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Regulation and risk The strategic response to insurance regulatory developments

Alex Thomson, May 2013

2 Financial Services Strategic Forum

Agenda

1. Strategic priorities and regulation

2. Global insurance regulatory developments

3. East African response

4. Core principles/focus areas

5. Deriving value from regulatory change

6. Closing


Strategic priorities and regulation


What are your strategic priorities as an insurer?

Typical strategic priorities list:

– Distribution

– Claims

– Administration, systems, payments and servicing, digital

– Products and underwriting

– …

These are clearly important, but are they enough?

What will be the factors driving market leadership in the next 5-10 years?

1. Finger on the pulse - Actuarial analysis and management information will be a key

differentiator

2. Eye on the ball - Effective governance will allow you to stay focused on what’s

important, and to grow sustainably


How does regulation fit in?

• Recent experience suggests that many of the principles underlying the new

regulations are aligned with good business practice

– Clear understanding of the business’s value drivers and risks

– Effective integration of the functional responsibilities within the business

(avoidance of silos)

• The theory may be good, but does this happen in practice?

• Businesses approach regulation reactively

– It’s an extra burden and cost, and does not add value

• The approach to supervision is also critical


Global insurance supervisory developments


The new insurance world…

In March 2013, Dr Richard Ward, Lloyd's Chief Executive Officer, rebuked European

regulators for further delays in Solvency II, highlighting that compliance with the rules had

already cost Lloyd’s about £300m to date, saying ”What planet are these

guys on?”

Andrew Bailey, head of the UK’s new Prudential Regulation Authority, said the mounting

costs – estimated to total at least £3bn for UK companies alone – were

“frankly indefensible”.


Global insurance supervisory developments

Solvency II:

• Since 2004 the European Commission was working towards a target completion date of

2008

• Level 1 directive was only eventually adopted in November 2009, providing for the

regime to come into force from 1 November 2012

• Owing to extensive economic impact debate and political challenges, implementation in

2015 seems unlikely, although various ‘interim measures’ are being pursued by country

regulators

Insurance core principles (ICP’s) and standards updated by the International

Association of Insurance Supervisors (IAIS) in February 2011

Similar principles pursued in many regimes globally. Eg in South Africa:

• Solvency Assessment and Management (SAM) QIS1 and QIS2 completed

• Non-life insurance quantitative interim measures in force

• Governance interim measures and group supervision expected 1/1/2014, light parallel

run in H2 2014, full parallel run in 2015, and full implementation 1/1/2016


Drivers of regulatory change in financial services

• Global Financial Crisis

• Insurance failures such as HIH, AIG, etc.

• Globalisation and the need for harmonisation of regulatory frameworks, reducing

regulatory arbitrage

• Convergence between banking and insurance, and similar developments in the banking

industry (Basel II/III)

• The International Association of Insurance Supervisors, supported by international

development organisations (IMF, World Bank), has played a key role in driving regulatory

change in the global insurance industry


East African response


East African response

Solvency II

IAIS ICP’s and standards

Global developments (eg

SAM)

In light of

Guidelines issued by Kenya’s Insurance Regulatory

Authority for observance by all insurers registered under the

Insurance Act Cap 487 (all effective from 30 June 2013, except Reinsurance (1 April 2013)) :

GUIDELINES ON ACTUARIAL

FUNCTION

GUIDELINES ON RISK MANAGEMENT

AND INTERNAL CONTROLS

GUIDELINES ON EXTERNAL AUDITORS

GUIDELINES ON REINSURANCE


East African response (2)

Pillar 1: Risk-based

restatement of balance

sheet, and insurer

specific capital

requirement

Pillar 2: Explicit

requirements and

principles on risk

management and

governance

Pillar 3: Increased

reporting on risk profile

and financials (public)

and strategies (to

regulator)

Own Risk and Solvency Assessment: Board and management’s own views of

risks and the appropriateness of capital requirements, strategies and risk appetite A

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Pillar 3: Increased



and strategies (to

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Solvency II/SAM

Kenyan guidelines


East African response (2)

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Pillar 1: Risk-based

restatement of balance

sheet, and insurer

specific capital

requirement

Pillar 2: Explicit

requirements and

principles on risk

management and

governance

Pillar 3: Increased



and strategies (to

regulator)

Own Risk and Solvency Assessment: Board and management’s own views of

risks and the appropriateness of capital requirements, strategies and risk appetite


Core principles/focus areas


Core principles/focus areas

1. Risk-based capital and risk-based management

2. Risk-based supervision

3. Governance models and the role of the board

4. Changing role of Risk and Actuarial

5. Principles based regimes, and proportionality

6. Data

* 2012 Ernst & Young European Solvency II survey


Risk-based capital and risk-based management

Requirements

• Company specific capital requirement, reflecting

all risks associated with insurance activities,

investments and financial decisions, and all

operational activities

• Management’s ownership through the ORSA, and

requirements for ‘use’ of ORSA and ‘embedding’

ORSA into decision making

Objectives and strategic impact

• Better understanding (and quantification) of risks

will improve decision making and increase

policyholder protection and stability of financial

system

• Competitive advantages associated with risk

selection, pricing and better informed strategies

Lessons learnt and next steps

• Change does not happen overnight – engage

stakeholders early

• Get buy-in from top, especially in the way the

performance of the business will be assessed in

the new world (including KPI’s)

• Structured and well-governed programmes ensure

coordination, recognition of dependencies and

responsibility for deliverables

• Recognise difference between project activities

and BAU, but emphasise focus on overlaps and

existing business calendar (strategy updates,

budgeting etc)


Risk-based supervision

Objectives

A structured process aimed at identifying the most critical risks that face each company through a focused review

by the supervisor to assess:

• The company’s management of those risks

• The company’s financial vulnerability to potential adverse experience.

Lessons learnt

• Mutually beneficial to regulator and Board

• Requires firms to embrace regime and the true underlying principles

• Requires extensive regulators’ skills, and regulators to embrace principles based approach (as opposed to tick

boxes)


Governance models and the role of the board

Requirements

• General good governance across the organisation,

with clear roles and responsibilities and mandates

• Explicit requirements for certain functions (‘control

functions’), including fit and proper

• Board responsible for policyholder protection and

broader stakeholder interests


• Regulator passes significant responsibility back to

Board

• Well defined and documented processes,

especially risk management, reduce risk of

extreme financial impact

• Avoidance of conflicts of interest reduces

compromised decision making


• Increased onus on board requires reconsideration

of individuals’ appropriateness or their willingness

to understand technical implications

• Operating model redesign often flows from

governance gap analyses

• While documentation (very often absent of existing

processes) is important, it should not be

excessive/generic, but company specific

• Communication/Reporting to Board should not be

excessive but should focus on key metrics and the

impact of key risks


Changing role of Risk and Actuarial

Requirements

• An effective risk-management system comprising

strategies, processes and reporting procedures

necessary to identify, measure, monitor, manage and

report, on a continuous basis the risks, to which they are

or could be exposed, and their interdependencies

• An actuarial function to give assurance on understanding

of risks and the balance sheet


• Traditionally, risk management functions have been

focused on operational risk, but will now be responsible

for all risks in the standard formula as well as risks not

covered by it

• The quantitative view of the risk position should form the

basis for monitoring the risk appetite


• A new paradigm for the Risk Function to

understand and monitor all risk

categories, and ultimately give

assurance to the board on the risk

position relative to the risk appetite

• Formulation of the risk appetite and

translation into metrics and subsequently

into limits and mandates

• Managing the first and second lines of

defence roles, with risk being close

enough to business to truly understand

it, and actuarial adding business value to

quantification and analysis of strategy,

YET able to provide assurance


Principles based regimes, and proportionality

Requirements

• The system of governance shall be proportionate to

the nature, scale and complexity of the operations

of the insurer

• Processes which are proportionate to the nature,

scale and complexity of the risks inherent in its

business and which enable it to properly identify

and assess the risks it faces


• Reasonable costs

• Comply with ‘Principles’ or ‘Spirit’ as opposed to

requirements

• Onus on organisation to demonstrate the methods

used in the assessment

• Proportionality must be linked to materiality


• Applies to the quantitative and qualitative aspects

• Size is not always a proxy for the degree of risk

and appropriate point on the spectrum of

proportionality

• In order to apply appropriate response, a

comprehensive understanding of the requirements

is critical

• Be proactive in performing assessment of

requirements and communicating proposed

response to regulator

• Evaluate comparable operating models, to explore

potential efficiencies (such as combining control

functions)


Data

Requirements

• Internal processes and procedures in place to ensure

the appropriateness, completeness and accuracy of

the data used

• Suitable processes and procedures to ensure the

reliability, sufficiency and adequacy of both the

statistical and accounting data to be considered both in

the underwriting and reserving processes


• Risk reporting will need to be more detailed and

transparent – the basis for this being robust data

platforms

• Incentive for capital requirement to be lowered in case

of adequate volume of credible historical data

• Need for detailed data to validate standard formula

and adjust it to be appropriate for the organisation

• Necessary for regulatory purposes, but also critical as

MI becomes a competitive advantage


• The data used in the calculations must be

capable of being traced from its sources

through to the end results

• Quality data key in establishing industrialised

calculation and reporting processes (as

opposed to current manual), or at least more

controlled and integrated calculations

• A significant component of many Solvency

II/SAM programmes, with many of our clients

spending more than a third of their total

programme costs on data gap analyses,

operating model redesign, systems

acquisitions or systems upgrades/self-build.


Deriving value from regulatory change


Irrespective of regulatory timelines and scope…

… the principles are sound, and the recognition of the strategic impact is what is driving change in industry leading insurers.

27%

9%

24%

10%

30%

0%

5%

10%

15%

20%

25%

30%

35%

VBM concept exists, with ratios at company

level.

VBM-metrics used for a VB-compensation

structure

VBM-metrics used to manage at company or

divisional level

VBM-metrics used for operational

management of portfolios & investments

VBM-metrics used for operational

management of new business

Value-based management by large European insurers *

* 2012 Ernst & Young European Solvency II survey * 2012 Ernst & Young European Solvency II survey


Irrespective of regulatory timelines and scope…

… the principles are sound, and the recognition of the strategic impact is

what is driving change in industry leading insurers.

Expected return due to value-

based management *

* 2012 Ernst & Young European Solvency II survey * 2012 Ernst & Young European Solvency II survey


Example: reinsurance structuring

• Moving towards a Solvency II world, insurers’ increased sophistication in quantifying and understanding risk is becoming the base for decision making

• The market is starting to prepare its commercial response as the acceptance,

transfer or pooling of risks becomes critical • Insurers are recognising that their existing reinsurance frameworks are yielding

inefficient structures or overpriced purchase, or not effectively addressing or covering risks as per the risk appetite


Example: reinsurance structuring Redefining reinsurance objectives

Risk Management

Instrument

Capital management

instrument

Business enabler Risk taking

vehicle

Limiting exposure to individual

large risks and concentration of

risks; explicitly addressing

components of the Risk Appetite

such as Solvency or Earnings

Volatility

A source of capital to underpin

volume of business, and to

reduce capital requirement as a

result of certain exposures

Supporting commercial

endeavours through capacity A source of profit, through

efficient structuring or

increased risk retention at

acceptable levels of risk/capital

(including inwards RI)

Efficient balance

of different

reinsurance

objectives


Example: reinsurance structuring An example roll-out


Regulatory Compliance

►Business Integration

►Understanding of Value Drivers

►Simplicity

►Scalability

►Minimise nasty surprises

►Reduce total cost of visible and invisible Risk

Management

►Clear Stakeholder Management

Summary

►Smart risk taking and risk

management – aligned with

Risk Appetite

►Consistent approach to

risk-based decision making

►Oversight of Risk Management

►Clear responsibilities and

effective communication

Effective Governance

►Examples

►Technical Pricing

►Price Optimisation

►Value Based Management

►Reinsurance

►Investment

►Capital Management

►Enablers

►Data

►Tools

►Skills – Actuarial, IT

►High quality admin systems

Actuarial Analytics


Insurers that use regulatory change to facilitate enhancements

to business analytics and governance will derive sustainable

competitive advantage and market leadership


Ernst & Young

Assurance | Tax | Transactions | Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 167,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve potential. For more information, please visit www.ey.com.

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Proprietary and confidential. Do not distribute

without written permission.

Contact: ► Alex Thomson - Director: Actuarial E: [email protected] C: +27 83 400 2380

mailto:[email protected]

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