projecting future expansion opportunities


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and related risk exposures, especially sociopolitical, regulatory, national economic barriers to continued expansion, and other factors in emerging markets not generally confronted in developed market economies. The CRO should be responsible for educating the appropriate committee or full board, as the case may be, on material enterprise risks and how they are to be addressed. Regardless, risk issues should be addressed first by the CEO with the board members. Assuming that the structure includes a risk committee, the committee, after offering its own substantive guidance, would receive a report from the CRO containing any suggested structural revisions to the risk strategy. The final risk strategy would be presented to the entire board for comment and any suggested revisions, after which the risk strategy would be adopted and implemented. Thereafter, the risk and audit committees would monitor the effectiveness of the ERM program, with support from the risk officer, internal audit, and the company’s independent auditor, ultimately producing recommended appropriate revisions. The Chairs of the risk and audit committees would need to coordinate oversight in order to avoid duplicate undertakings. Risk or audit committee agendas should periodically include reports from subsidiary risk officers, internal audit, the Chief Compliance Officer (CCO), and the General Counsel. Periodically, only independent board members should be present for such reports. This suggestion is based on my experience as an independent advisor on risk issues. It is not unusual to see a significant disparity among the risk perceptions of a CRO, subsidiary risk officers, and business leaders. This could be even more the case with affiliates. These disparities that often result in risk management failures. Independent directors must not be reluctant to dig deeper into the organization, especially when certain risk mitigation failures have previously occurred. In fact, this may be a critical step in the avoidance of repeated failures. ERM must allow time for the skills of the entire board to be applied during an annual strategy meeting to consider the “unthinkable.” CROs should organize teams to indulge in such thinking. The question of how corporations plan for extreme events, without losing competitive standing when their peers are not incorporating similar exposures in their strategic planning, cannot be overlooked. It is one thing to identify “unknowns” and another to be alone in addressing them. Is this where regulators can add value by leveling the playing fields? This is a dilemma that must be addressed on a case by case basis. The recommendations contained in this section were geared to foster robust, competent independent director engagement in ERM processes, which would hopefully result in more effective ERM.



Conclusions There are no perfect solutions to the issues addressed in this chapter. My recommendations propose what I consider to be minimalist steps to avoid more cumbersome rules, although I do understand that some may see even these recommendations as overreaching. The role of independent directors is now taken more seriously than ever before by policymakers, legislators, supervisory authorities, ratings agencies, and shareholders. Evolving standards ref lect this. This chapter has proposed initiatives


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to contribute further to the value offered by capable and diligent independent directors, especially in overseeing and assuring successful realization of ERM strategies.

1. (Schich 2009). 2. (HBR 2009). 3. (Subcommittee on Oversight and Investigations of the Committee on Energy and Commerce of the U.S. House of Representatives 1990). 4. (The de Larosière Group 2009). 5. (Insurance Groups and Cross-sectoral Issues Subcommittee in Consulation with IAIS Members and Observers 2009): “The IAIS recognizes that effective groupwide supervision can contribute to sound insurance markets, improved management of groupwide risk and capital and enhanced policyholder protection. At the same time, solo supervision will remain integral as the legal obligation to policyholders is established at the legal entity level. Therefore, to be effective and efficient, supervision of a group should be undertaken in a manner that recognizes the respective requirements for solo and groupwide supervision, establishes common understanding and coordination among supervisors, and avoids unnecessary duplication of supervision.” 6. (The de Larosière Group 2009). 7. (Gillispie and Zweig 2010). 8. (Kirkpatrick 2009), (Moody’s 2006), (Standard & Poor’s 2008). 9. (OECD 2009), (World Economic Forum 2009). 10. (Solomon 2007). 11. (IAIS and OECD 2009). 12. (Solomon 2007). 13. U.K. Listing Rules for the Main Market of the London Stock Exchange require companies to describe compliance or explain noncompliance with the Combined Code. 14. (Solomon 2007), (Corporate Governance Committee 2003). 15. (NAIC 2009): NAIC Corporate Governance Guidance for Principle-Based Reserves-VM-G as adopted and finalized Sept 21, 2009 stating that “Boards should understand processes undertaken by management to correct material weaknesses in internal controls of the company or group of insurance companies with respect to valuation, infrastructure regarding policies, procedures, controls and resources in place to implement and oversee principle-based reserve processes and documentation of review and action undertaken by the board, relating to the principlebased reserving function should be ref lected in the minutes of all board meetings where such function is discussed. 16. (Kirkpatrick 2009). 17. (IAIS 2009). 18. (Moody’s 2006) weighs the risks in subsidiaries and affiliates in rating life insurers. 19. (Gotshal 2009). 20. (Kirkpatrick 2009), (Connelly 2009), (Corporate Governance Committee 2003). 21. (Gotshal 2009), (Kirkpatrick 2009). 22. (Moody’s 2006).


Notes


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23. (Corporate Governance Committee 2003), (Committee of Sponsoring Organizations of the Treadway Commission 2009). 24. (The de Larosiere Group 2009): “So far banks and insurance companies have written off more than one trillion Euros. Even now, 18 months after the beginning of the crisis, the full scale of the losses is unknown. Since August 2007, falls in global stock markets alone have resulted in losses in the value of the listed companies of more than €16 trillion, equivalent to about 1.5 times the GDP of the European Union.” 25. (IAIS and OECD 2009). 26. (Senior Supervisors Group 2008) states that stronger companies engaged in “robust dialogue” across the firm on risk issues; internal processes that relied on numerous factors, include comfort with the ability to exercise judgment, looked at risk across the enterprise to establish liquidity and capital security, availability of a variety of tools including management information systems that integrated assumptions, balancing “quantitative rigor with qualitative assessments.” 27. (Salmon 2009): “The effect on the securitization market was electric. Armed with Li’s formula, Wall Street’s quants saw a new world of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities.” 28. (Cookson, Tett, and Cook 2009). 29. (Mikes 2008), (CRO Forum 2009). 30. (Bernanke 2008), (Furer and Haegli 2009). 31. (Senior Supervisors Group 2008), (Furer and Haegli 2009). 32. (CRO Forum 2009). 33. (Moody’s 2006), (Standard & Poor’s 2008). 34. (CRO Forum 2008), (Towers Perrin 2009).

Bibliography Bernanke, Ben S. “Risk Management in Financial Institutions.” May 15, 2008, http:// www.federalreserve.gov/newsevents/speech/bernanke20080515a.htm. Committee of Sponsoring Organizations of the Treadway Commission. “Strengthening Enterprise Risk Management for Strategic Advantage.” 2009. www.coso.org. Cookson, Clive, Gillian Tett, and Chris Cook. “Organic Mecanics.” Financial Times. November 27, 2009. Corporate Governance Committee. “The Dutch Corporate Governance Code.” December, 2003. http://www.ing.com/group/showdoc.jsp? docid=074107_EN&menopt=cog|dtc. CRO Forum. “The Financial Crisis-The Cro Sorum’s Views on the Consequences for Enterprise Risk Management and Regulation in the Insurance Industry.” October 24, 2008. www.croforum.org. CRO Forum. “Insurance Risk Management Response to the Financial Crisis.” April 2009. www.croforum.org. Furer, Guido, and Jerome Haegli. “Lessons Learned from the Financial Crisis: An Investment Practitioner’s Point of View, Commenting on Remarks by Chairman Bernanke.” Geneva Association. February 20, 2009. Gillespie, John, and David Zweig. Money for Nothing. New York: Simon & Schuster, 2010. Gotshal, Weil. “Weil Briefing.” 2009. www.Weil.com/files/upload/Weil_Briefing_ SEC_CG_.pdf. Harvard Business Review (HBR). “Spotlight On Risk.” October 2009. http://hbr. harvardbusiness.org.




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International Association of Insurance Supervisors (IAIS). “Guidance Paper on the Use of Supervisory Colleges in Group-Wide Supervision.” October 2009. http://www. iaisweb.org/_ _temp/Guidance_paper_No_ _3_8_on_the_use_of_super visor y_ colleges_in_group-wide_supervision.pdf/. International Association of Insurance Supervisors and Organization for Economic Cooperation and Development (IAIS and OECD). “Issues Paper on Corporate Governance (Draft).” March 13, 2009. http://www.oecd.org/daf/insurance/governance. Kirkpatrick, Grant. “Corporate Governance Lessons from the Financial Crisis.” 2009. http://www.oecd.org/dataoecd/32/1/42229620.pdf. Mikes, Anette. “Risk Management at Crunch Time: Are Chief Risk Officers Compliance Champions or Business Partners?” May 30, 2008. http://papers.ssrn.com/so13/ papers.cfm?abstract_id=1138615. Moody’s. “Moody’s Rating Methodology for Life Insurers.” Global Credit Research, 2006. National Association of Insurance Commissioners (NAIC). “Solvency Modernization Initiative (EX) Task Force.” December 7, 2009. http://www.naic.org/committees_ ex_isftf.htm. Organization for Economic Cooperation and Development (OECD). “Corporate Governance and the Financial Crisis: Key Findings and Main Messages.” June 2009. http://www.oecd.org/dataoecd/3/10/43056196.pdf. Salmon, Felix. “Recipe for Disaster: The Formula That Killed Wall Street.” Wired Magazine. February 23, 2009. http://www.wired.com/print/techbiz/it/magazine/17–03/ wp_quant. Schich, Sebastian. “Insurance Companies and the Financial Crisis.” 2009. http://www. oecd.org/dataoecd/0/41/44260382.pdf Senior Supervisors Group. “Observations on Risk Management Practices during the Recent Market Turbulence.” March 6, 2008. http://www.newyorkfed.org/newsevents/ news/banking/2008/SSG_Risk_Mgt_doc_final.pdf. Solomon, Jill. Corporate Governance and Accountability. West Sussex: John Wiley & Sons, Ltd., 2007. Standard & Poor’s. “Enterprise Risk Management:ERM Development in The Insurance Sector Could Gain Strength in 2008.” Rating Direct, 2008. Subcommittee on Oversight and Investigations of the Committee on Energy and Commerce U.S. House of Representatives. Insurance Company Insolvencies. United States Government Printing Office, 1990. The de Larosière Group. “Report of the High Level Group on Financial Supervision in the EU.” February 25, 2009. http://ec.europa.eu/commission_barroso/president/pdf/ statement_20090225_en.pdf. Towers Perrin. “Enterprise Risk Management, the Rating Agencies and You.” 2009. http://www.towersperrin.com/tp/getwebcachedoc?webc=USA/2008/200809/ERM_ RateAgencies_RoadMap_2008.pdf. World Economic Forum. “Global Risks 2009.” 2009. http://www.weforum.org/pdf/ globalrisk/2009.pdf.


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Aggregating Global Risks Arising from Regulatory Disparities Jerry M. de St. Paer and Michael E. Mathisen

Introduction The current transitional period of macrostructural change presents the leadership of the global insurance industry with significant risks, as well as opportunities. Many of these risks pose a threat to insurers, regardless of the type(s) of insurance they provide (life, property casualty, third market, or reinsurance), their ownership structure (mutual, fraternal vs. stock-owned), or their scope of operations (national or regional vs. global). And, regulators need to be concerned about the final risk. The global financial crisis accelerated this process of structural change that was already gaining steam in the form of efforts to harmonize global regulation of the insurance industry (International Association of Insurance Supervisors [IAIS]), national regulation (Solvency II),efforts by the Organization for Economic Cooperation and Development(OECD)1 to ensure tax revenues by focusing on so-called tax-advantaged jurisdictions, efforts to use insurance regulation to create advantages to locally domiciled insurers, and continuing efforts by banks to encroach on the insurance industry’s domain. Even those insurers around the world who emerged from the crisis in reasonably strong shape are now dealing with the urgent issues of expense reduction, a fall in revenues, soft markets, etc. At this difficult time, the insurance industry must find the resources and the cohesiveness to deal with the risks set forth here, as they also deal with the short-term business realities. This chapter examines some of the principal risks that should be on the industry’s radar screen.


CHAPTER 15

Setting the Stage The global insurance industry largely escaped the most severe perils of the global financial crisis. The exceptions are notable, but prove the point. The central involvement in the crisis of AIG (American International Group, Inc.) was almost


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exclusively due to its involvement in noninsurance, unregulated activities. And the authorities had allowed AIG to “shop regulators” in picking the Office of Thrift Supervision (OTS) as its overall regulator. The OTS was incapable of effectively regulating virtually any of AIG’s activities. Significantly, the AIG insurance companies that were regulated around the world by insurance regulators weathered the crisis. A couple of other insurers, similarly involved in unregulated activities, suffered from these activities but not via their regulated insurance entities. Finally, some insurers were overinvested in alternative investments, which were hard-hit by the crisis, and a very small minority of these received governmental assistance. However, to the political/regulatory world, it is often too tempting to fix that which isn’t broken, rather than adjust it for the areas that need correction. So, it is more difficult than ever to forecast where the chips of change are going to fall—or when.

The Primary Risk Drivers One principal driver is the desire to learn and apply the lessons of the global financial crisis, and to strengthen standards and regulatory frameworks to avoid a repeat experience. Even before the crisis, there were efforts in insurance to harmonize regulation driven by the European Commission (EC) with Solvency II, by the belligerence of the EC in attempting to create an uneven playing field for European headquartered insurers, and by the efforts of the International Association of Insurance Supervisors (IAIS) to strengthen the international framework of regulatory principles for statutory supervision of the industry. The IAIS is part of the Bank of International Settlements (BIS) structure in Basel, Switzerland, along with the Financial Stability Board (formerly the Financial Stability Foundation) and the global bank regulators. The International Accounting Standards Board (IASB) had already partnered with the Financial Accounting Standards Board (FASB) of the United States to converge toward a single global set of high quality accounting standards. The EU was the first major economic bloc to adopt the IASB standards—the International Financial Reporting Standards (IFRS), and other major countries such as China, India, Australia, Canada, Japan, Brazil, and many others had already committed to adopting IFRS in 2011 and the years beyond. Importantly, a tenet of the convergence effort was that General Purpose Accounting Principles and Statutory/ Regulatory Accounting Principles should be the same, with a few adjustments for Statutory. Many countries had already adopted this approach. So, this convergence process is important to regulation, as well as to general purpose public financials. The leaders of the G20 countries 2 issued a Statement at their Pittsburgh Summit in September 2009, which set forth their agreement on “Strengthening the International Financial Regulatory System.” The following excerpts include the insurance industry in the scope of their intentions:


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13. . . . The steps we are taking here, when fully implemented, will result in a fundamentally stronger financial system than existed prior to the crisis. If we all act together, financial institutions will have stricter rules for risk-taking,


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governance that aligns compensation with long-term performance, and greater transparency in their operations. All firms whose failure could pose a risk to financial stability must be subject to consistent, consolidated supervision and regulation with high standards. . . . we call on our Finance Ministers and Central Bank Governors to reach agreement on an international framework of reform in the following critical areas:

14. We call on our international accounting bodies to redouble their efforts to achieve a single set of high quality, global accounting standards within the context of their independent standard setting process, and complete their convergence project by June 2011. . . . 3

The speed and commitment with which the signatories to this statement actually move to execute their commitments remains to be seen. But, the international bodies involved, such as the IAIS, the FSB, and the IASB, are moving forward from their end with high energy. If change isn’t driven from the bottom up, it will be driven from the top down. A second principal driver is the need to fund the sovereign expenditures of the global bailout program, including tax policies and actions. After its Pittsburgh Summit, the G20 also had something to say about taxation, as well as prudential standards: 15. Our commitment to fight non-cooperative jurisdictions (NCJs) has produced impressive results. We are committed to maintain the momentum in dealing with tax havens, money laundering, proceeds of corruption, terrorist financing, and prudential standards. We welcome the expansion of the Global Forum on Transparency and Exchange of Information, including the participation of developing countries, and welcome the agreement to deliver an effective program of peer review. The main focus of the Forum’s work will be to improve tax transparency and exchange of information so that countries can fully enforce their tax laws to protect their tax base. . . . 4

Increasing pressure was being brought on jurisdictions that are truly domiciles of convenience, as well as on serious domiciles, such as Bermuda and Luxembourg, by the Organization for Economic Cooperation and Development (OECD) and the International Monetary Fund (IMF), as well as by national authorities, such as the United Kingdom’s Financial Services Authority (the FSA). U.S. tax legislation has been considered several times to “close loopholes” in taxation that is aimed at so-called NCJs. Cassell reports that the U.K. has just won a tax case which tightens the availability of “nonresident” status of Britons living abroad for U.K. income tax purposes. And, the U.K. isn’t alone. “. . . U.S. President Barack Obama has called for tax increases on families with income above $250,000. Meanwhile, Berlin is pursuing wealthy Germans who hold Swiss bank accounts that shield hundreds of billions of Euros, by some estimates.”5


• Building high quality capital and mitigating pro-cyclicality; • Addressing cross-border resolutions and systemically important financial institutions by end-2010.


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In the spirit of “be careful what you wish for,” insurance is now considered part of financial services pursuant to §13 above. The Financial Times reported that the list that the Financial Stability Board (FSB) of the Bank of International Settlements (BIS) is earmarking for cross-border supervision exercises “includes six insurance companies—Axa, Aegon, Allianz, Aviva, Zurich, and Swiss Re—which sit alongside 24 banks from the United Kingdom, continental Europe, North America, and Japan. . . . Insurers are considered systemically important for a variety of reasons: they might, for example, have a large lending arm, such as Aviva, or a complex financial engineering business, akin to that of Swiss Re. . . . The exercise follows the establishment of the FSB in the summer and is principally designed to address the issue of systemically important cross-border financial institutions through the setting up of supervisory colleges.”6 The FSB denies that it has finalized the list, but insurers are in the cross-hairs. Based on these developments, the current operating model to which the industry has become accustomed may become obsolete. The whims of politicians and regulators, some legitimately seeking a new generation of consistent global insurance regulation, some seeking to protect national markets/policyholders, some seeking enhanced tax revenue, and others seeking to protect their favored position as a domicile of choice for insurers and reinsurers seem certain to change the status quo once again. Where this change will steer the industry is open to conjecture. However, insurers that have the ability to react to this changing environment will again have a competitive edge over their less nimble brethren. The method used in this chapter to dimension the risks will be immediately recognized by a property and casualty (P&C) executive. The risk is driven by likelihood/probability times severity. A red/amber/green, or “R AG,” system is used for these dimensions. The ratings are very judgmental and are directional more than mathematically precise. They are loosely based on table 15.1.

All Insurance Lines: Attack on Noncooperative Jurisdictions Some domiciles that are considered NCJs will certainly be impacted by the greater global scrutiny. It is important to divide these jurisdictions into two subgroups: countries such as Ireland, Bermuda, and Luxembourg, which are significant and responsible regulatory domiciles, and others that are merely countries of convenience.

Table 15.1


Insurers in the Cross-Hairs: The Political Pressure for Global Action

The RAG (red/amber/green) system

Dimension

Red

Amber

Green

Risk

Both very Likely and Severely Damaging

Sufficiently Likely and Not to Worry Severe to be on Radar Screen

Probability/Likelihood 66% or Greater

33% to 66%

33% or Less

Severity

5% to 10% of Surplus

5% of Surplus or Less

10% of Surplus or Greater


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As an example, Bermuda is making a concerted effort to establish a regulatory framework that largely utilizes the principles embodied in IFRS, in the form of their Economic Balance Sheet project. Because Bermuda is the home domicile, or nearly so, of a significant portion of the nonlife insurance and reinsurance industry globally, the Bermuda Monetary Authority has tremendous incentive to be and be seen as a responsible player in the global regulatory framework. And, they have the support of the Bermuda industry to achieve that objective. Bermuda’s challenge is to maintain an insurance industry-friendly environment in which to do business. The record in this latter respect is far from comforting, and the recent redomestication to Switzerland of ACE, Bermuda’s largest company, should be a warning signal in that regard. Ireland has demonstrated that it will maintain a strong regulatory framework, and it strives to demonstrate enlightened regulation against that framework. In addition, Luxembourg is part of the European Union and has the benefit of the umbrella of the EU regulatory framework. These domiciles must strengthen their regulation frameworks, as the entire global industry is doing. They are not outside this challenge. But, they should be seen as part of the mainstream. The NCJs will go unnamed here, but insurance operations domiciled in those jurisdictions will almost certainly find the historic value in shielding business reinsured as a regulatory arbitrage coming under increasing, and likely successful, concerted attacks. This does not represent a significant, mainstream component of the industry and isn’t a material threat. The economic model of several domiciles of convenience for the insurance industry is based on low or nonexistent income tax rates, and they balance their budget with revenues from ancillary sources related to the benefits that the industry otherwise brings, including the significant spending power in the local communities. Interestingly, the opponents of these domiciles argue the lost tax revenues in their home jurisdictions, but they fail to note that some of the significant losses borne by carriers in these tax advantaged domiciles produce no tax deductions. Looking at the level of losses borne in Bermuda, for example, following 9/11 and the 2005 hurricanes, the impact was a huge inf low of funds to the United States, with no related tax deduction for the industry. Nevertheless, in the current environment where countries are paying out rescue expenditures to help stabilize their economies, there is going to be severe pressure for additional tax revenues. Some jurisdictions that proactively utilize taxes to attract insurance groups, such as Switzerland and Ireland, are strongly protected by tax treaties with the major affected countries and may be immune to these countries attempts to tax cross border. However, Bermuda is an attractive target and is not covered under the umbrella of treaties with the most of the G20 countries. As a political matter, Bermuda is exposed.



• Severity —The severity to certain companies/groups of the loss of the tax advantage in Bermuda and other jurisdictions would be very significant, increasing effective tax rates and putting pressure on return on equity (ROE) that often doesn’t fully ref lect the tax benefit received. Even the prospect of such action could provoke companies domiciled in these markets to redomesticate as a preventative matter, while they can utilize the maximum leverage of not making the move under duress. Therefore, the severity is red.


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• Probability —The exposure of the NCJs that are viewed strictly as tax havens is very high. And, moves against them will create political capital for those who promote such action. The exposure of the responsible domiciles is definitely heightened, but is put at moderate, or amber. • Risk —Because the severity of the impact is so great, even with moderate probability, the risk is deemed high, or red.

Attack on foreign carriers is to design strict “equivalence” standards for those carriers, based on the basis of regulation in their home domicile, thereby requiring higher capital levels and/or forcing costly restructurings in order to achieve a level playing field with locally domiciled carriers. A clear example of this type of “beggar my neighbor” policy is the European Union standards for “equivalence” and “passport” admission to write business applicable to a third country entity. This could trigger a major “trade war” if not managed properly. The “equivalence” move began at a time when EU regulators openly stated that this was an opportunity to create a playing field advantage for locally domiciled carriers versus third country carriers, both in the EU and globally. It was to be done under the guise that the regulatory framework of the EU was so advanced under Solvency II that a strict interpretation of equivalence could be used to the advantage of the local carriers. There was an outcry at the time about restraint of trade, and the rhetoric of the European regulators has been toned down. But, their actions are moving forward unrestrained. The significance of this is severe, if carried out as currently planned by the EU. A fundamental premise of Solvency II is that there are diversification benefits in an insurance group, which is certainly true. But, the benefit of this diversification is more obvious within legal entities than it is across multiple legal entities in a group. The latter assumes that the capital in the various legal entities is largely fungible and available to meet the group’s capital requirements in legal entities, beyond the ones where the capital resides. The financial crisis has demonstrated that local regulators around the world will restrict the movement of capital away from their policyholders in times of stress. Nevertheless, the EU continues to move down the path of granting significant diversification credit to EU-regulated groups and to third country groups that the EU deems equivalent. In short, this means that a qualifying group would be able to maintain less capital in support of its liabilities, on the mythical premise that capital residing in legal entities of the group other than the legal entities where the liabilities reside is available on some basis to meet those liabilities. A second significant component of Solvency II, which is designed to reduce capital requirements relative to other jurisdictions, is the assumption of a one-year measure of the risk exposure, plus some computation of the risk beyond the oneyear horizon. Insurers are exposed to risk over the full horizon of risk period, and a more conservative approach is to calculate the risk over the entire horizon period. The combination of diversification credit and using a less conservative measure of risk exposure results in a reduced level of capital required to support insurance liabilities. And, the equivalence regime of the EU that is being developed


All Insurance Lines: Attack on “Most Favored Nation” Treatment of Third Country Carriers


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will effectively put a ring-fence around these benefits for the advantage of Eurodomiciled groups, at the detriment of those third country groups who compete with them in both Europe and in their home domiciles. The “passport” regulation is equally insidious. Under the new EU regulation, insurance groups would have a primary regulator responsible for the overall surveillance of the group worldwide. Regulatory authority would be shared with the regulators in the local domiciles where those groups do business. For insurance groups from third countries, in order to gain “passport” admission to write business in the EU, it is necessary to have a group structure which brings the group’s entire European operation under the control of a single lead European regulator. Many of the most significant third country groups with operations in the EU launched those operations pre-EU, in adherence with the country-by-country regulatory framework at that time. Further, given the regulatory framework of the time, many of these operations in Europe were established using a branch of the parent company in the foreign domicile to achieve capital efficiency, which also brought the full faith, credit, and capital support of the home company to the benefit of the European policy holders. In order to get the benefit of a passport, they would be required to undergo a costly restructuring. • Severity —The severity of this is very significant, or red. • Probability —The probability is hard to judge because it is being driven by the EU. If the EU applies a very strict interpretation of equivalence, the probability of retaliation seems high. But, it’s not too late for cooler heads to prevail. So, hopefully, the probability is amber. • Risk —The risk is red.

Life Insurance and Annuities: Attack on Tax-Free Inside Buildup Regarding the attack on tax-free inside buildup—particularly on annuity products preferred by the upper income bracket—on the one hand, imposing such a tax would raise significant revenue. However, on the other hand, it would eliminate a major, unique competitive advantage of the life and annuity industry versus banking. The challenge faced by the administration/legislators is that the vast percentage of assets in life and annuity products belong to the middle class. The average size of an annuity principal in the United States is about $40,000. While there are annuities targeted for the upper income, they represent a small minority of the total body of such funds. So, the populist move would perversely take from the middle class. The Obama administration has signaled that they view annuities as a savings vehicle of choice, and also a means for those who lost so much of their retirement savings in the global financial crisis to regain some of their retirement financial security. Another significant hurdle of imposing such a tax is the political force of the life insurance and annuity sales agents. Their ability to generate national grass roots opposition to any moves that would affect the products they sell, or their own compensation, has been legion. Like another powerful political force, teachers, the agents live in the communities in which Congressmen and Senators must get their votes. They tend to be active in the community and inf luential. And, they have organizations that activate their networks with an efficiency that the U.S.




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• Severity —red • Probability —amber • Risk —red

Life Insurance and Annuities: Extension of Tax-Free Inside Buildup to Banks Because some of the products offered by the life insurance industry, such as funding agreements and guaranteed investment contracts, are so similar to products offered by the banking industry, this is a logical “ask” by the banks. If granted, it would represent a major inroad into the unique bastion of insurance, which is characterized by the use of actuarial spread of risk on the one hand, and tax-free inside buildup on the other. The consequences of such a move would not destroy the insurance industry franchise in these products, but it would put huge pressure on pricing margins. From a competitive perspective, the capital requirements of insurers for such products are higher than those of banks, which would place strains on insurer profitability, relative to banks in the same product lines. From a political perspective, such a move seems unlikely as it is counter to the objective of raising additional tax revenues to fund the government rescue expenditures in the crisis. Other than offering a subsidy to the banks, there doesn’t seem to be much of a public benefit to such a change. And, given the banks’ role in the financial crisis, there isn’t a lot of appetite for offering the banking industry benefits it doesn’t already have. • Severity —red: In those lines affected, the impact would be quite severe. However, these lines do not represent a significant portion of the industry’s book of business, so the overall impact would not be material. • Probability —green: Because the result of such a move would be to reduce tax revenue at the federal and state level, it seems reasonably remote. • Risk —amber to green. Risks that involve increasing tax revenues seem much more probable.


Special Forces would admire. The impact of such an attack, if successful, would be catastrophic to life and annuity firms that are already reeling from the impact of the financial crisis. In summary, while this risk represents a catastrophic severity to the industry, the probability of the risk does not rise above a cautionary amber. That doesn’t mean that such an attack won’t be mounted. As of now, the likelihood is that such an attack won’t prevail.

Life Insurance and Selected Other Long-Tail Liabilities: Cost of Capital/Access to Capital Markets This issue has two interlinked dimensions. The first is general purpose accounting for net income and return on equity/capital, which will affect the competitive


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position of life companies in the capital markets. The second is solvency, which will affect the amount of capital that life insurers are required to carry. Focusing first on general purpose accounting, if implemented as currently contemplated, the thrust of the IASB/FASB will dramatically damage the reported net income of these socially important products. The impact would be to produce general-purpose reporting, which is, perversely, the opposite of the underlying financial performance, by back-ending profitability of these products. Profitable financial growth will be ref lected as tepid reported growth. For long-tail liabilities, which include most traditional whole-life insurance, long-term care, long-term disability, financial guarantee insurance, etc.,? a major part of the value proposition offered by the insurer is the risk-mitigation benefit of the law of large numbers through Asset-Liability Management (ALM), actuarial science, and reinsurance to spread risk.

The Valuation Building Blocks The principles that form the foundation for valuing insurance liabilities are supposed to rely on market observable data: • Probability weighted cash flow projections —Life insurance accounting has long-relied on cash f low projections to value liabilities. The actuarial science around the methodologies involved is robust and time proven. However, estimated variability in the cash f lows is taken into account through adjustments for adverse deviation, rather than using probability weights for each factor. There is no generally accepted methodology for the approach proposed by IASB/FASB, the cost and time to develop these methodologies is an unknown, and there would be no benefit in accuracy, completeness, or transparency for users of the financial statements. This is an important issue for life companies, hugely inconvenient and costly, and without any redeeming benefit. But, it isn’t the worst of the problems with the proposed IASB/FASB approach. • Discount for the time value of money —The IASB/FASB concept is that somehow the only appropriate, fair value, discount rate is a risk-free rate. There is no generally accepted agreement as to what constitutes the most appropriate risk-free rate, but that’s a debate that can be readily resolved. More importantly, the IASB/FASB believe that the risk-free rate should be used for all insurance liabilities, regardless of tenure.



For many of the industry’s liabilities, this short-term rate concept is probably appropriate. The short-term nature of the liabilities means the industry’s ALM approach is to use a very short-term portfolio of investment assets. However, the argument that the short-term rate is necessary because it is the only “market consistent” rate fails from all perspectives. The earned rate of the portfolio underlying long-tail liabilities is equally “market consistent.” And, it can be based on “market observable data” if the appropriate methodology is applied, such as the Canadian methodology referred to as “CALM,” or the Canadian Asset Liability Method. There are other methodologies that are market proven that also achieve market observable market consistency.


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However, a very large portion of the industry’s book of business is designed to serve the long-term risk management needs of society for mortality and longevity risk. This long-term risk is mitigated by insurers by basing premiums on the actuarial basis of the law of large numbers, offering individual policyholders the benefit of this spread of risk. In addition, the insurer is able to bring to bear the benefits of ALM using a portfolio of investment assets that allow long-term investment returns to service the actuarial estimates of the cash f lows of the liabilities. The long-term investment strategy is crucial to the economics of the long-tail business and to the risk management of those liabilities. Use of the risk-free rate would completely ignore this significant economic benefit of the insurance business model. And, it would dramatically exaggerate the net value of the liability, versus using a discount methodology, which ref lects that actual, economic return embedded in the portfolio underlying the liabilities. The European industry has acceded to the risk-free rate for the purpose of academic consistency, and because it is unwilling to expend negotiating energy with the IASB/FASB on this issue. The bulk of long-tail liability insurance written on the continent contains optionality, which drives toward a short-term, riskfree rate conceptually. Many of the lines of business written on the continent, which ref lected long-term commitments, have either been rewritten to ref lect short-term methodologies or discontinued. However, the U.K. life companies have been severely affected by the risk-free rate methodology on their long-tail business written in the United Kingdom, and those European companies with significant books of long-tail business in North America have also been significantly adversely affected. • Provision for risk margins —The concept initially expressed by the IASB/FASB was that the risk margin would reflect the economic reality of the long-tail business, effectively resulting in the same outcome of using the portfolio rate for discounting. The European industry accepted this logic, and the life companies that had the greatest exposure felt they would be fairly treated if the risk margin for long-tail liabilities were reduced for their liabilities relative to shorter-tail, more volatile liabilities. The IASB and FASB have not stipulated a methodology for determining the risk margin, and they have simply said that this will be left to the industry, its actuaries, and its accounting firms. The IASB/FASB concept of the risk margin has been debated at great length since it was first proposed in the Insurance Contract Accounting Project. On the most fundamental level, this was intended to be an “add-back” to the liability valuation of the risk or volatility in the liability. The debate centers around whether there is a “service” or “profit” component to the margin, and whether the margin should be disaggregated or taken as a single factor. This is an important debate, but probably not central to the “risk” factor noted here. The simple fact is that there is no generally accepted methodology for determining risk margins. There has been a great deal of ink expended by all sides of this issue. Despite the fact that there is no generally accepted methodology for establishing risk margins on this broad basis, and the seemingly obvious fact that all insurance products don’t have the same risk margin, the EC adopted the 6% risk margin that had first been used by the Swiss Solvency Test on an arbitrary basis. The myths that


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this methodology was market observable or that some generally accepted methodology would be developed were never addressed. And, in an analysis done by Manulife and presented to the IASB and IAIS, the impact of this methodology would have put a hole of $6 billion in Manulife’s capital at year-end 2009, even though the firm’s capital was not impacted using the proven and generally accepted Canadian method, which values liabilities based on “fair value” of underlying assets, adjusted for specific risk factors in the cash flows of both the assets and liabilities.

Because they are locked into a principles-based approach, which is supposed to accommodate all businesses, it is very difficult for the IASB/FASB to recognize the reality of the insurance value proposition based on the law of large numbers, which uses ALM as a risk management tool. Somehow, these Boards also seem to believe, in error, that the argument for using the Business Model as a foundation for insurance accounting is an argument for a less rigorous and less robust approach. The IAIS is proceeding on the basis that it will assume the methodology adopted in the accounting standard for the measurement of long-term liabilities. The IASB’s principles stipulate that assets and liabilities should be valued independently of one another. This principle ignores the business model for long-tail insurance liabilities, which has been at the heart of insurance for over 150 years.

Market Consistent Embedded Value (MCEV) The origins of this methodology lie in the European-use MCEV. The actual methodologies employed by the European companies in generating MCEV are broadly based on a set of principles, and yet use significantly different, company-specific assumptions. And, they ignore the fact that there is no generally accepted approach to these calculations. Nevertheless the European Chief Risk Officers Forum (the CRO Forum) mounted a very effective effort to convince the European Union to basically adopt the MCEV methodology concepts as a foundation for Solvency II. They also mounted a similar effort to convince IASB/FASB that the methodologies should be applied to the new insurance contract accounting standard.

Solvency Solvency II adopted a similar cost of capital approach utilizing risk free rates to discount risk margins, and implemented it on a largely “untested” basis in 2009. There were laudable field test exercises, but they failed to identify the fatal f law for long-tail life liabilities. In the face of there being no generally accepted methodology of establishing risk margins, the European Commission arbitrarily adopted 6% as the “risk margin” for all insurance products, irrespective of the predictability or volatility of the coverages in question. Catastrophe insurance, long-tail liability coverages, and life insurance would all have a 6% risk margin. The logic was that the Market Consistent Embedded Value methodologies of the European Chief Risk Officers Forum were so well developed that using this methodology for statutory valuation of reserves and assets represented a step forward from the time proven risk-based capital methodologies widely in use.


The Business Model


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Regulatory vs. General Purpose Accounting Principles A premise of both the IASB/FASB and the IAIS is that general accounting principles should form the foundation of regulatory accounting, with modifications to meet the needs of sound regulation. For this reason, the developments of European solvency have both: (a) launched a debate regarding the use of risk-based economic models as the next generation of solvency measurement to replace risk-based capital, and (b) provided a context for IASB/FASB’s deliberations on the measurement of insurance liabilities. As a consequence, the application of the Solvency II methodology to general purpose accounting would result in the creation of an inappropriately large liability when a long-tail policy is written, with the recognition of the profitability economics of the ALM portfolio over the life of the policy. A firm that is growing would book large losses, and a firm that is shrinking would release large gains—exactly the reverse of the real economics of the actual business. Far from providing useful information to the users of general purpose financial statements, application of the Solvency II methodology would lead to inaccurate conclusions about the financial performance of the firm. Because of this dynamic, it would lead to a relatively higher cost of capital for the industry relative to other industries, impeding the industry’s access to much needed capital. • Severity —red: The consequence of this approach to the valuation of long-tail insurance liabilities on the capital health of the industry globally, wherever these types of liabilities are offered, would be catastrophic. Consequently, the risk is severely “red.” • Probability —red: The probability that the IASB/FASB would follow through in adopting this approach seems more likely than not, unless reason prevails at the 12th hour of drafting the standard. • Risk —red.


There have been unsubstantiated but serious reports that this methodology created a £30 billion hole in the capital of the British life industry. Because of this obvious and huge failure, the CRO Forum engaged an emergency effort to introduce a “liquidity premium” to fill the hole left by their risk margin methodology. This liquidity premium is as arbitrary and nonmarket observable as the risk margins. In addition, reports are that the EC is about to adopt a methodology offering a f lat liquidity margin based on the currency of the liabilities. As with the risk margin, this presumes that the liquidity characteristics of all insurance liabilities are the same, which is not “market observable” or “market consistent” and makes no sense.

Nonlife Insurance: Discounting Nonlife Reserves, Predatory Pricing, and Increased Cost to Responsible Market Participants IFRS introduces discounting of all primary nonlife insurance reserves with uncalibrated risk margins, giving weak companies a means for using discounting to mask capital weakness. This would cost the responsible market players by enabling predatory pricing, and, ultimately, by engaging mechanisms financed by the responsible companies.


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The three building blocks for the valuation of insurance liabilities operate differently in the case of nonlife insurance than in the case of life insurance. Life insurance has long relied on cash f low projections and risk-adjusted discounting techniques to value liabilities. Nonlife companies have not done so for two different reasons. For short-tail lines such as retail homeowners, and for auto and catastrophe lines such as wind and earthquake, there is no actuarially accepted method of calculating these cash f lows for either short- or long-tail lines. Virtually all claims of short-tail lines pay out within two years of the coverage period. As a consequence, the effort to project cash f lows, on top of actuarially determining the amount of the probable nominal claims payments, provides no greater accuracy or management information, and the discounting/risk margin process would not produce any significant value, due to the short payout period. For long-tail lines such as long-tail liability, the amount of the ultimate liability is heavily determined by litigation, which can result in wildly unpredictable outcomes, both as to amount and timing. These long-tail lines are concentrated in the London, New York, and Bermuda markets. There is no generally accepted method of calculating probability weighted cash f lows for either short- or long-tail nonlife books. The systems and process changes required to generate them would be timeconsuming, and costly. • Severity —red • Probability —red • Risk —red

Reinsurance: Higher Relative Premium Rates and Loss of Business. IFRS proposes to introduce discounting for all primary insurance reserves, reducing the accounting/regulatory arbitrage embedded in much reinsurance. The guiding principle is to adopt the same methodology for valuing reinsurance liabilities as for valuing primary coverage liabilities. The source of profitability reinsurance is assessing the soundness of the primary carrier’s underwriting, the determination of the type of cover (quota share, excess of loss, etc.) that the reinsurer is willing to provide, and the ceding commission. However, part of the economic attraction in many lines of reinsurance is the fact that reinsurance reserves are discounted, whereas the primary reserves are not. For these important lines, the loss of the arbitrage means that the reinsurer will be required to keep sufficient statutory capital to cover the risk on the same basis as the primary carrier.



• Severity —red • Probability —amber • Risk —red

Conclusions In sum, these risks have the potential to be game changing and represent serious threats to the industry. While the expressed intent is to make insurance solvency and accounting more ref lective of current market conditions, the risk margin


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methodologies being suggested cannot be calibrated to the market by any generally accepted actuarial principles. As a consequence, there is no objective, market observable benchmark to validate the risk margins selected. On the one hand, the IASB has said that it will depend on the accounting and actuarial firms to work with insurers to determine such rates. Beware of cockroach solutions, according to a tale related by one of the members of the first Policy Planning Staff at the U.S. State Department. The cockroach was visiting his friend the grasshopper in the country one beautiful fall day. It was warm, the air was fresh and clear, and food was abundant. The cockroach was impressed with the quality of life. But, the grasshopper explained that the winds would soon grow cold, food would be buried by snow, and most of the grasshoppers would likely perish. The cockroach had a brainstorm: the grasshoppers should turn themselves into cockroaches and move to the city with him for the winter. It was warm—smelly but warm. Food would be abundant. And, they could return to being grasshoppers in the spring and go back to the countryside. The grasshopper was impressed and remarked about the elegance of this strategy, but he asked the cockroach how he and his friends would turn themselves into cockroaches. The cockroach was indignant: “I’m the strategist, do I have to do all the work,” he said. “You can at least come up with the implementation.” On the other hand, the European Commission has come up with a solution for Solvency II, which doesn’t pretend to be market consistent by assigning all products a 6% risk margin. That failed for British life insurers in 2009 (and for continental carriers that had significant positions in the United Kingdom, the United States, and Canadian life liabilities). So, the European Commission is adding a liquidity premium to fill the hole. The risk margin and the liquidity premium are not market consistent, and they are likely to produce faulty results in times of future market stress. Neither the IASB nor the European Commission is, so far, prepared to depart from the conceptual principle they are applying broadly to use the market rates on the portfolios underlying the long-tail liabilities. Just because it isn’t possible to look these rates up in the Financial Times or the Wall Street Journal does not negate the fact that they are market driven and market consistent. Taking them by industry segments, the impact will fall very unevenly by segment and geography, depending on the types of policies written in that segment/ region. The impact of using risk-free discount rates for long-tail life insurance liabilities uniquely impacts selected markets, such as the United States, Canada, and the U.K. In continental Europe in any case, life policies often have options embedded in them that require short-term valuation methodologies. And, in several instances, European carriers have simply exited certain long-tail life lines that would be severely impacted by the proposed methodologies. Another example, the issue of discounting long-tail nonlife liabilities, such as liability, is much more severe on the London Market, U.S., and Bermuda, where the bulk of the global long-tail policies are written.


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Notes The views expressed in this chapter are the personal views of the authors and do not ref lect the position of any of the organizations with which they are affiliated.


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1. OECD (Organization for Economic Cooperation and Development) brings together the governments of countries committed to democracy and the market economy from around the world: Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. 2. The G20: The members of the G20 are the finance ministers and central bank governors of 19 countries: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom, and the United States, as well as the European Union, represented by the rotating council presidency and the European Central Bank. 3. (G20 2009). 4. (G20 2009). 5. (Cassell 2010). 6. (Ishmael 2009).

Bibliography Cassell, Bryan-Low. “UK Tax Ruling Resounds.” The Wall Street Journal, February 19, 2010. Ishmael, Stacy-Marie. “Thirty Financial Groups on Systemic Risk List.” Financial Times, November 29, 2009. The Group of 20 (G20). “Leaders’ Statement: The Pittsburgh Summit.” September 24, 2009. http://www.pittsburghsummit.gov/mediacenter/129639.htm.




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Risk Culture Prakash Shimpi and Heike Klappach

Introduction In analyzing what caused the 2008–2009 economic crisis, many experts point to a fundamental lack of risk management. But that is not entirely correct. For while it is abundantly apparent that most of the companies that failed lacked a sufficient risk management structure, there were also companies with rigorous risk management programs in place that failed as well. Theirs was not a failure of process, but a failure of commitment. Many of these companies had devoted considerable time and resources on elaborate risk management programs, but never really embraced them. Risk management never truly became part of the company’s belief system. Understanding risk was not part of their culture. On the other hand, those companies that had a robust and functioning risk culture did not merely survive, but are now f lourishing. Why? They understood their business. They understood which risks would pay off and which risks would not. But most importantly, they understood themselves. Risk culture is defined by how a company’s management and employees understand risk and manage it to maximize reward. It is both a formal and informal operating environment in which the right people do the right thing. There have been tremendous advances in the way insurance companies have viewed risk over the years. Early in the industry’s history, most insurers took a very basic approach by viewing risk as something that could go wrong. The simple solution to this basic view was to avoid risk altogether by playing it safe. During the later half of the twentieth century, a more sophisticated approach evolved, which entailed understanding, anticipating, and limiting exposure to risk—the modern application of risk management by risk managers. This approach began with the adoption of compliance rules and capital adequacy requirements, it progressed to loss minimization, and then it advanced to risk measurement with the help of quantitative risk models, and later, return optimization. However, a great f law in this approach was that companies tended to view and address their risks (underwriting risk, market risk, etc.) separately rather than together.


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ERM: The How and Why More than a tool, ERM is a process that creates value by reducing the cost of capital and increasing profits through better risk-based decision making. It analyzes risks in combination to reveal systemic risks and interactions, and considers the interrelationships and correlations between risks. ERM works best when it is viewed as an integral part of the business, coordinated with corporate planning and the allocation of capital and resources, and fully integrated into the decision-making process. Perhaps ERM is best described as a discipline, for it truly requires commitment, understanding, teamwork, resources, clear objectives, and honesty to follow through. To make ERM work, a firm must establish a framework that connects its various components. The starting point is a clearly articulated risk strategy. This includes defining the types of risks that will be addressed, the goals and objectives that the firm expects to achieve, and a description of the risks that the firm is willing to take. This framework forms the basis for the risk organization through which ERM will be delivered. It includes the governance and assignment of accountability, and, most importantly, the risk culture necessary to ensure that the right people are doing the right things. The processes then follow, supported by various tools that facilitate change management, as well as implementation and reporting. While the discipline is demanding, the mechanics of developing an ERM framework are quite straightforward: First a company must contemplate and articulate its risk strategy. What are the company’s goals and objectives going forward? What are the risks the company is likely to encounter? Is the company willing to take those risks? And if so, how much risk is it willing to take on? With general parameters of risk established, an organization can develop a risk organization, assign roles and responsibilities, hire new people, or engage outside consultants if necessary. With an organization in place, the ERM implementation process can begin. Working on the enterprise level, business unit level, or product level, risks and their potential interactions with other risks can be identified and quantified. Once the nature and size of the risk is known, ways to mitigate them can be developed. At most, companies’ risk management policies are just that: formal statements of intent that don’t always translate into expected behavior. Leadership is what shapes risk culture and helps an organization achieve its goals and embody its values. While most insurers are committed to, or at least resigned to, the fact that they need an ERM program, many are finding implementation difficult. A 2008 survey


Today, most insurance firms are adopting enterprise risk management (ERM) a process which takes a holistic approach to risk, minimizing the downsides and optimizing the upsides. Regulators and rating agencies are applying increasing importance to ERM implementation. Adding their voices to the ERM imperative are boards or directors, as well as investors. However, most companies have yet to make the final evolutionary step—implementing ERM as a core strategic operating principle that is understood and embraced by all employees, from CEO to clerk. In short, they have yet to develop a risk culture.


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by Towers Watson of insurance executives at leading firms found that less than one-fifth believed their companies had an ERM program that had appropriate capabilities in place for risk control, monitoring, and reporting. In Europe, approval of an internal capital model under the proposed Solvency II framework requires the model to be embedded in the management of the business. A use test must demonstrate that the model is fully integrated in the company’s decision-making process. Rating agencies have similar requirements for recognizing internal model results. However, only 11% of European insurers said their internal capital models were ready to meet the Solvency II requirement. Some 63% said embedding their models would be the greatest challenge to achieving internal model approval. Insurers also admitted that they had significant work to do before they would be able to use economic capital in performance management (60%) and decision making (55%). Only 30% of insurers said that they incorporate risk measures into their incentive compensation arrangements. When asked about the challenges of implementing ERM, participants generally highlighted the same three issues: data, systems, and people. The last factor, people, is often the most difficult. Companies take comfort in making lofty statements about their values. To implement an effective ERM program, however, it is vital to understand an organization’s existing risk management cultural baseline. To measure the progress of cultural change, an assessment tool or process is required. The place to begin is by assessing the opinions of those who live the organizational culture daily—employees and management. A risk culture assessment focuses on two major areas: Values and ethics—These are the core principles that drive behavior. Are the values of the organization clearly defined and communicated adequately? Does the organization’s culture support risk awareness? The application of those values and ethics—Is the culture open to challenging tradition and implementing new ways of doing things? Do employees feel it is safe to speak up? Is there talent management in place to retain experienced employees? Do leaders show commitment to values and ethics through their actions? Are roles and governance structures in place to manage risk? Collecting feedback is only the beginning. By conducting a thorough analysis of survey returns, leaders can rank issues that require action, understand how their culture compares with competitors’ cultures, and identify hot spots where employees are indicating the need for immediate intervention. Typically, three kinds of analyses are used to develop a picture of an organization’s risk management effectiveness:


Risk Culture

• Norm comparisons can help companies set benchmarks. Firms frequently conduct surveys of employees on a wide variety or risk management issues. These internal company databases of employee feedback, as well as industry data from consultants, can enable leaders to gauge how their employees’ opinions compare with those of employees at other companies in their sector or region, or with high performance organizations. These norms can help identify areas that present opportunities for improvement.


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• Key driver analysis is an advanced statistical technique that determines which topics measured in a survey most strongly predict the overall effectiveness of risk management. Such an analysis may show, for example, that communication, governance, and role structures most inf luence employees’ perceptions of a strong or weak culture. Follow-up efforts can be directed at topics that have the greatest likelihood of improving these perceptions. • Hot-spot analysis can zero in on problem areas. By examining the level of favorable opinion across the workforce, as well as the extent of consensus on those views, hot spots that require immediate action can be identified. Of most concern are business units in which employee views are unfavorable and consensus for negative opinion is strong. Findings like these suggest serious gaps between organizational goals and actual execution, as lived by employees. Internal survey findings enable company leaders to do more than just isolate the most critical issues. Assessing and interpreting the survey results creates value and provides the foundation for implementing activities to enhance the risk culture and reinforce the desired behaviors. Benefits of this kind of extended analysis include: • Uncovering enterprise-wide/entity-level strengths and weaknesses. By looking at both absolute scores and scores relative to benchmarked responses from employees at peer organizations, companies can determine which aspects of their culture are aligned with a proper risk management focus, and which are not. • Identifying strong and weak units. A cross-unit analysis will reveal which units have effectively incorporated risk management into the way they do business, as well as which units represent potential “risk danger zones.” • Laying the foundation for action planning. With a gap analysis completed, companies can agree on, rank, and sequence risk management activities. If appropriate, action planning can be incorporated into a broader road map that puts a company on a path to a genuine risk culture. • Monitoring improvements/deterioration over time. The first survey sets an invaluable baseline that can be used to determine where (and whether) the company is making progress, and where more attention is required.

Leadership Drives Culture Discovering, analyzing, understanding, and mitigating a company’s enterprisewide risks requires considerable skill and commitment. Creating a risk culture requires leadership. As a general rule, there are at least six important dimensions of an effective risk management culture. Leadership is crucial to every one.


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• Risk control. Merely having controls in place is not enough. It is up to management, whether at the enterprise level or at the business unit level, to make sure that employees understand the controls, and to make sure they are enforced. • Rewarding behaviors. The global financial crisis brought out a fundamental risk management disconnect at many companies. All too frequently, employees


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and senior executives were being rewarded for short-term gains that put the company at risk. Management must ensure that compensation is aligned with the risks of the entire enterprise. However, the impact of ERM may be limited unless attitudes to incentive compensation change. Only 30% of executives participating in the 2008 Towers Watson survey said that they incorporated risk measures of any kind into their incentive compensation arrangements, and only ten% used economic capital for this purpose. Furthermore, 66% of insurers said that they had no future plans to use economic capital in incentive compensation. Resourcing. Staffing levels, as well as knowledge, skills, and abilities, can all have a significant effect on a company’s risk management. It is up to management to ensure that this resource is maintained and developed. The Towers Watson survey found that larger insurers (those with revenues in excess of $10 billion) were significantly more advanced in most aspects of ERM implementation. Large companies demonstrated a superior level of commitment to economic capital, with 84% already calculating economic capital, compared to 69% of medium-size companies (firms with between $1 billion and $10 billion in revenues) and 37% percent of small organizations (those with less than $1 billion in revenues). Teamwork and collaboration. It is up to management to ensure that everyone in the organization understands the link between risk policy and everyday behavior. Communication. Ensuring that employees understand the underlying theory of ERM, along with corresponding policies and procedures, is a core responsibility. Leaders must also ensure that employees are free to ask questions, raise issues, and speak openly without fear or reprisal. Leadership commitment. Without a clear, articulated, and demonstrated commitment by leadership at every level, an organization’s risk culture cannot exist. Leaders must make themselves accountable to ensure that their subordinates are accountable. They must lead by example.

With increasing mandates from regulators, rating agencies, boards, and investors, most large companies will do a very good job at developing their ERM programs. But it won’t take long to determine which ones are taking it seriously and which are merely giving it lip service. Those companies that are better prepared to react to risks, create new products, and exploit new opportunities are the companies that have transcended ERM as a mere audit function and gone on to create a risk culture. They will prevail over their competitors and grow even more successful. Investors will recognize them and reward them. The great global financial crisis underscored the difference between risk management and risk culture.


Risk Culture

Appendix Hannover Re: Enjoying the Benefits of a Healthy Risk Culture Unlike many of its competitors, Hannover Re, a member of the Talanx Group and one of the world’s leading reinsurers, has been able to maintain its financial


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strength and high ratings despite the capital markets turmoil of 2008–2009 and large catastrophe losses. Before the crisis, the company had committed itself to the development of a robust ERM program, partly to satisfy impending requirements under Solvency II, but primarily as a decision-making framework. Today, most would agree that it is the company’s highly evolved risk culture that contributes significantly to Hannover Re’s ability to weather the storm. Reinsurance companies offer a variety of tailored risk mitigation products to primary insurers and corporations. Due to its global exposures, particularly in the natural catastrophe area, risk and capital management have always played a significant role in the management and growth of Hannover Re. Aware of the difficult challenges ahead, the company’s leadership is committed to developing and implementing its ERM program. Indeed, its commitment is such that it has developed its own internal system of checks and balances. Hannover Re’s risk management structure is split between risk-carrying and risk-monitoring functions. Separate from the functions that underwrite and control the risks, there is an independent group risk committee and the chief risk officer (CRO), both of which are supported by the group risk management (GRM) department that monitors the risks. The board has overall responsibility for both risk-taking and risk-monitoring functions, and the general audit function provides independent control on behalf of the board. Within this split of functions and responsibilities, it is important that the reporting structure be clearly defined. The GRM department (headed by the CRO) and the general audit function report directly to the CEO. The risk committee (whose members include the CEO and CRO, as well as the chief operating officers for life and nonlife) reports to the board of management. Finally, within the GRM, the organization is split into qualitative and quantitative risk management functions. Because of its high exposures to natural catastrophe risks and diverse portfolios across lines of business and regions, Hannover Re got an early start on its economic capital model. The company’s internal model is based on a risk map that identifies the most important risk drivers. For Hannover Re, the main drivers are premium risk, reserve risk, and natural catastrophe risk on the nonlife insurance side, and interest-rate risk and equity risk on the investment side. Most of the volatility in profits and capital over the previous ten years related to these risks. Hannover Re, therefore, defined and implemented clear guidance on these risks, which are constantly monitored. After 2008, the year of the worst credit crunch and financial crisis in decades, as well as large catastrophe losses from events such as hurricanes Gustav and Ike, Hannover Re’s risk management and financial modeling came under considerable scrutiny. But the company was able to demonstrate that when models are used appropriately, with proper assumptions and use of results, they provide valuable information for management, even in stressed markets. With a commitment so deep and wide, understanding and optimizing risk became strategic to the organization, from business units, to regions, to top management. As evidenced by its performance through the economic crisis, embedding ERM into its culture has served Hannover Re well. It survived 2008, the worst of the crisis, with an “A A” rating. Moreover, the company received a “strong” ERM assessment by Standard & Poor’s, enjoyed good stock price performance, and is well positioned for the adoption of Solvency II.


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Incorporating Capital Requirements in Risk Management Stephen P. Lowe

Introduction With the globalization of financial services, national interests and inconsistent financial services regulation can contribute to major economic upheavals. Indeed, most would agree that the lack of comprehensive regulation and adequate capital led to the collapse of numerous banking interests in the first decade of the twentyfirst century. During this same period, however, the insurance industry generally fared much better, and experts were quick to offer a host of reasons. First, the insurance industry, because of its long-term view of risk, was, and still is, inherently more conservative than the banking industry. And while rules may have varied significantly from region to region, regulations regarding capital adequacy did exist and were enforced. Lastly, as the business became more global and products grew in complexity, insurance companies adopted more sophisticated risk-based approaches toward capital adequacy. Indeed, these more sophisticated approaches not only enabled many companies to endure the economic crisis relatively unharmed, but left them well-positioned to doing business in the future. Nevertheless, shocks to the financial markets did serve as a reminder that even the best run insurance companies are vulnerable when extreme market conditions occur. Today, as in the past, insurers and their stakeholders need a clear idea of the risks they are taking. Capital adequacy requirements for insurers had been codified in some European countries as early as the fifteenth century. Today’s European capital adequacy regulations were developed in parallel with banking industry rules. Nascent globalization and a string of bank failures in the 1970s led to the development of the Basel banking accords, which were later roughly paralleled by Solvency I insurance standards in order to establish uniformity over the European insurance industry. At the time, calculating capital adequacy relied on the use of solvency ratios, factor formulas, and other methods that could vary significantly geographically.


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In the United States, meanwhile, the National Association of Insurance Commissioners (NAIC) acted as the unifying body working for uniformity in solvency regulation in an industry that has been regulated largely by individual states since the 1940s. Through the adoption of a standard risk-based capital formula and model laws enacted by the majority of the states, a common capital adequacy framework that is applicable to all insurers in the United States is now in place. As insurance companies grew, expanded across borders, began to offer multiple lines, and developed increasingly complex products, it became more and more apparent that old-fashioned capital adequacy ratios were completely inadequate for providing a true picture of a company’s ability to endure unexpected demands. Moreover, it became clear even to regulators themselves that instead of a safeguard, regulatory frameworks frequently acted as constraints on the industry. Rigid capital adequacy ratios required many firms to put too much capital aside or prohibited insurers from hedging risks. Newly formed companies chose to locate in jurisdictions with more favorable regulatory environments. Ultimately, the role of the regulator is to protect the consumer. With too little solvency regulation, there is a danger that insurers may default on their obligations. With too much regulation, policyholders may not be able to afford the coverage that they want. Today, the single most compelling force for change in capital adequacy regulation is Solvency II, an EU (European Union) directive that will radically change the regulation of the insurance sector when fully implemented in 2012. Solvency II is designed to provide a risk-based supervisory framework for European insurers and reinsurers, in which capital requirements and controls are more precisely proportionate to the level of risk borne. Countries outside of Europe, such as Japan and Bermuda, are moving to adopt regulatory regimes that parallel Solvency II. One of the most radical changes introduced by Solvency II is the use of internal company-produced models to calculate capital requirements, rather than rigid formulas laid down by the regulators. For insurers who obtain the necessary internal model approval, this has the significant benefit of allowing them to use a single model that has been tailored to their own specific risk profile, for both internal management and supervisory purposes. An equally ambitious initiative on a scale of political and technical complexity is currently under way in the United States for the life insurance sector, called the Principles-Based Approach (PBA), to reserving and capital requirements. This U.S. initiative is also based on company-specific modeling, so that the level of reserves and capital that each insurer needs to hold depends in part on the nature and size of the risks that are specific to them. Be it Europe, North America, or elsewhere in the world, the general aim is to overhaul the largely rules-based environment for the determination of technical provisions and capital, and replace it with one that is principles-based and that applies assumptions appropriate to the risks inherent in the specific products that are sold by each individual company. Most of the new internal models used are very complex. They must be able to consolidate market risk, insurance risk, credit risk, and operational risk across the spectrum of financial assets and liabilities specific to the company in order to gain a complete picture of risk across the entire organization. The need for a comprehensive understanding of the complex interactions of different risk factors across


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the balance sheet has lead to the development of economic capital, a discipline of self-evaluation that most global insurance firms have implemented in one form or another. The term economic capital is typically used to refer to a measure of required capital under an economic accounting convention, where assets and liabilities are determined using economic principles. It is an internal calculation of the capital required, based on the company’s own view of risk. Most insurers calculate economic capital as the capital that is required to provide a specified level of security to policyholders. The importance of economic capital as part of an active risk management framework has increased substantially in recent years. According to a 2010 Towers Watson survey, some 84% of European insurers, 53% of North American companies, and 66% of insurance firms in the Asia/Pacific region calculate economic capital. Also in the survey, 62% of respondents said they used economic capital for capital adequacy assessment, while an additional 26% said they would do so within the next 24 months. A well-implemented economic capital system can transform the way a company is run by providing a far better understanding of its risks. The insights drawn from economic capital allow the company to be more quickly notice and react appropriately to changing circumstances, leading to safer and more profitable results. For example, 56% of the Towers Watson participants felt the use of economic capital in risk-based decision-making processed enhanced their business performance during the turbulent market conditions experienced during the financial crisis that began in 2007. In contrast, only 6% felt economic capital calculations and their use in risk-based decision making hindered business performance during that period. While the development and adoption of economic capital models has been driven primarily by the willingness of regulators to take account of such models in capital adequacy assessments, the ratings agencies also recognize the increased complexity of insurers and the products they are rating. As a consequence, they, too, are developing their own risk-based economic capital calculations to use in addition to their more traditional formula-based standards. Rating agencies are also expressing openness to using the results of internal models developed by the companies they are rating. In addition to government regulators and rating agencies, among the biggest drivers of insurers’ expanding use of economic capital are internal factors. Under increasing pressure from policyholders, investors, and boards of directors, insurers are increasingly recognizing the benefits to be obtained in using economic capital as part of an enterprise risk management framework. This converging commitment represents a consensus among the full spectrum of the insurance industry that economic capital has become the key metric for assessing and quantifying a company’s risk, and can also help companies make better risk-based decisions in managing the business.


Incorporating Capital Requirements

Economic Capital Methodologies While economic capital is growing in importance within the insurance industry, there is currently no global standard on how to calculate it. In practice, two broad methodologies have emerged: a liability run-off approach and a one-year approach.


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Most insurers calculating economic capital use one or both of these approaches. Within each of these methodologies there are variations as to the valuation basis employed, with some employing an economic balance sheet (“mark-to-market”) approach, and others using a more traditional financial accounting balance sheet. In the liability run-off approach, economic capital represents the amount of assets required to pay all future policyholder benefits and associated expenses on all current contracts, at a chosen security level, less the current value of the liabilities. Conceptually, the question being asked is, “if the company stopped writing business today, in a theoretical wind down, could it pay all of its obligations as they come due, in all but the most extreme circumstances?” Most commonly in the runoff approach, the model projections ref lect financial accounting balance sheets and income statements, often to obtain realistic estimates of future income tax costs. The initial assets are often marked to market on the opening balance sheet. In the one-year approach, economic capital represents the amount of assets required to ensure that the value of liabilities can be covered in one year’s time, at the chosen security level, less the current value of the liabilities. Conceptually, the question being asked is, “if the company continues to operate as planned, will it have assets one year from now that equal or exceed the value of its liabilities at that time, in all but the most extreme circumstances?” Most commonly in the oneyear approach, the model projections ref lect economic balance sheets, with assets marked to market and liabilities valued on a market consistent basis. Among these approaches, the one-year, mark-to-market is gaining currency as the preferred approach for measuring economic capital. This is the approach adopted under Solvency II. From a modeling perspective, most companies also follow one of two approaches—stochastic modeling or stress scenarios testing. More than half (66% and 61%) of companies that responded to the Towers Watson survey said they favor the stochastic approach for Market and P&C Insurance risks. Close to half (49%) also favored the stochastic approach for Credit risk. Stress scenarios were the most preferred method for Life Insurance risk (46%) while factor-based testing was the dominant method for Operational risk (53%).

The Liability Run-Off Approach While there are a number of approaches to implementation, the liability run-off method is typically performed using a stochastic simulation approach. First, a set of (typically 1,000 or more) future scenarios for the run-off of the business is defined, and projected asset/liability cash f lows and balance sheets are developed for each scenario. The scenarios include specifications for economic and demographic conditions, including risk drivers such as interest rate scenarios, inf lation rates, and asset default rates. Then, under each scenario, the level of assets required at the beginning of the scenario to satisfy all obligations through to the end of the projection is determined. The level of required assets for all scenarios is then ranked to form a distribution. The economic capital is then defined by applying the chosen risk metric (for example, Value-at-Risk [VaR] or conditional tail expectation [CTE]) to this distribution of total required asset levels, and deducting the current value of the liabilities measured on the selected basis.


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The liability valuation basis used to define economic capital under the run-off approach can vary with a different valuation basis resulting in a different split between liabilities and economic capital, but with the same level of total required assets. In practice, mean or best estimate liability valuation bases are popular choices for a liability valuation basis. In its basic form, the liability run-off approach considers the asset level required to pay all claims and expenses throughout the run-off period, and does not explicitly take into account solvency levels at interim dates. There is an implicit assumption that adverse experience in earlier time periods can be offset against positive experience in later time periods. The methodology allows insurers to become technically insolvent in interim years, providing it rebounds before the end of the run-off. Alternatively, the liability run-off approach can incorporate a check on solvency at interim points during the run-off. This raises additional questions as to what measure of interim solvency should be used and how frequently it should be assessed. If the economic principles underlying the methodology are to be maintained, an economic basis of interim solvency should be required. The liability run-off approach (with interim solvency assessments) is the methodology currently preferred by U.S. regulators. It underlies the current risk-based capital formulas, which are based on run-off risks for policy liabilities.

The One-Year Mark-to-Market Approach The one-year mark-to-market approach usually requires three main steps. First, an economic balance sheet is developed at the valuation date on a mark-to-market basis, with assets at market values and liabilities on a market consistent basis. The difference between the value of assets and the value of liabilities provides the economic value of net assets, or the available capital at the valuation date measured on an economic basis. For a number of scenarios, assets and liabilities are projected forward for one year, at which point a projected economic balance sheet (on a mark-to-market basis) is developed. The resulting projected economic value of net assets is then discounted to the valuation date, using the projected earned investment return over the year. A negative discounted value quantifies the additional initial asset value that the insurer needs to hold in order to ensure it remains solvent. A positive discounted value quantifies the excess initial asset value over the amount needed to ensure solvency. The discounted value of the projected economic value of net assets is subtracted from the market value of assets at the valuation date, to arrive at the required assets for that scenario. The one-year mark-to-market approach can also be implemented by using a stochastic simulation approach. The steps described above are performed for a large number of scenarios—perhaps 10,000 or more, given the higher security levels that would typically be used in a one-year approach. This gives a distribution of required assets by scenario, from which the overall level of required assets can be determined by calculating the chosen measure at the target confidence level. The economic capital requirement is then determined by deducting the initial market consistent value of the liabilities from the required assets.




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It is also common to implement the one-year mark-to-market approach by using stress tests. This has tended to be more common for businesses with significant financial options and guarantees, where the market consistent value of liabilities requires the use of a risk neutral stochastic valuation. For businesses with options and guarantees, implementing a one-year stochastic approach to economic capital requires challenging stochastic-on-stochastic calculations. With a stress-testing approach to implementation, the full multidimensional distribution of required capital described is not developed. Rather, a limited number of stress scenarios are run in which the scenarios have each been calibrated to the chosen security level. Scenarios are chosen to explore key risks, while the capital results for each risk are typically combined by using a correlation matrix approach. In some cases, a number of multirisk scenarios may also be considered, again calibrated to a security level, to examine potential nonlinearity in risk interaction. It is important to note that even under the one-year approach, a run-off projection is still required since a terminal value of liabilities at the end of the one-year horizon is needed. The future uncertainty that surrounds the risk beyond the oneyear horizon (including the cost of capital required to support that uncertainty) is captured within the market consistent value of the liabilities at the end of the year. By its nature, the mark-to-market balance sheet is sensitive to market conditions and prices. Some feel that this results in market movements having undue inf luence in setting capital requirements. Others see the link to market prices as an advantage because they reveal the true market volatility of the balance sheet, and prices may be very relevant when assessing risk management options available in adverse scenarios.

Pros and Cons of the Two Approaches Risk Management Considerations The risk of failure is not only a function of available capital, but also of the way a company is managed. Therefore, the economic capital that is required by an organization depends on the actions it will take in managing risk, as well as the selected level of security. This interaction between the calculated economic capital measure and the strategies for managing risk within the organization is an important aspect, and one in which the two primary approaches to economic capital take very different paths. The one-year mark-to-market approach examines a short period during which adverse experience emerges and management actions are taken. At the end of the one-year period, there is an assumption that risk and capital can be brought back into alignment. First, excess risk can be closed out by transactions at market prices, either through risk hedging (hedging of market risks, reinsurance of nonmarket insurance risks) or through risk transfer via a sale of all or part of the portfolio to a third party. Second, capital shortages can be addressed by raising additional capital. This ability to recalibrate risk and capital at the end of the year is one of the driving assumptions of the use of the one-year mark-to-market approach. Proponents argue that it is consistent with the actual management of the business, and with the regulatory and rating agency oversight processes.


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Risk over a longer time horizon is not examined by the one-year mark-to-market approach, although the market consistent value of the liabilities does bring in the price of such risks and how they might be managed. Likewise, the multitude of other management actions that are available over the longer term are also excluded, including variation in the asset strategy, the reinsurance strategy, the volume and pricing of new business, and the ability to raise additional capital or restrict shareholder dividend payments. This is not to say that organizations that adopt a one-year mark-to-market approach do not recognize the need to address longer-term risks and their potential consequences. They typically prefer to address such issues separately, outside the economic capital assessment. The stochastic liability run-off approach, on the other hand, does bring in all risks during the run-off of the portfolio, albeit often only those relating to the existing portfolio. A number of the actions that are available to management during that period may also be allowed for through formulas included in the stochastic model. However, it is very rare for the full range of such actions to be incorporated, as it is difficult to allow formulaically for such actions like additional capital raising and increased utilization of hedging/reinsurance, as the capital position of the organization varies over time. The liability run-off approach also requires assumptions about potential changes in risk factors over an extended period, which some may find troubling. For example, while the one-year approach requires us to make assumptions about the probabilities of various interest rate changes over the next year, the run-off approach requires us to make assumptions about the potential changes in interest rates over the next ten years and beyond. The further out one goes, the greater the potential for whole scale state changes. In this context a number of pros and cons can be observed: The one-year mark-to-market approach gives strong recognition to the fact that an organization’s principal ability to control risk in the short term is through trading assets and/or liabilities. However, the lack of data available to calibrate a distribution of market consistent prices for nonhedgeable liabilities, such as mortality/ morbidity, property and liability claim costs, etc., may be regarded as a potentially significant weakness. The liability run-off approach, on the other hand, can give insufficient recognition to this ability to control risk through asset/liability trading, unless sophisticated algorithms are built into the model to allow for it. The one-year mark-to-market approach relies on deterministic adverse scenario analysis to examine longer-term risks and their management. This, too, has a weakness in that it is reliant on management’s scenario selection, as opposed to using a stochastic scenario generation process. Conversely, it has a strong advantage in allowing management to make a realistic assessment of all the risk management actions that it might take in such a scenario. Management can then make a conscious choice between taking such action and holding additional capital, additional to the one-year mark-to-market economic capital, effectively to cover their preference not to take such management action. The liability run-off approach aims to build longer-term management actions into the stochastic model, although, in practice, this can be difficult to perform comprehensively. While this approach




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Both approaches to economic capital allow longer-term risk issues to be addressed, but in different ways.

Risk-Measurement Based Performance When it comes to performance measurement, a one-year mark-to-market approach to economic capital assesses the quantum of risk over the same one-year period, as is typically used for shorter-term performance measurement purposes. This allows the consistent assessment of risk, capital, and performance. A liability run-off approach to economic capital can result in a timing mismatch, with short-term performance being compared with risk and capital assessments based on a longerterm horizon.

Ease of Communication and Understanding Most would agree that a one-year approach is generally easier to understand and explain, especially to nontechnical audiences. This can be particularly important when the economic capital results are being shared externally or discussed with the board of directors. The fact that the one-year approach is consistent with similar measures used in other industries is also helpful. At a conceptual level, a liability run-off approach can also be relatively easy to understand. However, complexities with respect to model assumptions, risk interactions, and management actions can make this approach to economic capital difficult to explain and understand at a more detailed level.

Implementation Considerations To be effective, the liability run-off approach requires a wide range of management decisions to be modeled, each of them interacting with the scenario characteristics and the impact of that scenario on the organization. While the results can provide significant insights, there is a danger that model complexity can lead to longer implementation time frames and add to the opaqueness of the process. A key component of risk to the existing policyholders relates to management plans for new business and their ability to control its volume, mix, and price. Modeling new business can add to the complexity of a run-off model, with additional factors such as how many years of new business to include, what sales volumes to include in each projection year, and what pricing terms to assume. In addition, the insurer would need to consider how each of these decisions would change under


removes the reliance on management scenario selection, stochastic projections of longer-term risk emergence and its management can be less clear and more difficult to analyze than with a deterministic equivalent. There is a risk that economic capital can be overstated through the omission of actions that might reasonably be taken, or, alternatively, that the reason for the high capital requirement is not clearly understood. In addition, in an environment where management changes can occur fairly frequently, making assumptions as to management actions over the longer term can be considered speculative.


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different projected paths. It is debatable whether such assumptions can realistically be represented formulaically beyond the first few years of the projection. Each scenario path would need to be carefully considered for reasonableness. A one-year mark-to-market approach, on the other hand, includes projected new business over the one-year time period. While a one-year mark-to-market approach typically requires fewer management decisions to be modeled, it does have a number of implementation challenges. For liabilities, including options and guarantees, the end-year market consistent liability valuations that are required can lead to the need for stochastic-on-stochastic calculations. Consequently, the one-year mark-to-market approach is often implemented, initially at least, by using stress testing. While a stress-testing approach eases and speeds the computation and can give further benefits in terms of transparency and communication, the full capital distribution is not developed, and the approach cannot, therefore, be considered to be as rich as a stochastic approach. Calibrating appropriate stress tests to a target security level can also be challenging, particularly where complex, nonlinear risk interactions exist, or where the relationship between risk distributions and capital distributions is not monotonic.

Calibration It is generally viewed as easier to calibrate economic capital to a target security level under a one-year approach. Indeed, there is a significant body of statistics available regarding corporate bond defaults, against which a reasonable calibration can be made. These statistics relate primarily to annual rates of default and take into account all risks to which the organization is exposed over that one-year period. The more limited data available regarding insurer defaults are determined in a similar way. These datasets are, therefore, derived from the same situation as is represented in a one-year approach to economic capital, including new business. Calibration of a liability run-off approach to an external data source is more difficult, as the block of business and its risk exposure are typically reduced over time, and the projection typically does not include all risks for all time periods. Therefore, there may not be external statistics available against which to calibrate the target security level, and some approximations become necessary. In addition, different lines of business run off over different periods and may need different calibrations.



Aggregation Under the one-year mark-to-market approach, all risks are measured over the same time horizon, thus ensuring consistent aggregation of risks. Providing strong justification of diversification benefits to rating agencies and regulators is critical to achieving the reductions in capital requirements that most insurers seek from their economic capital calculations. Under the liability run-off approach, if no interim solvency assessments are made, the approach will implicitly assume that short-term losses on one line can be offset against longer-term profits on another. Justifying this, and the consequent


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diversification benefits, can be challenging. However, the issue is moot if interim solvency assessments are included.

Other Aspects of Economic Capital Methodology

Measure of Risk While a number of different measures of risk can be used within an economic capital calculation, in practice most can be categorized into one of two groups. These groups ref lect the two aspects of downside risk that policyholders face, namely the probability that they suffer a loss compared to their expectations (probability of ruin), and the extent of that loss (cost of ruin). VaR and CTE are the most common probability of ruin and cost of ruin measures. Both risk measures can be used with either of the two main approaches to calculating economic capital. However, both have relative advantages and disadvantages. Conceptually, VaR is relatively simple to understand and use. It is widely known and is the approach favored in Europe under Solvency II. VaR is also generally consistent with the majority of the calibration data that are available from rating agencies. Computationally, CTE is more demanding to calculate and can be more difficult to calibrate to historical data. Nevertheless, it is the approach proscribed by the U.S. regulator in C-33 capital calculations. Achieving an accurate CTE result requires knowledge of the shape of the risk and loss distributions in the extreme tail of the distribution. VaR is less demanding in terms of modeling extreme scenarios, and it requires fewer scenarios to achieve a stable result. However, it can result in inadequate, possibly even zero, levels of capitalization for low probability, high-loss lines of business like reinsurance or earthquake cover. Perhaps the single most important difference is that CTE is a coherent risk measure, thereby ensuring reasonable results when aggregating capital across risks or business units. VaR, on the other hand, is not a coherent risk measure and can lead to inconsistent results when aggregating/allocating capital. In practice, however, this does not present an issue for most risk distributions that are encountered within the life industry. Property and casualty insurers, however, often face more skewed distributions, and the coherence of the measure is therefore a more important factor.


There are two other key aspects to economic capital methodology that need to be considered: the measure of risk to be adopted and how to calibrate it for economic capital.

Target Security Level The calculated level of economic capital is designed to provide a target level of protection to policyholders, which can be communicated meaningfully to relevant stakeholders, including regulators and rating agencies. This target security level forms one component of the company’s risk appetite.


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There is no prescribed way in which such a target security level should be expressed, although it is logical to relate it in broad terms to other measures of financial strength and resilience, such as rating agency assessments (A A A, A A, A, etc.) of the company’s corporate debt and insurance financial strength rating. In structuring a target security level, it is worthwhile to observe certain characteristics of insurer and corporate bond default experience. The probability of default increases with the duration of exposure to the company. That is, there is a higher probability that a ten-year corporate bond will default at some point during its term than a five-year bond of the same rating. Thus, it would appear reasonable to adopt a similar approach for insurance policyholders, namely, to offer a higher level of security to short-term policyholders than to long-term policyholders. Indeed, targeting the same level of security for policyholders of all durations seems doomed to failure. In calibrating such a target security level, the most natural approach might be to relate it to an insurer’s financial strength rating by deriving a probability of default, or an expectation of loss on default, from historical experience of insurers of that same financial strength rating. However, there is relatively little data available on insurer defaults. Therefore, most companies rely on the much larger body of data on corporate bonds. The level of security provided to policyholders is thus set to be broadly equivalent to the level of security available to holders of corporate bonds. This provides an approach that is justifiable in broad terms, can be calibrated to a fairly extensive dataset, and can be communicated to the relevant stakeholders.

Factors in Developing an Economic Capital Program Insurers face many challenges in implementing economic capital, ranging from the definition of the core metric to the quantification methodologies and choice of systems. A number of factors need to be considered when choosing among these options: The insurer’s goals and objectives, the risk profile of the business it writes, and any implementation restraints.

Goals and Objectives of Economic Capital implementation An insurer’s objectives for calculating economic capital, including how the results are to be used in the business, can have an important inf luence on the implementation approach. Among other things, the intended utilization of economic capital will have an impact on the level of detail and frequency of the calculation required. These factors, in turn, will inf luence choices around economic capital definition, calculation approach, and systems design.



Capital Adequacy The core use of economic capital for most insurers is as an assessment of their true level of capital adequacy calculated on an economic basis, and not distorted by regulatory or financial reporting requirements. Capital adequacy is relatively undemanding on the level of detail included in the economic capital calculation. An assessment of capital adequacy on a more granular


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Risk Monitoring and Control Economic capital is a key measure of risk from a policyholder perspective. It, therefore, frequently features as an important component of an insurer’s risk appetite framework, and in the risk measurement and monitoring processes that are implemented to ensure that the insurer remains within that risk appetite. For this purpose, economic capital needs to be captured not only at the corporate level but also at a more granular level. The decision to use economic capital at an operational level can also have significant implications for the model design and choice of systems. Economic capital needs to be calculated at a level and frequency appropriate to the risk being captured. For example, weekly or daily updates may be needed where economic capital is used to monitor asset/liability or hedging exposures, given the rapid pace of market movements and potential changes in asset exposure. Because of the difficulties in calculating economic capital at the level of granularity and at the frequency required for risk monitoring, companies often use alternative metrics for monitoring and controlling risk, albeit with the intention that these are broadly consistent with the economic capital measure. Advances in modeling approaches are permitting the direct use of economic capital as a risk measure for such purposes.

Performance Measurement and Management The use of economic capital to measure and manage performance requires a level of granularity and frequency that is appropriate to the pace of change in risk profile. In addition, there is a need to demonstrate the consistency of the economic capital metric across different risks and lines of business if it is to be applied uniformly in performance measurement and management. Use of economic capital for this purpose requires that the approach be robust, objective, and honest. These requirements need to be ref lected in the governance of the economic capital process, and have resulted in some companies adopting a greater degree of central control over modeling systems and their parameterization than would otherwise be the case.


product-level or business-unit basis can only be made to the extent that assets are specifically allocated. Thus, risks that diversify significantly within the insurer attract less focus than they would for a product-level economic capital assessment. As for the frequency of calculation, annual results are a core requirement, but quarterly, if not monthly, updates are increasingly needed. A process to determine capital adequacy at any point in time is also increasingly a requirement, especially for market risk, given the speed at which movements can occur and the need to demonstrate externally that the economic capital measure is at the core of the insurer’s risk management framework.

Risk-Based Decision Making Economic capital is often implemented with the objective of providing management with a better informed basis from which it can make risk-based decisions,


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including hedging, reinsurance, and mergers and acquisitions. For economic capital to be a useful tool in this regard, companies need to ensure that it can be applied at a sufficient level of granularity and accuracy for the range of possible decisions with which they could be faced. For example, an approximate approach to economic capital that does not ref lect the full detail of asset/liability mismatches would be of limited use in determining a detailed asset strategy.

Economic capital is often incorporated in the product pricing process, so that risk and capital are charged on an economic basis and pricing ref lects the true nature of the underlying business. To do so requires a process for allocating economic capital down to the product level, including the level of diversification credit considered appropriate. It also requires the projection of the chosen measure of economic capital over the term of the products being priced.

Type of Business The type and range of business, and the consequent risk written by an insurer, is an important factor in selecting an economic capital implementation approach. Consistency across different business units, product lines, and risks is essential. This applies, in particular, to the use of economic capital in performance measurement/management and product pricing, as well as risk monitoring, decision making, and capital adequacy. In fact, the main benefits of an economic capital calculation can be lost if inconsistent approaches are taken. For example, it is difficult to argue for diversification benefits if a one-year approach is adopted for life business and a run-off approach is adopted for property and casualty (P&C) business. To do so would suggest that an offset between short-term losses within the life business, and longer-term gains within the P&C business, could be justified. The principal economic capital implementation issue that tends to vary by type of business is the appropriate time horizon to use. This relates to the different pace at which different risks evolve, and the timing of the management actions available to mitigate those risks. For example, market risk exposure may be measured over a very short time, while longevity risk is measured over a long time horizon. Differences are also ref lected in the nature of the systems that are required to support the economic capital calculation. The market risk in a bank trading operation may require a daily economic capital calculation using real time asset feeds, whereas for the longevity risk in the life insurance operation, an annual detailed economic capital calculation may suffice.


Risk-Based Pricing

Constraints While an insurer’s objectives for calculating economic capital would typically determine the main factors that need to be considered when developing economic capital, most companies are also faced with a number of constraints that can inf luence the selection of an economic capital approach.


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Budget Constraints

Time Constraints As with budget constraints, a company faced with tight timeframes may decide to opt for an approach with a shorter implementation time frame. For example, a company may assume a phased approach, where a simpler and quicker approach to economic capital is adopted initially but then molded over time to become an approach that satisfies the company’s long-range objectives. Companies may also face time constraints on an ongoing basis. For example, once economic capital has been implemented, it may be necessary to calculate it with a fast turnaround time to support a frequent risk monitoring and control process. In this case, the company may have to settle for a simpler approach to economic capital, even though it might not be the most appropriate approach for that application.

System Constraints Increases in computing capacity and improved systems design are frequently matched by increased demands on the part of users. Systems capabilities are, therefore, likely to continue to be a constraint in the implementation of economic capital. A particular issue is the potential need to calculate a projected mark-to-market balance sheet for business with embedded optionality, either in the context of a one-year economic capital time horizon or as an intermediate solvency check within a run-off approach. If a stochastic approach to economic capital is adopted, this theoretically requires “stochastic on stochastic” modeling, which remains highly system intensive, even with the latest hardware and software. As a result, companies have often implemented simpler approaches to economic capital such as stress testing-based approaches. These give a good indication of overall economic capital requirements and of the exposure to specific risk factors, although careful thought needs to be given to how the impact of the different risk drivers is aggregated. The recent application of replicating portfolio techniques to insurance business can have a significant effect in reducing the system constraints on economic capital implementation. Where system constraints prevent a sophisticated but system-intensive approach to economic capital being run frequently, it may still be possible to benefit by calibrating a simpler economic capital methodology to the more sophisticated approach, say annually, and using this simpler methodology for intermediate reporting.


Approaches to economic capital can vary significantly in commitment and costs. A company may decide to opt for a less sophisticated approach to economic capital if it can be implemented and maintained on a lower budget, yet still allow the company to meet its high priority objectives. Alternatively, a company faced with budget constraints may adopt a phased implementation, beginning with an approach that can be put in place fairly easily, and then expanded and made increasingly more sophisticated over time.


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Successfully Implementing Economic Capital: Management Issues Since economic capital is more than just a calculation, successfully implementing a program depends on several key factors, including governance, management buy-in, human resources, system resources, time frames, budgets, and computer processing ability.

Governance and Achieving Buy-In Good governance is a critical factor in economic capital implementation, both in development and in an ongoing basis. Successful economic capital implementation demands active participation and direction by senior management. Economic capital is usually viewed within the context of a broader enterprise risk management (ERM) framework and, therefore, needs to be viewed as part of a company’s broader risk governance structure. Economic capital is a tool to help management make better informed decisions by providing them with quantitative assessments of the true risks within the business. However, an economic capital program should go beyond a calculation process. To be considered successful, economic capital needs to be embedded within the organization, providing valuable information for better decision making on a consistent basis to senior executives and business managers throughout the enterprise.

Centralized Versus Decentralized In establishing the internal infrastructure and processes for implementing economic capital and calculating it on an ongoing basis, a question that many insurers face is to what extent the work should be maintained at the corporate level, for example by a dedicated ERM team, or pushed down into the business. There are certain aspects that typically remain at the centralized level, such as setting out the high-level methodology, aggregating results across the businesses and reporting in a consistent manner, and determining capital allocation and the use of diversification credits. Irrespective of long-term plans, it is natural for most economic capital implementations to start at the corporate level. The decision to embark on an enterprise-wide economic capital implementation needs to be endorsed at the highest level of the firm. Nonetheless, an early consideration in making long-term plans for economic capital is the extent to which a company’s leaders ultimately want


Last, but certainly not least, the limited availability of skilled staff can restrict an insurer’s options. This constraint may apply separately in the implementation phase or on an ongoing basis. In implementation, companies may simply find that they do not have a sufficient number of skilled or knowledgeable staff. On an ongoing basis, the company may not be able to justify the cost of a large, dedicated economic capital team. Many companies make use of external consultants to overcome these problems.


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responsibility to be apportioned. Areas where control and decisions can be made centrally or at the business level include:

These considerations are obviously much more relevant for larger insurers with business spread across multiple lines and geographies. In practice, this decision is often driven by the existing organizational structure and broader corporate culture within the organization. When more control is kept at the center, the business will not be as directly involved in the development or operation of the economic capital processes, and this, in turn, may make it more difficult to embed economic capital within the decision-making processes.

Human Resources Implementing economic capital typically involves the development and introduction of new concepts, methodologies, and tools within an organization. As well as requiring specific skills, it also typically involves a significant one-off effort. Consequently, it is common for companies to recruit additional staff and/or to hire external consultants. On an ongoing basis, most companies recognize the importance of being able to run and maintain their economic capital process internally. Nonetheless, a number of companies retain consultants on an ongoing basis to provide an independent review of the economic capital methodology, assumptions, models, and results. This can be particularly important where companies are disclosing economic capital information publicly or to external third parties, or using the information as the basis to make strategic decisions.

System Resources The process of selecting a software provider should not be underestimated. While systems are mostly used for the same purposes, the differences between providers and their systems can be considerable. Several parties should be involved in the selection process, including the actuarial department, IT, and financial reporting, to ensure that the most suitable system is selected, and to ensure a high level of buy-in from key parties after the choice has been made.


• Overall economic capital methodology, including how it is defined, what the model outputs will be, how it will be used in decision-making processes; • Building and running of models, including decisions around what software to use; • Assumptions underlying the calculations.

Time Frames and Budgets Time and financial budgets are often the most significant constraints that an insurer faces when embarking on an economic capital implementation. An important factor inf luencing expected resources and costs over the long term will be the frequency and level at which economic capital is used within the organization.


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Use and Implementation Trends The use of economic capital frameworks has evolved at a rapid pace in recent years. According to the Towers Watson survey, the use of economic capital in decision making has increased for a wide variety of strategic business applications, including capital adequacy/capital management (from 44% in 2008 to 62% in 2010), asset/ investment strategy (from 36% to 54%), strategic planning and capital allocation (from 31% to 52%) and annual business planning (from 30% to 46%). The survey results also indicate that the industry’s use of economic capital in these and other areas (including reinsurance purchasing, product design and pricing, performance measurement and incentive compensation) is expected to increase even more significantly in the two years following the 2010 survey. Calculating economic capital and applying it to risk-based decision making processes (e.g., ALM, reinsurance, capital management, performance management, pricing) remains a priority for development or improvement for many insurers (41% and 39%, respectively). [Q3] Few insurers have garnered a Strong or Excellent Rating by S&P for their ERM programs, and one-fifth (21%) cite their risk and economic capital models as a primary focus for improvement relating to S&P’s ERM rating criteria. [Q35, Q36] For insurers calculating economic capital, the biggest challenges in implementing or using economic capital are availability of resources (49%), determining the appropriate approach or methodology (44%), lack of data or data integrity issues (44%). Technology (35%) and securing management buy-in (33%) are also challenges for some. That economic capital modeling is still a work in progress is reinforced by the fact that planned improvements to economic capital frameworks continue to be concentrated on basics such as improving data quality (44%), enhancing modeling methodology for individual risks (39%), and extending the risks covered by their models (31%). However, progress is notable compared to the 2008 survey results, with a relatively higher proportion of respondents now also focusing on areas such as improving speed and granularity of models, as well as on governance issues such as improving controls and documentation related to models and related processes. In Europe, approval of an internal capital model under the proposed Solvency II framework requires the model to be embedded in the management of the business. Rating agencies have similar requirements for recognizing internal model results. In 2010 only 12% of European insurers subject to Solvency II said they expected to obtain internal model approval from supervisors without significant additional work. Thirty-eight percent of European insurers subject to Solvency II said that use


For example, an aggregate economic capital calculation that is updated annually will require far fewer resources than if economic capital is used frequently in risk monitoring and control, pricing, performance measurement, and other periodic activities. In addition, many of the factors that impact budgets in the implementation phase can also have an impact on the ongoing costs associated with having economic capital calculations and processes in place. Clearly, a company that uses a highly complex economic capital methodology and models should count on higher costs, both in implementation and on an ongoing basis.


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test requirements are the greatest challenge to achieving internal model approval, followed by statistical quality standards (16%) and validation standards (14%). Large companies demonstrated a superior level of commitment to economic capital, with 87% already calculating economic capital, compared to 78% of medium-sized companies (firms with between $1 billion and $10 billion in revenues) and 46% of small organizations (those with less than $1 billion in revenues). However, when it comes to actually using economic capital in decision making, smaller firms have virtually caught up with their larger counterparts. For example, 51% of small insurers that calculate economic capital said they used it in strategic planning and capital allocation, compared to 50% of large firms calculating economic capital. Similarly, an equal proportion of small and large insurers (35%) that calculate economic capital said they use it in product design and pricing. The more advanced insurers have now reached the stage where they perform economic capital calculations at least quarterly. They use economic capital routinely in many business processes, including business planning, product pricing, and reinsurance purchasing. Many companies are assessing their outward reinsurance program by comparison to other capital alternatives; they view reinsurance as a form of “rented” capital, and calculate the “cost of reinsurance capital” for each element of their program. The most advanced companies are linking economic capital models to economic value models. (Economic capital is a balance sheet item; economic value is its income statement analog.) This allows them to introduce new performance measures based on economic value added. Overall, while companies are proceeding at different paces, with differing priorities, most companies are now on a path to implementing economic capital models. It is fair to expect that, eventually, methodological differences will be resolved and standards will be set that ensure reasonable consistency in approach. Those that have led the way believe that they are getting real value from their efforts to develop economic capital, beyond mere compliance with regulatory requirements.


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Securitization and Insurance Marcelo Ramella

Introduction Is securitization the financial equivalent of penicillin, a panacea . . . or does it help some patients, cure none, and produce iatrogenic illnesses? 1

As financial markets display signals of growing convergence, attention is dedicated to understanding the dynamics that underpin this development. Shedding light on the securitization process is part of this endeavor, as securitization constitutes one key element of the convergence process. As the financial crisis has demonstrated, the cross-sectoral and cross-country convergence of financial markets brings with it an array of fundamental challenges, many of which are far from being understood, let alone managed. This chapter aims to contribute to the debate on the many faces of financial convergence by focusing on one such example, that is, insurance securitization. It does so by identifying and examining the phenomenon of insurance securitizations from a variety of perspectives: from the conceptual architecture of the securitization process, to the practical application of insurance securitizations and the regulatory and supervisory responses to the matter. Insurance securitization, it is argued, constitutes a socially useful financial innovation that provides valid sources of risk capital for insurance and reinsurance companies, and also offers clear attractions to capital market investors. On the other hand, as the effects of the 2008 financial crisis continue to unfold, insurance securitizations have to be handled and understood as inextricably tied to the wider financial markets, that is, not immune from events that occur outside the narrow realm of insurance. The chapter is divided into five sections. The first section outlines the basic features of the securitization process, placing emphasis on key differences between securitization of assets and securitization of liabilities. The following section focuses on insurance securitization, reviewing the main debates around the value-adding potential of these arrangements, particularly the relation between insurance securitization and financial stability. Next, this chapter looks at the current landscape of


CHAPTER 18


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Securitization in Finance: Asset-Backed and Liability-Based Securitizations From the perspective of finance, securitization can be understood as the process by which something, which is not a security, is converted into a security, that is, into a capital market instrument. 2 In a nutshell, this process involves three main sets of players. First, we have the entity (or entities) that will provide something to be converted into a security. Second, there is the entity (or entities) carrying out the conversion. And finally, we have the entity (or entities) acquiring the securities. We call the first set of entities originators or sponsors, the second set special purpose entities (SPEs), and the third set capital market investors. Two different names for the first set of players have been provided in order to highlight the fact that while one of these names, the originator (e.g., a bank), indicates those entities that provide assets to be converted into securities, the other name, sponsor (e.g., an insurance or reinsurance company), designates entities providing liabilities to be converted into securities. Moreover, we call asset-backed the securitization process that involves the conversion of assets into securities, and liability-based the process that involves the conversion of liabilities. In asset-backed securitizations, the originator sells a pool of assets to an SPE. The SPE issues the securities and uses the proceeds from the sale of these to pay for the assets sold by the originator. Securities issued and marketed in this manner are referred to as asset-backed securities. On the other hand, liability-based securitizations (i.e., insurance securitizations) enable sponsors such as insurers and reinsurers to transfer underwriting risk out of the company to capital market investors. This is done by ceding risk to an SPE that will issue securities and will use the proceeds from the sale to pay out any claims emerging from the risk transferred.3 Securities issued and marketed in this manner are referred to as insurance-linked securities (ILSs). Figure 18.1 illustrates the structure of these two processes.4 Although asset-backed and insurance securitization processes share basic key features (indeed, liability-based securitizations developed out of asset-backed ones), there is a fundamental difference between the two. In asset-backed securitizations, originators consider the asset transferred to the SPE as a “true sale,”5 which enables them to capitalize on a future f low of funds. On the other hand, sponsors in insurance securitizations retain a contractual liability to the underlying policyholders, notwithstanding the economic transfer of the risk. Asset-backed securitizations could be equated to a sale transaction; liabilitybased securitizations entail the transfer of an insurance risk against the payment


insurance securitization arrangements, discussing market data with respect to the types and volume of risks transferred via securitization processes, and identifying emerging trends on the matter. The chapter then looks at regulatory and supervisory issues regarding insurance securitizations, and provides descriptions and analyses derived from the main existing frameworks worldwide. The final section examines all cases to date in which insurance securitization arrangements suffered distress, with a look at two main distress sources, which are the occurrence of an event covered by the securitization arrangement, and the impact on insurance securitizations from the 2008 financial crisis. Finally, this chapter concludes with an examination of some emerging themes from the insurance securitization debate.


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Basic Securitization Structure Asset-backed Securitization Asset

Securities Special Purpose Entity

Originator e.g. bank Cash

Capital Markets Investors Investment

Insurance risk

Securities Special Purpose Entity

Sponsor e.g. (re)insurer Coverage

Capital Markets Investors Investment

Figure 18.1

of a premium. Capital market investors in insurance securitizations benefit from the interest that is yielded by the securities issued through the SPE, and from the premium paid by the sponsor to the SPE. In exchange, SPEs provide coverage for the risk ceded. However, should the risk transferred to the SPE materialize, investors are exposed to the possibility of losing their investment that is at risk. This fundamental distinction between asset-backed securitizations and insurance securitizations lies at the heart of the different regulatory and supervisory treatment given to securitization arrangements by banking and insurance supervisors. This latter point is addressed in more detail throughout the chapter. Notwithstanding the fundamental difference mentioned above, asset-backed and insurance securitizations share many key features. For example, in both types of transactions, the SPE remains a passive financial entity that exists solely to house the assets or liabilities transferred to it. They also issue the securities and hold the proceeds of the issuance. 6 In addition, with both arrangements, the SPE appears as bankruptcy remote from the originator or sponsor. Bankruptcy remoteness brings about a clear separation of the SPE from either of them. The credit risk of the SPE is based on the quality of the SPE’s assets, and SPE creditors will have no access to assets of the originator or the sponsor. Moreover, both arrangements often rely on so-called credit enhancement mechanisms, that is, tools added to improve the credit quality of the securitization. These can be internal (e.g., a reserve account established to collect the excess cash f lows) or external (e.g., a letter of credit issued by a bank). Securitization arrangements often use combinations of more than one credit enhancement mechanism.7 Furthermore, insurance securitizations rely on two key additional arrangements to further enhance the credit worthiness of the SPE. First, SPEs commit to hold at all times assets equal to or in excess of the insurance exposure assumed, also known as the fully funded condition. Second, SPEs agree to maintain their assets in accounts, usually trust accounts, which have the sponsor as the beneficiary. In other words, there is a collateralization of the SPEs’ exposure.


Liability-based Securitization


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There is a growing body of literature concerned with understanding the valueadding potential treasured within insurance securitization undertakings. 8 Studies look at the impact of insurance securitization on the insurance markets, the reinsurance markets, and the capital markets. The paragraphs below focus on the insurance and reinsurance markets, reviewing some of the key findings related to the value-adding potential of insurance securitization. A primary effect of insurance securitization is its potential to contribute to enhancing the efficiency of insurance markets. Securitizations can act as a complement to traditional reinsurance, expanding the capacity pool at the disposal of insurers and reinsurers, and contributing to the competitiveness of premium prices. Moreover, securitization arrangements can impact the capital requirements of cedents, contributing, along with other things, to lowering the cost of capital. Also, when used as vehicles for transferring catastrophe risks out of the insurer and into the capital markets, securitizations help to smooth annual results by reducing the negative effects of extreme risks. In addition, they expand the reach of insurable risks into layers not previously covered by traditional reinsurance. Hand in hand with the efficiency-enhancing potential of insurance securitization, there are several factors that may act as counterforces. For example, arrangements are usually cost-intensive, proving particularly burdensome for small insurers and reinsurers. This may be detrimental to the overall efficiency of the market. Moreover, the contractual apparatus that supports the insurance securitization process is more often than not a complex one. This may have an impact on the transparency of the market dynamic, negatively affecting its overall efficiency. In addition to impacting market efficiency, insurance securitization undertakings can contribute to limiting the cyclical nature of insurance markets. The potential for securitizations to contribute to the shortening of the spike in premium increases has been documented by the International Monetary Fund in its Global Economic Outlook of April 2008.9 Figure 18.2 reports the IMF finding. As illustrated, the cycle appears more short-lived in the post-2005 period (e.g., after the U.S. hurricane season, especially, Katrina, Rita, and Wilma) than in the post-1992 period (e.g., after Hurricane Andrew). Albeit with extreme caution, the differences between the Andrew spike and the Katrina one could be interpreted as related to the entrance of securitization arrangements in the insurance and reinsurance markets. While insurance securitizations were not in existence in the early 1990s when Hurricane Andrew hit the United States, by 2005 (i.e., the year of hurricanes Katrina, Rita, and Wilma) they had become a standard feature of the insurance and reinsurance markets. The final part of this section analyzes the relationship between insurance securitization and financial stability. It also explores the potential of insurance securitizations as a contributing factor to financial stability. It first looks at the debate on the concept of financial stability. Second, it examines the impact of the financial stability debate on the insurance and reinsurance markets. The section concludes with some considerations on the role of insurance securitization on financial stability. Defining financial stability has so far proven a “thorny” endeavor, in the words of Allen and Wood;10 attaining it, an “elusive” one, according to Poloz.11 Research


The Value-Adding Dimension of Insurance Securitization: Market Efficiency and Financial Stability


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●

233

200 Andrew 180 Katrina 160

Post 9/11

140

100 80 60 40 20

1985 87

89

91

93

95

97

99 2001 03

0 05 07:Q1

Figure 18.2 Catastrophic insurance premiums.

aimed at understanding financial stability, as well as policy developments toward achieving it, appear to have been more successful in finding consensus with respect to describing and prescribing absence of instability (e.g., the occurrence of a major financial crisis) than with understanding and achieving financial stability as such.12 In doing so, a wealth of effort has been geared toward identifying and preventing sources of instability. Considerably less productive has been the stream of thought focusing on financial stability in terms of the identification and promotion of key elements in a position to enhance the resilience of both financial institutions and financial markets. With specific reference to insurance companies and markets, the debate about whether, and eventually to what extent, insurance or reinsurance pose systemic risk is a significant one. There is a considerable body of literature arguing that insurance and reinsurance pose little or no risk that can be defined as systemic.13 In a nutshell, the justification is both theoretical and empirical. Regarding the former, systemic risk stems largely from banking institutions, as these operate via converting short-term liabilities into long-term assets, as opposed to insurance companies that convert long-term liabilities into short-term assets. With respect to the latter, and with specific reference to the current financial crisis, insurance companies appear to have not played a substantive role in the triggering of the crisis, although they have been affected by it. When assessed against the potential to contribute to managing systemic risks or to enhance institutional or market resilience, there are some valuable pointers


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that emerge from insurance securitization. First, insurance securitization provides an institutionalized channel for the convergence of two different markets, that is, reinsurance and capital markets. The crystallization of convergence into institutionalized arrangements offers the potential to contribute to the transparency and overall robustness of both markets. This point is developed further, later on in this chapter. Second, the ability of a market, in our case the reinsurance market, to rely directly on a different market (e.g., the capital market) can exercise shock-absorbing effects, particularly those stemming from unexpected events such as the September 11th terrorist attacks or the 2005 U.S. hurricane season. The remarks on countercyclicality, discussed above, echo this claim. Third, access to additional capital resources—if looked at from the reinsurance market perspective, or, to additional diversification sources, if looked at from the capital markets perspective—offers the potential to strengthen players and markets within both areas. On the other hand, convergence between different markets intensifies the interconnectedness among institutions and markets, thus augmenting the probability and intensity of the transmission of shock-causing episodes. While the paragraphs above have sought to cast some light on the potential of insurance securitization in relation to market efficiency and financial stability, the sections below look at empirical data and try to assess whether and to what extent this potential has materialized in practice.

Overview of the Insurance Securitization Landscape to Date This section provides an overview of the main types of securitization arrangements, looking at their key characteristics and their usage in practice. Insurance securitization can be understood as belonging to the realm of Alternative Risk Transfer arrangements (ART) at the disposal of insurers and reinsurers.14 Securitization arrangements exist to transfer property and casualty insurance risks, as well as life insurance risks. Moreover, risks transferred cover both catastrophic and noncatastrophic risks. Figure 18.3 provides examples of the four types of risks that are covered under insurance securitization arrangements.15 With respect to securitization arrangements that cover property and casualty (P&C) risks, although there have been cases of high-frequency, low-severity risks transferred to the capital markets (e.g., auto insurance), the bulk of the P&C securitization work has been done on risks of a catastrophic nature. Further, the securitization arrangements that have been mostly used are catastrophe bonds, or “cat bonds,” and sidecars. Cat bonds are covered elsewhere in this book.16 Sidecars are reinsurance special purpose companies that, unlike traditional reinsurers, are attached to one single client—the sponsor—usually by one quota share contract covering catastrophic risks, and doing so for a limited period of time (i.e., not exceeding 36 months). Sidecars allow sponsors and capital market investors to tailor-make the terms and conditions of the company and the risks it takes, and to do so in an extraordinarily short period of time. Investors in sidecars are usually hedge funds and private equity funds that participate largely as equity investors (i.e., as shareholders, as opposed to bondholders). Usually, sidecars’ liabilities are fully collateralized and are set at an aggregate limit, although in some cases these are calculated at a multiple of the probable maximum loss (PML), or to a loss ratio cap.17


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Property & Casualty

Life

NON-CAT

Mass risk protection

Financing tool by turning future income into capital

CAT (Peak risk transfer)


Protection for extreme events (low-frequency, high severity) • Hurricane and earthquake cat bond • Sidecar

235

• Embedded value securitisation • Reserve funding

Extreme risk transfer • Morbidity bond • Longevity bond

Main Purposes/Benefits – Increase growth, by freeing up or accessing capital – Improve ROE – Reduce earning volatility Figure 18.3 Insurance securitizations-matrix of arrangement types.

With respect to life insurance, securitization arrangements can be divided into three broad categories. Two of these pertain to noncat risks, that is, embedded value securitizations and reserve funding securitizations, and one of a cat nature (e.g., extreme mortality/longevity bonds). Embedded value securitizations offer financial relief, similar to that offered by financial reinsurance. This is achieved by securitizing a block of insurance or annuity business to achieve a business objective, such as capitalization of prepaid acquisition expenses or monetization of the embedded value from the block. In short, raising cash is central to these kinds of arrangements. This type of transaction also includes closed block and open block securitizations that are undertaken to support demutualization. Reserve funding securitizations, which make up the majority of life insurance securitizations by size issued to date, are used to finance U.S. regulatory reserve requirements, such as those associated with Regulation XXX18 and Actuarial Guideline AXXX,19 over and above the economic reserves. Finally, extreme mortality/morbidity bonds are transactions designed to protect life (re)insurers against peaks in mortality or longevity. The spectrum of insurance securitization arrangements available for both P&C and life risks should be seen in the context of a market that began to materialize in concrete examples in the second half of the 1990s. Further, after over a decade of activity on this front, the market share of insurance securitizations remains small when compared to traditional approaches to risk transfer, particularly reinsurance. Figure 18.4 shows insurance-linked securities issuances for the period 1997–2009, which peaked to over $15 billion in 2007, from $1.3 billion raised ten years prior. 20


• Motor insurance securitisation

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18000 16000

2007: Record issuance of US$ 15.6 bn with CAGR of 28% (’97–’07) 2008: Impact of financial crisis 2009: Rebound; 1Q09 had second biggest issue activity ever (cat) In comparison, still a small market

Non life Life

155581)

12000

7885 10101

10000 K/R/W 8000

5118

C/F/J/I

9/11

6000

Gustav/lke

5711

4701 4131

2483

4000

1991

2842

2000 0

1701

1966

1275 1110 165

1635

1096

1616

1125

605

350

510

1014

2041 1260

1828

7673

3220 1306

4983

3092

3228

2710

896

1914 781

1039

755 141

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Year of Issuance

Figure 18.4 Insurance securitizations 1997–2009.

Also, approximately $11 billion of the nonlife issuances are outstanding at the time of writing this report. According to Lane and Berwick, 21 there were 328 issuances in total during this period. Of these, 83 were carried out by 2003, while 245 took place from 2004 to the first quarter of 2009. These figures yield an average of 16 issuances per annum in the first period, against 40 issuances in the second. Further, direct insurers carried out just over 50% off all issuances, with the vast majority of the remainder done by reinsurers (i.e., as retrocessional coverage). Issuances directly by noninsurers are very rare, for example, a cat bond issued to cover risks related to the construction of Tokyo Disneyland. Finally, there are cases of government-led issuances like the 2006 and 2009 Mexico earthquake bonds, or the Caribbean Catastrophe Risk Insurance Facility, launched by the World Bank in 2007 and covering hurricane risk for 16 Caribbean countries. A key trend emerging from the data discussed above is that, although alternative risk transfer appears comparatively small when looked at in relation to traditional insurance and reinsurance, the picture changes if the focus of observation concentrates on new capital coming into the market, as opposed to all the capital in it. In this respect, the share of alternative risk transfer increases substantially in comparison to traditional arrangements. As shown in figure 18.5, 22 and with particular reference to the aftermath of the 2005 U.S. hurricane season (hurricanes Katrina, Rita, and Wilma [KRW]), 20% of the new capital raised to replenish capacity was originated in ART arrangements (9% in cat bonds and 11% percent in sidecars), a stark comparison to the post-Andrew recapitalization, where there were no insurance securitizations. Last, but not least, there has been growth in the number of insurance and reinsurance companies that have opted to raise capital through direct cross-sectoral


Principal value in USD m

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Marcelo Ramella


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80

4

9 11

30 36

23 60 40

237

70

60

57

9/11

Katrina/Rita/ Wilma

Cat Bonds Sidecars Start Ups Recapitalisation

20 0 Andrew

Cat Event Figure 18.5 New capital following large catastrophes.

risk transfers into the capital markets. The number of “first timer sponsors” more than doubled between 2002 and 2007. 23 Also, in addition to the growth of new entrants, there has been growth in the average size of each individual issuance, as well as a lengthening of the average maturity (e.g., while pre-1999 cat bonds had on average a 12-month maturity, ten years later, this was nearly three times as long). This has impacted on the variety and mix of perils that are covered. While multiperil bonds were rare in the mid 1990s, they represented over 50% of all issuances by 2008/2009. Moreover, while the first cat bonds covered mostly U.S. wind and U.S. earthquake, by 2007 perils coverage spanned from European hail to Puerto Rican hurricane to Taiwan earthquake.

Regulating and Supervising Insurance Securitization The quantitative growth in insurance securitization and the qualitative expansion of securitized arrangements have been accompanied by a variety of developments in regulatory and supervisory frameworks. 24 It is important to note that regulatory developments that address insurance securitization have followed national policies on the matter, resulting in a variety of dissimilar frameworks and approaches. The European Union’s (EU) work in this respect, in particular the Reinsurance and the Solvency II Directives, 25 provide the only examples of a regional approach to the issue. However, both directives still leave plenty of implementation latitude to EU members. Outside the EU, and as early as 1999 in the United States, the National Association of Insurance Commissioners (NAIC) developed and adopted a model act 26 for the regulation and supervision of protected cell companies aimed at facilitating onshore securitizations. 27 Further, NAIC’s efforts to contribute to the regulation and supervision of insurance securitization continued with the adoption in 2001 of a model act on special purpose entities. 28 Within North America, Bermuda has, over the years, developed a regulatory and supervisory framework to handle insurance securitizations. The first step in this direction was the 1998 Amendment of Bermuda’s Insurance Act (1978), in


Share of New Capital (%)

100

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order to provide a mechanism to facilitate the creation of insurance securitization arrangements. 29 Further, in 2000 legislation that enabled the creation of segregated accounts companies was passed.30 But probably the most comprehensive revision of Bermuda’s regulatory and supervisory framework with respect to insurance securitization was undertaken in 2008 and 2009. During this period, the introduction to law of the Special Purpose Insurer31 via the Insurance Amendment Act (2008), and the publication in 2009 of the Guidance Note on Special Purpose Insurers (SPIs)32 by the Bermuda Monetary Authority (BMA)33 occurred. The BMA’s Note sets out guidance in relation to the Authority’s licensing and supervisory regime in relation to SPIs. Notwithstanding national differences, there are some common threads that are emerging among most regimes. These include: the creation in law of the category of the special purpose insurer; the differentiated nature of the special purpose insurers, particularly in relation to licensing, ongoing supervision, and capital requirements; the subordination of investors’ claims on the assets of the special purpose insurers to those of the cedent; and the fully funded nature of the special purpose insurer. Importantly, a common element among most supervisory arrangements is the reliance on both quantitative and qualitative information in the assessment of the soundness of insurance securitization arrangements.34 Finally, the International Association of Insurance Supervisors (IAIS) is currently engaged in the production of dedicated standards and guidance, with respect to the supervision of insurance risk transfer to the capital markets.

Lessons Learned from 14 Years of Insurance Securitization Practice This section revisits the 320-plus insurance securitization arrangements that have taken place since 1996, by looking at them as a body of empirical evidence from which to gain understanding on the working of insurance securitizations in practice. The analysis focuses on those cases that have put the soundness of the securitization arrangements under stress. In particular, attention is paid to the sources of stress, the response of the arrangements, and the markets to the stress sources, as well as the overall consequences and lessons from the stress episode. For the purpose of analytical clarity, the section is broken down into two parts: the first section looks at those deals put under stress by sources originating in the core insurance underwriting element of the securitization arrangement (e.g., the occurrence of a cat event), while the second part discusses arrangements distressed by motives other than insurance underwriting (e.g., stress emerging from financial difficulties faced by a participant in the deal). Since insurance securitization’s beginnings in 1996, there have been seven cases of arrangements that have been tested by the occurrence of an event that was part of the insurance coverage provided by them. Of these seven, three cases precede 2005 (Georgetown Re, Kelvin Re, and SFL IV), three relate to the 2005 U.S. hurricane season (Kamp Re, Avalon Re, and Olympus Re), and one pertains to the 2008 cat season (Nelson Re). Of these seven cases, one was a sidecar (Olympus Re), while the other six were cat bonds. Although the risks covered by these arrangements were varied, the vast majority were risks to property, with just two arrangements covering casualty risks (Georgetown Re and Avalon Re).


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An important finding from the analysis conducted on these seven cases is that following the materialization of the risks insured, all securitization arrangements paid out the claims presented by the sponsors. In short, they fulfilled the purpose for which they were created, that is, to assume risks from a cedent in a manner not dissimilar to a traditional arrangement. Moreover, as claims were paid out from monies held in the SPE created as part of the securitization arrangement, investors in those SPEs suffered losses in relation to the interests and/or dividends yielded by the SPEs, as well as to the principal contributed to the SPEs. Further, with the exception of Avalon Re, which has undergone legal problems emerging mostly from the nature of the casualty risks covered, all other six insurance securitizations tested by the occurrence of cats functioned as expected, suggesting that despite their complex structure, the road from theory to practice proved not to be particularly rough. Attention is now turned to those arrangements distressed by motives other than insurance underwriting. In particular, analysis focuses on distressed insurance securitization arrangements that were affected by the 2008 financial crisis. The cases discussed comprise Willow Re, Ajax Re, Carillon Re, Newton Re, Ballantyne Re, and Orkney Re. Ajax Re, Carillon Re, Newton Re, and Willow Re are four SPEs that were arranged between 2006 and 2007 to issue cat bonds in order to provide their sponsors with property catastrophe risk coverage, from California earthquakes to U.S. windstorms. Importantly, all four bonds benefited from Total Return Swap (TRS) arrangements entered into with Lehman Brothers Special Financing, a subsidiary of the investment bank Lehman Brothers. The TRS acted as a credit enhancement tool for both the cedents and investors. The TRS committed Lehman Brothers Special Financing to paying fixed interest rates to investors, that is, Libor plus set spread (i.e., interest rate swap element of the total return swap), and to make up for any funding deficiency experienced by the funds held by the SPEs to cover any losses experienced by the sponsor, or to pay back the principal to investors at maturity. Lehman Brothers declared bankruptcy in September 2008. The bankruptcy triggered the termination of the TRSs. This severely affected the structure of the four securitization arrangements, changing the fully funded nature of the transaction, and triggering a series of security downgrades by the rating agencies. In addition, the secondary market value of the bonds dropped dramatically.35 Looking at the interest rate element of the TRSs, all four cat bonds lost the ability to guarantee a fixed return to investors. In the case of Willow Re, as the bond’s coupon became due, the bond defaulted on its obligations. With respect to the principal element of the TRSs, all four cat bonds lost the ability to guarantee a committed level of funding. Different from the interest rate issue that affected investors in the bond, this has serious implications for both investors and cedents. The SPE’s funds, it should be remembered, are there to protect cedents from losses emerging from the insurance risks ceded, and, should no loss occur, funds are there to be returned to investors. The adverse market conditions that stemmed from the 2008 financial crisis generated deterioration in the value of the assets held in the SPEs. As bonds matured, the SPEs became unable to return principal to the investors. It is important to note that while the value of three of the four bonds was almost halved (i.e., Carillon, Newton Re, and Willow Re), one bond lost four-




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Marcelo Ramella Deterioration of Four ILS which had Lehman as a Swap Counterparty (Lehman Bankruptcy September 15th)

110

100

90

70 $ 60

50

Ajax Carillon A-1 Newton Re 2008 A-1 Willow Re

40

30

Aug

15-Sep

30-Sep

15-Oct

30-Oct

20 14-Nov

Figure 18.6 ILSs and the 2008 financial crisis.

fifths of its value (Ajax Re). Among the factors that help better illustrate this difference, it should be pointed out that in the case of Ajax Re, funds invested in collateral to secure the swap arrangements included bonds issued by another SPE called Ballantyne Re, a life insurance securitization. Ballantyne Re, in turn, held a significant amount of assets in subprime and Alt-A mortgage-backed securities.36 As the market value of these assets declined significantly, Ballantyne Re’s assets suffered substantial impairment and the market value of the securities issued by Ballantyne Re also declined, generating a contagion effect impacting on the drop in the value of funds held by Ajax Re. To conclude, looking at 14 years of practice in relation to insurance securitizations, two key messages emerge. First, albeit based on a small pool of seven cases, the empirical evidence yielded by all the insurance securitizations tested by the materialization of the risks insured shows that these have proved to cope well. Second, the analysis of the impact that the 2008 financial crisis has had on insurance securitization indicates that insurance securitization has to be understood and handled as inextricably tied to the wider financial markets, that is, not immune from events occurring outside the narrow realm of insurance.


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Our exploration of insurance securitization has taken us through the conceptual and empirical building blocks and the forces shaping these arrangements, and in particular through some of the key challenges presented by this type of convergence between financial markets. From this journey, some clear messages have emerged. First, insurance securitization constitutes a socially useful financial innovation that provides valid sources of risk capital for insurance and reinsurance companies, and also offers clear attractions to capital market investors. It is a phenomenon which has experienced a steady growth since it emerged in the second part of the 1990s. Second, and as the effects of the 2008 financial crisis continue to unfold, insurance securitizations have to be understood and handled as inextricably tied to the wider financial markets, that is, not immune from events occurring outside the narrow realm of insurance. Finally, in light of the wealth of regulatory and supervisory developments that have accompanied the growth process of insurance securitization, the emerging trend toward incorporating securitizations into the supervisory machinery seems to offer a sound path toward handling this type of innovation in a systematic and coordinated manner by regulatory and supervisory authorities worldwide. This, as the 2008 financial crisis has made evident, must be applauded as a sound and very timely development.

Notes This chapter draws on contributions made by the author to the first Midyear Edition of the Global Reinsurance Market Report (MYE GRMR) by the International Association of Insurance Supervisors (IAIS 2009). As a member of the working group responsible for drafting the MYE GRMR, the author acknowledges his indebtedness and gratefulness to all the other members of group for the many insights that the stimulating discussions and exchanges had in the process of developing the IAIS paper. The views expressed in this chapter are the author’s own and do not necessarily ref lect the views of the Bermuda Monetary Authority. 1. 2. 3. 4. 5.

6. 7. 8.

9. 10. 11.

(Awerbuch and Hyman 1997). (Kothari 2006). (Cummins 2008). (IAIS 2009). Although the concept of “true sale” may, in theory, imply a complete disengagement from the part of the seller (the originating bank) with respect to the item sold, in practice other factors (e.g., reputational risks considerations from the part of the originator) have blurred this distinction. (Cowley and Cummins 2005). For details see (The Joint Forum 2009). (CEIOPS 2009), (Finken and Laux 2009), (Froot 2001), (Froot and O’Connel 2008), (Topolek 2009), (Wharton Risk Management and Decision Processes Center 2008), (World Economic Forum 2008). (IMF 2008) (available at www.imf.org). (Allen and Wood 2006). (Poloz 2006)


Conclusions


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12. (Schinasi 2003), (Weber and Arner 2007) 13. (Sigma 2003), (Trainar 2004), (Group of Thirty 2006), (Harrington 2009), (Brunnermeier et al. 2009). 14. Please refer to (Cummins and Weiss 2009) for a review of ART. 15. (IAIS 2008). 16. Please refer to chapter by John Schwolsky and Matthew Stern. 17. For a comprehensive review of sidecars please refer to (Ramella and Madeiros 2007). 18. For details on “Regulation X X X” please refer to “Valuation of Life Insurance Policies Model Regulation,” printed in VIII National Association of Insurance Commissioners, Model Laws, Regulation and Guidelines, 830–1 (April 1999). 19. For details on “Actuarial Guideline AX X X” please refer to National Association of Insurance Commissioners, Accounting Practices and Procedures Manual, Statement of Statutory Accounting Principles, Appendix C, at C-130 (2004). 20. (Boller 2009). 21. (Lane and Berwick 2009). 22. (Lane, in Klein 2008). 23. (AON 2008). 24. (Wang 2003), (Klein and Wang 2007), (Klein 2009). 25. Directive 2005/68/EE of the European Parliament and of the Council of November 16, 2005, on reinsurance, or the “Reinsurance Directive”; Directive of the European Parliament and of the Council on the taking-up and pursuit of the business of insurance and reinsurance, or the “Solvency II Directive.” 26. Model acts provide nonmandatory frameworks to be adapted or adopted by U.S. states. 27. See (NAIC 1999) “Protected Cell Company Model Act.” 28. See (NAIC 2001) “Special Purpose Reinsurance Vehicle Model Act” of October 24, 2001. 29. See (Bermuda Insurance Act 1978) and (Bermuda Insurance Amendment Act 1998), in particular with respect to Section 57A ) (available at www.bermudalaws.bm). 30. See (Bermuda Segregated Accounts Companies Act 2000), (Segregated Accounts Companies Amendment Act 2002), and (Segregated Accounts Companies Amendment Act 2004) (available at www.bermudalaws.bm). 31. See (Bermuda Insurance Act 1978) and (Bermuda Insurance Amendment Act 2008) (available at www.bermudalaws.bm). 32. See Bermuda Monetary Authority Guidance Note N.20 ‘Special Purpose Insurers’ (available on www.bma.bm). 33. See The Bermuda Monetary Authority is Bermuda’s single financial services regulator. 34. For further discussion on qualitative approaches to insurance securitization regulation and supervision see (Ramella and Madeiros 2007), and (Machler 2009). 35. (Lane 2008). 36. Alternative A-paper, or Alt-A, are mortgage-backed securities which are considered of less risk than subprime mortgage-backed securities, but riskier than Á-paper or prime mortgage-backed securities.


242

Bibliography Allen, W. and G. Wood. “Defining and achieving financial stability.” Journal of Financial Stability 2, no. 2 (2006): 152–172.


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AON. Insurance Linked Securities 2008. Chicago: AON Capital Markets, 2008. Awerbuch, S. and S. Hyman. “Demystification—the economic realities of securitization.” The Electricity Journal 10, no. 8 (1997): 27–37. Boller, H. “The Market for Insurance Linked Securities: An Investor’s Perspective.” Presentation delivered at the Future Talk Series (n. 1) of the Institute of Insurance Economics of the University of St. Gallen, May 2009. Brunnermeier, M., A. Crocket, C. Goodhart, A. Persaud, and H. Shin. The Fundamental Principles of Financial Regulation—Geneva Reports on the World Economy 11, Geneva, Switzerland: International Center For Monetary And Banking Studies, 2009. CEIOPS. “Draft CEIOPS Advice for Level 2 Implementing Measures on Solvency II: Special Purpose Vehicles, Consultation Paper No. 36.” March 2009. Cowley, A. and D. Cummins. “Securitisation of Life Insurance Assets and Liabilities.” The Journal of Risk an Insurance 72, no. 2 (2005):193–226. Cummins, D. “Cat bonds and other risk-linked securities: State of the market and recent developments.” Risk Management and Insurance Review 11, no. 1 (2008): 23–47. Cummins, D and M. Weiss. “Convergence of Insurance and Financial Markets: Hybrid and Securitized Risk Transfer Solutions.” The Journal of Risk and Insurance 76, no. 3 (2009): 493–545. Finken, S. and C. Laux. “Catastrophe Bonds and Reinsurance: The Competitive Effect of Information-Insensitive Triggers.” The Journal of Risk and Insurance 76, no. 3 (2009): 579–605. Froot, K. “The Market for Catastrophe Risk: A Clinical Examination.” Journal of Financial Economics 60 (2001): 529–571. Froot, K. and P. O’Connel. “On the Pricing of Intermediated Risks: Theory and Application to Catastrophe Reinsurance.” Journal of Banking and Finance 32 (2008): 69–85. Group of Thirty(G30). “Reinsurance and International Financial Markets.” 2006. http://www.group30.org. Harrington, S. “The financial crisis, systemic risk, and the future of insurance regulation—public policy paper of the National Association of Mutual Insurance Companies, Issue Analysis—September 2009.” National Association of Mutual Insurance Companies. 2009. IAIS. “Developments in (Re)insurance Securitization.” 2009. www.iaisweb.org. ———. “Global Reinsurance Market Report.” 2008, www.iaisweb.org. IMF. “Global Economic Outlook of April 2008: Housing and the Business Cycle.” 2008. Klein, R. “Securitizing Catastrophe Risk in the U.S.—An Economic and Regularoty Perspective.” In Convergence of Capital and Insurance Markets, edited by D. Topolek. St. Gallen, Switzerland: Institute of Insurance Economics, University of St. Gallen, 2009. Klein, R and S. Wang. “Catastrophe risk financing in the US and the UU: A Comparative Analysis of Alternative Regulatory Approaches.” Georgia State University Department of Risk Management and Insurance. 2007. http://www.rmi.gsu.edu/insurance_ regulation/rel_papers/KleinWang_Regulation_11–19-07.pdf. Kothari, V. Securitization: the Financial Instrument of the Future. Singapore: John Wiley & Sons (Asia) Pta. Ltd, 2006. Lane, M. “What Were We Thinking?” Wilmette, IL, USA: Lane Financial, LLC, 2008. Lane, M. and R. Berwick. “The Annual 2009 ILS Review—And Q1 2009 Quarterly Performance Review: Change We Can Believe In.” Wilmette, IL, USA: Lane Financial, LLC, 2009.




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Machler, M. (2009) Insurance regulation of securitization evolving towards more qualitative methodologies. In D. Topolek (ed) Convergence of Capital and Insurance Markets. St. Gallen, Switzerland: Institute of Insurance Economics, University of St. Gallen. Poloz, S. “Financial stability: a worthy goal, but how feasible?” Journal of Banking and Finance 30 (2006): 3423–3427. Ramella, M. and L. Madeiros. “Bermuda Sidecars: supervising reinsurance companies in innovative global markets.” The Geneva Papers on Risk and Insurance—Issues and Practice 32, no. 3 (2007): 345–363. Schinasi, G. “Responsibility of Central Banks for Stability in Financial Markets.” IMF Working Paper WP/03/121. Washington DC, USA: International Monetary Fund, 2003. Sigma. “Reinsurance—A Systemic Risk?” Number 5/2003. The Joint Forum. “Report on Special Purpose Entities.” Basel, Switzerland: Joint Forum. 2009. www.bis.org. Topolek, D. “Convergence of Capital and Insurance Markets.” Institute of Insurance Economics, University of St. Gallen, 2009. Trainar, P. “Insurance and Financial Stability.” Banque de France—Financial Stability Review No. 5 (November 2004). Paris, France: Bank de France, 2004. Wang, W. “Reinsurance Regulation—A Contemporary and Comparative Study.” The Hague, Netherlands: Kluwer Law International, 2003. Wharton Risk Management and Decision Processes Center. “Managing Large-Scale Risks in a New Era of Catastrophes.” 2008. Weber, R. and D. Arner. “Toward a New Design for International Financial Regulation.” University of Pennsylvania Journal of International Law 29, no. 2 (2007): 391–453. World Economic Forum. “Convergence of Insurance and Capital Markets.” 2008.


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Structuring Catastrophe Bonds: A Functionalist Perspective John Schwolsky and Matthew Stern

It is the pervading law of all things organic and inorganic, of all things physical and metaphysical, of all things human and all things super-human, of all true manifestations of the head, of the heart, of the soul, that the life is recognizable in its expression, that form ever follows function. This is the law. —Louis Henri Sullivan

Introduction Developed in the mid-1990s as a way to tap additional retrocessional capacity, catastrophe bonds combine aspects of both the reinsurance and capital markets.1 While this dual nature often gives rise to advantageous pricing opportunities for companies looking to reduce their property and casualty (P&C) risk, it also presents several structural challenges resulting from the different, and sometimes incongruous, manner in which the reinsurance and capital markets operate. In particular, the counterparty relationship for securities offerings is fundamentally more diffuse and passive than traditional reinsurance. Consequently, catastrophe bonds are more susceptible to collective action problems, such as inherent difficulties policing loss development and monitoring collateral stability. In addition, capital markets transactions typically require a greater degree of loss transparency and standardization in order to enhance liquidity, something that is generally not a concern for traditional reinsurance. 2 This chapter is about structuring catastrophe bonds; told from a functionalist perspective, it seeks to analyze the goals and effectiveness of various catastrophe bond structures. More specifically, this chapter is about how, through careful planning, many of the incompatibilities between the reinsurance and capital markets can be eliminated, or at least significantly reduced. Because a useful and detailed discussion of every type of catastrophe bond would require an undertaking far


Chapter 19


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John Schwolsky and Matthew Stern

greater (and lengthier) than the present work, we will focus on general structural decisions that transaction parties must consider in the offering process. In order to highlight the salient aspects of structural design, we will examine three broad categories. First, we will provide a brief analysis of the overall catastrophe bond architecture, including a high-level summary of how the various components fit together. Second, we will compare common loss triggers, focusing on certain advantages and disadvantages of each mechanism, in light of the risk transfer and capital markets nature of catastrophe bonds. In particular, we will analyze each loss trigger by the often competing criteria of basis risk, moral hazard, transparency, and timely loss development. Finally, we will examine the main collateral structure employed by many older catastrophe bonds, and we will highlight recent innovations in the wake of the global financial crisis. The bankruptcy of Lehman Brothers in 2009, which was then swap counterparty to four outstanding bonds, was a landmark event for the catastrophe bond market, and brought renewed attention to reducing credit risk and increasing transaction transparency. As investors continue to express a demand for assets that offer high investment return without being directly correlated to the broader financial markets, we believe that the potential for catastrophe bonds as an alternative asset class is just beginning to be realized. The continuing efforts to fine-tune existing structures, as well as improving the reinsurance and capital markets component of design, will only further enhance catastrophe bonds as a popular vehicle for risk transfer.

Overview General Description of Catastrophe Bonds Catastrophe bonds are principal-at-risk debt securities that are sponsored by insurance or reinsurance companies in order to facilitate the direct transfer of low frequency, high severity risk to the capital markets. Unlike more traditional debt securities, which obligate the issuer to repay the full principal amount at maturity, the outstanding principal of a catastrophe bond is reduced upon the occurrence of one or more specified “catastrophe” events. These catastrophe events often include natural disasters, such as hurricanes and earthquakes, 3 but can include extreme mortality resulting from pandemics and terrorism. While there are many variations on a theme, figure 19.1 illustrates a common catastrophe bond structure. This structure typically has three component elements: (1) the risk transfer contract, which can take the form of a reinsurance agreement or derivative contract; (2) the securities issued to investors, the proceeds of which are used to collateralize the risk transfer contract; and (3) the collateral arrangement, whereby the issuer invests the proceeds from the bond issuance in order to generate additional earnings for investors. The particular structure depicted in figure 19.1 utilizes a triparty repurchase agreement to generate a London Interbank Offered Rate (LIBOR)- or Euro Interbank Offered Rate (EURIBOR)-linked return for investors. This collateral arrangement, which is a recent innovation in the catastrophe bond market, resolves some of the investment deficiencies that existed in offerings prior to the global financial crisis, while at the same time reducing inf lation risk.


246


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Triparty Agent

Investment earnings Quarterly repurchase transactions*


Repurchase Counterparty

Eligible Investments (trust or collateral account)

Triparty Repurchase Agreement

Daily margining of assets

*

ad

re

Proceeds from notes

p ps

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e

nc re

te ra

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fe Re

Issuer

Interest spread* Outstanding principal amount at maturity

Investors

Floating reference rate*

Figure 19.1

Premiums

*Paid on a quarterly basis

Sponsor

Contingent loss payments

Underlying Portfolio of Risk

Administrative costs

Collateral spread* (if applicable)

Interest spread*

Contingent loss payments

Risk Transfer Contract

Original principal amount


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In a typical catastrophe bond structure, an insurance or reinsurance company, often referred to as the sponsor, enters into a risk transfer contract with a newly formed and nonaffiliated special purpose entity (SPE), usually domiciled in either the Cayman Islands or Ireland.4 This special purpose entity, which is the issuer of the catastrophe bond, is thinly capitalized, has no employees, and is restricted from engaging in business activities other than those related to the risk transfer contract and the securities. Because the issuer does not have the capabilities to manage its initial start-up and ongoing activities for the life of the transaction, it enters into an administration agreement with a reputable financial services company to provide day-to-day administrative service. In addition, because the issuer is thinly capitalized and does not have independent opportunities to generate revenue, the sponsor of the transaction is contractually obligated to pay for the issuer’s ongoing administrative costs, including any service contracts into which the issuer has entered. These administrative costs are generally small compared to the overall size of the transaction.

Loss Payments At the heart of the catastrophe bond structure are the contingent loss payments that the issuer may become obligated to pay the sponsor pursuant to the risk transfer contract. In order to fund and collateralize these loss payments, the special purpose entity issues principal-at-risk variable rate debt securities to investors, with terms that mirror the risk transfer contract.5 Catastrophe bonds are almost always offered only to large, sophisticated institutional investors in certain permitted jurisdictions 6 pursuant to an exemption from registration under Rule 144A. This means that the catastrophe bond market, both for primary and secondary sales, typically includes only large, institutional investors in major financial jurisdictions. If a covered loss occurs to the layer that is at-risk, the principal of the notes (and interest earned on such principal) will be reduced by such loss, and certain of the issuer’s collateralized assets will be sold to fund a loss payment to the sponsor pursuant to the risk transfer contract. Figure 19.2 depicts a hypothetical layer of risk that is ultimately transferred to bondholders. The attachment and exhaustion level are typically set in advance of the offering, and are subject to annual, or more frequent, resets that adjust the layer in order to maintain a maximum attachment probability and expected loss throughout the life of the transaction.7 The calculation of losses, which determines whether the sponsor has reached the at-risk layer, can be based on several trigger types, including an indemnity-based, index-based, parametric, or modeled loss trigger. In addition, losses under the risk transfer contract can accrue on a per occurrence basis for each catastrophe event, or be aggregated over a specified period. These loss triggers have enormous implications on the basis risk of the transaction and the pricing of the security.


The Issuer

Interest Payments In exchange for ceding a layer of catastrophe risk, the sponsor of the transaction will make periodic payments to the issuer that are used to fund a fixed rate of


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Structuring Catastrophe Bonds

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249

Sponsor’s Risk Layer Closing Date

Reset Date

$100 million Attachment Level

$245 million

Retained share*

Updated Exhaustion Level

$95 million Updated Attachment Level The Updated Attachment Level is set such that the probability of attachment is no greater than the initial probability

*Assumes an original principal amount of $100 million. Many catastrophe bonds utilize a coinsurance percentage in order to take account of a layer that is larger or smaller than the outstanding principal amount of the notes.

Figure 19.2

interest on the bonds, typically referred to as the interest spread. As a result of the at-risk nature of the security, the interest spread that is paid by the sponsor ref lects the attachment probability and expected loss of the transaction. Just as the traditional bond market demands an interest rate based, in part, on the risk of default, the fundamental risk for a catastrophe bond investor is tied to contingent covered events that imperil the return of principal. To the extent that other forms of risk seep into a particular structure, including credit and inf lation risk, this will make the offering a less attractive investment and put upward pressure on the interest spread that the sponsor must pay to the issuer. While the issuer pays premiums linked to the catastrophe risk component of the transaction, many transactions utilize a collateral arrangement to generate additional investment returns for bondholders and to reduce inf lation risk. Prior to the collapse of Lehman Brothers, the vast majority of transactions utilized a total return swap to fund a LIBOR/EURIBOR-linked return for investors, while harnessing the balance sheet of the swap counterparty as credit support against potential investment losses. However, these structures proved inadequate to deal with simultaneous declines in asset value and counterparty insolvency. In response to the global financial crisis, several catastrophe bonds that were issued during


$300 million

Retained share*

Exhaustion Level

33%

50%

The Updated Exhaustion Level is independent of the Updated Attachment Level and is set such that the expected loss is no greater than the initial expected loss


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2009 invested their offering proceeds in highly conservative assets, such as U.S. Treasury-backed money market funds, and paid investors the actual investment yield in lieu of a f loating reference rate. More recently, as financial markets have started to stabilize, some issuances have utilized a triparty repurchase agreement to generate a LIBOR/EURIBOR-linked return. The triparty repurchase arrangements utilized to date require the counterparty to margin assets daily, and have been enhanced to significantly reduce the credit and counterparty risks inherent with the older total return swap technology. As central banks begin to reverse quantitative easing, and the spread between money market funds and LIBOR/ EURIBOR widens, we believe that the triparty repurchase agreement will become increasingly attractive to sponsors and investors, relative to other collateral funding mechanisms.

Loss Triggers Criteria Catastrophe bonds utilize four principal trigger types to calculate losses—indemnity-based, index-based, modeled loss, and parametric triggers—although there are many different variants that may not fit neatly into these broad categories. Each of these four trigger types has unique competitive advantages that make it the best fit for a specific offering. In selecting a particular loss trigger, one should be mindful of both the sponsor’s risk transfer goals and the needs of the capital markets, which are sometimes in tension with one another. Therefore, before analyzing the specific mechanics for each broad category, it is helpful to review the criteria by which such loss triggers should be evaluated by investors and sponsors. These include: Basis Risk. In the context of a catastrophe bond, basis risk is the risk that the loss trigger will not accurately replicate actual losses that are incurred by the sponsor. As a vehicle for transferring catastrophe risk to the capital markets, the removal or reduction of basis risk is one of the most important concerns of the sponsor in structuring a transaction, as well as a potential issue for rating agencies and regulators. If catastrophe bonds could not transfer risk as effectively as traditional reinsurance, their viability as an alternative risk transfer product would be severely challenged. Moral Hazard. In the context of a catastrophe bond, moral hazard is the risk that the sponsor will act differently because the risk transfer contract with the issuer provides the sponsor with protection for certain losses. This risk is most applicable to indemnity-based transactions for which the sponsor may have an incentive to pay out losses to cedants or policyholders, rather than challenging claims. In addition, although moral hazard is a function of all insurance and reinsurance, it has increased importance for a catastrophe bond because investors have an inherently more passive role in the loss development process. While moral hazard can be reduced in indemnity-based transactions, it cannot be eliminated entirely.


250

Transparent and Predictable Metrics. As a capital markets product, the metrics for determining losses should be transparent, accurate, quantifiable, reasonably simple, and clearly defined. 8 In order for a liquid market to develop, investors need to


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be able to appreciate and price the risks to which they are exposed, both at the beginning of the transaction and after a loss event has occurred. Loss Development Period. It is important for a loss trigger to quantify a final loss number over a reasonably short period of time. An inordinately long development period will cause uncertainty for the market, and have an adverse effect on liquidity and secondary market prices.

With these criteria more clearly defined, we can more easily observe the advantages of each trigger type, as well as the purpose for their design. Each loss trigger has evolved in different ways to meet the often competing goals of transaction sponsors and investors. Consequently, determining which loss trigger is optimal for a particular transaction requires a fact-specific analysis of the sponsor’s risk transfer needs and the broader market conditions.9 Indemnity-Based Trigger. In an indemnity-based transaction, losses under the risk transfer contract are based on actual losses to the sponsor. Unlike other loss triggers, an indemnity-based transaction most closely resembles traditional reinsurance in that there is little basis risk, if any. The main forms of basis risk in an indemnity-based transaction are from contract and loss types that cannot be easily modeled and included in the risk analysis. In these cases, sponsors typically use an adjustment factor in the modeling and loss calculation in order to approximate actual losses from these contract or loss categories. While the opportunity to reduce basis risk is attractive to sponsors, indemnitybased transactions present several challenges for the capital markets. For example, indemnity-based transactions are subject to moral hazard risk that may be difficult for investors to monitor. In order to mitigate this risk, most indemnity-based transactions require the sponsor to retain 10% of the at-risk layer. This gives the sponsor “some skin in the game,” and helps reduce moral hazard by more closely aligning the sponsor’s and investors’ interests. In addition, because losses under an indemnity-based transaction are idiosyncratic to a particular sponsor, the loss development from a covered event is generally not as transparent or uniform as other loss triggers, particularly index-based or parametric triggers. This means that it is often more difficult for investors to price a security accurately, or to monitor the loss development when a covered event has occurred. Consequently, as an important concession to investors in policing the loss development process, many transactions have utilized a third-party claims reviewer and a loss reserve specialist to verify the claims submitted under the risk transfer contract. Finally, losses in an indemnity-based transaction develop over a relatively long period of time, particularly compared to the three-year maturity of most catastrophe bonds. For example, many indemnity-based transactions permit the sponsor to commute the issuer’s liability for loss reserves only after a minimum loss development period, which is typically 18–24 months. If a covered event has occurred toward the end of the scheduled maturity date, this long loss development may subject investors to an extension event, whereby the sponsor has the right to extend


Trigger Mechanisms


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the transaction (although not the risk period) for up to 18–24 months at a much lower interest spread.

Index-based transactions, especially those that use reliable and transparent indices, have certain key advantages over indemnity-based offerings.10 First, because losses under the risk transfer contract are based on an external index, there is only limited moral hazard risk in the structure. Second, the use of a widely-recognized index gives the investor a degree of transparency, standardization, and simplicity that is difficult to achieve by using indemnity-based triggers. All of these factors are important for creating a liquid market for the securities. Nevertheless, index-based triggers insert basis risk into the structure, because the risk exposure to a particular sponsor may not match the wider industry. This exposure to basis risk is often undesirable for sponsors, especially if significant. For example, a sponsor may write more of its business in certain geographic regions than the broader industry, or it may (re)insure a specific kind of property risk that is not accurately ref lected in the industry data. In order to mitigate basis risk, many index-based transactions utilize payout factors to approximate market share and risk exposure in particular geographic areas. These payout factors usually apply to state losses (in the case of U.S. perils), although certain modeling techniques have been utilized recently to provide granularity to the county level. Determining whether the basis risk from an index-based trigger is acceptable to a sponsor requires a highly fact-specific analysis of the underlying portfolio and the sponsor’s tolerance for basis risk. In addition, index-based transactions often take a long time to develop. Like the losses to a particular sponsor in an indemnity-based transaction, the losses to the wider industry will develop over a relatively long period of time, sometimes lasting up to 18–24 months, and subject investors to the uncertainties of multiple extension events. Parametric Trigger. In a transaction that utilizes a pure parametric trigger, the reported physical properties of the catastrophe event (e.g., windspeed, magnitude, or some other applicable metric) are applied to a predefined formula in order to determine losses under the risk transfer contract. Like an index-based trigger, a parametric trigger inserts basis risk in the structure, which is undesirable from the sponsor’s perspective. While this basis risk can be reduced by fine-tuning the formula and using more granular data, it cannot be eliminated entirely. Key advantages for parametric triggers include the transparency, simplicity, and rapidity of the loss development. Once the physical properties of an event are reported, the loss to the bond can be calculated quickly and by nearly all market participants.


Index-Based Trigger. In an index-based transaction, losses under the risk transfer contract are based on an index of total industry losses provided by a recognized reporting service. The most common index used for U.S. perils is published by Property Claims Services, although certain European-based indices have become increasingly popular in recent years.

Modeled Loss Trigger. Similar to a parametric trigger, in a modeled loss transaction, the reported physical properties of the catastrophe event are entered into a customized model of the sponsor’s portfolio. This model is typically created before the transaction and placed into escrow at the time of closing. To the extent that the underlying portfolio has shifted over the course of the transaction, the underlying


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In selecting a particular loss trigger for a catastrophe bond offering, there is an inherent tension between the sponsor’s aversion for basis risk and the investors’ needs for a transparent, predictable, and expeditious loss development. While indemnity-based triggers typically have the lowest amount of basis risk, the presence of moral hazard in the structure, as well as the relatively long and idiosyncratic loss development process, can have negative implications for investors. On the other hand, while index-based, parametric, and modeled loss triggers are more beneficial from a market perspective, they insert basis risk into the structure, which may be undesirable for the sponsor. Consequently, there is no one loss trigger that will enable all of the risk transfer and capital markets goals to be achieved. However, careful design in the structuring process, including using the proper loss trigger for the particular circumstance, can enable an offering to achieve its most fundamental goal—transferring risk effectively to the capital markets at an optimal price.

Collateral Arrangements Catastrophe bonds have traditionally been viewed as vehicles for transferring catastrophe risk, with less attention paid to the uncertainties of credit and counterparty risk.12 As the recent global financial crisis has demonstrated, however, large market dislocations can affect catastrophe bond investors and sponsors in a manner that is similar to actual catastrophe events.13 While market participants have long recognized that catastrophe bonds were not immune from credit and counterparty risk, the sudden collapse of Lehman Brothers and other financial institutions has brought renewed attention to the collateral arrangement, particularly the total return swap structure that was utilized prior to 2009.

Pre-Lehman Bankruptcy Total Return Swaps Under the pre-Lehman bankruptcy total return swap arrangement (figure 19.3), the proceeds from the catastrophe bond offering were invested in certain “hardwired” permitted investments and held as security for the issuer’s obligations to the swap counterparty, the sponsor, and the noteholders.14 In part because U.S. employee benefit plans could hold beneficial interests in the bond offering (which could subject the issuer, sponsor, and swap counterparty to heightened duties under the Employee Retirement Income Security Act [ERISA], many structures utilized investment guidelines, negotiated prior to closing, that limited the active management of the collateral through a predetermined list of securities and methodology for investing. Absent a downgrade or default of permitted investments, these guidelines made it difficult for the issuer to replace at-risk investments with more liquid assets, even when the value of such assets had deteriorated significantly. Once invested, the issuer would typically swap the investment earnings in the collateral account with the swap counterparty, in exchange for a f loating reference


basis risk will increase. Also similar to parametric triggers, the loss development period in a modeled loss transaction is relatively short, and a final loss amount can be determined quickly by the third-party calculation agent by entering the physical characteristics of the peril into the model. However, unless investors have access to a copy of the model, this process can act as a “black box” and reduce transparency.11


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John Schwolsky and Matthew Stern Pre-Lehman Total Return Swap

fe

nc

e

ra

te

±

sw

ap

sp

re

ad

*

Realized losses

re

Investment earnings**

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Figure 19.3

rate. To the extent that the permitted investments generated any interest or realized gains, the issuer was obligated to pay these investment earnings to the swap counterparty as they accrued. Conversely, the swap counterparty was obligated to make quarterly payments to the issuer equal to the f loating reference rate,15 and to pay the issuer for any losses on the permitted investments on the redemption date and following the occurrence of one or more covered events.16 This collateral structure utilized a two-pronged mechanism to mitigate any credit and counterparty risk: (1) to the extent that the assets declined, the issuer could look to the swap counterparty for investment losses; and (2) to the extent that the swap counterparty was insolvent, the issuer still had recourse to the highly rated underlying assets. Nobody fully appreciated that both the credit and counterparty risk in the total return swap structure was so inextricably correlated—at least not until the global financial crisis.

Lessons Learned


Issuer

Proceeds from the notes

In designing new collateral arrangements for catastrophe bond structures, certain lessons can be learned from the pre-Lehman bankruptcy total return swaps, including: • Limiting the definition of permitted investments to fit more squarely with sponsor and investor risk appetite. For instance, many new collateral structures have tightened the investment criteria by, among other things: (i) prohibiting the issuer from investing in illiquid categories of securities, such as collateralized debt obligations and mortgage-backed securities; (ii) placing concentration limits on the overall mix of the portfolio; and (iii)


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•

•

•

•

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shortening the maximum duration of investments to be more consistent with the medium-term nature of catastrophe bonds. To show how far the pendulum has swung in this direction, the majority of catastrophe bonds in 2009 invested the collateral in U.S. Treasury-backed money market funds, which are believed to be one of the safest investments in the marketplace. Regularly requiring the counterparty to margin or top up the assets in order to account for any unrealized losses to the collateral. While some offerings in late 2007 and during 2008 began to utilize a “top-up” mechanism if the market value of the permitted investments fell below a predefined threshold, in hindsight these provisions were not robust enough to deal with a Lehman bankruptcy-like event. In contrast, under the triparty repurchase agreements that were utilized in midto late 2009, the repurchase counterparty is required to margin the assets on a daily basis, based on a third-party valuation of the collateral. In addition, depending on the particular asset class or the counterparty’s financial strength rating, the repurchase counterparty may have to overcollateralize the investment account. This means that, on any given day, the market value of the collateral is required to be equal to or greater than the outstanding principal amount. Allowing for greater discretion and f lexibility in the investment of catastrophe bond proceeds. As discussed previously, the older total return swaps hardwired the investment methodology prior to closing. In contrast, the triparty repurchase collateral structure has been designed with these ERISA considerations in mind; this structure generally permits assets to be added to or removed from the collateral account on a regular basis. Requiring the counterparty to post additional collateral if it is downgraded or shows other designated signs of credit weakness. This could be contingent upon a rating agency downgrade, as is usually the case, or other, more sensitive, metrics. As recent events have shown, a financial institution’s credit rating may be a lagging indicator of its current health and stability. Increasing the transparency of collateral investments so that the market can independently and regularly assess the credit risk that underlies the catastrophe bond. In many new transactions, such as in offerings that utilize a triparty repurchase agreement, asset valuations are posted regularly to an intralinks website set up by the company. This increased transparency has allowed investors to monitor the collateral in real time, which is an important component of enabling liquidity.

New Solutions



In order to reduce credit and counterparty risk for future offerings, several enhanced collateral arrangements have been developed since the last pre-Lehman bankruptcy offering in August 2008. These new collateral arrangements have trended toward two main solutions: (1) investing the proceeds from the issuance in U.S. Treasurybacked money market funds, and eliminating the LIBOR/EURIBOR component of interest to investors; and (2) utilizing a triparty repurchase agreement that is accompanied by daily margining of assets. While the catastrophe bond market has experimented with several other options, including enhanced total return swaps, direct U.S. government obligations, and other government-backed paper, we believe that the market is beginning to settle on these two structures as standard


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Eligible Securities include securities that satisfy one or more of the following criteria:

Eligible Securities

The following are the concentration limits applicable to Eligible Securities: (i) in the case of corporate debt, the adjusted value of the corporate debt of any one issuance of an issuer must not represent more than 5% of the aggregate adjusted value; and (ii) in the case of sovereign debt, the adjusted value of the sovereign debt of any one issuance of an issuer must not represent more than 15% of the aggregate adjusted value. The assets will be margined on a daily basis by the Triparty Agent such that the market value of assets divided by the adjustment percentage is equal to the Outstanding Principal Amount.

Concentration Limit

Margining of Assets


Austria, Belgium, Canada, Cayman Islands, Cyprus, Denmark, Finland, France, Germany, Japan, Jersey, Luxembourg, Malta, the Netherlands, the Netherlands Antilles, Slovakia, Slovenia, Switzerland, the United Kingdom, and the United States.

Eligible Issuer Jurisdictions

(vii) satisfies the Concentration Limit.

(vi) has a quotation age (as determined by the Triparty Agent) of not more than five days; and

(v) is not a mortgage-backed security, an asset backed security, or a collateralized debt obligation;

(iv) is not a convertible instrument;

(iii) has not been issued by any of the following or any affiliate of the Repurchase Counterparty, the Sponsor, and certain correlated issuers;

(ii) has a stated maturity of less than 10 years;

(i) (a) debt securities that are issued by or guaranteed by an Eligible Issuer Jurisdiction, and are rated at least “A-” by S&P; or (b) debt securities that are issued by any corporation incorporated under the laws of an Eligible Issuer Jurisdiction, provided that such corporation has a long-term debt credit rating of at least “BBB” from S&P;

Sample Terms

Structural Issue

Table 19.1


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118 120

102

103

105

113

115

U.S. Agency Debentures

Non-U.S. Sovereign Debt (AA– and above)

Non-U.S. Sovereign Debt (A– and above A+)

Corporate Debt (AA– and above) Corporate Debt (BBB to A+)


110

108

100

101

101

U.S. Treasury Securities (including TIPS and STRIPS)

100

100

Cash

The value of each Eligible Security will be adjusted pursuant to the percentages set forth below in Column I. For the avoidance of doubt, if more than one criteria below applies to any one asset, the relevant percentage shall be the aggregate of the applicable percentages; provided that if the repurchase counterparty is downgraded below [x] by S&P, the percentages set forth in Column II shall be applicable.

Adjustment Percentages

Column I Column II (%) (%)

In respect of an Eligible Security as of any date, an amount determined by the Triparty Agent and equal to the sum of (i) the most recently available closing bid price available to the Triparty Agent from pricing information services generally used by it in pricing securities, and (ii) with respect to fixed income debt securities, accrued but unpaid interest or other distributions, if any; provided that the market value of cash will be its face amount; and provided, further, that where the Triparty Agent is unable to obtain the price of an Eligible Security from the pricing information services it generally uses, the Market Value shall be as determined in good faith by the Triparty Agent in the reasonable exercise of its discretion, based on information furnished to the Triparty Agent by one or more brokers in such Eligible Security or on the basis of a formula utilized by the Triparty Agent for such purpose in the ordinary course of its business.

Market Value

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alternatives. Each of these alternatives has unique advantages and disadvantages that should be considered in selecting a collateral arrangement. On the one hand, investing in money market funds is the simpler of the two structures—a fact that should not be overlooked in today’s market environment. For investors with an insurance background, or those with a newfound aversion to overly structured products, money market funds eliminate many of the complexities found in the total return swap or triparty repurchase agreement. Money market fund investments can be very attractive for catastrophe bonds as an asset class because they showcase the catastrophe risk nature of the security, which is not necessarily correlative to market events. On the other hand, because of the low investment yield generated by U.S. Treasurybacked money market funds, investors in these transactions will not receive an interest rate that is pegged to LIBOR/EURIBOR. To the extent that spreads between money market funds and key interbank offering rates are expected to increase in the near- and medium-term, investors may price this lower yield into the interest spread component of the security, which will increase the cost to the sponsor. The principal advantage of the triparty repurchase agreement structure is that it enables the issuer to fund a LIBOR/EURIBOR component of interest. And, unlike the older total return swap technology, those transactions that utilize triparty repurchase agreements have the hindsight of learning from the Lehman Brothers bankruptcy. New mechanisms have been designed to address the lessons outlined above. Table 19.1 summarizes certain sample terms for a transaction that utilizes a triparty repurchase agreement. No one collateral structure will be a panacea for reducing credit risk and balancing the interests of transaction constituencies. Increased reinsurance premium to offset more restrictive permitted investments may reduce the economic benefit to sponsors. For instance, investing in only U.S. Treasury-backed money market funds may result in lower investment risk, but the increased costs, including shouldering a greater burden of the overall interest rate, may be prohibitive to some sponsors. Conversely, failing to reduce credit risk exposure sufficiently may dissuade investors from purchasing notes at historic coupon levels. How far the market should go to address these issues is ultimately a question for investors, sponsors, and other transaction participants.

Conclusions In this chapter, we have tried to highlight common catastrophe bond structures, with a view toward further refining and reconciling the capital markets and reinsurance components of design. Like in other areas of the law, a well-structured catastrophe bond possesses some basic characteristics that transcend the specificities of form: efficacy; transparency; and simplicity. How “well” a particular structure works will depend on a combination of these characteristics. At its core, catastrophe bonds are mechanisms for risk transfer. In order to be successful, the structure must transfer risk effectively without exposing the parties to unintended or undesirable consequences, such as basis or credit risk. For example, if catastrophe bonds could not transfer catastrophe risk as well as traditional reinsurance solutions, or if the structure exposed sponsors and investors to unacceptable levels of credit risk, the insurance-linked securities (ILS) market would cease to be a viable source of retrocessional capacity.


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In addition, as a capital markets product, catastrophe bonds must be transparent. Investors need to appreciate the risks to which they are exposed, sponsors need to fully understand the reinsurance cover that they are purchasing, and markets need to have sufficient information to price and balance these two interests. If catastrophe bonds are not transparent, regardless of how fair and efficacious the structure, they will not be able to succeed as an asset class in the capital markets. Oftentimes, these two goals are in tension with one another. For example, investors want more transparent and standardized loss triggers, while sponsors want to reduce basis risk as much as possible. Balancing the interests of these two constituencies requires careful planning and the tailoring of a structure to the specific risk portfolio. Finally, a well-structured, insurance-linked security must strive for simplicity. This is not to say that a structure must be simple (far from it), but that it should not be unduly complex. As any practicing transactional attorney knows, the simplest solution is usually the best (although not the easiest)—strive for simplicity, and efficacy and transparency will surely follow.

Notes The views expressed in this chapter are those of the authors and not necessarily those of Dewey & LeBoeuf LLP. 1. (MMC Securities 2007). 2. (Swiss Re 2009): “Despite the progress that has been achieved with these newer financial instruments, the share of insurance risks transferred directly to the capital markets has been low. Moreover, insurance risk transfer markets have remained relatively illiquid. The markets could benefit from the creation of new and improved indices that broaden the product space and reduce basis risk for (re)insurers. More consistent accounting, regulatory and rating agency treatment of index-linked instruments would promote their wider use.” 3. Other common perils include European windstorm and Japanese earthquake and typhoon, although virtually any peril can be included if there is an accepted model to determine the attachment probability and expected loss. 4. Selecting the issuer’s domicile is typically based on several legal and market considerations, most notably achieving tax efficiencies and regulatory and accounting requirements. 5. Use of a collateral or trust account will depend on credit-for-reinsurance accounting requirements specific to the sponsor. 6. In every jurisdiction in which the securities may be sold, both globally and in each state in the United States, there is a question of whether investors, by taking on insurance risk, will be characterized as engaging in the business of insurance and whether underwriters are thereby acting as unlicensed insurance agents. In order to reduce this risk, the underwriters and legal counsel typically rely on letters from local counsel in various jurisdictions stating that, in the view of local counsel, they do not believe that the offering will be characterized as insurance in such jurisdiction. Catastrophe bonds typically have selling and transfer restrictions that require investors to be residents of and purchasing the securities in one of these “permitted jurisdictions.” 7. The attachment probability and expected loss are typically modeled by a third-party catastrophe modeling firm, although some transactions are self-modeled. The modeling results are attached to the offering circular. Each year, and sometimes intrayear, the attachment and exhaustion levels will be reset. 8. (Swiss Re 2009). 9. (MMC Securities 2007).




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10. To a certain extent, the advantages to an index-based transaction are dependent on the transparency, accuracy, and reliability of the index that is used. Swiss Re cites several requirements for an index “to be accepted by the relevant financial market players,” including that: “(i) the index must be transparent, that is, it has to be observable, quantifiable and clearly defined; (ii) the index and the contract related to it should be reasonably simple in order for investors to be able to judge the risk/ benefit of assuming the risk; (iii) the values of the index should be published without significant delay so that financial transactions can be processed speedily; (iv) the index should be accurate and reliable, and be subject to as little revision as possible; (v) the more credible the index provider, the greater the benefit of the index, as this will help diminish inherent subjective risk (moral hazard) and increase the reliability of the index; and (vi) moreover, an index’s usefulness increases over time. Long-term historic values allow the correlation between the index and past loss events to be analyzed and calculated precisely.” See Swiss Re Sigma No. 4/2009, The Role of Indices in Transferring Risk to the Capital Markets. 11. (MMC Securities 2007). 12. (Stern and Spitzer 2008). The distinction between risk and uncertainty was prominently articulated by the economist Frank Knight. Knight defined risk as measurable uncertainty that can be objectively analyzed from historical experience. Uncertainty, on the other hand, is a more immeasurable form of risk that is subjective, relatively unpredictable, and without sufficient precedent. Certain forms of risk and uncertainty blur the distinction. 13. Many market participants often overlook the significant ramifications that collateral declines can have on sponsors. To the extent that the collateral goes down in value, the sponsor will not have the reinsurance cover for which it is paying those high premiums. Therefore, it is in everyone’s interest to reduce credit and counterparty risk. 14. The definition of permitted investments typically includes four main categories of securities, including: (i) debt securities issued or fully guaranteed by the U.S. government at the time of investment; (ii) highly rated, short-term commercial paper at the time of investment; (iii) highly rated, long-term debt securities at the time of investment; and (iv) money market funds rated in the highest investment category at the time of investment. 15. Plus or minus a relatively small swap spread. 16. Before 2008, most swaps only required the swap counterparty to pay the issuer for “realized” losses on permitted investments. As described in greater detail below, beginning in late 2007 some catastrophe bond offerings began utilizing a collateral or “top-up” mechanism to account for “unrealized” losses.


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Bibliography MMC Securities. “Appendix 1: Catastrophe Bonds 101—An Overview of Structure and Pricing Drivers.” The Catastrophe Bond Market at Year-End 2006, 2007: 25−29. http://w w w.guycarp.com/portal/extranet/pdf/GCPub/Cat%20Bond%202006. pdf?vid=1. Stern, Matthew, and Richard Spitzer. “Beyond Catastrophe Risk.” Trading Risk 2008 Annual Review, 2009: 12−14. Swiss Re. “The Role of Indices in Transferring Risk to the Capital Markets.” Sigma, No. 4/2009. http://www.swissre.com/pws/research%20publications/sigma%20ins.% 20research/sigma_no_4_2009.html.


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Growth and Diversification of the Captive Insurance Market Peter Neville

Introduction There has been a tendency by insurers and insurance supervisors to view captive insurers as creatures that inhabit a world somehow apart from that of “real” insurance. To some extent, this misunderstanding of what captive insurers are and what they bring to the insurance sector has arisen because their operations combine providing insurance with controlling and managing risks within the insured party. The early years of the captive insurance industry added to this sense of it being alien, because many captive insurers were established offshore in jurisdictions where they could benefit from advantageous tax regimes. This chapter aims to remove the mystique by explaining the nature of captive insurers and by considering why they are becoming increasingly important. It addresses certain misconceptions and explains the benefits that captive insurers bring both to the insured parties and to the insurers with which their risks are placed. Captive insurers provide a flexible and positive contribution to the insurance industry but, as with all forms of insurance, there are risks, and in some ways these risks differ from those faced by more conventional insurers. It is the role of the supervisor to identify and address these risks. This chapter, therefore, also sets out the steps taken by the International Association of Insurance Supervisors (IAIS) to help supervisors understand and deal with the risks they will encounter when overseeing captive insurers. The role played by captive insurers is growing in importance worldwide, and it is therefore essential that the particular challenges they raise are recognized and addressed by way of appropriate regulation and supervision.


CHAPTER 20

The Development of Captive Insurance A brief examination of the history of captive insurance, and a consideration of the reasons why it has grown as it has, provides a better understanding of the sector.


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The establishment of mutual arrangements to retain and share the risks associated with a venture between the businessmen involved can be traced back to at least the seventeenth century, when Edward Lloyd founded what is now Lloyd’s of London at his coffeehouse. There are a number of other instances from around that time of mutual insurance companies being formed by firms to cover risks within their particular industry. Somewhat later, during the nineteenth century, in the United States a group of New England textile manufacturers established a mutual insurer in order to overcome the problem of high fire insurance rates and, in London, a group of merchants set up their own insurance company, the Commercial Union, again in response to the increasing cost of insurance. Subsequently, the twentieth century saw an increasing number of major corporations establishing either mutual insurers or their own insurance companies. Of far greater significance in the development of the modern captive insurer, however, was the industrial expansion following Second World War. It was at this time that Frederic M. Reiss coined the term “captive,” drawn from the word used to refer to mines whose output was used solely by the company that owned the mines. The term came to be applied much more widely to denote an insurer that was owned by—and therefore captive to—the policyholder. Mr. Reiss was a U.S. fire protection engineer, and the concept of captive insurance developed as he became aware that companies were having difficulty obtaining insurance cover. He realized that there was a way in which the companies could insure their risks while bringing down the net cost, by setting up a subsidiary company to insure the risks of the parent, thereby reducing the amount of capital required to cover those risks. There was a difficulty, however, in that supervisors in the United States, the United Kingdom, and many other countries did not, at the time, acknowledge the controlled and limited nature of the risks, and therefore required captive insurers to have the same level of capital as a traditional insurance company. Captive insurers also had to file annual returns. These requirements made it expensive to form a captive insurer in the same country as the parent. Therefore, during the 1950s, the industry grew by virtue of companies increasingly establishing captive insurers in jurisdictions other than that of the parent—jurisdictions that were more welcoming and provided a less costly and more f lexible environment. Other factors subsequently gave impetus to the move to establish captive insurance subsidiaries overseas. For instance, in 1962 the U.S. Tax Reform Act was passed; it taxed captive insurers’ investment income, removed their advantageous tax position in respect to domestic risks, and introduced the taxation of offshore U.S.-controlled companies. In Europe, tariff insurance arrangements resulted in great difficulties obtaining realistic pricing and discounts for self-insured deductibles. In the early 1970s, not only were the Bermuda exchange control restrictions relaxed, but the sector also became aware of the advantages to be gained by setting up a captive insurer. Reinsurance companies, and somewhat later the direct insurers, recognized that a client that retained a portion of its own risks was very likely to want to manage those risks more effectively. The establishment around this time of reinsurance pools, both in the United States and Europe, involving underwriting committees that encouraged the use of risk engineering programs to establish better loss estimation and risk management, contributed to the growing realization that captive insurers were a valuable addition to the insurance scene as a whole.


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At that time, the established insurance jurisdictions tended to focus their legislation and regulations on prudential and market controls in ways that catered to traditional insurance vehicles but did not allow the f lexibility in policy cover and wording that potential captive insurer owners were seeking. As a result, the owners favored jurisdictions that had very light regulation—and in some cases no regulation at all—together with low or no taxation on the captive insurers’ earnings. Over time, as the sector grew, these jurisdictions developed the legal, accounting, actuarial, banking, and specialist captive insurance management skills to serve this new area of business. Innovations within the captive jurisdictions, and developments in the wider world, meant that the nature of the sector continued to develop. For example, in response to demands from smaller companies to have access to captive insurance programs, without the costs and management expertise of running a captive insurer themselves, Bermuda introduced “rental captives” in 1976. (The nature of rental captives is explained later in this chapter.) In addition, in 1977 the United States removed the admissibility of insurance between a parent and a wholly owned insurance subsidiary that insured only parent company risks, on the grounds that there was no transfer of risk out of the economic group. This led to changes within the industry and the formation of group captive insurers serving the interests of a number of companies, and also to the underwriting by certain captive insurers of unrelated third-party risks, making them, in effect, full-f ledged insurance companies. Despite this, many companies continued to form wholly owned captive insurers in order to simply take advantage of the benefits of more focused risk management, and to provide access to the specialist insurance and reinsurance markets. During the 1970s and 1980s, the increasing demand for captive insurers resulted in several jurisdictions introducing new insurance legislation and regulations that were designed specifically to cater to them. In line with this trend, the enactment of captive legislation in Vermont in 1981—mainly to provide for workers’ compensation and property/casualty risks—set a trend in the United States that many other states have followed. In 2006 the IAIS reported that the growth of the sector in the United States has been such that at least 30% of global captive insurance entities were based in the United States, and these had broadened their scope to include areas such as product liability and employee benefits. The United States was seen as one of the most significant growth areas for captive insurers.1 The way that the captive insurance sector has evolved ref lects the fact that there are many reasons why companies form captive insurers. These include:


Captive Insurance Market

• providing a focus for the management of risks, which can considerably reduce the severity and cost of claims; • providing a structure and organization where risks within a group can be pooled, controlled, and managed; • reducing the costs of insurance by avoiding the overheads and profit margin included in commercial insurers’ premiums, tailoring the reinsured cover more precisely, retaining investment income within the group, and avoiding difficulties in having insurers give adequate recognition to deductibles; • providing direct access to the reinsurance market; • providing cover where none is available in the commercial market;


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• allowing more f lexible management of cash f lows within the group; • providing an additional source of revenue if unrelated third-party risks are underwritten; • where relevant, taking advantage of lower operational and other costs, including lower taxes, in the jurisdiction where the captive insurer is based.

The simplest, most traditional form of captive insurer is one that is wholly owned and underwrites only the risks of its parent. There are, however, various other types. The following list contains examples of the broad classifications that are in current use, although the list is not exhaustive. • Pure captive insurers : single parent companies writing only the risks of their owner and/or affiliates; • Group and/or association captive insurers : multiowned insurance companies writing only the risks of their owners and/or affiliates, usually within a specific trade or activity; • Rental captive insurers : insurers specifically formed to provide captive facilities to unrelated bodies for a fee. They are used by entities that prefer not to form their own dedicated captive insurer; • Diversified captive insurers : captive insurers writing a limited proportion of unrelated business, in addition to the risks of their owner and/or affiliates. Some jurisdictions consider that an insurance company writing any unrelated party business cannot be classified as a captive insurer. Quite properly, captives that underwrite significant unrelated business are treated as normal commercial insurers. In some jurisdictions, captive insurers underwrite some unrelated business in order to be able to obtain tax deductibility for the insurance premiums paid by the parent, although the exposures are often very limited, and it is then up to supervisors to determine what level of supervision to apply; • Producer-owned reinsurance companies (PORCs) : captive insurers that reinsure a fronting insurer, which underwrites risks for individual consumers generated by the captive owner. Supervisors have been advised by the IAIS to treat PORCs in the same way as commercial insurers when considering consumer protection issues, because the sale of the product could be inf luenced by the owners of the PORC. 2


Types of Captive Insurers

A more comprehensive description of the various types of captive insurer is contained in the October 2008 “Guidance Paper Number 3.6 on the Regulation and Supervision of Captive Insurers,” published by the IAIS. The purpose of this chapter is to consider captive insurers and their growing importance in general terms, and, therefore, no attempt is made to set down a definition. Captive insurance may involve a wide spectrum of activities, and attempts to define its nature are hampered by the absence of a consensus on certain important issues, including the meaning of “unrelated parties,” and on whether or not a captive insurer should be able to provide cover to the general public. In addition, many definitions are concerned principally with the nature of the risks underwritten


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(such as “health care captive” and “life captive”) or the nature of the owners of the captive insurer (such as “multiowner captive” and “governmental pool captive”). A captive insurer may take various legal forms, including limited company, limited partnership, and limited liability partnership. The relatively new vehicle, known as the protected cell company (PCC), is also popular in those jurisdictions that provide for the establishment of this form of company (the number of such jurisdictions is growing), and it is increasingly being used as a captive insurer, in addition to being used in the investment and other sectors. A PCC (which may also be known as a segregated cell company, a segregated account company, or a segregated portfolio company) is a single company consisting of a core and a potentially infinite number of cells, which are legally separate from each other. Each cell has assets and liabilities attributed to it, and its assets cannot be used to meet the liabilities of any other cell. The duty to ensure that this segregation is achieved is placed on the directors of the PCC. The company will also have noncellular or core assets, which may be available to meet liabilities of the PCC as a whole. A PCC can create and issue shares in each of its cells, but the company is managed by a single board. The structure enables different risks to be written in separate cells. In the event of the insolvency of a cell, its creditors have access only to the assets of that cell, and possibly to the assets held in the central core. A cell of a PCC can be used as a captive insurer, with the shares in that cell being held by the parent company. One method of operating is for an insurance manager to establish a PCC that it manages, and for which it obtains an insurance licence, on the basis that it charges for the use of the cells. When individual cells are created, they are offered to clients as separate captive insurers without the need for entire new companies to be set up. This is similar to the rent-a-captive arrangement. In many jurisdictions, the establishment of a new captive cell requires the permission of the supervisor, because it has many of the characteristics of a standalone insurance operation. The PCC structure has allowed smaller companies to make use of captive insurance arrangements, because in a PCC, the costs of capitalizing and managing the company are shared. There are a number of aspects of captive insurer regulation that are specific to PCCs. When assessing solvency, a supervisor will consider both the consolidated position and the solvency of the individual cells in order to avoid problems that arise if a consolidated calculation would mask problems in certain cells. A variation of the PCC concept is the incorporated cell company, in which individual cells are distinct legal entities.3



The Position of Captive Insurers within the Insurance Chain A captive insurer may be involved at any point in the insurance chain, from writing directly, through operating as a reinsurer, to acting as a retrocessionaire. In certain jurisdictions, it is legally necessary for some or all types of insurance (such as motor third-party and workers’ compensation) to be provided by insurance companies that are licensed and supervised in that jurisdiction, making it impossible for a captive insurer established in another jurisdiction to write that business. In other situations, commercial considerations may mean that it suits the captive for the primary insurer to be another company. In either case, the primary or fronting insurer will issue the policy, and then reinsure all or part of the risk with the


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captive insurer by way of a fronting agreement. In this way, the ultimate liability remains with the fronting insurer, although at least part of the risk is transferred to the captive insurer. In return, the captive insurer has to provide appropriate security to the fronting insurer. The fronting insurer may well provide loss prevention, claims management, and other services. The arrangement often benefits both insurers, where the captive insurer provides an effective risk management function and additional premium income, and the fronting insurer allows the captive parent to consolidate its insurance program through one company. The support given by the reinsurance sector to the captive insurance sector is evidenced by the establishment of significant reinsurance pools in order to provide extensive capacity at prices that are commercially attractive. Many of the original captive insurance programs were based on property insurance of well-protected risks that were subject to extensive loss prevention surveys, exposure analysis, and active management of the exposures. The placing of group risk within the captive insurer, and the active management of that insurance risk, may enable the owner of the captive insurer to accept higher deductibles on its primary program and, by insuring the risk through the captive insurer, to obtain reinsurance coverage at lower cost. Often, a captive insurer will be set up to insure or reinsure the deductible of its parent’s insurance policies with a conventional company, and there will be an agreed maximum level of claim payments in a particular period. These deductibles, or retentions, are an agreed amount of each claim that the insured company will meet from its own resources before receiving payment from its insurer. Some captive insurance programs offer risk exposures that are well managed and realistically priced at a level where there is a minimal cost of administrative and claims handling activity. The working risk is effectively managed by the captive insurer in conjunction with the parent, an arrangement which, in itself, encourages better risk management. The appeal of captive insurer partnerships for the insurance industry is that financial interests will be mutually aligned. The financial benefits of aggressive risk management can be shared by both parties, and they should lead to lower retained losses and less expensive charges for the risk transfer. The majority of pure captive insurers are owned and utilized by noninsurance companies that are looking for stable and economic premiums, an increased retention in the quantifiable and manageable risks of the entity, or secure insurance cover, of which there is little capacity available from the conventional market. The economic life cycle of the commercial and industrial companies that own captive insurers is likely to affect the level of insurance risk that is retained in the captive insurer.4


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Risks Underwritten by Captive Insurers Captive insurers have been established by a very wide range of commercial and industrial companies, and not surprisingly, therefore, captive insurers underwrite all types of risk. The most common areas are property and casualty, general liability, and workers’ compensation. There appears to be an increasing use of captive insurers to cover environmental risks, and a growing interest in considering the writing of employee benefits business. The wide-ranging nature of the cover provided, including directors and officers policies, demonstrates that even long-tail risks may be considered appropriate for captive insurers.5


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Captive insurance, which by nature involves risk self-retention, is a form of Alternative Risk Transfer (ART) when compared with conventional insurance. In turn, a captive insurer may itself become involved with other types of ART strategies, such as loss portfolio transfer. 6

Some captives are set up as freestanding insurance companies with their own management. This is, however, relatively expensive. Very frequently, therefore, some or all of the captive insurer’s management is outsourced. Most jurisdictions licence and supervise insurance management companies to ensure that they are fit, proper, and competent. A group of specialist captive management companies has sprouted up, including not only subsidiaries of most of the major worldwide insurance brokers, but also a number of independent insurance management companies. It is not unusual for the client of a major broking group to appoint a different group as captive manager, for governance reasons, and to provide advice about market alternatives. The services provided by captive insurance managers include company management, administration, accounting, company secretarial services, underwriting, the arranging and placing of reinsurance, claims handling, and compliance functions.

Regulation and Supervision of Captive Insurers During the early years of the development of captive insurance, some jurisdictions that were chosen by the owners of captive insurers had very low legislative and supervisory standards. This situation changed very substantially as pressure from the established insurance domiciles to adopt good practices grew, and as the international community demanded that all jurisdictions meet the growing body of globally adopted standards. Inspections by the International Monetary Fund (IMF) and a number of other international and regional bodies have ensured that these standards are being applied. Recognition that there is no longer a divide between the newer, “offshore” jurisdictions and the more established jurisdictions came in 2008 when the IMF dropped its review program that was targeted at offshore centers, and instead brought all jurisdictions within its Financial Sector Assessment Program. All jurisdictions are expected to meet the same standards, and the only distinction now drawn is between those jurisdictions that meet international standards and those that do not. A number of the offshore jurisdictions have obtained as good, if not better, reports from the IMF than established “onshore” centers. The principal driving force behind the development of international standards in the insurance area has been the IAIS, which sets international insurance supervisory standards and is increasingly concerned with the implementation of those standards by its member jurisdictions. The following section of this chapter is based primarily on the work of the IAIS.7 The purpose of insurance regulation is to protect policyholders who are, in the case of captive insurers, most commonly also the shareholders, and also to safeguard investors and other stakeholders. This is achieved by ensuring that appropriate standards are applied, first by the local supervisory body, and then by the


Captive Insurance Managers


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captive insurer itself, with respect to corporate governance, financial strength and management, and market conduct. In the same way that the IAIS approaches the supervision of other insurance entities, the application of the IAIS Core Principles to a captive insurer takes account of its particular characteristics. The IAIS permits local supervisors to apply a risk-based approach, which ref lects both the nature of captive insurance and the form and activities of the particular captive insurer. For example, a pure captive that underwrites only the property risks of a single parent without recourse to reinsurance, such that there are no unrelated party policyholders or potential third-party beneficiaries, poses risks that are little different from the situation that would apply if the risks were retained on the parent’s balance sheet. Where, however, a pure captive insurer interfaces with other parts of the insurance market, for example by reinsuring a fronting insurer or by reinsuring part of its own program, there are both commercial and supervisory pressures on the captive insurer to meet international standards. On the one hand, the parent will want to know that the captive insurer is accessing the market in the most cost-effective way. On the other hand, the supervisor and the other insurance bodies will want to be sure that the captive insurer is being run properly, and that it does not represent any undue risk to policyholders in those other bodies or to the wider market. Captives that underwrite risks for unrelated party policyholders or compulsory third-party liability risks are, in effect, operating in the same way as a normal commercial insurer, and represent a much higher supervisory risk. In such cases, it is essential that adequate standards are applied in order to protect all policyholders and other stakeholders. The application of appropriate regulation also reduces the risk that a captive insurer may become involved in fraudulent activities or be used as a vehicle for money laundering. In order to assist supervisors to address the particular issues raised when supervising captive insurers, the IAIS has published two papers: the “2006 Issues Paper on the Regulation and Supervision of Captive Insurance Companies” and the “2008 Guidance Paper Number 3.6 on the Regulation and Supervision of Captive Insurers.” (Both papers are available on the IAIS website at http://www.iaisweb. org.) Reference should be made to those documents for further information on all aspects of the supervisory standards relevant to captive insurers. The IAIS Core Principles are applied as appropriate. For example, a captive insurer is usually an integral part of its owner’s risk management program. It is important, therefore, that the supervisor understands the nature and scope of the captive insurer’s business, and that, where its owners may not be familiar with the operational and prudential requirements for an insurer, the supervisor satisfies itself that the captive insurer will be managed by experienced professionals. In many cases, much of the burden of complying with the regulatory requirements is placed on the captive manager. Owners of captive insurers must be fit and proper for that role, and the supervisor should carry out sufficient investigations to satisfy itself that this is the case. The board and management of the captive insurer must demonstrate that they have the skills and experience required to carry out the roles they are playing. This responsibility is much greater when the services of an insurance manager are not employed. In these circumstances, the board and senior management must demonstrate that they have all the necessary skills and experience, including those required with respect to accounting and underwriting.


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• the need to control outsourced functions, including the management of the captive insurer; • the owner’s location, which may be relevant in case there are difficulties, for example resulting from restrictions on information f low or the provision of financial or other support when the captive insurer is not located in the same jurisdiction as its parent; • the potential dangers of a concentration of assets where the captive insurer holds relatively few assets; • the failure of a fronting insurer; • a lack of risk diversification; • high claims volatility (and, potentially, a high-liquidity risk), particularly when a single line of business is written; • the possibility of the captive insurer being used for criminal purposes, for example fraud or money laundering; • the financial strength of the parent, particularly when there are loans or outstanding premiums, and when the captive insurer is dependent on contingent capital from the parent. Some of the risks associated with a commercial insurer are of much lower likelihood, or of potentially less impact, in the case of a captive insurer. For example: • The legal risk may be low, for example where there is little chance of the captive insurer being sued because the main policyholder is its owner; • The operational risk may be low if the captive insurer has few transactions or a limited number of policies; • There is a reduced need for transparency toward the wider market when the captive insurer is not acting as a life insurer or reinsurer, as long as there is no potential threat to the financial system, no public interest need for disclosure, and as long as no legitimately interested party (such as unrelated policyholders, fronting insurers, reinsurers, and third-party claimants) is prevented from receiving the information it requires.


Although the principal areas of focus are the same, the nature and extent of monitoring that is carried out by a supervisor will depend on the risks involved, and will ref lect the fact that a captive insurer frequently poses less risk to external stakeholders and to markets than commercial insurers or reinsurers. There are, however, some areas where the risks may be greater. For example, regard has to be paid to connected party transactions, the amount of unrelated party business, and the existence of third-party liabilities. Other points of focus include:

Location Choice The reasons why companies establish captive insurance subsidiaries are discussed earlier in this chapter. The specific commercial and other factors that determine a potential parent’s strategy depend on the circumstances of the company and the alternative arrangements available to it. Not surprisingly, the nature of the insurance market, and, therefore, the range of those arrangements, is continually


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evolving. The introduction of new kinds of Alternative Risk Transfer is a part of this process, as jurisdictions revise their laws and regulations to meet changing international standards, and as they react to commercial pressures to remain competitive. Choice of domicile for a captive insurer is inf luenced by many considerations, including political and financial stability, access to markets, ease of travel, availability of good banking and other financial services, adequacy of IT and telecommunications infrastructure, accessibility and adaptability of the supervisor, speed of captive insurer formation, types of insurance structures available, quality of local support services (including insurance managers, lawyers, accountants, and actuaries), and operational costs (including taxation and the fees payable, both to the supervisor and to professional service providers). The regulatory and supervisory regimes also vary, as do the attitudes of the parent’s home jurisdiction to the different jurisdictions’ regimes. All of these are considered by the company when deciding where to base its captive insurer. Although, at first, captive insurers were established in the same jurisdiction as the parent, other jurisdictions grew in popularity when it became known that they offered benefits that were not available at home. These included lower taxes, less rigorous regulation, lower costs, and greater commercial f lexibility. A number of jurisdictions—including, principally, Bermuda—led the field by introducing legislation that took advantage of their positions. Over time, a number of the differences between regimes have been removed, as taxation and regulatory requirements have become increasingly global in nature, and as complying with them has become increasingly mandatory. This process is likely to continue, driven by the work of the Organization for Economic Cooperation and Development (OECD) in the tax field, which is aimed at ensuring transparency (reinforced by initiatives in a number of countries to reduce tax avoidance by their residents), continuing work to improve supervisory standards (including the introduction of Solvency II in the European Union [EU]), and maintaining the efforts to harmonize international accounting standards. Despite this, it is far from the case that all jurisdictions are the same. Indeed, there is continuing pressure on every captive insurance jurisdiction to distinguish itself from the others, as the number of such jurisdictions increases. For example, some jurisdictions offer access to specific markets, as in the case of Ireland, Luxembourg, and Malta, which are members of the EU. Others have developed new insurance structures such as the PCC, which was introduced in Guernsey in 1997, although, following its success there, similar structures have since become available in a number of other jurisdictions. With respect to regulation, the nature of captive insurance, particularly that undertaken by pure captive insurers, means that jurisdictions often adapt their requirements, while still keeping them within the IAIS standards, when applying them to captive insurers. For example, although the IAIS Insurance Core Principles apply equally to captives as well as commercial insurers, the requirement to make adequate technical provisions may mean a higher level of provision is required in order to ref lect the higher potential claims volatility of captives. In addition, when a captive insurer reinsures a significant portion of its risks, the supervisor may well look very closely at the contract wording and the credit standing of the reinsurer when deciding whether to give full credit for reinsurance


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in the calculation of technical provisions. Where a pure captive insurer already has knowledge of all claims—because its owner is the only claimant—the regime may provide that the reserve for incurred but not reported (IBNR) claims may be zero, as long as there is a sufficiently robust reporting procedure. The supervisor may, on the other hand, consider it appropriate to require the captive insurer to take actuarial advice before setting provisions for outstanding claims, IBNR or other reserves. On the investment side, because of the nature of their business, many captive insurers have very straightforward investment strategies, which may be tied to the investment and risk management strategies of their owner. The supervisor may, therefore, decide that the full range of requirements that would apply to a commercial insurer need not apply; the processes and systems required in each case being proportionate to the nature, scale, and complexity of each captive’s activities. As with all insurers, captive insurers must hold sufficient capital to ensure that, in adversity, its obligations to policyholders will continue to be met as they fall due. The form of capital may, however, be adapted to ref lect the nature and complexity of the business and the strength and characteristics of the owner. The minimum capital adequacy and solvency requirements may be based on the overall level of risk that is retained by the captive, measured in an appropriate way. The scope and quality of the captive insurer’s reinsurance program may also be relevant to the requirements placed on a captive insurer, when, for example, the percentage of reinsured risk is high and the captive insurer is exposed to a single event. In such circumstances, both captive insurer and parent may fail as a result of a major disaster, in which case reinsurance may be a more appropriate risk mitigant than capital. When the captive insurer’s risk portfolio is unbalanced, a formulaic approach to setting solvency requirements may not be appropriate, and when there are thirdparty liabilities to consider, there may be a need to set requirements closer to those applied to commercial insurers. 8

The International Nature of Captive Insurance and Its Challenge to Supervisors It is clear that the captive insurance market is inherently cross-border. In many cases the parent is based in a jurisdiction other than that of the captive insurer and, in addition, many of the risks covered by captive insurers are located outside their home jurisdictions—a situation made even more significant by virtue of the fact that many parents are multinational companies with interests, and therefore risks, throughout the world. Having said this, a global spread of risks does not appear to be an equally prominent feature of captive insurers in all jurisdictions. Those owned by U.S. and Canadian companies are more likely to have a domestic focus than, say, those in Europe, the Middle East, Africa, and the Asia Pacific regions.9 There are significant variances between regions with respect to the percentage of reinsurance purchased by captive insurers. Nevertheless, it is probably fair to assume that, since many of the major reinsurers are not based in the principal captive domiciles, a great deal of the reinsurance purchased by captive insurers involves cross-border transactions.




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Reports that comment on the growth of the captive insurance market differ in their estimates of the numbers of captives in the various jurisdictions over the years, but the underlying message is clear: growth in this sector has been rapid. From a very modest base some 40 years or so ago, one report lists 32 U.S. states and a further 26 jurisdictions that currently have captive insurance regimes.10 Another source concludes that there are almost 6,000 captive insurers globally, of which around one-fifth are in runoff and the remaining four-fifths generate premium incomes of approximately £81 billion.11 There is a widespread belief that the number of captive insurers and captive domiciles will continue to increase. The combination of a soft market and the global financial crisis—during which companies focused on survival—resulted in a slowdown in the formation of captive insurers. Growth has continued, however, albeit at a lower level. On the one hand, 2009 saw some potential owners questioning whether starting a new captive insurer represented the best use of scarce capital, while, on the other hand, growth in the numbers of captive insurers continued in the United States and the Caribbean.12 The lines of business covered by captive insurers are being expanded, for example into areas such as employee benefits and other health benefits lines. The geographic spread of the captive market is also broadening. Although the strongest recent growth has been in the United States, partly as a result of a move by some captive insurers from offshore to onshore, countries in Latin America and the Gulf region are looking seriously at the concept, and, although it is as yet little developed, the potential demand for captive insurers in China and South East Asia is substantial. The well-established captive insurance jurisdictions appear likely to continue to be the main centers for some time to come, because of their greater experience and more developed infrastructure, but competition will increase as jurisdictions update and adapt their legislation and regulations.13 In addition, pressures with respect to taxation and regulatory standards will have their consequences. For example, it is currently unclear how the development of the EU Solvency II regime will impact on captive insurers, particularly those based outside the EU that use EU-domiciled fronting insurers. One of the most pressing issues facing captive insurers at present is the need to clarify how they can achieve equivalence with the new regime. In another context, PCCs may well play an increasing role if, as some expect, middle-sized companies increasingly enter the captive insurance market.

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The overall picture is that the captive sector has become a very important part of the insurance market. It provides a conduit for insurance and reinsurance, an effective risk management tool, and an adaptable insurance mechanism. The regulatory and supervisory risks may, to some extent, be different from those posed by commercial insurers, but they exist and have to be addressed. The cross-border nature of captive insurance presents challenges for supervisors, particularly in view of the drive to achieve greater stability for the global financial system. It is only by ensuring that there are effective cross-border cooperation and information-sharing mechanisms that supervisors will be able to address the risks involved in a way that provides adequate protection for policyholders and third parties.


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1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13.

(IAIS 2006). (IAIS 2008). (IAIS 2006, 2008). (IAIS 2006). (Marsh 2008, 2009), (Saville 2009). (IAIS 2006). (IAIS 2006, 2008). (IAIS 2008). (Marsh 2009). (Marsh 2008). (Bradshaw 2009). (Bradshaw 2009). ( Best 2009), (Marsh 2009), (Bradshaw 2009).

Bibliography Best, A.M. “A.M. Best’s July 2009 Special Report on European Captives—A Growth Market During a Challenging Time?” Business Wire. July 2009. (© A.M. Best Company. Used with permission.) Bradshaw, Gavin. Captive Review Annual Domicile Directory. Published by Pageant Media. October 2009. http://www.captivereview.com . International Association of Insurance Supervisors (IAIS). “Guidance Paper No. 3.6 on the Regulation and Supervision of Captive Insurers.” October 2008. www.iaisweb. org. (Reprinted with permission.) ———. “Issues Paper on the Regulation and Supervision of Captive Insurance Companies.” October 2006. www.iaisweb.org. (Reprinted with permission.) Marsh EMEA (Marsh). “Next Generation Captives—Optimising Opportunities.” Global Benchmarking Report. April 2008. http://www.marsh.co.uk/service/captive/ index.php. (© Marsh EMEA, 2008. All rights reserved.) Marsh Inc. (Marsh). “2009 Captive Benchmarking Report—Single Parent Captives—A Global Analysis.” 2009. http://global.marsh.com. (© Marsh Inc., 2009. All rights reserved.) Saville, Adam. “Why Captives.” Captive Review Magazine, issue number 69. July 2009. http://www.captivereview.com.


Notes


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PART III

Global Insurance Markets


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Past, Present, and Future Insurance Markets and Regulations in China Dongmei Chen and Xian Xu

Introduction China’s insurance industry has made an eye-catching achievement in the world during the past three decades of reform and opening up. The numbers of insurance companies, insurance asset management companies, specialized insurance agencies, and insurance practitioners have all increased significantly. The insurance market took the lead in opening to foreign participants and establishing a modern insurance regulatory system. The insurance industry has also played an increasingly more important role in social and economic development, which has, in return, further expanded room for development of the industry. This chapter begins with an overview of the history of the insurance market in China, followed by the recent developments in the domestic market. The reinsurance market is then discussed, focusing on the history and current market conditions. The fourth section presents insurance regulations; finally, this chapter analyzes the main characteristics and future of the Chinese insurance market.

History of the Chinese Insurance Industry


CHAPTER 21

Establishment of the Chinese Insurance Industry (1949–1958) In 1949, after the foundation of the People’s Republic of China (P.R. China), the first insurance company owned by the government—the People’s Insurance Company of China (PICC)—was established in Beijing. Its working principles were to “develop economics, protect of national and social assets and provide the welfare for people.” Due to the support of the government, by June 1950, the PICC had already owned five regional companies, 31 branch offices, and 564 agencies. Figure 21.1 illustrates the national insurance premiums from October 1949 to May 1950.


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Dongmei Chen and Xian Xu Insurance Premium Proportion in China (October 1949 – May 1950) Foreign Insurance Companies 22%

People’s Insurance Company of china 70% Figure 21.1 Insurance premium distribution in China (Oct. 1949–May 1950)

The characteristics of this period are: • Compulsory insurance for state-owned enterprises, trading cooperatives above county level, state governments’ properties, and passengers on trains, ships, and aircrafts. • In 1951, the Government Administration Council enacted “Resolution of the implementation of compulsory insurance for state governments, state-owned enterprises, and properties of cooperatives,” “Property Compulsory Insurance Regulations,” “Ship Compulsory Insurance Regulations,” “Railway Vehicle Compulsory Insurance Regulations,” “Accident Compulsory Insurance Regulations for Passengers on Ship,” “Accident Compulsory Insurance Regulations for Passengers on the Trains,” and “Accident Compulsory Insurance Regulations for Passengers on Aircrafts.” • By the end of 1952, all the properties in state-owned enterprises and trading cooperatives above county level had been insured. Property and transport compulsory insurance premiums reached 770 billion RMB (Renminbi, the old Chinese currency, the same below). Compulsory passenger accident insurance was throughout the country. • Voluntary agricultural insurance. From 1950 to 1952, the PICC mainly conducted livestock insurance businesses and pilot programs of the crop insurance. Agricultural insurance premiums were more than 4,800 billion RMB, paying claims of more than 1,800 billion RMB. • Fire insurance, insurance for transportation goods, hull insurance, and voluntary life and health insurance provided the appropriate protection for private businesses and urban residents. From 1950 to 1952, the fire insurance premiums of the PICC were more than 4300 billion RMB, paying claims of 28.9 billion RMB, and voluntary life and health insurance premiums were 881 billion RMB, paying claims of 18.5 billion RMB. • Foreign insurance businesses were developed for the protection of national import and export trade, such as the ocean marine insurance. The cession is to spread risk and reduce foreign exchange disbursements. The foreign insurance business was operated by the national insurance institute—the PICC.


Private Insurance Companies 8%


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In March 1953, the Third National Insurance Conference was held in Beijing. The meeting argued that compulsory insurances should be closed down due to the compulsory insurance premiums paid by the state budget. State-owned enterprises (including cooperatives) should continue to apply for compulsory insurance. Other businesses participated voluntarily. The meeting decided that the agriculture insurance business should also be closed down because there was no urgent need for it. In November 1954, the Fourth National Insurance Conference came up with this basic principle: all kinds of insurance businesses should be open to different industries in order to absorb scattered social funds, and the insurance funds should be established to enrich the state’s financial reserve. Accordingly, in 1955 the focus was on the rehabilitation of agriculture insurance and urban insurance, while suspending part of the state-owned enterprises compulsory insurance businesses.

Closed Period of the Chinese Domestic Insurance Business (1959–1978) From 1958 to 1978, China’s economy experienced the “Great Leap Forward,” three years of natural disasters, and the “Great Cultural Revolution,” in which the economic development was severely affected, thereby affecting the insurance industry. There was a view during this period that, with the realization of people’s communes and the government-supplying system, social security could replace national insurance. So it was deemed not necessary to continue to run domestic insurance businesses. To diversify risk and protect national import and export trade, the foreign insurance businesses continued to be operated abroad. The PICC specialized in these businesses, which belonged to the People’s Bank of China (PBC).

Recovery and Reconstruction Period of the Chinese Domestic Insurance Business (1979–1991) From 1978, China entered a historical period of reform and opening up. To meet the needs of economic expansion and restoration, development of a domestic insurance business was necessary. By the end of 1980, the PICC reestablished its franchises in 28 provinces, employed 3,423 people, and strengthened insurance personnel training. In March 1985, the State Council issued “Provisional Regulations on the Insurance Business Management,” which was New China’s first insurance legal document, stipulating that the state insurance regulatory institute was the PBC. Insurance businesses were subject to its approval. With China’s insurance market opening up gradually, foreign insurance companies were allowed to establish representative offices in China, but they were not approved to set up any entity with business activities. In 1980, American


• The government strengthened the management of private insurance companies, such as the development of management regulations, rechecked assets, etc. • At the beginning of the founding of P.R. China, the increasingly tense international situation resulted in government-imposed restrictions on foreign insurance companies in China, so reinsurance premiums were decreasing rapidly. By the end of 1952, foreign insurance companies in China gradually closed operations and withdrew from the Chinese insurance market.


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Rapid Development Period of the Chinese Insurance Industry (1991–2000) China began to allow foreign capital to enter China’s insurance market. In October 1992, a subsidiary of AIG was allowed to set up branches in Shanghai, marking the opening of the insurance market. Then foreign insurance companies entered the Chinese market with one or two companies per year. In 1995, China’s first special legislation that related to the insurance industry— The People’s Republic of China Insurance Law—was formally promulgated, marking the legalization and standardization of China’s insurance industry. From 1994 to 1996, insurance market competition had undergone new changes. Many domestic insurance companies were set up, such as Taikang Life Insurance Company Ltd., Xinhua Life Insurance Company Ltd., and Tian An Property & Casualty Company Ltd. In 1998, the China Insurance Regulatory Commission (CIRC) was established. The insurance industry was regulated by this commission. As the organization of insurance supervision and legal systems evolved, China’s insurance industry entered a healthy development period.

Comprehensive Opening Period of the Chinese Insurance Industry (2001 onward) In 2001, China joined the World Trade Organization (WTO). The opening of the insurance market continued to be strengthened, and the number of insurance market participants significantly increased. The shareholding reform of Chinesefunded insurance companies was completed. China Life and the PICC were listed. Market competition was enhanced, and the performance of the insurance market was improved markedly. The types of insurance and the premium income continued to increase. The insurance industry strategy was changed from “quantitative expansion, extensive operation” to “quality and quantity, intensive operation.” In January, 2003, the new Insurance Law was promulgated, and it ref lected three features: deregulation, strengthening supervision, and establishing the credit of insurance companies. The CIRC promulgated a series of regulations, such as Insurance Company Solvency Margin Regulations, Regulatory Indicators, and Provisions on Administration of Insurance Solvency.


International Group (AIG) and Tokyo Fire & Marine Insurance Company Ltd., set up the liaison offices in Beijing. Subsequently, many international insurance companies have come to China, setting up liaison offices in Beijing, Shanghai, Guangzhou, and other cities. At the end of 1992, 22 insurance companies set up 28 representative offices in China. They cooperated with domestic insurance companies and government institutions, actively participating in various social welfare activities. They intensified the competition and broke the monopoly of the People’s Insurance Company in the Chinese insurance market.

Market Overview In 1980, insurance premiums of China totaled only RMB 0.46 billion, but this number increased rapidly to RMB 703.5 billion by the end of 2007, achieving 28%


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annual growth rate, far higher than the GDP growth rate, making the insurance industry the fastest growing in China. In 1980, insurance penetration was 0.1% and insurance density was RMB 0.47; these two numbers reached 3.3% and RMB 736.7 in 2008. By premium, China was the sixth in the world in 2008, and sixteenth in 2000, showing the rapid growing rate relative to other countries. By the end of 2007, there were 76,000 people working in insurance, including 28,000 senior management officers; while the number of professionals in actuarial, underwriting, claim assessment, and investment had reached over 170,000 people. In addition, salesmen have also increased from 1.18 million in 2002 to 201 million, while insurance regulators have increased from 672 in 2001 to 1,816 by the end of 2007. With regard to assets, by the end of January 2009, total assets of insurance companies reached RMB 3.4 trillion. From 1990–1999, the growth rate of life insurance premiums of developing countries was 10.5%, compared with 4.8% in developed countries and 5.3% for the world average level. The growth rate of nonlife insurance premiums of developing countries was 6.3%, compared with 1.1% in developed countries and 1.6% for the world average level. The Chinese insurance market outpaced not only developed countries but also developing countries, and that was why many experts concluded that insurance markets in developing countries were the most burgeoning markets in the world, and China was the country with the fastest development. Although the size of the premium was the sixth in the world in 2008, China’s insurance market is still fairly far behind the major developed markets, as well as certain other emerging regional markets. In China, insurance density was 736.7 Yuan (about U.S. dollar [USD] 105.4) in 2008, and insurance depth was 3.3%. While the world average insurance density reached USD 633.9, China’s insurance density was less than one-sixth of the world’s average. The world’s average insurance penetration level was 7.1%. China’s insurance penetration was less than half of the world average.

Reinsurance Before 1996, there was no professional reinsurance company in China, but domestic insurers could reinsure in foreign countries. After the China Reinsurance Corporation was established in 1996, the reinsurance market became dominated by this state-owned monopolistic conglomerate, which had 20% of statutory reinsurance. However, as China became the member of the WTO, state-owned reinsurance business decreased at a 5% annual rate, until it was cancelled in 2006. From then on, the state-owned monopoly fractured. Up to the present, some foreign reinsurance companies have set up branches in China and taken part in competition with domestic reinsurers. From a solvency perspective, the ratio of the net insurance premium to the equity of Chinese reinsurers was 8:1, compared to 1:1 to 1:6 of foreign reinsurers, showing an obvious gap. At present, there are some Chinese reinsurers offering professional reinsurance services, such as China Reinsurance, China Property Reinsurance, and China Life Reinsurance. Although many other domestic insurers have reinsurance licenses, they just use the reinsurance business as a tool of risk management, rather than a steady income resource. Many Chinese insurers only cede reinsurance without assuming reinsurance business. In some




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cases ceded business accounts for a small amount. Fewer participants in the reinsurance market leads to capacity issues and the lack of intermediaries of insurance, which has become an obstacle to the Chinese reinsurance market development. Weak domestic demand for reinsurance, lagging technology on reinsurance, lack of business and management experts in this field, as well as limited capital and lower solvency margins, and all factors stated above caused procurement from insurers overseas. In 2000, domestic insurers ceded premiums of RMB 1.9 billion, with only RMB 140 millions ceded to domestic insurers, accounting for only 7.4% of total reinsurance premiums, which meant 92.6% reinsurance business moved abroad. In 2001, total ceded premiums reached RMB 2.554 billion, with RMB 0.361 billion (14.13%) going to the domestic market, and RMB 2.193 billion (85.87%) going overseas. We can see that the overreliance on overseas reinsurance market was a major problem for China’s insurance companies. In addition, domestic reinsurers also lack the scale effect, underwriting capacity, and risk diversification technology needed against catastrophe and special risks. Given that the RMB is not freely exchanged under capital accounts, premiums denominated in RMB cannot be brought in line with international insurance market. Therefore, it was difficult to diversify risks that were caused by the domestic insured with high risks, thereby impeding the internationalization of the Chinese insurance market. It is estimated that China’s nonlife reinsurance business rate was about 9% in 2005, which was the lowest among Asian countries. In the world’s major developed countries, the reinsurance rate was about 20%. The retention ratio of China’s major insurance companies was significantly higher than 75% in 2009. Most of China’s major insurance companies are not following the Insurance Law requirements. There is a phenomenon of overretention.

Insurance Regulations Historical development After P.R. China was founded in 1949, the PBC was the regulatory authority for the insurance industry for a long period. The only exception was the period from Table 21.1

Milestones of insurance regulations in China

Year

Significant Regulatory Event

1983 1985 1995 1995 1998 1998 2001 2002 2003 2003 2008 2009

The People’s Republic of China Property Insurance Act Provisional Act on the Insurance Enterprise Management Insurance Law of the People’s Republic of China (1995) China Life Insurance Mortality Table (1990–1993) Creation of China Insurance Regulatory Commission Regulations on Administration of Insurance Companies The People’s Republic of China foreign insurance regulations Establishment of Reinsurance Companies Provisions Insurance Law of the People’s Republic of China (2003) Insurance Company Solvency Margin Regulations and Regulatory Indicators Provisions on Administration of Insurance Solvency Insurance Law of the People’s Republic of China (2009)


282

Source: http://www.circ.gov.cn/web/site0/.


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Main laws on insurance regulations

Insurance Law of the People’s Republic of China Motor Vehicle Traffic Accident Liability Compulsory Insurance Regulations Regulations on Administration of Insurance Companies The People’s Republic of China Foreign Insurance Regulations Establishment of Reinsurance Companies Provisions Insurance Company Solvency Margin Regulations and Regulatory Indicators Provisions on Administration of Insurance Solvency Rules on Administration of Insurance Agency Institutions Rules on Administration of Insurance Broker Institutions Rules on Administration of Insurance Appraisal Agency Provisional Act on Insurance Investment in Securities and Funds Provisional Act on Overseas Investment for Insurance Funds Source: http://www.circ.gov.cn/web/site0/.

1952–1959, when the Ministry of Finance (MoF) regulated the insurance industry in China. In 1959, the domestic insurance business ceased to exist, and only the PBC was allowed to handle foreign insurance business. PBC was the regulatory agency for the insurance business in China during this period. In September 1983, the State Council decided to have the PBC function as a central bank. The insurance regulation became one of the important functions of the PBC. All of the regulations and laws promulgated at that time, such as “Insurance Business Management Temporary Regulation” (1985), “The Law of the People’s Bank of China” (1995), and “Insurance Law of the People’s Republic of China” (1995), prescribed that PBC was the insurance regulatory agency. In November 1998, the CIRC was established by the State Council as the regulatory authority for the insurance industry in China. The rationale was to fulfill the management goal of “separating operation and regulation” of the banking, securities, and insurance industries. It currently has 15 internal departments and a nationwide network of delegated offices in various regions (local offices). Tables 21.1 and 21.2 present the milestones of insurance regulations and the main insurance laws.

Regulatory Framework The regulatory framework applicable in China to insurers and insurance intermediaries is set out in the Insurance Law of P.R. China, and a series of regulations issued by the state council or its regulatory authorities, mainly by the CIRC.


Table 21.2

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Insurance Law of P.R. China The Insurance Law of P.R. China was enacted by the National People’s Congress, the Chinese legislator. This law is the basic law of the insurance legislation system. It came into force in 1995. In 2002, the Insurance Law of P.R. China was amended in order to satisfy the WTO’s requirements. With rapid development of the insurance industry, this law was amended for a second time in 2009, and the amendment was more systematic and comprehensive.


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The Chinese Insurance Law covers both the insurance business (contract) and insurance participants (insurer and insured). The Insurance Law has eight chapters: the General Provisions, Insurance Contract, Insurance Company, Insurance Operation Rules, Insurance Agents and Insurance Brokers, Supervision and Administration of the Insurance Business, Legal Liability, and Miscellaneous Provisions.

The second composition of the Chinese legislation system is the administrative regulations, which are promulgated by the highest administration of the central government of China, the State Council. In terms of law, administrative regulations are lower in position than the Constitution and other statutes, but higher than local ordinances and regulations, and effective for the entire country. The administrative regulations govern much wider social relations and specify a wider range of matters than those stipulated in the laws of the National People’s Congress and its Standing Committee. There are many administrative regulations promulgated by the State Council, such as “Regulation on Compulsory Traffic Accident Liability Insurance for Motor Vehicles” (State Council Order No. 462) and “Work-related Injury Insurance Regulations” (State Council Order No. 375). These administrative regulations have played an important role in the insurance regulation in China.

Ministerial Rules of CIRC (CIRC-Rules) The most important and comprehensive part of the insurance regulatory framework is the ministerial rules of CIRC (CIRC-Rules). CIRC-Rules cover many important issues such as: the administration of insurance companies, brokers, agents and representative office of foreign insurers; the prudential supervision of insurance industry; the administrative rules over daily operation of insurance companies; and the protection of the policyholder’s interests. In the next section, the function of the CIRC and some essential issues of the CIRC-Rules will be further discussed.

Ministerial Rules of Other Regulatory Authorities In addition to the CIRC, a number of ministerial rules of other regulatory authorities are involved in the regulation of the insurance industry in China. Nearly all of the government department and institutions are, to some extent, related to the regulation of the insurance industry. Table 21.3 provides an overview of the regulatory authorities with their ministerial rules.


Administrative Regulations

The China Insurance Regulatory Commission (CIRC): Functions and Structure As the insurance regulatory authority in China, the CIRC gives approval to market access, enacts relative rules, and supervises the development of the national insurance market and business activities. According to relevant laws and administrative regulations, the major responsibilities of the CIRC are as follows:


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Overview of the regulatory authorities with their ministerial rules

Regulatory Authority

Scope of the Ministerial Rules

State Administration of Industry and Commerce (SAIC)

organizational registration, alteration, and deregistration of insurance institutions

State Administration of Taxation (SAT)

tax collection of insurance institutions

Ministry of Finance (MoF)

accounting systems and standards, with regard to insurance companies and insurance contracts

State Administration of Foreign Exchange (SAFE) Ministry of Labor and Social Securities (MOLSS)

business related to foreign exchange human resources

Source: Website of the Central People’s Government of the P.R. China (2010).

• To formulate guidelines and policies for developing insurance business, to draw up development strategies and plans for the industry; to formulate laws, rules, and regulations for insurance supervision; and to introduce rules and regulations for the insurance industry; • To examine and approve the establishment of insurance companies and their branches, insurance groups, insurance holding companies, and insurance asset management companies in conjunction with other relevant authorities. These tasks include: examination and approval of the establishment of representative offices by overseas insurance organizations within the territory of the P.R. China, intermediaries such as insurance agencies, brokers, loss- adjustment companies, and their branches; examination and approval of overseas insurance invested by domestic insurance and noninsurance organizations; examination and approval of mergers, divisions, alterations, and dissolutions of insurance organizations; and participating in bankruptcy and liquidation processes of insurance companies; • To examine and confirm the qualifications of senior managerial personnel in all insurance-related organizations, and to establish the basic qualification standards for insurance practitioners; • To examine and approve the clauses and premium rates of insurance products, with reference to public interest, statutory insurance products, and newly developed life insurance products, and to accept the insurance clauses and premium rates of other insurance products for documentation; • To supervise the solvency and market conduct of insurance companies according to law, manage the insurance protection fund, monitor the insurance guarantee deposits, formulate rules and regulations on insurance fund managements on the basis of the Insurance Law and relevant polices of the state, and supervise insurance fund management; • To supervise the business operation of public policy-oriented insurance and statutory insurance, supervise organizational forms and operations such as captive insurance and mutual insurance, and conduct the administration of institutions such as the China Insurance Association; • To conduct investigations and mete out punishment against unfair competition and illegal conduct of insurance institutions and individuals, as well as


The China Banking Regulatory Commission (CBRC); insurance funds utilization China Securities Regulatory Commission (CSRC)


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the operations of noninsurance institutions and disguised insurance operations; To supervise and oversee organizations that are stationed overseas by domestic insurance and noninsurance institutions, according to law; To lay down standards for the information systems of insurance industries, in order to establish risk-assessment, risk-warning, and risk-monitoring systems; and compile the statistics and report forms of the insurance industry, and disclose them in accordance with relevant regulations of the state; and To undertake other assignments delegated by the State Council. As a ministerial institution since 2003, the CIRC currently has 15 internal departments. In addition, the CIRC sets up regulatory bureaus in the provinces, autonomous regions, municipalities, and cities whose economic plans are listed directly under the central government and separately from the provinces where they are located.

Main Issues in the Praxis of the Chinese Insurance Regulation Since China’s access to the WTO in 2001, the Chinese insurance industry has undergone substantial reforms in terms of regulation and supervision. The CIRC is working toward the supervisory framework by developing a strong risk-based insurance industry, strengthening the legal and regulatory framework, enhancing the regulator’s powers, establishing an internal solvency rating system, and improving the financial fitness of insurance companies. Those measures bring the supervisory framework of the CIRC fully in line with best practices, including the standards of the International Association of Insurance Supervisors (IAIS). Based on a comprehensive legal and regulatory framework centered on solvency regulation, market conduct, and corporate governance, the CIRC has realigned its regulatory objectives and taken a number of initiatives in the areas of on-site and off-site inspection, corrective measures and sanctions, and information disclosure and transparency.

Solvency With respect to capital adequacy, the Insurance Law and the 2004 Administrative Provisions on Insurance Companies provided for the minimum required capital for the establishment of an insurance company. Regarding the calculation of the minimum solvency, the CIRC promulgated the Rules on Solvency Margin and Regulatory Index for Insurance Companies in March 2003. In August 2007, the Insurance Sector Solvency Regulatory Standards Committee was created to improve regulatory mechanisms over solvency. Solvency-related on-site inspections were also intensified, and violations/violators were penalized in 2007. In addition, the CIRC takes various measures to strengthen the solvency of Chinese insurance companies. The Measures on Administration of Reserves for Non-life Insurance Business of Insurance Companies (Tentative), which were issued by the CIRC on December 15, 2004, have made the requirements on liabilities more prudential and standardized. In addition, the Rules of Solvency Reporting of Insurance Companies, composed of a series of regulations of the CIRC, have made the solvency assessment


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of insurance companies more scientific and accurate by introducing a quarterly solvency report system, and creating a specialized financial analysis team. Further, the CIRC issues Regulatory Opinions to insolvent insurance entities, asking them to correct their problems within the time frame prescribed. According to the new, amended Insurance Law, when an insurance company fails to meet the solvency requirements promulgated by the CIRC, the CIRC is empowered to take measures against the company, including: (a) ordering the company to increase its capital and obtain additional reinsurance cover; (b) restricting the business scope of the company; (c) restricting distribution of dividends to the shareholders; (d) limiting the remuneration paid to its directors and senior management; and (e) ordering the company to stop writing new policies (§139 Insurance Law). If an insurance company is, or is at substantial risk of, being restructured, taken over, or placed in liquidation, the CIRC may take further measures to restrict its directors and senior management from traveling out of P.R. China and disposing of their assets (§154 Insurance Law).

Corporate Governance In 2006, the CIRC adopted a comprehensive set of laws and regulations in the area of corporate governance, including the Administrative Provisions on the Postholding Qualifications of Directors and Senior Managers of Insurance Companies, and the new regulations for foreign insurers in China. These CIRC-issued regulations are aimed at enhancing the corporate governance framework for the insurance sector in China. The regulations require Chinese insurers to amend their corporate governance and internal control rules to clarify the functions and duties of directors, board committees, and management. Further, the Guidelines on Regulating the Governance Structure of Insurance Companies, issued in 2006, address internal control, risk management, and compliance issues of insurance entities in China.

Accounting and Reporting Standards The CIRC has the authority to review insurance companies’ financial statements. It further supervises and examines the implementation of the accounting and reporting standard by insurance companies, insurance intermediaries, and insurance asset managers. As for accounting standards in China, the Ministry of Finance (MoF) of P.R. China supports international accounting harmonization, and is working to achieve convergence of Chinese accounting practices with the requirements of International Financial Reporting Standards (IFRS), as issued by the International Accounting Standards Board (IASB). In February 2006, the MoF formally announced the issuance of the Accounting Standards for Business Enterprises (ASBE), which became mandatory for listed Chinese enterprises on January 1, 2007. The new ASBEs are substantially in line with IFRSs, although differences exist.



Reinsurance Business The CIRC promulgated the Administrative Provisions on Reinsurance Business in October 2005, which covered the entire reinsurance market. Prior to the insurance


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Investment Avenues In August 2005, the CIRC enacted the Measures for the Administration of Bond Investments of Insurance Institutions. The CIRC permits direct investment by insurers in the stock market. Further, foreign exchange insurance funds may be invested abroad, and foreign invested insurance companies may enter into deposit arrangement with banks. Insurers are also permitted to invest in convertible corporate bonds and subordinated bonds issued by banks. Further, under the Insurance Law, as amended in 2009, the investment avenues of the insurance companies have been expanded, and, for the first time, they will be able to invest funds in immovable assets (presumably the real estate). The 2009 law also authorizes the CIRC to promulgate regulations that implement and clarify these provisions.

The Main Characteristics of China’s Insurance Market Insurance Market Transformed from Monopoly to Monopolistic Competition From 1978–1988, when in the early stage of reform and opening up, China had only one insurance company (PICC) and the market was pure monopoly. From 1989–2000, pure monopoly had been replaced by oligopoly, as the first shareholding insurance company—China Pacific Insurance Company—was established, and the business of Ping An Insurance Company covered the whole country. After 2001, the Chinese insurance market entered a transition period from oligopoly to monopolistic competition. As China participated in the WTO at the end of 2001, the insurance market accelerated opening up, allowing more foreign and joint ventures, as well as domestic-funded enterprises. Market shares of the PICC and China Life had gradually decreased. The market gradually experienced new reasonable, competitive patterns, with state-owned and shareholding insurance companies as the main part. Meanwhile, the market had been mixed with comprehensive and professional companies, domestic-funded companies, and foreign-funded companies.


law reform of 2009, the China Insurance Law required that, when seeking to reinsure their direct P.R. China insurance business, insurers had to give priority to reinsurance companies located in P.R. China. The former China Insurance Law further gave the CIRC the right to restrict or prohibit insurance companies in China from reinsuring with or accepting reinsurance business from overseas insurers. These restrictions have now been removed by the amended Insurance Law. Under the new law, reinsurance business may be ceded to foreign reinsurers. However, the law still imposes the 50% Restriction Rule, whereby the insurance companies must offer at least 50% of its reinsurance risk to at least two professional reinsurers in China before taking their business abroad.

Insurance Industry Had Been Transformed from Extensive to Intensive The market system had gradually played an effective role in the process of the Chinese insurance industry development. Clauses and premium rates of most commercial insurance products were determined by insurers, as long as they were in


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compliance with relevant regulations. Ruled by the market system, insurance companies put more emphasis on internal management, improving profit by reducing cost when exploring market. Instead of scale, modern insurers strike an appropriate balance among quality, structure, and efficiency. The mature market will take the lead in the transformation.

The insurance industry was the first Chinese financial market to open up. According to the commitment of the WTO, by the end of 2004, when in the final phase of the WTO transition, the Chinese insurance industry nearly opened up, except for the provisions that prevented foreign capital from accounting for more than 50% in joint ventures, and prevented foreign property insurers from selling certain policies. Since 1980, foreign insurers could establish representative offices in China. In September 1992, American International Assurance set up the first foreign branch company in Shanghai, which represented a breakthrough of the free flow of foreign insurance capital. In the subsequent years, foreign insurers spread their business from Shanghai to Guangzhou, from coastal areas to inland, from life insurance to nonlife insurance, with various organizing patterns such as branch offices, joint ventures, and subsidiaries. At the end of the WTO transition in December 2004, the Chinese insurance market entered a new phase in which foreign insurers become an important part of the Chinese insurance industry. By the end of 2007, 46 foreign insurance companies were listed on the “Treasure Top 500,” and of those, 27 had set up branches in China. There had been totally 134 organizations in China set up by forty-three foreign insurers coming from fifteen countries. Given the processes of globalization and financial integration, the Chinese insurance market would have closer relations with world markets, which brought advanced cooperation and competition for opportunities in the Chinese insurance industry.

Regional Imbalance of Insurance Market Given the imbalanced economic structure of China, the insurance market has not struck a balance from the perspective of regions. More insurance organizations, fierce competition, and strong demand in eastern areas outpaced the western inland, where there is weak demand and low awareness of insurance. The gap with the developed countries, as well as the gap between different regions of China, not only illustrates the relatively low level of development of China’s insurance market, but also the great potential of the China’s insurance market for development.


The Market Had Transformed from Partial Opening Up to General Opening Up

The Future of the Chinese Insurance Market The insurance market will grow more rapidly and be sustainable. At present, Chinese insurance services cannot satisfy social demand, regardless of quantity or quality. As the domestic economy grows at a steady pace, people have more income to pursue a higher standard of living, which produces the potential for a huge


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demand for insurance services. China’s industrialization and urbanization are growing rapidly as consumer demand, health care, pensions, and education increase. The insurance industry can provide services in many areas. For example, they can accelerate rural development, improve the social security system, and participate in social risk management. Increased private savings and trading transactions advance the insurance market. Chinese cities draw most insurance market shares, leading to a low penetration in country areas. However, given the surging GDP and the changing policy stance, the current situation will soon be altered. Exploring markets in country areas might be a major challenging strategic theme for the Chinese insurance industry, and the key to the strategy is to emphasize individual policy insurance business over commercial and social insurance business. More attention will be paid to risk management. Against the background of financial globalization and mixed operation, a series of new risks are spreading onshore and offshore, challenging the effectiveness and efficiency of current regulation tools. These issues must be addressed. The insurance market will tend to integrate with financial markets. In order to maximize profit through fierce competition, the borders between insurance, banks, and security firms will gradually blur, especially the integration of insurance, and banks will be featured in the future. Insurance intermediary agencies will advance. Good intermediary agencies can help insurers control cost and protect their interests; they are also helpful for insurance operation reform. Chinese insurance intermediary markets lag behind other countries, causing obstacles for insurers exploring markets. Recently, deficient intermediary systems became a bottleneck for the Chinese insurance industry; without fixing this bottleneck, it will be difficult to accelerate development. Insurance awareness will be improved. During a long period of planned economic systems, the Chinese people lacked insurance awareness. As the market-led economy developed over the years, people have attached importance to insurance for transferring risks and minimizing losses, and have perceived insurance products as investment tools, like stocks and bonds. The improving awareness will help advance insurance markets. Insurance competition will become more standardized. In order to get more clients, premiums and market shares, Chinese insurance companies use many methods to face competition, such as reliable services and good reputation, but some use administrative interference, decreased premiums, or increased fees that could devastate market efficiency. Only through legislation, management, and supervision can the Chinese insurance market become fair and perfect.


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Conclusions China’s insurance industry is a sunrise industry; compared to developed countries, China’s insurance industry is not yet mature enough. Despite the adverse impact of the financial crisis, China’s insurance industry still has a bright future. Many small companies may have closed down; many large companies will still grow. Moreover, in order to prevent international financial risks from transferring to the domestic insurance market, international exchanges and cooperation in insurance supervision should be strengthened.


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Financial Services Firms in India: The Road Ahead and the Challenges Anita Pennathur

Introduction The landscape in which financial services firms operate in India has changed tremendously since the financial liberalization of the 1990s. Prior to this time, the financial sectors were heavily regulated in order to be aligned with the economic and social goals of the government. Similarly, to many emerging market countries, India today is faced with delicately balancing liberalization versus adequate regulation and supervision, to allow a safe and sound financial system to f lourish. Currently, India has rebounded from the economic crisis of 2007–2008 relatively unscathed, especially when compared to the developed market economies. The Indian economy demonstrated resilience and recorded a better than expected growth of 7.9% for the second quarter of 2009–2010. The Reserve Bank of India (RBI), India’s central bank, projected a 6% GDP growth for 2009–2010, but has subsequently revised this projection to 7.5%, ref lecting the continued recovery.1 Indeed, the major risk that India faces at this phase deals with inf lationary pressures associated with a quick recovery. The intent of this chapter is to provide a brief history of the financial services sectors, the relevant reforms, and a discussion of the issues and challenges faced by the sectors.


CHAPTER 22

The Banking Sector The banking landscape is comprised of: (a) banks, either owned by the government, the RBI, or the private sector (domestic or foreign); (b) development financial institutions and refinancing institutions; and (c) nonbank financial companies, owned privately. The legislative framework that governs public sector banks was amended in 1994 to enable them to raise capital funds from the market for up to 49% of their equity. The easing of entry regulations has spawned the presence of 30 new


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banks (foreign and domestic) since liberalization, and today there are 27 public sector banks, 31 private banks, and 38 foreign banks in operation.

India had a well-established banking sector at the time of Independence in 1947. The State Bank of India (SBI) was created by the government in 1955 with the aim of ensuring better access to banking for all of India’s constituencies. In 1969, the government took control of the banking sector; 14 of the largest banks were nationalized, and six more banks were nationalized in 1980. This two-phased nationalization of banks was carried out with the aim of equalizing banking access to all areas and segments of society, and it resulted in 92% share of total deposits for the public sector banks. These banks did the majority of lending until the early 1990s. The government also controlled banks’ funds by increasing the Statutory Liquidity Ratio (SLR) and the Cash Reserve Ratio (CRR) from 25% and 2% respectively in 1960, to 38.5% and 15% in 1991. The RBI also controlled deposit rates on savings and time deposits, and specified differential lending rates linked to borrowers’ incomes and types of lending. The net effect of these controls was an inefficient allocation of resources, ref lected in poor customer service, high nonperforming assets, low capitalization, and low profits. 2

Banking Sector Reform The 1991 Narasimham Committee Report served as an impetus for the financial sector reforms, with the intent of increasing efficiencies in the banking sector, to allow them to move toward a market-driven financial system. The reforms, initiated over 1991–1992, were part of a broad economic liberalization to allow free and increased participation of capital markets and the private sector. Some of these reforms include: adoption of capital adequacy in line with international norms, deregulation of interest rates, lowering of the SLR and CRR, opening of the sector to private participation, granting of permission to foreign banks to expand their operations through subsidiaries, introduction of Real Time Gross Settlement (RTGS), and liberalization of Foreign Direct Investment (FDI) norms. Another major element of financial sector reforms in India has been focused on ensuring safety and soundness through greater transparency, accountability, and public credibility. Basel capital standards were adopted for domestic and foreign banks beginning in 1992. Capital adequacy norms for banks are in line with the Basel Committee standards, and from the end of March 2000, the prescribed ratio has been raised to 9%. Banks are also required to comply with Basel II norms.


Background

The Road Ahead and Challenges Faced by the Banking Sector The liberalization reforms have been most successful in this sector. The challenges and the opportunities faced in this sector at a macro level involve the risks inherent in globalization. At a micro level, the implementation of Basel II; new, uniform accounting standards, governance, transparency, and disclosure issues; the implementation of technology; and the enhancement of customer service remain major challenges.3 Globalization has opened up the market, yet, as the recent crisis


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proves, also opens up the sector to contagion. The risk management techniques used in this sector must quickly adapt to and manage the potential risks in new financial products, including derivative instruments such as credit and interest rate derivatives. The timeline for the adoption for Basel II norms has been extended for both the private and public sector banks. The challenge for banks in Basel II implementation is to adopt a comprehensive, enterprise-wide risk management approach, as opposed to an individual risk-silo approach. Given the diversity in the banking sector, this move toward integrated risk management is a supervisory, logistical, and monetary challenge. Governance and transparency are crucial issues in a sector that was, until recently, solely government owned, bringing with it the history of opacity, poor management styles, conf lict of interest, and inadequate board oversight. These issues have important ramifications in times of financial crisis, and new risk management policies should clearly address governance and transparency in bank operations.4 While the financial sector has seen new product innovations, including derivatives, there are no clear accounting guidelines for dealing with these instruments. Accounting rules that would parallel those followed elsewhere in the world should be quickly adopted. From a profitability perspective, increased competition has banks moving into nontraditional sources of income, impacting the risk profile of such banks.5 Furthermore, in a landscape plagued with poor customer service and rudimentary technology, enhancing such service and modernizing technology in a cost-effective manner is imperative.

The Insurance Sector According to the Insurance Regulatory and Development Authority (IRDA) 2007–2008 annual report, the sector is served by one public and 20 private sector firms in the life insurance segment, and six public and 14 private sector firms in the nonlife segment. The public sector has sole control over the reinsurance segment, with one government-controlled insurer in this segment. The total premiums in the insurance market amount to U.S. dollar (USD) 54.38 billion, compared to the global insurance market of USD 4.061 trillion. India’s insurance market is poised for tremendous growth; the inf lation-adjusted growth in this industry was 13% for the year 2007–2008, compared to a rate of 35% for the previous period of 2006–2007. 6

Background


Financial Services Firms in India

Passed in 1912, the Indian Life Assurance Companies Act was the first statute to regulate the life insurance business, followed by the Indian Insurance Companies Act in 1928. The earlier legislations were consolidated and amended into the Insurance Act in 1938. Following this period of open competition, the life insurance industry was nationalized in 1956. The 245 Indian and foreign insurers and provident societies taken over by the central government. An act of Parliament also formed the Life Insurance Corporation (LIC). The nonlife insurance industry was nationalized by the General Insurance Business (Nationalization) Act of 1972, and the 107 insurers were consolidated into four companies, namely, the National Insurance Company Ltd., the New India Assurance Company Ltd., the Oriental


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Insurance Company Ltd., and the United India Insurance Company Ltd., which were subsidiaries of the General Insurance Corporation of India (GIC).

Following the deregulation of the banking sector in the early 1990s, the 1993 Malhotra Committee was formed to evaluate and recommend reforms for the insurance industry. The Committee proposed several recommendations, including opening the industry to the private sector, decreasing governmental ownership, revising the Insurance Act, and forming an insurance regulatory body. The IRDA Act was passed in 1999, and the industry emerged from tight public sector control into a more competitive and market-based environment. Private Indian insurers entered both the life and nonlife business. In addition, foreign firms were also allowed entry into the lucrative Indian markets, although the government capped foreign ownership at 26%. The liberalization of the insurance industry also paved the way for new innovations in products and distribution channels. The UnitLinked Insurance Products (ULIP) is an example of an enormously popular new product.

The Road Ahead and Challenges Faced by the Insurance Sector According to the IRDA, the general insurance business registered a growth of 11.72% in 2007–2008, compared to a growth of 3.52% in 2006–2007. Despite the fact that India is ranked 12th in GDP, 4th in Purchasing Power Parity (PPP), and 2nd in population,7 insurance penetration (measured as premium volume as a ratio of GDP) is low. Total insurance penetration was 1.5% in 1990, while the latest figures for 2007–2008 show insurance penetration to be 4% for life insurance and 0.60% for nonlife. Life insurance penetration tends to rise in tandem with income levels, and the burgeoning middle class of India shows immense growth potential for the life segment. The share of the public sector in the life business is decreasing from 65.89% in 2007–2008 to 47.77% in 2008–2009. Insurance density, measured as a ratio of premium (in USD) to total population, has traditionally been considerably lower than the peer emerging market countries. However, an examination of this ratio over the last few years once again demonstrates the enormous market for insurance in India; total insurance density increased from USD 11.5 in 2000, to 46.6 in 2007, with the life segment increasing from USD 9.1 to 40.4, and nonlife increasing from USD 2.4 to 6.2 respectively. For comparison purposes, insurance density figures for 2007 are USD 202.2 for Brazil, 209.4 for Russia, and 69.9 for China. 8 The life insurance segment is comprised mainly of individual business, as opposed to group business. Like many other emerging market countries, life insurance is deemed a savings mechanism rather than a risk protector. Unlike the saturated life insurance market in developed countries, the strong economic growth, expanding middle class, and relatively young population in India have contributed to the high growth in insurance sales. Yet, according to the IRDA Annual Report, the short-term outlook is grim for both life and nonlife insurers against the backdrop of the global financial crisis. The profitability for nonlife insurers has been


Insurance Sector Reform


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impacted by reduced premiums due to detariffication. The demand for the popular ULIPs had greatly decreased, and the nonlife segment expects, at best, a stagnant premium growth. The medium-term outlook for life remains positive, with the expectation of continued strong growth. The new frontier is the immense market in the health insurance segment. Due to the cap on foreign holdings, foreign firms have set up partnerships with private domestic firms, and the market share of these firms is increasing over time. Along with the impact of the worldwide economic slowdown, the major challenge that the industry faces deals with the continued struggle to allow increased foreign participation. Unlike the banking sector, the insurance industry has been much slower to open to foreign participation, and is viewed as a difficult and protectionist market. First suggested in 2004 and introduced in 2008, a bill allowing an increase of foreign ownership from 26% to 49% has been stalled in Parliament for more than a year, due to intense lobbying from domestic business and political interests. It appears that India recognizes the immense growth potential in this sector and desires to protect its domestic firms in this arena.

The Asset Management Sector Background In general, the asset management industry is comprised of mutual funds, pension funds, and hedge funds. The Indian asset management industry is primarily comprised of the mutual fund and pension fund sector. Established in the 1960s, the mutual fund industry also benefited from the financial liberalization policies, and it grew tremendously in the 1990s with the entry of private players into this market. Pension funds have always been an important institutional feature in India, and pension reform has been ongoing.

Mutual Funds Reform In 1963, the government established the Unit Trust of India (UTI) as the first mutual fund in India. Seven more mutual funds were introduced in the following decades; all were government controlled. At the time of liberalization in the early 1990s, there were 59 mutual fund schemes operating in the state-controlled arena. In 1993, the newly established Securities and Exchange Board of India (SEBI) allowed the private players into this industry. The private players included both domestic and international asset management firms; the international firms were set up as joint ventures with domestic firms. The RBI allowed Money Market Mutual Funds (MMMF) to be introduced via private sector participation in 1995. The 1996 SEBI Mutual Funds Regulation Act further revised the existing regulations. The UTI remained the largest mutual fund in India until 2002, at which time it was impacted by a major financial crisis and was split up into two separate entities in 2003. In 2009, the mutual fund industry had 38 fund families in operation, controlled by public sector banks, public sector financial institutions, and the private sector. In the private sector, the players are domestic, foreign, and joint ventures. The total assets under management for the top five fund families accounts for more than




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Pension Funds Reform The Indian pension sector has been experiencing a series of continual reforms over the last decade. Despite India’s vast population, only 11% of the workforce enjoys pension benefits. The pension system is categorized into two major plans. The Employee Provident Fund Organization (EPFO) manages the contributions of the private sector and offers a defined contribution plan (the Employee Provident Fund [EFP]) and a defined benefit plan (the Employee Pension Scheme [EPS]). The other plan is an unfunded defined benefit plan for government employees. The 1998 New Pension Scheme (NPS), a defined contribution plan, and the Pension Fund Regulatory and Development Authority (PFRDA) opened up the pension industry to professional pension fund managers. The NPS is open to government employees and is being expanded to cover the private sector as well. However, the PFRDA and the PFRDA Bill (introduced in 2005) are awaiting formal approval.

The Road Ahead and Challenges for the Asset Management Sector While the Assets Under Management (AUM) in the mutual fund industry witnessed a Compounded Annual Growth Rate (CAGR) of 35% for the period 2005– 2009, India’s mutual fund penetration ratio (AUM to GDP) is at 9%, substantially lower than developed countries’ ratios, which range from 35%–85%. Furthermore, ref lecting the global crisis, AUM decreased by 13% in 2009.10 While investment managers face challenges through redemptions, lower sales, and a f light to safety, the industry should use this period to proactively manage risks and to provide product innovations that go beyond the traditional asset classes. The pension industry reported a CAGR of 122.44% from 1999–2000 to 2006–2007, yet the vast majority of the relatively young population in India is not covered under any pension scheme. According to the 2005 data from the Organization for Economic Cooperation and Development (OECD), pension assets in India comprise only 5.3% of the GDP, compared to 64.9% in Chile, 62.6% in Singapore, and 56.7% in Malaysia.11 Necessary changes in the pension system include improving the coverage, reducing the administrative difficulties, increasing linkages with the insurance and capital markets, and increasing private domestic and foreign participation. Adequate reform should also reduce the government burden and depoliticize the system, making pensions an economic, and not a political issue.


56% of the industry, and 80% of the industry is controlled by private sector funds. Funds are also allowed to engage in the derivatives market, with a maximum net derivatives portfolio of 50% for portfolio balancing reasons.9 The product range is ref lective of others available elsewhere in the world, with open-end, closed-end, income, index, equity, and money market schemes available. Despite the immense growth in mutual funds, only 3% of Indian households use mutual funds as a savings mechanism. It appears that, despite the downward spiral of the equity markets over the last few years, Indian mutual funds have generally outperformed their relevant indices.


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According to the RBI, the forecasted GDP growth rates will be sustained for the fiscal year 2009–2010. The Wholesale Price Index (WPI) inflation was projected to be 6.5% for year-end March 2010. As feared, the unfortunate side effect of the recovery phase is an upward revision to 8.5% for March 2010. The macroeconomic risk factors that the financial services industries in India face include the uncertainty concerning the larger, global recovery, the volatility of crude oil prices, and a continued upward spiral in inflation. Furthermore, the rapid growth of an increasingly diversified financial sector requires an interregulatory body to identify cross-segment risks. An interregulatory working group with members of the RBI, SEBI, and IRDA has been formed, with the intent to facilitate the flow of information across different segments. More important, however, is adequate and strategic management of governmental deficits, and the reining in of fiscal and monetary interventions. As the RBI aptly puts it, India should move from “managing the crisis” to “managing the recovery.”

Notes 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

(RBI 2009). (RBI 2002−2008). (Leeladharan 2007). Ibid. (Pennathur, Subrahmanyam, and Vishwasrao 2010). (IRDA 2007−2008). (World Bank 2008). Ibid. (SEBI 2002−2009). Ibid. (OECD 2005).

Bibliography Insurance Regulatory and Development Authority (IRDA). “Annual Report.” 2007−2008. http://www.irdaindia.org/. Leeladharan, V. “Indian Financial Sector Reforms.” 2007. http://www.bis.org/review/ r070315d.pdf. Organization for Economic Cooperation and Development (OECD). “Global Pensions Statistics Project.” 2005. www.oecd.org. Pennathur, A., V. Subrahmanyam, and S. Vishwasrao. “Ownership Structure and NonInterest Income in Indian Banks.” Florida Atlantic University working paper. 2010. Reserve Bank of India (RBI). “Annual Report.” 2008−2009. http://www.rbi.org.in/ home.aspx. ———. “3rd Quarter Review of Monetary Policy.” 2009. http://www.rbi.org.in/home. aspx. ———. “Report on Trend and Progress of Banking in India.” Various Issues. 2002−2008. http://www.rbi.org.in/home.aspx. Securities and Exchange Board of India (SEBI). “Various Reports and Statistics.” 2002−2009. http://www.sebi.gov.in/. World Bank. “Data and Statistics.” 2008. http://siteresources.worldbank.org/ DATASTATISTICS.


Conclusions


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Insurance Underutilization in Emerging Economies: Causes and Barriers Rodolfo Francisco Wehrhahn

Introduction The relevance of the role that insurance plays in the development of the economy is undisputed, and almost any government strives to promote an insuranceenhancing policy. Notwithstanding all good intentions, it remains a fact that insurance has not developed as expected in most emerging economies, or at least this is the overall existing impression among government, industry, and experts. The insurance penetration in emerging economies is about a third of the insurance penetration in the OECD (Organization for Economic Cooperation and Development) countries. This is the most commonly encountered statement in the literature, and a topic of several conferences. Here, I want to dig deeper into this statement and discuss a better tool to measure the development of the insurance sector that takes into consideration the state of economic development of the different countries. I have found that using the world average insurance penetration as a function of income per capita as the benchmark for the insurance development makes sense when trying to understand what a reasonable development of the insurance sector in a given economy should be. Using this benchmark suggested by Zheng, Liu, and Deng1 in their paper “New Paradigm for International Insurance Comparison: With an Application to Comparison of Seven Insurance Markets” shows that while the low development of the insurance industry is a reality in several developing economies, the above statement is not as dramatic as it sounds. I find that developing economies, in spite of the relatively low insurance penetration, do have a well-developed and sound insurance sector in accordance to the necessities of their current economy. I then turn to understanding the barriers that still exist in those economies with stagnated insurance industries—barriers that need to be removed to allow for a swift development of the sector. I also focus on the enhancers that should be encouraged in order to boost insurance development. A major insurance developmental barrier identified in this paper, and matter of


CHAPTER 23


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discourse, is the institutional quality and the related Knightian uncertainty. The World Bank Governance Indicators measuring the institutional quality thus become possible predictors of future performance of the insurance industry. Improvement of these indicators would support development and growth.

The importance of the financial sector in the development of a country has been the subject of many publications. There is agreement that the financial sector plays a paramount role in the development, both as a supply-leading mechanism as well as a demand-following instrument. Both types of mechanisms coexist and, as suggested by Patrick, 2 in the early stages of development, the supply-leading mechanism is the dominant instrument for development. Insurance, as part of the financial sector, has a relevant role supporting development. The literature has identified a vast area where insurance contributes to development. The following list is only meant to highlight the main aspects of insurance that have an impact on development. • Insurance, by pooling risks together, lowers the overall cost of risk, reducing volatility. • Households and enterprises have a mechanism to transfer risk at an efficient cost, and to release both financial and human resources to focus on their core production activities. • The long-term character of life and pension insurance promotes long-term internal savings, a key element in any economy to boost development. • Insurance supports trade and other activities by incorporating risk-averse individuals and enterprises into the production chain. • Government’s fiscal budget is relieved from the social security and retirement programs to the extent that these are covered by the insurance sector. • Catastrophic insurance allows governments to reduce the fiscal impact, especially when international reinsurance is available to spread the risk outside the country. Insurance is thus a recognized important tool for supporting and encouraging development. As such, governments are almost always interested in promoting the growth of the insurance sector. Successful policies in the form of tax incentives, education, and mandatory insurance programs, as well as an effective regulation, have helped the growth of the industry in several countries, as discussed later regarding the insurance penetration into various countries and the underlying forces that have resulted in the faster or slower development of the sector.


The Role of Insurance in the Growth of the Economy

The Underutilization of Insurance in Emerging Economies As mentioned in the introduction, the dramatic statement on the underutilization of insurance in developing economies (The insurance penetration in emerging economies is about a third of the insurance penetration in the OECD countries) is the most commonly encountered statement in the literature, and the topic of several conferences. Let us


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examine the way that the development of the insurance industry is usually measured in a given country. When comparing the depth of the insurance sector in a country, a frequently used approach is to compare the total premium income. This number reflects the total volume of the industry, but it says very little about the true development of insurance in the country, since the population factor is not considered. Indonesia, for instance, had a premium volume of around USD 7 billion in 2008, higher than the Chilean insurance volume of USD 5.7 billion. But with a population of 235 million only USD 29 are spent per capita on insurance in Indonesia, compared to USD 344 in Chile, clearly showing the difference in the development of the insurance industry in both countries. While insurance density, defined as insurance premium per capita, better measures the development of the insurance industry, it does not consider the economic development of the country. A more commonly used measure is the insurance penetration or insurance density per gross domestic product (GDP) per capita, or premium volume per GDP. Insurance penetration has been the most frequently used measurement for comparison and development assessment of the insurance industry. Insurance penetration in the development of economies is about one-third of that of the OECD countries as, table 23.1 shows.3 Insurance penetration, while a good indicator of the significance of the insurance industry in a country, fails to take into consideration the development state of the given economy when compared with other economies, as pointed out by Zheng, Liu, and Deng.4 In their paper, a benchmark ratio of insurance penetration is suggested as a better measurement for the development of the insurance sector for comparison purposes. The central idea of this method is to take into consideration the variant significance that insurance has to an economy at different stages of its development. Like with most goods, the income elasticity demand for insurance follows the shape of an S curve, as discussed and pointed out by Enz,5 using GDP per capita as a proxy for income.6 The resulting S curve is displayed in figure 23.1.7 Table 23.1

Insurance penetration and total premium of selected developing economies

Country

Argentina Brazil Chile China Colombia Egypt India Indonesia Morocco Peru Philippines Russia Thailand OECD Average

Insurance Penetration (Total Business)

Total Premium (in millions of USD)

2006

2007

2008*

2006

2007

2008*

2.6 2.8 3.3 2.7 2.4 0.8 4.8 1.3 2.9 1.2 1.5 2.3 3.5 7.0

2.5 3.0 3.5 2.9 2.4 0.9 4.7 1.6 3.4 1.1 1.5 2.4 3.4 7.0

2.5 3.0 4.0 3.3 2.2 0.9 4.6 1.3 2.9 1.1 1.4 2.3 3.3 6.7

5,643 3,0365 4,704 7,0737 3,200 861 40,334 4,846 1,675 1,083 1,751 22,337 7,127 109,676.2

6,315 3,8786 6,169 9,2487 4,103 1,090 5,4375 6,938 2,153 1,187 2,105 29,846 8,285 11,9556.7

8,396 47,493 5,783 1,40,818 4,106 1,389 56,190 6,903 2,538 1,481 2,299 38,778 9,138 No info


Insurance Underutilization

Note: * estimated or provisional.


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When assessing the benchmarked level of insurance development (BLID) in a given country, the ratio between the current insurance penetration of the country and the corresponding world average insurance penetration at the given country’s GDP per capita value is taken. Used as a measure for the insurance development, the BLID basically eliminates from the measurement the inf luence of the stage of economic development ref lected by the size of GDP per capita of the given country. Thus, a ratio of 100% would mean that the country’s insurance level is that of the world average. Higher ratios are assigned to countries that have outperformed the world average, and, of course, ratios lower than 100% describe those countries that are lagging in the insurance development. Because of the strong dependency of tax incentives on the development of the life insurance business, the BLID measurement is best applied to nonlife business. Table 23.2 indicates the BLID next to the current nonlife insurance penetration for a set of developing economies.

World Average Insurance Penetration 8 7 Percentage

6 5

Total Insurance Nonlife Life

4 3 2 1 0 100

1,000

10,000

100,000

GDP per Capita Figure 23.1 World average insurance penetration.

Table 23.2

Nonlife insurance development metrics in 2008 Nonlife Insurance penetration (%)

Penetration as a percentage of OECD average penetration (%)

1.60 1.00 1.60 0.70 2.30 0.60 2.40 2.40 1.50 0.40 0.50 1.60

48 30 48 20 68 18 71 71 44 12 14 48

Brazil Mexico Chile Peru Russia India Ukraine Bulgaria Thailand Indonesia Nigeria Kenya

BLID (%)


302

78 45 77 43 97 52 160 128 95 31 41 141


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Insurance Underutilization Table 23.3

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The BLID for nonlife insurance for selected countries

Brazil Mexico Chile Peru Russia Ukraine Bulgaria India Thailand Indonesia Nigeria Kenya

97 54 73 52 70 31 147 51 93 58 304 267

102 50 68 50 80 26 125 52 91 56 72 239

106 52 67 50 88 67 79 66 86 60 72 251

113 51 71 59 114 83 102 49 76 68 84 235

118 48 73 50 104 112 129 51 79 58 50 180

126 52 83 52 117 134 111 52 86 54 53 176

129 58 98 60 136 178 112 62 90 74 48 214

122 61 86 63 151 308 126 57 90 73 59 205

112 58 75 54 143 404 116 59 116 58 71 185

106 50 68 43 125 237 151 55 118 59 57 163

91 50 62 42 124 209 144 54 112 49 45 154

84 53 62 39 114 190 136 52 99 40 44 152

78 45 77 43 97 160 128 52 95 31 41 141

106 53 74 51 112 164 124 55 95 57 77 197

Source: Own calculations.

The above table restates the point made in the introduction that while the low development of the insurance industry is a reality in several developing economies, there are countries, like Ukraine, Bulgaria, Kenya, Russia, and Thailand, where the development of the insurance industry is more than reasonable for their current economic development. Other developing economies, like Indonesia, Nigeria, Mexico, and Peru, clearly show a poor development of this financial sector. India is of particular interest since it has an extremely low insurance penetration, but already a 52% BLID. It is also of interest to follow the progress of the insurance industry at different stages of the economic development of the countries. Table 23.3 indicates the BLID for the nonlife business of selected developing economies since 1996. Again, our focus here is the development of the nonlife business, to minimize the effects related to tax policies that strongly affect the life insurance business. At different stages of their economic development, Brazil, Russia, Bulgaria, Ukraine, and Thailand outperformed the world averaged insurance penetration, as illustrated in table 23.3. In the case of Mexico, India, and Peru, for instance, the insurance development was constantly below the world average insurance penetration throughout the last 13 years.

Growth Forces in the Development of the Insurance Sector


1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Average

The world average insurance penetration curve allows for further analysis of the development of the insurance sector. The forces that are gearing the development of the insurance sector can be split as coming from three different sources. 8 Figure 23.2 shows that the world average insurance penetration is drawn together with a parallel, dotted S curve that crosses the value of the insurance penetration P90 of a given country in the year 1990. Let P06 be the country’s insurance penetration in 2006, and RG be the insurance penetration equal to the country’s insurance penetration in 1990 but at the country’s GDP per capita value of 2006, and DG the insurance penetration on the parallel world average insurance penetration curve at the country’s GDP per capita value of 2006.


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Rodolfo Francisco Wehrhahn Growth patterns

8 7

P06

Percentage

6 5

World Average penetration Parallel development

4 DG

3

1

P90


2 RG

0 100

10,000

1,000

100,000

GDP per Capita Figure 23.2

Growth forces analysis.

Table 23.4 Growth patterns of selected developing economies over five years from 2003 through 2008 Growth patterns 2003–2008 GDP/cap 2003

GDP/cap 2008

P03 (%)

P08 (%)

World Avg World Avg Institutional Deepening 2003 (%) 2008 (%) Growth Growth (%)

Brazil Mexico

2.8 5.9

8.1 10.1

1.68 1.10

1.60 1.00

1.38 1.79

2.04 2.24

0.66 0.45

–0.74 –0.55

Chile Peru Russia Ukraine Bulgaria India Thailand Indonesia Nigeria Kenya

5.3 2.2 3.0 1.0 2.5 0.6 2.3 1.0 0.4 0.4

8.6 4.6 11.7 3.7 6.6 1.0 4.2 2.2 1.5 0.9

1.47 0.83 2.13 3.52 1.69 0.62 1.19 0.83 0.63 2.20

1.60 0.70 2.30 2.40 2.40 0.60 1.50 0.40 0.50 1.60

1.71 1.31 1.41 1.14 1.35 1.09 1.32 1.14 1.07 1.07

2.09 1.63 2.36 1.50 1.87 1.15 1.57 1.30 1.21 1.14

0.38 0.32 0.95 0.36 0.52 0.06 0.26 0.16 0.14 0.06

–0.25 –0.45 –0.78 –1.48 0.19 –0.08 0.05 –0.59 –0.27 –0.66

Now, the development of the insurance industry in the given country can be divided into three segments. The line between P90 and RG represents the growth of the insurance industry driven by the economic growth.9 According to the world average insurance penetration S curve, at a higher level of GDP per capita, a higher consumption preference of insurance is expected, and this is ref lected by the line between RG and DG.10 The growth represented by the line between DG and P06 is called institutional growth by the same authors. This growth beyond the parallel shifted world average insurance penetration curve is attributed to country-specific measures like tax policy, institutional quality, mandatory insurance, tradition and religion, social programs, etc.


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Table 23.4 exhibits the different growth patterns of the nonlife insurance sector between 2003 and 2008 for selected developing economies. The numbers in this table identify the most attractive countries from the growth perspective of their insurance sector, as those countries show the largest expected deepening growth. Russia, Brazil, Mexico, and Bulgaria clearly showed important growth potential over the observed period of time. The resulting actual growth, however, was severely diminished by a strong negative institutional growth in Brazil, Russia, and Mexico, contrary to Bulgaria, where institutional growth was positive. Indonesia had limited growth opportunity, based on its economic developmental stage and ref lected in the low expected deepening growth in 2003. The resulting growth over the next five years, however, was even more disappointing, due to a negative institutional growth wiping out the small expected deepening growth. Thailand, on the other hand, boosted its expected deepening growth with a positive institutional growth, almost reaching world average insurance penetration in 2008.

The Role of Institutional Quality in the Advancement of Insurance As discussed in the previous section, there is a clear correlation between the level of income or GDP per capita and the insurance development state. The S curve that represents the world average insurance penetration captures such a dependency. Thus, insurance penetration is expected to grow as the economy or GPD per capita increases. The insurance growth, as discussed above, can be attributed to three types of effects: the regular growth related to having higher GPD per capita to be spent in insurance but without increasing the insurance penetration, the deepening growth related to the economic growth according to the world average insurance penetration S curve, and the institutional growth. To throw clarity into the institutional effect on the level of insurance penetration, and using the results found in the paper by Erbas and Sayers,11 I first note that not only insurance penetration is correlated to GDP per capita, but also, as several studies indicate, there is a strong correlation between the income level across countries and the level of institutional quality, as measured, for instance, by the World Bank Governance Indicators (WBGI): Voice and Accountability, Political Stability, Government Effectiveness, Regulatory Quality, Rule of Law, and Control of Corruption. OECD countries exhibit WGI above 80%, while developing economies are usually below 50%. Table 23.5 contains the Voice and Accountability values for selected developing economies, and figure 23.312 contains the OECD average values of all WGI. Now, going back to the established correlation between insurance penetration and GDP per capita on the one hand, and GDP per capita and the WGI on the other, and using the transitivity property of correlation, it follows that insurance penetration should be correlated with the WGI representing institutional quality. Erbas and Sayers13 actually found that the correlation between insurance penetration and institutional quality is stronger than the correlation with the level of income. Erbas and Sayers14 focused on nonlife insurance markets across a sample of 70 countries, since nonlife is less dependent of country-specific tax and other fiscal incentives, and they found, through multiple regressions, that the explanatory power of the WGI is stronger than that of level of income. Their findings are summarized in table 23.6.15




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54.5 44.0 69.4 40.2 34.9 38.8 52.2 52.6 58.4 14.4 3.8 25.4 40.7

1996

55.2 45.6 65.7 36.5 33.6 39.1 56.2 55.4 59.8 15.4 8.2 24.0 41.2

1997 55.8 47.1 62.0 32.7 32.2 39.4 60.1 58.2 61.1 16.3 12.5 22.6 41.7

1998 54.6 51.0 67.8 39.2 33.0 35.4 61.6 58.0 62.5 26.4 20.2 23.1 44.4

1999 53.4 54.8 73.6 45.7 33.7 31.3 63.0 57.7 63.9 36.5 27.9 23.6 47.1

2000 55.3 55.6 76.7 49.6 36.3 31.5 64.2 58.4 61.1 37.3 26.5 24.8 48.1

2001 62.0 54.8 78.8 49.5 33.7 27.4 62.5 58.2 55.3 38.0 27.9 37.5 48.8

2003 59.6 58.2 87.5 45.7 31.3 28.8 66.3 61.1 55.3 38.5 26.4 43.3 50.2

2004 63.0 56.3 88.9 49.5 27.9 35.1 64.4 62.5 50.0 43.8 24.5 41.8 50.6

2005 62.0 51.4 76.0 50.0 22.6 45.2 63.0 58.7 30.8 41.3 36.1 47.6 48.7

2006


57.2 56.3 79.8 53.4 38.9 31.7 65.4 59.1 58.2 38.0 25.0 26.0 49.1

2002

Voice and Accountability

Voice and Accountability in selected developing economies.

Source: World Bank for the even years and the odd years calculated using basic extrapolation

Brazil Mexico Chile Peru Russia Ukraine Bulgaria India Thailand Indonesia Nigeria Kenya Average

Table 23-5

59.1 49.5 81.7 48.6 21.6 46.2 67.3 58.7 30.3 43.3 31.7 44.7 48.6

2007

61.1 50.5 76.9 49.0 21.6 47.1 65.9 58.7 32.2 44.2 31.3 43.3 48.5

2008


●

307

OECD Voice and Accountability

Political Stability

Regulatory Quality

Rule of Law

Control of Corruption 0

25

50

75

100

Country’s Percentile Rank (0–100) Figure 23.3

OECD countries WGI average over 13 years.

Table 23.6

Cross-Correlations (t-values)

Per capita income (PCI) M2/GDP Nonlife claims/premiums (C/P) Overall index Voice and accountability Political stability Government effectiveness Regulatory quality Rule of law Control of corruption

Insurance Penetration

PCI

C/P

5.6 2.0 4.5 6.9 8.5 5.4 5.6 5.9 5.3 5.7

2.9 4.6 9.5 6.3 8.6 8.6 6.9 9.1 9.1

4.9 3.9 3.7 4.9 3.9 5.1 5.0

Source: (Erbas and Sayers 2006).


Government Effectiveness

The above table indicates several other parameters that have also been examined by Erbas and Sayers to determine their significance in explaining the differences in insurance penetration found in the 70 countries. Among those parameters, the claim ratio, defined by the ratio of the insurance claims to the premium, is found to be significant. Insurance penetration is higher when the claim cost is high or when the insurance coverage provides a higher value to consumers. This seems to indicate that when the insurance penetration grows, competition tends to decrease the supplier’s profit margins. This provides an additional reason to encourage the development of the insurance sector for the benefit of consumers. On the other


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hand, and somehow confirming the coexistence of important discrepancies between the development of the banking sector and the insurance sector in several countries, there is no strong correlation between insurance penetration and the financial depth, as indicated by the ratio M2/GDP

The section on the discussion of the forces relevant to the development of the insurance sector made it clear that countries exhibiting in their forecast a steep world average insurance penetration S curve have a high potential growth of the insurance sector. However, the realization of such potential can be severely hindered by negative institutional growth. In this section, the argument is made that the World Bank Governance Indicators, and particularly the Voice and Accountability indicator, can be used as an important predictor of the institutional growth. Using the results from the preceding section on the role of the institutional quality in the advancement of the insurance sector, which indicate the strong correlation that exists between insurance development and the WGI, particularly the Voice and Accountability indicator, I examined the correlation between this indicator at the beginning of a period of three and five years and the resulting observed institutional growth of the insurance sector for 13 developing economies. I found, for the period 2003–2008 and the period 2005–2008, strong positive correlations of 56% and 60% among these parameters respectively (table 23.7). Taking into consideration that the institutional growth is defined as the deviation from the world average S curve in insurance penetration attributed to other factors excluding the economic growth, the correlation found between this parameter and the Voice and Accountability indicator of 56% and 60% for periods of five and three years of growth, suggests that the WGI may be used to partially forecast the expected behavior of the institutional growth, and, thus, the ultimate insurance growth. The WGI cover several aspects of the institutions, like the extent to which a country’s citizens are able to participate in selecting their government, as well as freedom of expression, association, and the press; thus, any policy that improve these aspects will have direct consequences in the insurance sector growth.

Table 23.7 Correlation between institutional growth and World Bank Governance Indicators in 2003–2008 and 2005–2008


World Bank Governance Indicators as Useful Predictors of Insurance Development

Correlations

Voice and accountability Rule of law Control of corruption Government effectiveness Regulatory quality

2003–2008 (%)

2005–2008 (%)

57 49 39 34 39

60 49 42 31 45

Source: World Bank and own calculations.


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The use of the world average insurance penetration as the benchmark for the development of the insurance penetration allows looking into more detail the forces that play a role in the insurance advancement of emerging economies. Interpreting the different growth patterns as “growth forces,” it can be argued that countries lacking of the expected development of the insurance sector, according to their current economic stage, can be attributed to low or even negative institutional growth forces. Now, using the results found by Erbas and Sayers, which show the strong correlation between insurance development and institutional transparency as measured by the World Bank Governance Indicators, I show the existence of a positive correlation between the institutional growth forces of the insurance sector over three and five years periods and the World Bank indicators at the beginning of those periods. Table 23.7 indicates the correlations of the institutional growth with five different WGI. The WGI Voice and Accountability, which captures the essence of transparency, has the largest correlation. It is also of interest to note that the quality of regulation seems to have a more immediate effect than other indicators, as the three-year development period shows a much stronger correlation than the five-year period. Rule of law measuring the extent to which agents have confidence in and abide by the rules of society, including the quality of property rights, the police, and the courts, as well as the risk of crime, also shows a relevant correlation. The results found here are to be taken as indicative for relationships that seem to exist between the insurance development and the different aspects of the economy and governance. A much deeper and detailed statistical analysis would be necessary to come to stronger results. Nevertheless, this preliminary analysis already suggests important relationships and the consequent recommendations to the growth of the insurance market. I would like to complete the chapter by pointing out that, besides factors external to the industry, like the economic development and the institutional quality and transparency, other aspects that can be directly inf luenced by the insurance industry are relevant to its development. Central to this discussion is the question of adequacy of the insurance offering in the developing economies. Currently, available products in most developing economies mainly target the population at the top segment of the financial pyramid, albeit the concept of microinsurance aiming at the low-income people has generated substantial interest among industry and government. Moving away from the traditional thinking of insurance, an effective implementation of microinsurance should be explored as a possible way to expand the supply for insurance.


Conclusions

Notes 1. 2. 3. 4. 5. 6.

(Zheng, Liu, and Deng 2008). (Patrick 1966). (Swiss Re 2007, 2008, 2009). (Zheng, Liu, and Deng 2008). (Enz 2000). In (Zheng, Liu and Deng 2008), the average of the world insurance penetration is calculated using data from 1980 to 2006 for 95 countries. 7. (Zheng, Liu, and Deng 2008). 8. (Zheng, Liu, and Deng 2008).


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(Zheng, Liu, and Deng 2008) call this regular growth. (Zheng, Liu, and Deng 2008) call it deepening growth. (Erbaş and Sayers 2006). (Kaufmann Kraay, Mastruzzu 2009): The governance indicators presented here aggregate the view on the quality of governance provided by a large number of enterprise, citizen, and expert survey respondents in industrial and developing countries. These data are gathered from a number of survey institutes, think tanks, nongovernmental organizations, and international organizations. 13. (Erbaş and Sayers 2006). 14. (Erbaş and Sayers 2006). 15. (Erbaş and Sayers 2006).

Bibliography Enz, R. “The S-Curve Relation Between Per Capita Income and Insurance Penetration.” The Geneva Papers on Risk and Insurance 25, no.3 (2000): 396−406. Erbaş, S., and Sayers, C. “Institutional Quality, Knightian Uncertainty, and Insurability: A Cross-Country Analysis.” IMF Working Papers, 2006. http://www. imf.org/external/pubs/ft/wp/2006/wp06179.pdf. Kaufmann, D., A. Kraay, and M. Mastruzzu. “Governance Matters VIII: Governance Indicators for 1996–2008.” The World Bank Policy Research Working Paper. 2009. http://www.wds.worldbank.org/external/default/WDSContentServer/IW3P/IB/200 9/06/29/000158349_20090629095443/Rendered/PDF/WPS4978.pdf. Patrick, H. “Financial Development and Economic Growth in Underdeveloped Countries.” Economic Development and Cultural Change 14, no.2 (1966): 174−189 Swiss Re. “Sigma No4.” 2007. http://www.swissre.com/resources/78a2a38048cc8193b 5bebff786c7c74e-sigma_4_07_e_rev.pdf. ———. “Sigma No3.” 2008. http://www.swissre.com/resources/d901cb004a24e38e9426 d71e1eec54e8-sigma3_2008_e_rev.pdf . ———. “Sigma No3. 2009. http://www.swissre.com/resources/bf78dc004eaf bb13ab72afc270ecaac9-sigma3_2009_d_rev.pdf. Zheng, W., Y. Liu, and Y. Deng, “New Paradigm for International Insurance Comparison: With an Application to Comparison of Seven Insurance Markets.” 2008. http://www. iisonline.org/pdf/Geneva%20IIS%20Research%20Papers.pdf#page=49.


9. 10. 11. 12.


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Editors Cecelia Kempler, J.D. (New York Law School, 1979, Cum Laude), is an Executive in Residence at Florida Atlantic University as of June, 2010. She was the director of the Barry Kaye School of Finance, Insurance, and Economics at Florida Atlantic University. Prior to joining FAU, Ms. Kempler was the chair and co-chair respectively of then LeBoeuf Lamb Greene & MacRae’s (now Dewey & LeBoeuf ) Life Insurance Practice Group and General Insurance Practice. She is admitted to practice law in New York, the District of Columbia and before the United States Supreme Court. Ms. Kempler has published numerous articles relating to insurance regulation, reinsurance, and insurance insolvencies. Ms. Kempler serves on the Supervisory Board of Aegon NV and serves on its Risk and Nominating Committees. Michel Flamée, Ph.D. (Free University of Brussels, 1984, Cum Laude), is a professor at the Economic and Financial Law Center of the Free University of Brussels. Professor Flamée is vice-chairman of the Banking, Finance and Insurance Commission (CBFA), past chairman and member of the Executive Committee of the International Association of Insurance Supervisors (IAIS). Professor Flamée has been heavily involved with the international repositioning of the Belgian supervisor, both at European level and worldwide. He was strongly involved in the setting up of the Solvency II directive. During his career Professor Flamée has been for many years a member of the Belgian Competition Council. His teaching areas and research interests include financial and economic law. He has regularly complemented and updated a prominent Belgian reference work in economic law and published numerous articles in this domain.


Editors/Contributors

Charles Yang, Ph.D., is assistant professor in the Department of Finance, Florida Atlantic University. Professor Yang graduated from the University of Texas at Austin, with a Ph.D. degree in Insurance and Risk Management. He has been teaching insurance, risk management, financial planning, and general finance. His research interests include insurance, enterprise risk management, alternative risk transfers, and exotic derivatives. Professor Yang’s research has appeared in Geneva Risk and Insurance Review, Journal of Risk and Insurance, North American Actuarial Journal, Review of Quantitative Finance and Accounting, Financial


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Contributors

Paul Windels, Ph.D., CIA, CFSA, is an auditor at the Banking, Finance and Insurance Commission (CBFA) and an assistant professor in Finance and Risk Management at the Hogeschool-Universiteit Brussel. Professor Windels graduated from the Ghent University with a Ph.D. in applied economics and an advanced master in public management. He obtained a postgraduate degree of internal auditing from the University of Antwerp Management School. His research interests include European and international developments in financial sector supervision, accounting, and auditing. His work has been published in international academic journals and books such as Local Government Studies, Comparative International Governmental Accounting Research (CIGAR) and Review of Business and Economics.

Contributors Jérôme Berset is the senior regulatory officer and vice president, Regulatory Affairs for Swiss Re, Zurich, Switzerland. He has expertise in risk and capital management, regulatory affairs, and government relations, and a strong track record of effectively communicating with and educating various company internal and external stakeholders on complex risk-related issues. Peter Braumüller is managing director in the Austrian Financial Market Authority (FMA), responsible for Insurance and Pension Supervision. He has held this position since the foundation of the FMA in 2002. He is a certified actuary with the Austrian Actuarial Association. At present, he is chair of the Executive Committee of the International Association of Insurance Supervisors (IAIS) and vice chair of the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS). Paolo Cadoni is currently a manager in the Solvency II Project Office where he is leading on FSA’s input into the Committee of European Insurance and Occupational Pensions Supervisors’ (CEIOPS) Internal Models Working Group. Dr. Cadoni joined the FSA in 2004 where he has held a succession of posts both in banking and insurance.


Review, Risk Management and Insurance Review (RMIR), and other journals. He has won research awards such as the Robert C. Witt Outstanding Feature Article Award and the RMIR Best Perspectives Award in risk management and insurance.

Dongmei Chen is an associate professor of Insurance and Risk Management at the School of Economics and standing deputy director of the department of Insurance at Fudan University. She received her doctorate degree in economics from Fudan University in 2003. Her research has focused on the insurance economics, insurance law, and social insurance. Mark Freedman is a principal in the Insurance and Actuarial Advisory Services practice of Ernst & Young. He has more than 30 years of experience in the life insurance industry, including over 25 years of experience serving clients. He has extensive experience in GA AP, IFRS, statutory financial reporting, mergers and


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acquisitions, and modeling, and leads actuarial audit support efforts at large life insurance companies.

Patricia Guinn, CER A, FSA, MA A A, is the Risk and Financial Services (RFS) business segment leader for Towers Watson. Ms. Guinn’s consulting expertise includes risk management, mergers and acquisitions, financial analysis, and performance measurement for insurance companies. She is a fellow of the Society of Actuaries, a member of the American Academy of Actuaries and a Chartered Enterprise Risk Analyst. Debra Hall is principal of Global Regulatory and Risk Consultants and arbitrator and mediator of insurance and reinsurance disputes involving a variety of issues, including sub-prime related disputes. Ms. Hall has extensive involvement in the national Association of Insurance Commissioners (NAIC) representing the interests of the Illinois Director of Insurance, and later, the U.S. reinsurance industry. She is an active observer member of the IAIS and property/casualty chair of the NAIC Reinsurance Task Force Interested Persons group. Tara Hansen is a senior actuarial advisor in the Insurance and Actuarial Advisory Services practice of Ernst & Young. Ms. Hansen has 14 years of experience in the life insurance industry, with an emphasis on financial reporting and mergers and acquisitions. She is a fellow of the Society of Actuaries and a member of the American Academy of Actuaries. Peter Ivanick is one of the senior bankruptcy and insurance insolvency partners at Dewey & LeBoeuf LLP. He has played significant roles in most of the major American insurance insolvencies over the last 25 years, including Harvard Pilgrim, Reliance, Mutual Benefit, Executive Life, and Baldwin-United. In addition, Mr. Ivanick has represented petitioners and other interested parties in connection with solvent schemes and foreign insurance insolvencies. Heike Klappach is a senior consultant of Towers Watson in Cologne, Germany. Ms Klappach is specialized in the areas of reinsurance and asset liability management. She is also involved in the development and marketing of the German version of the firm’s financial modeling software for nonlife companies, and is a qualified member of the German Actuarial Association (Aktuar DAV).


Douglas French is the managing principal of Ernst & Young’s Insurance and Actuarial Advisory Services practice and is based in the firm’s New York office. In addition, he is responsible for all advisory services for the insurance sector within the firm’s Financial Services Office. He is a fellow of the Society of Actuaries and a member of the American Academy of Actuaries.

Stephen Lowe, CER A, FCAS, MA A A, is a managing director in Towers Watson’s global property/casualty insurance practice. Mr. Lowe specializes in assisting clients in understanding the interplay between risk and capital, and how that interplay translates into the creation of value. Mr. Lowe is a fellow of the Casualty Actuarial Society (FCAS) and has served on its Board of Directors. He is also a member and past vice president of the American Academy of Actuaries (MA A A). Monica Mächler is the vice chair of the Board of Directors of the Swiss Financial Market Supervisory Authority (FINMA). In the International Association of


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Insurance Supervisors she is a member of the Executive Committee, vice chair of the Technical Committee and chair of the Task Force developing a Common Framework for the Supervision of Internationally Active Insurance Groups.

Michael Mathisen is a principal in KPMG’s New York office and is the lead insurance tax partner for the Northeast and Mid-Atlantic. He is responsible for tax accounting and planning for insurance clients with an expertise in international tax consulting for cross border Insurance clients. Mr Mathisen has 30 years of insurance company tax experience with positions both in industry and the Big 4. Peter Neville held various positions at IMRO—the Investment Management Regulatory Organization which is now part of the Financial Services Authority in the United Kingdom. In 1997 he joined Lloyd’s of London—the insurance market—as a general manager in the Regulatory Division, and in April 2001 he was appointed director general of the Guernsey Financial Services Commission, a position he held until retiring at the end of May 2009. Jerry M. de St. Paer is senior vice president at the American International Group. Mr. de St. Paer is responsible for a number of major AIG corporate control and transformation initiatives. He is also executive chairman of GNAIE, the association of North American insurers (including AIG) representing the North American insurance industry’s perspective in the development of international insurance accounting and solvency standards. Anita Pennathur is associate professor of finance at Florida Atlantic University. She received a Ph.D. in finance from the University of Alabama. Dr. Pennathur is an accomplished researcher. Her research interests are in the areas of financial institutions and markets, privatization, corporate governance, and mutual funds. She has published articles in the Journal of Financial Research, Real Estate Economics, Journal of Real Estate Finance and Economics, and Financial Review, to name a few. Marcelo Ramella is assistant director of research at the Bermuda Monetary Authority and visiting fellow at the U.K. London School of Economics and Political Science (LSE). He has a long-standing research interest in innovative practices, especially processes of social and institutional legitimation of innovation.


Therese Masiello is an actuarial analyst in the Insurance and Actuarial Advisory Services practice of Ernst & Young. She has more than six years of industry experience with emphasis on financial reporting and life pricing. She is a fellow of the Society of Actuaries (FSA) and a Member of the American Academy of Actuaries (MA A A).

Lynn Roberts is counsel to Dewey & LeBoeuf LLP. Ms. Roberts advises clients in structured finance transactions, including, in particular, transactions that raise capital to fund reserves required of insurance company clients. She also assists in international reinsurance-related, transactional matters. Pamela Schuermans is responsible for the coordination of the Solvency II project and for the support of the Financial Requirements Expert Group at the Committee for European Insurance and Occupational Pensions Supervisors (CEIOPS). She is also responsible for the regulatory dialogues with non-European countries. Before


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that, she worked as an insurance supervisor for the Belgian Banking, Finance and Insurance Commission (CBFA).

Paul Sharma is the director, Wholesale and Prudential Policy at the Financial Services Authority (FSA). He leads a division of over 100 policy staff responsible for capital, liquidity, client money, and wholesale conduct of business standards applicable to banks, insurance companies, and other financial firms. Paul also leads on the FSA’s negotiation and implementation of the EU/international Solvency II and Basel II initiatives. Prakash Shimpi, CER A, FSA, MA A A, CFA, is Chief Risk Officer of ING U.S. responsible for enterprise-wide risk management to measure, monitor, control, and mitigate risk. Previously, he was president & CEO of Towers Watson Capital Markets, a broker-dealer specializing in asset risk management, insurance-linked and retirement-related transactions. Mr. Shimpi has worked across academic disciplines and professional associations to develop both the theory and practice of ERM. Raj Singh is chief risk officer and member of Executive Committee, Swiss RE America Holding Corporation. Mr. Singh previously worked for Citigroup, where he held a number of senior positions, mainly in the area of credit and structured finance and was also the managing director Risk/Merger & Acquisitions for Citibank Northern Europe, which included site responsibility for Citibank Belgium. Matthew Stern is an associate in the New York office of Dewey & LeBoeuf LLP and a member of the firm’s Capital Markets and Corporate Finance practice. Mr. Stern has represented issuers and underwriters in a variety of capital markets transactions. In addition, Mr. Stern has extensive experience advising on insurancelinked securitizations. Mr. Stern received his J.D. from Cornell University. John Trowbridge, BSc, BE, BA, FIA, FIA A, is one of three government-appointed executive members of the Australian Prudential Regulation Authority (APR A), Australia’s national prudential regulator for banking, insurance, and superannuation. He has served in that capacity from 2006‒2010. He is also a member of the Executive Committee of the International Association of Insurance Supervisors.


John Schwolsky is a partner of Dewey & LeBoeuf LLP and the global co-chair of the Capital Markets and Corporate Finance Practice Groups. Mr. Schwolsky’s practice deals with corporate and capital market transactions involving the insurance industry. Mr. Schwolsky has been recognized as a leading insurance transactional lawyer in Chambers USA. Mr. Schwolsky received his J.D. from Cornell University.

Theresa Vaughn is the CEO of the NAIC, and serves as the association’s primary representative and chief spokesperson in Washington D.C. She is a CPCU, an associate of the Society of Actuaries, an associate of the Casualty Actuarial Society and a member of the American Academy of Actuaries. She is the co-author of two college textbooks on insurance: Essentials of Insurance and Fundamentals of Risk and Insurance. Her research has appeared in the CPCU Journal, Journal of Risk and Insurance, Journal of Insurance Regulation, and other publications.


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Alexander Warzilek works with the Austrian Financial Market Authority (FMA) where he coordinates insurance supervision at the Division of International Affairs and European Integration. He represents Austria in various Committees of the IAIS and the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS).

Xian Xu is an assistant professor of the Department of Insurance and Risk Management at the School of Economics, Fudan University. Xian Xu’s research has focused on insurance economics, insurance business administration, and risk management. He has more than 40 publications in German and Chinese academic journals.


Rodolfo Francisco Wehrhahn is the senior insurance specialist, Global Capital markets for the World Bank. Former managing director Latin America, he was responsible for the Latin American operation for Transamerica Reinsurance and also member of the AEGON Group, United States of America.


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accounting standards, viii, 4, 29–30, 41, 69, 71, 84, 88–9, 98, 140, 145, 190–1, 199, 270, 287, 292 See also International Accounting Standards Board Accreditation Program (NAIC), 26, 28–9, 33–4 Actuarial Guideline AXXX (U.S.), 235 Aegon, 112, 192 AIG Financial Products, 137, 141 Ajax Re, 239–40 Allianz, 122, 192 alternative risk transfer instruments (ART), 101–2, 234, 267–70 American International Group, Inc. (AIG), 21, 34n1, 109–10, 112, 137, 141–2, 147–9, 161–2, 171–2, 189–90, 279–80 AMP, 140–1 annuities, 195–200 See also variable annuities Articles of Framework Directive, See NAIC Framework Asset-Liability Management (ALM), 197–9 Asset Valuation Reserve (AVR), 31 assets, 38, 40–3, 55–6, 60–1, 75, 83, 85, 88–9, 130, 145, 177, 199, 212–13, 215, 265 See also mark-to-market approach assurfinance model, 123 Australia, 29, 84, 95, 110, 118n4, 137–52, 152n2, 159, 190, 203n1,2 Australian insurance industry, 137–52 background of (1970–2010), 138–40 and group supervision, 140–52

Australian Prudential Regulation Authority (APRA), 137–8, 146–52, 159 Austria, 104n2, 159, 203n1, 256 Avalon Re, 238–9 Aviva, 192 Axa, 122, 192 Ballantyne Re, 239–40 bancassurance model, 122–33 Bank of International Settlements (BIS), 190 bankruptcy law (U.S.), viii, 161–6, 166n3,7, 167n8 Basel Committee on Banking Supervision (BCBS), 125 Basel II, 16, 29, 57, 69–60, 84, 111, 125–6, 128, 211, 292–3 Basel II banking rules, See Pillar I; Pillar II; Pillar III benchmarked level of insurance development (BLID), 302–3 Bermuda, 5, 7, 29, 84, 110, 159, 191–3, 201–2, 212, 237–8, 262–3, 270 Bermuda Insurance Act (1978), 237–8 Bermuda Monetary Authority (BMA), 5, 193, 238 Bernanke, Ben, 182 Better Business Bureau (BBB), 77, 100, 256–7 boards (corporate), 175–86, 186n15 engagement of, 177–80 and ERM, 180–6 structures of, 175–6 and subsidiary boards, 179–80 third-party board assessments, 178–9


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Index

Brazil, 92, 190, 203n2, 294, 301–6 Bretton Woods system, 12 British Aviation Insurance Company Limited (BAIC), 165 Bulgaria, 302–6 Campagne, Cornelis, 54 Canada, 29, 84, 92, 95, 105n24, 110, 118n4, 175, 190, 197, 202, 203n1,2, 256 Canadian Asset Liability Method (CALM), 197 capital adequacy, 14, 27, 57, 89, 92, 123, 129–30, 148, 161, 205, 211–13, 221–3, 227, 271, 286, 292 capital flows, 12, 71 capital requirements and financial conglomerates, 125–6 and risk management, 211–28 See also economic capital methodology of Solvency II, 5, 38–40, 42–4, 47, 58, 60, 61–2 See also minimum capital requirement; solvency capital requirement U.S., 25–34 captive insurance, 261–72 development of, 261–4 and location, 269–71 managers of, 267 position of, 265–6 regulation and supervision of, 267–9 risks underwritten by, 266–7 types of, 264–5 Caribbean Catastrophe Risk Insurance Facility, 236 Carillon Re, 239–40 Cash Reserve Ratio (CRR), 292 catastrophe, vii, 3, 7–9, 75, 85, 195, 220, 229–41, 245–59 figures, 233, 237 catastrophe bonds (cat bonds), 234–9, 245–59, 259n6 and collateral arrangements, 253–8 description of, 246–8 and interest payments, 248–50 issuer, 248 loss payments, 248 loss triggers, 250–3 CEIOPS, See Committee of European Insurance and Occupational Pensions Supervisors CFO Forum, 4, 70, 76, 81

Chief Compliance Officer (CCO), 185 Chief Executive Officer (CEO), 173, 175, 177, 179, 184, 210 Chief Risk Officer (CRO), viii, 6, 85, 179–81, 184–5, 199–200, 210 China, viii, 7, 159, 190, 203n2, 272, 277–90, 294, 301 China Insurance Regulatory Commission (CIRC), 280, 282–4, 286–8 Chinese insurance industry, 277–90 figures, 278 history of, 277–80 insurance regulations, 282–3 and the law, 283–4 market overview, 280–1 ministerial rules, 284 reinsurance, 281–2 and solvency, 286–7 Citibank, 131 Citizens Property Insurance Corporation (U.S.), 8 College of Supervisors (IAIS), 86–7 ComFrame (IAIS), 103, 112, 116–17 Committee of European Banking Supervisors (CEBS), 45–7 Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), viii, 44–8, 55, 58, 86, 98, 100–2, 111, 132, 312, 314–15 Committee of European Securities Regulators (CESR), 45–6 Companies Act (U.K.), 162 conditional tail expectation (CTE), 214, 220 Conference of the Insurance Supervisory Services of the Member States of the European Union, 55–6 conglomerate groups, 147–8 Consultation Paper on Regulatory Capital Requirements and Overarching Accounting/Valuation Issues for the Solvency Modernization Initiative (2009), 31–2 contagion risk, 11, 129, 140–3, 146, 148, 151–2 corporate boards, See boards corporate governance, 171–86 and boards, 175–80 and enterprise risk management, 174–5 and risk committees, 179–80 two-tier boards, 175–6 unitary boards, 175–6


318


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Cost of Non-Hedgeable Risk (CNHR), 81–2 credit default swaps (CDS), 181 credit rating agencies (CRAs), 174 creditors’ rights, 161–6, 166n1,3,7 and Part VII transfers, 163–6, 166n7 and the U.S. courts, 163–6 and uniform treatment, 162–6 cross-border issues, 12, 15–20, 46–7, 86–7, 125, 127, 131–3, 153–5, 162, 172, 191–2, 271–2 Current Exit Value (CEV), 81 Current Fulfillment Value (CFV) model, 81 de Larosière Group, 172 de Larosière Report, 12, 64, 111 Denmark, 103n2, 203n1, 256 Dexia, 112 Directive 98/78/EC of the European Parliament, 111 Directive 2002/87/EC of the European Parliament, 111 Directive 2009/138/EC of the European Parliament, 111 discount rate, 72, 81 dot-com bubble (2000), 12, 97 Dow Jones (DJ) Sector Titans Insurance Index, 107 earthquakes, 33, 85, 201, 220, 235–7, 239, 246, 259n3 Economic and Financial Affairs Council (ECOFIN), 65n24, 97 ,104n19 economic capital methodology, 211–28 approaches to, 213–16 and business types, 223–7 and capital adequacy, 221–2 and constraints, 223–7 factors in developing, 221 management issues, 225–8 other aspects of, 220–21 pros and cons of, 216–20 trends in, 227–8 See also liability run-off approach; oneyear mark-to-market approach economic total balance sheet, See total balance sheet EIOPA, See European Insurance and Occupational Pensions Authority embedded values reporting, 70

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emerging economies, 299–310 and institutional quality, 305–8 role of insurance in, 300–5 statistical tables, 301–3 and World Bank, 300, 305–9 Employee Provident Fund Organization (EPFO) (India), 296 Employee Retirement Income Security Act (ERISA), 253 Enterprise Risk Management (ERM), 3, 6, 9, 14–15, 103, 174–86, 187n27, 206–10 and corporate governance, 174–86 how and why of, 206–8 and independent directors, 182–3 industry, 180–2 overview of, 183–4 and quantitative measurements, 181–2, 187n27 and subsidiaries, 184–5 ESFS, See European System of Financial Supervisors ESRB, See European Systemic Risk Board ESRC, See European Systemic Risk Council EU Insurance Supervisory Conference, 56–7 EU Member States, 38, 42, 45–8, 53–6, 58, 85, 104n19, 111, 123, 175 EU Reinsurance Directive, 62 EURIBOR, See Euro Interbank Offered Rate Euro Interbank Offered Rate (EURIBOR), 246, 249-50, 255, 258 European Commission (EC), 38–9, 41, 45, 56–7, 59, 102, 124, 127, 161–3, 172, 190, 198, 200, 202 European Council, 38, 45, 57–9, 84, 97 104n19 European Economic Area (EEA), 46, 96–8, 102, 121, 132 European Economic Community (EEC), 53 European Insurance and Occupational Pensions Authority (EIOPA), 45–8 European insurance market, history of, 53–65 first stage (1973–1979), 53–4 second stage (1988–1990), 54 Sharma Report, 56–7 Solvency I, 55–6 and Solvency II, 56–65 third stage (1992), 54–5 European Parliament, 45, 57–9, 84, 97, 111


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Index

European Standard Formula (“standard formula”), 62 European Supervisory Authority (ESAs), 17, 19, 21, 47, 87, 131 European System of Financial Supervision (ESFS), 19, 45–8 European Systemic Risk Board (ESRB), 45–7, 87 European Systemic Risk Council (ESRC), 45 European Union (EU), 4, 29, 37, 53–7, 62, 83, 95, 111 See also EU Member States; Solvency II FASB, See Financial Accounting Standards Board Federal Insurance Office (FIO), 74, 87 Federal Insurance Office Act (2009), 74 Financial Accounting Standards Board (FASB) (U.S.), 4, 29, 71–3, 81–2, 84, 88, 105n24, 172, 190, 197–200 Financial Analysis Working Group (FAWG), 27–9 financial conglomerates, 7, 121–33, 140–3 and assurfinance model, 123 bancassurance model, 122–32 and capital requirements, 125–6 and contagion risk, 140–3 directive of, 123–4, 133 and group supervision, 131–2 and moral hazards, 130–1 and regulatory complexities, 124–5 and risk, 125–9 and special purpose entities, 130 Financial Conglomerates Directive (FCD), 123–4, 133 financial crisis, See global financial crisis Financial Services Authority (FSA) (U.K.), 35n5, 191 Florida Hurricane Catastrophe Fund (FHCF), 8 financial reporting, 71–3 See also IFRS; U.S. GAAP Financial Services and Markets Act (FSMA) (U.K.), 163–6 Financial Stability Board (FSB), 19–22, 149, 172, 182, 190–2 Finland, 104n2, 203n1, 256 First Non-Life Insurance Directive (1973) (EU), 53–4 Florida Hurricane Catastrophe Fund (FHCF), 8

Foreign Direct Investment (FDI), 292 Fortis, 131 France, 104n2, 118n4, 159, 175, 203n1,2, 256 general insurance industry, 138–40 Generali, 122 Generally Accepted Accounting Principles (GAAPs), 40, 69–71, 80, 105n24, 177, 190 Georgetown Re, 238 Germany, 97, 104n2, 118n4, 159, 175, 191, 203n1,2, 256 Glass-Steagal Act (1933), 131 global financial crisis (GFC) (2007–), 3–4, 6–9, 11–22, 25, 42, 64, 69–70, 83–4, 86–9, 92, 102–3, 111, 116, 121, 131, 137, 141–2, 149–50, 161–2, 172, 189–90, 205, 209–10, 240–1, 253 Global Reinsurance Market Report (IAIS), 92–3 globalization, vii–viii, 7, 11, 12–13, 21, 83, 86, 88, 91, 121–2, 129, 172, 211, 289–90, 292–3 group (insurance), 107–8, 113–16, 146–7 business mix of, 114–15 complexity of, 113–15 definitions of, 108, 146–7 economic impact of, 115–16 importance of, 107–8 structure of, 113–14 See also IAIS ComFrame Group of Thirty Report, 12 group risk management (GRM), 210 group supervision, 11–22, 40, 86, 89, 107–17, 137–52, 186n5 architecture of, 137–52 background of (1970–2010), 138–40 challenges to evolution of, 112–17 and conglomerate groups, 147–8 consolidated, 146–7 and cross-border cooperation, 17–20 definition of, 108 designing, 143–4 evolution of, 107–17 existing and planned approaches to, 108–12 and financial conglomerates, 131–2 forward-looking approach to, 14–15 and IAIS, 186n5


320


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group supervision—Continued industry involvement in, 20–1 integrated prudential model, 12–14 and legislative powers, 144–6, 148 lessons learned about, 150–2 need for effective, 140–50 principles for future action, 11–22 and the “prudential hierarchy,” 144 and regulation, 15–17, 116–17, 146–8 and scrutiny, 149–50 and Solvency II, 40 types of, 108–12 G20 major economies, 18, 154, 179, 190–1, 193, 154, 179, 190–1, 193, 203n2 G20 Pittsburgh Summit (2009), 190–1 H.R. 2609, See Insurance Information Act of 2009 Hannover Re, 209–10 Hazardous Financial Condition Model Regulation (NAIC), 27–9, 32 HB1A, 7–8 High-Level Committee (HLC) (IAIS), 154–5 HIH Insurance, 137, 140–1, 149, 152 HIH Royal Commission, 137, 149, 152n2 Hopewell court case, 165 hot-spot analysis, 208 hurricanes, 7, 85, 210, 232–3, 236–7, 246 Andrew, 232–3, 237 Gustav, 210 Ike, 210 Katrina, 7, 232–3, 236–7 Rita, 7, 232, 236–7 Wilma, 7, 232, 236–7 IAIS College of Supervisors, 86–7 IAIS ComFrame, 103, 112, 116–17 IAIS Core Principles, 268, 270 IAIS Executive Committee, 154–5 IAIS Global Reinsurance Market Report, 92–3 IAIS High-Level Committee (HLC), 154–5 IAIS Triannual Meetings in Chinese Taipei (June 2009), 159 IASB, See International Accounting Standards Board incurred but not reported (IBNR), 165, 271 independent directors, 171–85 IFRS, See International Financial Reporting Standards

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321

India, viii, 7, 190, 203n2, 291–7, 301–4, 306 Indian financial services industry, 291–7 and asset management, 295–6 and banking sector, 291–3 and insurance, 293–5 Indian Independence (1947), 292 ING, 112, 122, 162 Institute of International Finance (IIF), 12 insurance/reinsurance regulation and capital requirements (U.S.), 25–34 and creditors’ rights, 161–6 expansion, contraction, and consolidation of, 3–10 and financial conglomerates (U.K.), 121–32 global approach to, 83–9, 91–103 and group supervision, 11–12, 107–17, 137–52 See also group supervision and the IAIS, 153–9 and market consistent reporting, 69–82 and Solvency II, 37–49, 53–65 insurance-linked securities (ILSs), 230, 240, 258 Insurance Amendment Act (2008), 238 Insurance Contracts Phase II (IFRS), 77, 80 insurance group, See group insurance group supervision, See group supervision Insurance Information Act of 2009 (H.R. 2609), 96 Insurance Receivership Model Act (IRMA), 166n1 Insurance Regulatory and Development Authority (IRDA), 293–4, 297 insurance securitizations (1997–2009) (figure), 236 insurance securitizations-matrix of arrangement types (figure), 235 insurance system (U.S.) and financial reporting, 71–3 issues for, 80–1 and market-consistent frameworks, 69–70 and reinsurance, See reinsurance industry (U.S.) statutory accounting rules, 83–4 and statutory capital requirements, 78–9 supervisory authorities, 83 See also risk-based capital (RBC) system integrated prudential model, 12–14


Index


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Index

Interim Signatories Working Group (ISWG), 155 internal rate of return (IRR), 79 International Accounting Standards (IAS) IAS 37, 72, 81 IAS 39, 71 International Accounting Standards Board (IASB) (EU), 4, 29, 69, 71–3, 81–2, 84, 88, 105n24, 172, 190–1, 197–200, 202, 287 International Association of Insurance Supervisors (IAIS), viii, 5, 16–20, 29, 86–7, 91–4, 96, 103, 108, 112, 116–17, 124–5, 153–9, 161, 172, 174–5, 179, 181–2, 186n5, 189–91, 197–200, 238, 241, 261, 263–4, 267–8, 270, 286 high-level committees, 154–5 and insurance groups, See IAIS ComFrame and Multilateral Memorandum of Understanding, 153–9 and mutual recognition, 93 and reinsurance regulation, 91–4 International Financial Reporting Standards (IFRS), 4, 40–2, 69–71, 73–4, 77, 80–2, 88, 98, 105n24, 177, 190, 193, 200–1, 287 and Phase II, 4, 77, 81 International Institute of Finance (IIF), 12 International Monetary Fund (IMF), 12, 22, 35n5, 191, 232, 267 International Organization of Securities Commissions (IOSCO), 125, 159 Ireland, 192–3, 203n1, 248, 270 Irish Republican Army (IRA), 8, 10n2 Italy, 104n2, 118n4, 203n1,2 Japan, 7, 84–5, 190, 192, 203n1,2, 212, 256, 259n3 Joint Committee on Financial Conglomerates (JCFC), 124–5 Joint Forum, 16, 22, 112, 124–5, 127–8 Kamp Re, 238 KBC, 112 Kelvin Re, 238 key driver analysis, 208 Knight, Frank, 260n12, 299–300

Lamfalussy process, 45–6, 58–9 “lazy capital,” 139 leadership, 208–9 Lehman Brothers, 131, 161, 239–40, 246, 249, 253–5, 258 Lehman Brothers Special Financing, 239 Level 3 Committees, 45–7 Li, David X., 181, 187n27 liabilities, 38, 40–3, 55–6, 60–1, 75, 83, 85, 88–9, 130, 145, 177, 199, 212–20, 265 liability run-off approach, 214–20 LIBOR, See London Interbank Offered Rate Life and Health Actuarial Task Force (NAIC), 31 Life Insurance Corporation (LIC) (India), 293 Life Insurance Directive (1979) (EU), 53–4 life insurance industry, 138–40, 195–201, 212, 214, 223, 234–5, 240, 281, 285, 289, 293–4, 302–3 and annuities, 195–200 liquidity, 11–12, 15–16, 22, 62, 72, 76, 79, 81, 88, 100, 103, 112–15, 128–30, 132, 182, 187n26, 200, 202, 245, 251, 255, 269, 292, 315 liquidity risk, 11, 22, 79, 88, 100 Lloyd’s of London, 164–5, 262 London Interbank Offered Rate (LIBOR), 246, 249–50, 255, 258 long-tail liabilities, 65n15, 101, 196–202, 266 losses-given-default (LGD), 100, 105n26 Luxembourg, 191–3, 203n1, 256, 270 Malta, 100, 170, 256 Manulife, 199 margins, 72, 81, 198–9 mark-to-market approach, 61 mark-to-model approach, 61, 89, 215–16 market consistent embedded value (MCEV), 70, 76, 81–2, 199 market consistent reporting, 69–82 and financial reporting, 71–3 impacts of, 77–80 introduction to, 60–70 and pricing, 78–9 and regulatory accounting, 73–7 and reinsurance, 77–8 and risk management, 79–80 and the U.S., 69, 76–7


322


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market consistent valuation, 41–2, 83, 88–9 medical malpractice insurance, 55 mergers and acquisitions (M&A), 6–7, 113, 139 Mexico, 84, 159, 203n1,2, 236, 302–6 minimum capital requirement (MCR), 38–9, 43, 61–2, 76 Money Market Mutual Funds (MMMF), 295 moral hazard, 122, 130–3, 246, 250–3, 260 Morgan, J.P., 97 “Müller report” (1997), 55 multilateral holistic group supervision, 111–12, 115–17 Multilateral Memorandum of Understanding (MMoU) (IAIS), 17, 86, 112, 116, 153–9 accession process, 155 framework of, 154–9 key principles of, 155–6 launching of, 154–5 and the status quo, 159 multinationals, 6–7 Munich Re, 100 NAIC Proposal, See Reinsurance Regulatory Modernization Framework Proposal National Association of Insurance Commissioners (NAIC) (U.S.), vii, 4–5, 25–34, 34n4, 35n7,9, 74, 86, 91, 94–6, 104n12, 132, 161, 163, 166n1, 172, 186n15, 212, 237, 313, 315 Accreditation Program, 26, 28–9, 33–4 consultation papers, 30 Hazardous Financial Condition Model Regulation, 27–9, 32 Life and Health Actuarial Task Force, 31 Proposal, 94–6, 104n12 and reinsurance regulation, 91 Reinsurance Supervision Review Department (RSRD), 94, 96 Risk-Focused Surveillance Framework, 34n4 See also risk-based capital (RBC) system; Solvency Modernization Initiative national interests, vii, 172, 211 National Provident Institution (NPI), 141

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323

National Reinsurers status, 94, 104n12 Nelson Re, 238–40 net asset value, 42–3, 70 Netherlands, 104n2, 159, 175, 203n1, 256 no group supervision, 108–9 non-cooperative jurisdictions (NCJs), 191–4 nonlife insurance, 54, 200–1, 302–3, 305 Non-Life Insurance Directive (1992) (EU), 54 nonoperating holding companies (NOHCs), 138, 145–6, 150–1 norm compliance, 207 Obama, Barack, 74, 87, 191, 195 Office of Thrift Supervision (OTS), 34n1, 149, 190 Olympus Re, 238 one-year mark-to-market approach, 215–20 Organization for Economic Cooperation and Development (OECD), 172, 174–5, 181–2, 189, 191, 203n1, 270, 296, 299–302, 305, 307 Orkney Re, 239 Other Comprehensive Income (OCI), 71 own risk and solvency assessment (ORSA), 33, 58, 60, 63, 99 Part VII of FSMA, 163–6, 166n7 “passport” regulation, 54, 97, 99, 194–5 Pearl Assurance in the UK, 140–1 Pension Fund Regulatory and Development Authority (PFRDA) (India), 296 People’s Bank of China (PBC), 279, 282–3 People’s Insurance Company of China (PICC), 277–80, 288 People’s Republic of China (P.R. China), 277, 279, 282–3, 285, 287–8 People’s Republic of China Insurance Law, 280 performance measurement, 222 personal auto insurance, 55 Pillar I, 20, 38–41, 60, 75, 84, 104n21 Pillar II, 20, 38, 40, 60, 74–5, 84, 104n21 Pillar III, 20–1, 38, 60, 63, 75, 84, 104n21 policyholder behavior, 72–3 Pool Reinsurance Company Limited (Pool Re), 8, 10n2 Port of Entry Reinsurer (“POE Reinsurer”), 94


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Index

Portugal, 92, 104n2, 203n1 pricing, 78–9, 223 Principles-Based Approach (PBA), 4, 212 probable maximum loss (PML), 234 producer-owned reinsurance companies (PORCs), 264 product development, 3, 8–9, 12 property and casualty (P&C), 192, 214, 223, 234–5, 245 proportionality principle, 59 protected cell company (PCC), 265, 270, 272 prudent person principle, 62–3 “prudential hierarchy,” 144 Purchasing Power Parity (PPP), 294 QIS, See Quantitative Impact Study Quantitative Impact Study (QIS), 20, 62, 98, 101 “RAG” (red/amber/green) system, 192 Real Time Gross Settlement (RTGS), 292 regional holistic group supervision, 111, 114–17 regulation, See insurance/reinsurance regulation Regulation XXX (U.S.), 235 regulatory accounting, 73–7 regulatory convergence, 15–17 regulatory disparities, and global risk, 189–202 and life insurance and annuities, 195–200 and noncooperative jurisdictions, 192–4 and nonlife insurance, 200–1 and politics, 192 primary risk drivers, 190–1 and reinsurance, 201 and third country carriers, 194–5 regulatory system (U.S), 25–34, 73–80, 85–6, 93–6 and accounting, 73–80 and current capital requirements, 30–3 modernization of, 85–6 and regulation system, 25–34 and reinsurance, 85–6, 93–6 reinsurance and Bermuda, 5 and China, 281–2 and the financial crisis, 102–3 and IAIS, 92–4

and market consistent frameworks, 77–8 regulation of, 85–6, 91–105 and Solvency II, 96–102 and SMI, 95 and third-country issues, 102 and the U.S., 85–6, 93–6, 104n2 Reinsurance Directive (RID), 62, 91, 97, 99–100, 124, 242n25 reinsurance industry (U.S.), 5, 85–6, 93–6, 104n2 and accounting standards, 88–9 and federal regulatory initiatives, 96 and financial crisis, 86–8 modernization initiative, 5 reformation of, 94–5 Reinsurance Regulatory Modernization Framework Proposal (NAIC Proposal), 94–6, 104n12 Reinsurance Supervision Review Department (RSRD), 94, 96 renewal premiums, 73, 82 Report on the Prudential Supervision of Insurance Undertakings (2002), 97 report to supervisors (RTS), 63–4 reporting, 69–82 global financial standards of, 3 and international insurance supervision, 12 market consistent, 69–82 and risk-based solvency, 14 supervisory, and Solvency II, 63–4 Reserve Bank of India (RBI), 291–2, 295, 297 risk-based capital (RBC) system (U.S.), 27–8, 30–3, 35n7,8,9, 74, 78, 83, 95, 220 C-3 phases, 30, 33, 35n9, 220 risk-based pricing, 223 Risk-Focused Surveillance Framework, 34n4 risk committees, 179–80 risk concentrations, 126–7 risk culture, 205–11 risk management, 3–4, 8–10, 11–15, 55–6, 63, 69, 79–80, 84–5, 89, 125–32, 140–2, 171–86, 189–202, 205–28 analyses of, 207–8 and capital requirements, 211–28 See also economic capital methodology and corporate governance, 171–86


324


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risk management—Continued culture of risk, 205–11 and financial conglomerates, 125–9 and leadership, 208–9 modeling and mitigating risk, 126–32 and pricing, 11–12 and regulatory disparities, 189–202 See also Enterprise Risk Management (ERM); securitization risk margins, 198–9 risk mitigation, 129–32 risk modeling, 127–8 Romania, 159 Rose court case, 164, 166n7 Russia, 203n2, 294, 301–6 Sarbanes-Oxley Act (2002), 6, 27 Second Life Insurance Directive (1990) (EU), 54 Second Non-Life Insurance Directive (1988) (EU), 54 Securities and Exchange Board of India (SEBI), 295, 297 securities sector (U.S.), 71, 128, 176 securitization, 15, 22, 85, 101, 125, 129–30, 181, 187n27, 229–41 basics of, 230–1 figures, 235–6 landscape of, 234–7 lessons learned, 238–41 and market efficiency, 232–4 regulating, 237–8 September 11, 2001, 8, 97, 193, 233 shareholding-centric group supervision, 109–10 Sharma Report (2002), 56–7, 97, 315 sidecars, 5, 234, 236–7, 242n17 Signatories Working Group (SWG), 155 Singapore, 159, 296 single-premium immediate annuity (SPIA), 78–9 solo supervisory approach, 15–16, 40, 48, 53, 108–9, 114–15, 117, 132, 139–40, 142–5, 147, 149–50, 186n5 SMI, See Solvency Modernization Initiative solvency and financial conditions report (SFCR), 63–4 solvency capital requirement (SCR), 38–9, 43, 61–2, 75, 84–5

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325

Solvency Modernization Initiative (SMI), 4–6, 25–6, 29–34, 74, 95, 161 direction for, 32 impact of, 31–2 and regulatory capital requirements, 30–3 Solvency Policing Agenda (1989) (U.S.), 25, 33–4 Solvency I (2002), 55–7, 65n16, 83, 85, 98, 211 Solvency II (EU), vii–viii, 4–5, 14, 17, 37–49, 53–65, 60–5, 70, 74–82, 83–5, 96–102, 104n21,22, 105n25, 111, 126–8, 161, 189–90, 194, 199–200, 207, 210, 212, 214, 220, 227, 237, 270, 272 and assets and liabilities, 61 basics of, 38–41 and capital requirements, See capital requirements economic total balance sheet, 41–5 and financial stability, 46–8 future of, 56–64 as global benchmark, 84–5 and group supervision, 40, 111 investment strategy of, 62–3 and market consistent valuation, 41–2 net asset value, 42–3 new supervisory architecture of, 45–8, 58 overview of, 97–9 and past regulations, 53–6 and proper calibration, 43–5 and the proportionality principle, 59 and prudent person principle, 62–3 and reinsurance regulation, 96–102 and supervisory reporting, 63–4 and transparency, 75–6 unveiling, 57–8 See also Pillar I; Pillar II; Pillar III Solvency II Framework Directive, 17, 41, 57, 59, 84, 102, 104n17, 105n25, 127, 237 Article 101, 105n25 Articles 134, 172, and 173, 102 Article 309, 104n17 South Africa, 84, 203n2 special purpose entities (SPEs), 130, 230–1, 239 Special Purpose Insurers (SPIs), 238


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Index

Standing Committee for Supervisory and Regulatory Cooperation (FSB), 20 State Bank of India (SBI), 292 State Insurance Commissioner (U.S.), 26 Statements of Financial Accounting Standards (SFAS), 71 Statutory Liquidity Ratio (SLR), 292 stress testing, 33, 128–9, 216, 219, 224 subsidiary boards, 179–80 supervision of groups, See group supervision supervisory review process (SRP), 58, 63 Swiss Insurance Supervisory Act, 118n6 Swiss Re, 99, 192, 260n10 Swiss Solvency Test (SST), 14, 83, 100, 128, 198 Switzerland, 29, 95, 97, 100, 110, 118n4,6, 124, 132, 145–6, 190, 193, 203n1, 256 systemic risk, 13, 15, 34n1, 45–6, 48, 87–8, 131, 133, 150, 206, 233 See also European Systemic Risk Board (ESRB) Talanx Group, 209–10 Temporary Increase in Coverage Limit (TICL), 8 terrorism, 8, 97, 193, 233 Terrorism Risk Insurance Act (TRIA), 8 Thailand, 92, 301–6 third-party board assessments, 178–9 third country carriers, 15, 102, 194–5 Third Life Insurance Directive (1992) (EU), 54 Tokyo Disneyland, 236 Tokyo Fire & Marine Insurance Company Ltd., 280 “too big to fail,” 122, 130–1, 133 total balance sheet, 41–5, 57–8, 60, 84, 86, 98, 127

Total Return Swap (TRS), 239 Towers Watson, 6, 9, 206–7, 209, 213–14, 227, 313, 315 Treaty of Rome (1957), 53–4 two-tiered board structure, 175–6 U.S. Congress, 74, 195–6 U.S. Constitution, 95, 162–3, 166n3 U.S. GAAP, 70–1, 80, 98, 105n24 U.S. Model Holding Company Act, 109, 118n5 U.S. Securities and Exchange Commission (SEC), 71 U.S. Treasury, 250, 255, 257–8 underwriters, 140 unilateral holistic group supervision, 110 Unit-Linked Insurance Products (ULIP) (India), 294 Unit Trust of India (UTI), 295 unitary board structure, 175–6 United Kingdom, 97, 104n2, 118n4 United States, See bankruptcy law; insurance system; regulatory system Value-at-Risk (VaR), 44, 61–2, 105n24, 220 variable annuities, 9, 30–1, 74 Willow Re, 239–40 world average insurance penetration (figure), 302 World Bank, 236, 300, 305–9 World Bank Governance Indicators (WBGI), 300, 305–9 World Economic Forum Report of 2009, 112 World Trade Organization (WTO), 280–1, 283, 286, 288–9 Zurich, 192


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