Articles - Where is insurance prudential regulation going?

In mid- July the International Association of Insurance Supervisors (IAIS) published its latest iteration of the Insurance Capital Standard (ICS 1.0) for extended field testing. How important is this development for the insurance industry? If you’re reluctant to get dragged into global initiatives with many complex acronyms you have my sympathy. Having said that, there is value in knowing what regulators consider appropriate insurance prudential regulation for the 2020s.

 By Kareline Daguer, Director, PwC
 To put it in context, the ICS is part of an ambitious Common Framework (ComFrame) being developed by the IAIS for the supervision of internationally active insurance groups and global systemically important insurers (IAIG and G-SIIs, but I will call them big groups). ComFrame includes regulation in areas such as Enterprise Risk Management (ERM) and reporting. It is expected to be adopted by the IAIS by the end of 2019 and for national supervisors to implement around 2020. The ICS is being formulated as a prescribed capital requirement that may be seen as a minimum level of capital below which national regulators should intervene.

 The main features of the draft standard are:
 - Group-wide – to be applied to big insurance groups rather than solo entities
 - Risk-based capital requirement– calibrated to VaR 99.5% - the same as Solvency II
 - Regulatory balance sheet – consistent valuation principles for assets and liabilities
 - Definition of qualifying capital resources – the equivalent of eligible own funds under Solvency II
 - Captures all material quantifiable risks – on and off balance sheet, insurance and non-insurance alike. But risks that are not quantified are addressed by other areas of ComFrame such as ERM.

 The ICS 1.0 is a significant development for the IAIS as it narrows down the number of options for calculating capital requirements.

 The regulatory balance sheet will be calculated following a Market-Adjusted Valuation approach (MAV) and GAAP with adjustments (GAAP Plus). The impact of the new insurance contract standard is being considered by the IAIS and will represent a challenge for the potential use of a GAAP Plus method.

 On capital resources the ICS proposes a two tier framework for regulatory capital based on the quality of the capital instruments.

 The capital requirement under ICS 1.0 is to be calculated based on a standard model. This model includes similar components to Solvency II’s standard formula and follows a like-minded approach where some modules are subject to scenario-based calculations and others factor-based calculations. The IAIS will explore the use of internal models, external models and mixed approaches as alternatives to the standard model over the next two years before finalising the ICS.

 You may have noticed that the ICS has more than a passing resemblance to the Solvency II Pillar I requirements. The building blocks of Solvency II were laid out more than a decade ago which leads me to ask - has so little changed in the insurance industry and risk modelling in a decade that no changes are needed when building a new standard? I also question what could be the consequences of global supervisory convergence on this scale.

 Insurance products and distribution channels tend to be very particular to each jurisdiction. This is one of the main reasons why developing an insurance contracts standard has been so difficult and has taken two decades. The IAIS is looking to achieve global comparability of regulation with ComFrame. But I believe that achieving this goal can be detrimental to the ability of national regulatory frameworks to adapt to the risks that might threaten local markets. With the ICS, regulators are working together to build the same formula that was fit for purpose ten years ago and hold it up as the benchmark everybody should use for regulating the industry.

 So what might be missing from ICS 1.0? I will venture a few areas but I’m sure there are many more. First, clear identification of tacit and silent cyber risks, how they are quantified and managed, and their impact on capital requirements. Secondly, operational risk tends to be oversimplified and overlooked when it comes to capital. The increased complexity of products, distribution chains and outsourcing caused by the digital revolution may make it more difficult to understand and quantify the impact of operational failures. Finally, the impact of automation on insurance products will be dramatic and I would argue that regulators need to put more emphasis on understanding their effects and risk quantification. It seems insurance prudential regulators are avoiding going into the future, and are relying instead on the old models and hoping they will be fit for purpose for years to come.

 Insurers willing to keep up with the risks emerging from a changing landscape should send their message to regulators. Taking the case of automation as an example; robotics and sensors will gradually form part of insurance products but there is a grey area of responsibility for their performance. This is an area where insurers could end up being at risk without consciously being aware of it. In order for the industry to thrive in the future, a number of these developments will require legislation and regulation. The development of a new global capital standard could still be a catalyst to think about the risks the insurance industry will face in the future, but will the industry and regulators take the opportunity to rethink their old models?

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