Insurance solvency regulation in Latin America : modernizing at varying speeds

Transcription

1 January 2015 Insurance solvency regulation in Latin America : modernizing at varying speeds Economic Research & Consulting 01 Executive summary 02 Generations of solvency regimes 05 Solvency regimes in Latin America 17 Outlook and risks 20 Conclusion

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3 Executive summary Economic risk-based solvency regulation is coming to Latin America. New solvency regulations are likely to have far-reaching consequences for the region s re/insurance industry. The trend of regulatory modernization will likely continue in the coming years although restrictive measures, macro instability and a lack of institutional capacity are countervailing forces. Latin America is part of a global move towards economic risk-based solvency regulation. Three countries in the region are already in advanced stages of implementing economic risk-based capital (RBC) models: Mexico, Brazil and Chile are expected to adopt frameworks similar in design to the EU s Solvency II over the next one to three years. The remainder of the countries operate regimes akin to the European Union s (EU) Solvency I framework, although Colombia, Costa Rica and Peru are laying the groundwork for comprehensive regulatory reform while simultaneously incorporating risk capital requirements in a piecemeal fashion. The other countries in the region have made no firm commitment to modernize. The impact of the regulatory changes will vary from country to country depending on the final model designs. For some, diversification effects and reinsurance capital solutions will help mitigate the impact of additional risk capital charges. The changes will also affect insurers differently. In general, smaller and less diversified carriers (both geographically and by line of business) will be at a distinct disadvantage. Some will become candidates for mergers and acquisitions while others may choose to exit the market altogether. Insurers will also be incentivized to focus on less capitalintensive products, which may lead to a shift in the overall product mix. The use of reinsurance as a capital management tool may also grow in the region. The trend towards economic risk-based solvency regulation is set to continue in the coming years. There is no formal or concerted regional harmonization project in Latin America, but two forces are driving the modernization agenda forward. The first is the influx of internationally active insurance groups that have, to a large extent, already internalized global best practices in capital and enterprise risk management (ERM). The resulting competitive pressures are prompting many local insurers to modernize their risk management practices and systems in advance of regulation. The second is the influence of international standard setters such as the International Association of Insurance Supervisors (IAIS) that promote harmonization of supervisory standards across the globe. Three stumbling blocks could delay or derail solvency regulatory reform in Latin America. First, restrictive measures reducing market incentives to modernize are prevalent in several jurisdictions like Argentina, Brazil and Venezuela, and the prospect of their spread to other countries in the region is a concern. Second, to the extent that macro instability complicates the task of implementing economic riskbased solvency regimes, countries experiencing economic difficulties may be less inclined to undertake reforms. Finally, the more demanding institutional requirements of economic risk-based solvency regimes may put them beyond the reach of smaller or less wealthy countries in the region. Swiss Re Insurance solvency regulation in Latin America : modernizing at varying speeds 1

4 Generations of solvency regimes Solvency regimes are assuming ever-greater scope and complexity. Solvency II has become an important reference point for regulatory modernization. Advanced economies have made the biggest strides towards economic risk-based solvency regulation. Among the emerging markets, countries in Asia have made most progress. Solvency I vs. Solvency II Regulatory trends in the insurance industry have run broadly parallel to developments in the wider financial sector, with solvency regimes assuming ever-greater scope and complexity. The European Union (EU) has developed the most comprehensive approach to insurance industry regulation so far with its Solvency II Directive (see Box 1 for details). This new regulatory framework sets out more dynamic and risksensitive solvency capital requirements than under the current Solvency I framework. It also incorporates qualitative aspects largely omitted from earlier generations of solvency regimes that address risks stemming from inadequate internal control, reporting and risk management systems. Solvency I remains the default model for most countries around the world (see Figure 1). However, more and more countries are migrating towards economic riskbased capital (RBC) requirements, and many are taking measures to bring qualitative risks under their supervisor s purview. For several countries on the path of regulatory modernization, Solvency II has become an important reference point. Migration has not been uniform across or within regions. RBC requirements are the norm in advanced economies, though only Australia and Switzerland currently allow re/insurers to use internally-developed models to determine their economic capital. Australia, Bermuda, Canada, Singapore and Switzerland are the first countries to have implemented corporate governance and risk management requirements for solvency processes. The EU will follow suit in January 2016 when Solvency II is due to come into force. Re/insurers in the US will face similar requirements from 2015 onwards. 1 The current US RBC solvency regime, in place since the 1990s, is a legal entity-level capital requirements framework that prescribes ladders of regulatory intervention as an insurer s capital approaches a minimum level. Among emerging markets, Asian countries have made significant progress in upgrading their solvency regimes. Latin America currently counts one country (Brazil) with a partial RBC model in place, while Mexico and Chile are expected to implement economic risk-based solvency regimes by 2015 and 2016, respectively. Countries in Central and Eastern Europe are moving at varying speeds depending on their broader policy inclination. Africa is the farthest from the regulatory frontier; so far only South Africa is undertaking comprehensive reforms. Figure 1 Global comparison of capital regimes (status as of late 2014) No data Solvency margin RBC Transition to economic, risk-based solvency regime Economic, risk-based solvency Source: Swiss Re Economic Research & Consulting. 1 Evolving Insurance Regulation: The kaleidoscope of change, KPMG, March Swiss Re Insurance solvency regulation in Latin America : modernizing at varying speeds

5 Solvency II is an economic risk-based solvency framework, requiring more capital to be held for riskier insurance and investment activities. Box 1: What is Solvency II? Solvency II is a harmonized economic risk-based solvency framework that promotes group supervision for the European Economic Area. When implemented in 2016, the new rules will apply to insurance and reinsurance companies (but not to pension funds) on a consolidated group and solo legal entity basis (ie, not branches). Solvency II establishes three pillars of supervision. The first is quantitative and covers economic valuation, available capital, the solvency capital requirement (SCR) and a minimum capital requirement. The SCR is defined as the capital sufficient to cover a re/insurer s obligations for one year on a 99.5% confidence level (ie, equivalent to a 0.5% target default probability). It targets all quantifiable risks to available capital underwriting, financial market, credit, and operational and takes full account of diversification and risk mitigation. The SCR can be calculated using a predefined Standard Formula or internal models (full or partial) approved by the supervisor. Furthermore, assets and liabilities are evaluated on an economic, market-consistent basis, in contrast to book value accounting used in older generations of solvency regimes. Figure 2 Solvency II economic balance sheet Assets at market value Risk margin Best estimate liabilities Available capital Hybrid debt Economic net worth Solvency capital requirement Free capital Source: Swiss Re. It imposes tougher standards of risk management and governance. It aims to enhance transparency for supervisors and the public. The second pillar aims to embed risk governance into a firms corporate structure and day-to-day operations. To that end, it sets out procedural and organizational requirements for risk management and internal control functions such as audit, actuarial control and finance. An Own Risk and Solvency Assessment (ORSA) requires that firms conduct self-assessments of short- and long-term risks to solvency, including those that are not quantifiable (eg, reputational risks) or directly related to solvency (eg, liquidity risk). ORSA also assesses the adequacy of capital resources to meet solvency requirements under a variety of scenarios. Senior management is ultimately held responsible for ensuring coherence between a firm s business strategy and its risk tolerance. The third pillar ensures that all relevant solvency-related information is disclosed to the public and reported to the supervisory authorities. The underlying premise is that market forces provide additional incentives for disciplined underwriting and risk management. This is achieved through annual reporting to investors and other stakeholders of insurers solvency and financial conditions. Swiss Re Insurance solvency regulation in Latin America : modernizing at varying speeds 3

6 Generations of solvency regimes Figure 3 The three pillars of Solvency II Solvency II Pillar I Quantitative requirements Pillar II Qualitative requirements Pillar III Market discipline mechanism Market-consistent valuation of assets and liabilities Calculation of available capital Capital requirements based on Standard Formula or internal model approaches Internal model validation System of governance Internal control Consistent risk management Own Risks and Solvency Assessment (ORSA) Supervisory review process Supervisory intervention Public disclosure requirements solvency and financial condition report Information to be provided for supervisory purposes Consistent information on a timely basis Source: Swiss Re. 4 Swiss Re Insurance solvency regulation in Latin America : modernizing at varying speeds

7 Solvency regimes in Latin America There are three broad groupings of solvency regimes in Latin America. Mexico introduced Solvency II-type legislation in The implementation timeline is fairly tight. The new framework will have the familiar three-pillar structure. In the meantime, Mexican insurers operate under a factor-based model. Overview Latin American countries can be grouped into three broad categories based on their current phase of regulatory modernization: (1) those countries in the process of implementing economic risk-based supervisory frameworks (Mexico, Brazil and Chile); (2) those transitioning to such a regime (Colombia, Costa Rica and Peru); (3) and the region s remaining countries that have undertaken few or no actions to modernize. Mexico A new insurance law to consolidate existing regulations into a single coherent framework aligned with international standards was introduced in The Insurance and Surety Institutions Law (Ley de Instituciones de Seguros y de Fianzas, LISF) was five years in the making prior to receiving congressional approval in February Since its publication in April of that year, the insurance regulator, the Insurance and Surety National Commission (CNSF), has been working in consultation with re/insurers and industry associations to draft enabling legislation (Circular Única de Seguros y de Fianzas, CUSF). According to the original timeline, LISF was due to be implemented in April However, three quantitative impact studies (QIS) have revealed certain technical issues that call for structural changes to the solvency model. As a result, in October 2014 it was reported that the Ministry of Finance had agreed to extend the grace period for certain LISF provisions to January 2016, thereby giving the CNSF and the industry enough time to test and calibrate the new SCR. 2 In addition, the CSNF announced two further QIS to be held in Insurers will still be required to run the new SCR calculations and submit their results to the CNSF as of April However, they will not be penalized for failing to meet the new requirements. The April 2015 launch date will remain in place for qualitative requirements, but that should not cause undue pressure on the industry. 3 LISF establishes a three-pillar solvency framework incorporating elements of Europe s Solvency II, US insurance regulation and the Swiss Solvency Test (SST). Pillar I establishes quantitative capital requirements covering all major risk exposures (see Box 2 for details). Pillar II encompasses aspects of corporate governance, specifically: (1) ERM; (2) internal control systems; (3) internal audit functions; (4) actuarial functions; and (5) outsourcing policies. 4 In order to meet these qualitative requirements, re/insurers must undertake organizational and procedural changes (eg, create an investment committee), and upgrade their risk measurement, reporting and control systems. An annual Institutional Risk and Solvency Self-Assessment (the local equivalent of ORSA) to which the supervisor will be privy, determines a company s risk appetite, monitors compliance and proposes solutions to any shortcomings. 5 A Solvency and Financial Condition Report, available to the public, is intended to increase transparency and to provide an added layer of supervision. 6 Pending LISF implementation, Mexican insurers will continue to operate under a factor-based solvency framework that contains certain risk-sensitive components. On top of minimum paid-up capital requirements, insurers are required to meet solvency margins equal to the greater of net annual premiums written or claims incurred during the past three years, multiplied by some factor. That factor varies by line of business and is adjusted for the credit quality of reinsurance counterparties. 2 Se pospone entrada en vigor de la CUSF, en aspectos específicos, El Asegurador, 20 October 2014, 3 The third qualitative impact study completed in July 2014 indicated that 65% of market participants were in compliance with the new rules. The average remaining time to full implementation was estimated at seven months, which places most insurers well within schedule. See Informe Sectorial Del Estudio de Impacto Cualitativo 3, CNSF, August See LISF Article 69 of April Autoevaluación de Riesgos y Solvencia Institucionales (ARSI), see CUSF Chapter 3.2, 6 Reporte sobre la Solvencia y Condición Financiera (RSCF), see CUSF Chapter 24.1 of July Swiss Re Insurance solvency regulation in Latin America : modernizing at varying speeds 5

8 Solvency regimes in Latin America The capital requirements to cover earthquake and hurricane exposures are based on net retained probable maximum loss (PML) estimates, thereby giving due consideration to the Mexico s high exposure to natural catastrophe risk. In addition, Dynamic Solvency Testing (DST) requires that insurers test their capital positions against periodically-updated stress scenarios. 7 This ensures that solvency margins capture a wider array of risks and that the contingency plans stay current with changing circumstances. Both PML and DST have been incorporated into the LISF. Brazil is adopting RBC regulation in a piecemeal fashion. The regulator plans to implement ORSA requirements in Brazil Unlike Mexico s big bang approach of comprehensive regulatory reform, Brazil s insurance market regulator, the Superintendence of Private Insurance (SUSEP), is implementing new rules and directives in a piecemeal fashion. The underwriting component of the risk capital requirement remains factor-based, but correlation and pricing-risk coefficients were built into the model in 2007 for non-life insurers and in 2013 for life and pensions insurers. 8 Charges for credit and operational risks have been in place since 2010 and 2013, respectively. 9 Finally, market risk regulation will be added in 2015 and capital charges will be phased in over the subsequent three years (50% by end-2017 and 100% by end-2018). 10 Draft regulation indicates that market risk capital will be calculated using a value-at-risk methodology and factor in concentration and liquidity risks. SUSEP has recently taken steps to strengthen the areas of supervision and corporate governance. In April 2014, it applied for transitional equivalence with Solvency II, which applies to reinsurance and group supervision activities. To that end, SUSEP has set up a working group tasked with developing an ORSA framework. Implementation is targeted for Figure 4 Evolution of Brazil s minimum capital requirement (MCR) 2010 CNSP Resolution CNSP Resolution CNSP Resolution 302*** MCR = max (BC+AC; SM) 1. Base capital (BC)* 2. Solvency margin (SM) 3. Additional capital (AC) Underwriting risk Credit risk MCR = max (BC+RC; SM) 1. Base capital (BC)* 2. Solvency margin (SM) 3. Risk capital (RC)** Underwriting risk Credit risk Operational risk MCR = max (BC; RC) 1. Base capital (BC)* 2. Risk capital (RC)** Underwriting risk Credit risk Operational risk Market risk *Base capital = minimum fixed level of capital + variable capital depending on the region of operation. **Risk capital (formerly additional capital ) = requirement reflects re/insurers underlying risk profiles. ***Will be replaced by CNSP Resolution No. 316, issued in September 2014 and take effect in Source: CNSP, SUSEP, CNSeg. Pillars II and III require reinforcement. Public disclosure in Brazil is extensive and timely, though a scarcity of financial and human resources often constrains SUSEP s ability to scrutinize companies more deeply and frequently. 12 In particular, insurance subsidiaries of large financial groups and conglomerates, which dominate the local market, are supervised on a standalone basis rather than at the group level. This may cause certain vulnerabilities 7 See: CNSF Circular S of May See: CNSP Resolution No. 158/06 and SUSEP Circular No. 411/10. 9 See: CNSP Resolution No. 228/10, CNSP Resolutions No. 280/13, 282/13, 283/13, and 302/13, and CNSP Resolutions No. 316/ Latin America: insurance risk and regulatory developments, Ernst & Young, See: 12 Brazil: Detailed Assessment of Observance of Insurance Core Principles of the International Association of Insurance Supervisors, International Monetary Fund, Swiss Re Insurance solvency regulation in Latin America : modernizing at varying speeds

9 and contagion risks from other entities in the group to go undetected. Similarly, rules on corporate governance and ERM apply at the solo level, and are still fairly nascent. Chile s transition to an economic risk-based regime has been ongoing for more than 10 years. Implementation of Pillars II and III provisions has proceeded much faster. Risk-based capital will replace the existing solvency margin. Chile Chile s insurance regulator, the Superintendence of Securities and Insurance (SVS), committed to a risk-based supervisory regime as early as Since then, SVS has laid the groundwork for a Solvency II-type framework by bolstering its own institutional capacity and refining the methodology for calculating RBC. Enabling legislation was finally drafted and presented to Congress in September 2011, kicking off a series of consultation rounds and impact studies. Two revised draft methodology documents and a quantitative impact study have been concluded so far, with final congressional approval expected in Pillar I provisions will be subsequently phased in over the course of three to five years. Unlike legal reforms to capital adequacy requirements, those pertaining to Pillars II and III do not require congressional approval. Revised risk-based supervisory standards for corporate governance and ERM were introduced in 2011 and 2012, respectively, and are currently being implemented. 13 Once in force, insurers will be obliged to self-assess their corporate governance structures and ERM procedures and align them with the revised standards, for example, through the creation of chief risk officer (CRO) positions and risk committees, or by the strengthening of internal audit functions. Qualitative assessment of a company s ERM procedures then feed into capital requirements via capital add-ons. On Pillar III, the adoption of IFRS accounting standards in 2012 has helped improve transparency and comparability of financial statements. Until Pillar I legislation is enacted, Chilean insurers will continue to operate under a factor-based capital model similar to Solvency I but with some local adaptations. 14 As in Mexico, insurers are required to post a fixed amount of minimum capital that is adjusted for inflation. The solvency margin is a factor of net premiums written or claims incurred, whichever is higher. Factors vary by line of business and the credit quality of reinsurance counterparties. In addition, Chilean insurers must comply with a Statutory Debt Relationship which stipulates that total debt cannot exceed a certain multiple of capital (five times for non-life insurers, 15 times for life insurers), and that debt to third parties (excluding technical reserves) cannot exceed total capital. 15 This long-standing provision and the minimum capital requirement will be carried over into the new economic risk-based solvency regime. 13 Regulation for corporate governance and ERM is set out in Norma de Carácter General (NCG) 309 and NCG 325, respectively. 14 The Ley De Seguros was approved by the lower house Cámara de Diputados and is being reviewed by the Senate s upper house. 15 See SVS Circular No. 215 of August Swiss Re Insurance solvency regulation in Latin America : modernizing at varying speeds 7

10 Solvency regimes in Latin America Mexico, Chile and Brazil s economic RBC models are unique while sharing the broad contours of Solvency II. Box 2: Economic risk-based solvency models in Mexico, Brazil and Chile The three countries at the forefront of Latin America s regulatory reform process differ in their adaptation of economic RBC models. Mexico s draft model is a blend of Solvency II, the Swiss Solvency Test (SST), elements of the US framework and local adaptations drawn from the existing framework. Brazil employs a hybrid approach, whereby insurers must post the higher of minimum base capital and risk capital. Chile also retains a minimum base capital requirement and a debt leverage requirement. Like Mexico, Chile s model will use a value-at-risk (VaR) methodology to determine risk capital requirements, including for the underwriting component. In Brazil, the underwriting component is factor-based but accounts for pricing/ provision risks as well as correlation between classes of business and region. All three solvency capital regimes permit partial or full internal models, provided that these are approved by the respective supervisor. Table 1 Comparison of prospective solvency regimes Key criteria Mexico 16 Brazil 17 Chile 18 Standard model SCR calculation Risk types covered Diversification Sum of 1-year 99.5% value-at-risk (VaR 99.5%) corresponding to loss distribution for six risk categories (insurance, counterparty, catastrophe, pension, surety, operational). Underwriting, market, credit, catastrophe risks, liquidity, concentration and operational risks (expected in 2015). Correlation between lines of business considered through copula models. Higher of: (1) base capital, which varies by region for primary insurers; and (2) risk capital. Underwriting risk capital uses a similar square root formula as the SCR under Solvency II. Non-life underwriting (2007), credit (2010), life and pensions (2013), operational (2013) and market (expected by the end of 2014) risks. Correlation between risk types and lines of business. Highest of: (1) base capital; (2) capital to meet maximum debt leverage ratio; and (3) RBC-model based on sum of 99.5% VaR per risk category. Underwriting, market, credit and operational risks (effective date to be determined). Correlation between risk types and lines of business. Valuation Economic valuation of assets and liabilities (expected in 2015). Economic valuation of assets and liabilities, as per IFRS since Economic valuation as per IFRS standards since Marketconsistent valuation with the introduction of RBC. Standards for corporate governance (NCG No. 309) and ERM (NCG No. 325) with capital implications. Corporate governance and ERM Establishes a corporate governance system (Sistema Gobierno Corporativo) that ensures compliance with ERM processes and procedures, including ORSA, audit and actuarial functions. Proposals for an ORSA framework are expected in November 2014; implementation targeted for Source: National superintendencies of insurance. 16 Based on Ley de Instituciones de Seguros y de Fianzas published on April 4th 2013, see: 17 Based on CNSP Resolution No 316/ Based on the latest draft methodology document, see: Borrador de Metodología para la Determinación del Capital Basado en Riesgo (CBR) de las Compañías de Seguros (segunda versión), Superintendencia de Valores y Seguros de Chile, January Swiss Re Insurance solvency regulation in Latin America : modernizing at varying speeds

11 Colombia, Peru and Costa Rica are undertaking piecemeal reforms to align with international best practices. Colombia supplements a factor-based solvency margin with credit and market risk charges Peru goes one step further and includes operational risk. Costa Rica goes farthest with three additional capital charges covering catastrophes risks, reinsurance and asset-liability mismatches. Colombia, Peru and Costa Rica Similar to Brazil, Colombia, Costa Rica and Peru are introducing incremental changes to their existing solvency frameworks to gradually align with international best practices. All three countries are supplementing their factor-based capital models with additional risk capital charges. None has presented a timeframe for transition to an economic risk-based solvency regime, but the respective national superintendencies of insurance have made regulatory modernization a priority. 19 The Peruvian Superintendence of Banking, Insurance and Private Pension Funds (SBS) is using Solvency II as its reference guide, while the Colombian Superintendence of Finance (SFC) and the Costa Rican General Superintendence of Insurance (SUGESE) are pursuing more eclectic approaches. 20 Colombia incorporated credit ( asset ) and market risk capital charges in its factorbased solvency framework in 2010 and 2012, respectively. 21 Similar to Solvency I, the underwriting risk component is a function of premiums, claims and, in the case of certain life lines of business, mathematical reserves. To calculate credit risk capital, assets are weighted in accordance with their underlying credit quality (eg, 0% for risk-free assets and 8.5% for sub-investment grade assets). Market risk capital is based on a value-at-risk (VaR) methodology. The standard formula assumes perfect correlation between risk components, such that the final solvency capital requirement is a simple summation of the three risk capital charges. However, companies may employ internally-developed models that include diversification effects provided that these are approved by the SFC. Similar to Colombia, Peru s solvency capital requirement is equal to the higher of: (1) an inflation-adjusted minimum capital requirement; and (2) a solvency margin based on annual premiums written and net claims incurred. Separate capital charges for credit, market and operational risk were introduced in For all three risk capital calculations, insurers can choose between a fixed-factor standard formula and an internal risk-based model that is subject to approval by the SBS. In 2014, the SBS added a concentration risk component to the market risk capital requirement that accounts for vulnerabilities arising from over-exposure to certain investments. Furthermore, like Chile, Peru has a statutory debt limit for insurance companies, whereby total debt is not allowed to exceed total solvency capital. Costa Rica has gone farthest in the adoption of additional risk-capital charges. The Regulation on the Solvency of Insurance and Reinsurance Entities, which dates back to 2008 but was significantly modified in 2013, subjects local re/insurers to credit, operational and market-risk charges. 23 Like Colombia, Costa Rica employs a VaR methodology for market risk exposures and credit-risk weighting of invested assets. Like Peru, the market risk component factors in concentration risks. In addition, Costa Rica s solvency framework differs from Colombia and Peru s in three important respects. First, it includes a separate solvency capital requirement for catastrophe risks, which is calculated as the probable maximum loss (PML) of catastrophe exposures net of reinsurance. Second, it has a separate capital requirement for reinsurance operations that accounts for credit and concentration risks. And finally, it takes into consideration maturity and currency mismatches on insurers balance sheets, also through a separate capital charge. 19 See Memoria annual 2009, SBS, y AFP, Peru s SBS created a Special Committee on Basel II-Solvency II in 2008 with the aim of aligning regulation to the European model. Colombia s Internal Supervisory Framework (Marco Integral de Supervisión) draws on Canadian insurance regulation as well as Solvency II. See: Prioridades de Política de la Industria Aseguradora, Fasecolda, June Costa Rica s supervisory model is based on IAIS principles. See Informe Final de Labores en el Cargo Intendente General de Seguros, SUGESE, See Decreto No of August 2010 and SFC Circular Externa 045 of November See Articles 298 to 305 of the Ley General del Sistema Financiero y del Sistema de Seguros y Orgánica de la Superintendencia de Banca y Seguros (# 26702) of Reglamento sobre la Solvencia de Entidades de Seguros y Reaseguros, Superintendencia General de Seguros, July 2013 (updated on October ). Guidelines for calculating risk capital requirements were introduced in August of 2013 following five years of development. See Lineamientos Generales Para La Aplicación del Reglamento sobre la Solvencia de Entidades de Seguros y Reaseguros, Superintendencia General de Seguros, July Swiss Re Insurance solvency regulation in Latin America : modernizing at varying speeds 9

12 Solvency regimes in Latin America All three countries are striving to overcome capacity constraints. RBC in Argentina, Venezuela and the region s smaller economies remains a distant prospect. Argentina has an ambitious reform plan but has made no firm commitments. Venezuela has not published any solvency reform proposals since Modernization in the region s smaller countries is advancing very slowly. Notwithstanding these accomplishments, the three countries are not expected to have fully-fledged economic risk-based capital regimes for some time yet. There are currently no formal commitments to switch from fixed-factor solvency margins and none of the three has applied for Solvency II equivalence. Insufficient institutional and human capacity, particularly the availability of actuarial talent, is a binding constraint, though the countries superintendencies are taking steps to address this. 24 They are also seeking to bolster supervision of corporate governance, ERM and economic valuation, which are relatively underdeveloped from a risk and solvency perspective and vary widely among insurers. 25 Argentina, Venezuela and the rest of Latin America Argentina and Venezuela the third and fourth largest insurance markets in the region, respectively and most of the other countries in Latin America have undertaken few modernizing reforms in the recent past. Like Colombia, Costa Rica and Peru, these countries operate under factor-based capital models (ie, some factor of net premiums or claims written over a specific period of time). However, few have specific surcharges for non-technical investment or operational risks, and those that do (eg, Panama) so far only consider asset risks. Rules and guidelines pertaining to corporate governance and ERM are scattered and lack a clear solvency focus. 26 While many of the countries have expressed support for the risk-based supervisory agenda, none has committed to a concrete timetable. In 2012, the insurance regulator in Argentina, the National Superintendence of Insurance (SSN), introduced an eight-year Strategic Plan for Insurance (Plan Nacional Estratégico del Seguro , PlaNeS) to modernize and strengthen the existing supervisory framework. 27 The plan includes objectives to explore the possibility of introducing risk capital provisions, risk-based supervision and IFRS accounting standards for re/insurers. A working group was subsequently established to study the implications of IFRS adoption, and the SSN has reportedly been evaluating the applicability of solvency and regional capital models. 28 However, no timetable for either RBC or IFRS adoption has been forthcoming as of yet. Venezuela s authorities have not presented any new solvency reform proposals since the enactment of the landmark Insurance Activity Bill in 2010 (Ley de la Actividad Aseguradora, LAA). That law paved the way for improvements to reserve and minimum capital provisions, yet neither the LAA nor any legislation since has made specific mention of RBC models or supervision. 29 Venezuela adopted IFRS accounting standards in 2008 for all companies including insurers, with certain modifications to account for the high inflation environment. Companies are required to present pricelevel adjusted financial statements when the rate of inflation is 10% or more. The remaining countries in the region have made minimal progress towards an economic risk-based solvency regime. This is in large part a function of their relatively small markets and institutional constraints. 24 For example, the SBS has launched an Institutional Strengthening Programme ( ). See Memoria anual 2012, Superintendencia de Banca, Seguros, y AFP, See Colombia: Financial System Stability Assessment, International Monetary Fund, February See Memoria anual 2010, SBS, 2010, and Memoria anual 2013, SBS, Costa Rica has had comprehensive corporate governance regulation in place since 2009, but not an ORSA process. See Reglamento de Gobierno Corporativo, Superintendencia General de Valores, July Argentina: Detailed Assessment of Observance of Principles for Insurance Supervision, International Monetary Fund, September Plan Nacional Estratégico del Seguro : Documento de Proyecto, Superintendencia de Seguros de la Nación, May A un año de la implementación del PlaNeS: Plan Nacional Estratégico del Seguro , Superintendencia de Seguros de la Nación, October 2013, p Ley de la Actividad Aseguradora, Superintendencia de la Actividad Aseguradora, , Swiss Re Insurance solvency regulation in Latin America : modernizing at varying speeds

13 Colombia, Costa Rica and Peru s solvency frameworks are similar. Box 3: Economic risk-based solvency in Colombia, Costa Rica, and Peru The solvency frameworks of Colombia, Costa Rica and Peru share the same basic structure: (1) a minimum paid-up capital requirement, in each case adjusted for inflation; (2) a factor-based solvency margin for underwriting risks; and (3) additional risk capital charges for certain non-technical risks. Costa Rica differs in that it uses technical reserves net of reinsurance rather than net premiums or claims to calculate the underwriting portion. Also, it has a separate capital requirement for catastrophe risk, whereas this are included in the reserve requirements in Peru and Colombia. Table 2 Comparison of current solvency regimes Key criteria Colombia 30 Costa Rica 31 Peru 32 Standard model SCR calculation Underwriting SCR Higher of (1) minimum required base capital plus minimum additional capital by line of business; and (2) risk SCR determined using a function of underwriting, risk, and asset SCRs. Non-life: higher of (1) annual net premiums written multiplied by a factor, and (2) net claims incurred during the previous 36 months multiplied by a factor. 33 Life: mathematical reserves multiplied by a factor, net of reinsurance. Higher of (1) minimum base capital requirement by carrier (personal insurer, general insurer, cpmposite and reinsurer); and (2) linear sum of underwriting and risk capital requirements. Non-life: sum of technical provisions by line of business multiplied by a risk factor, net of reinsurance. Life: sum of mathematical reserves multiplied by a risk factor, net of reinsurance. Risk capital components Asset (2010), market (2012). Credit and catastrophe (2009), operational and market (2014). Diversification So far only for approved internal Not applicable. models. Valuation Corporate governance and ERM Source: National superintendencies of insurance. Economic valuation as per IFRS (expected end-2015). Code of Best Practices in Corporate Governance since It does not include an ORSA. 35 Economic valuation in accordance with IFRS since Corporate governance regulation has been in place since It does not include an ORSA. 36 Higher of: (1) minimum fixed capital; (2) solvency margin. Capital for non-technical risks is to be held in Guarantee Fund (Fondo de GarantÍa). A separate statutory debt limit equal to total effective capital. Life and Non-life: higher of (1) annual net premiums written multiplied by a factor, and (2) net claims incurred during the previous 36 months multiplied by a factor. Credit, market, and operational (2013). Not applicable. Economic valuation as per IFRS since Code of Best Practice in Corporate Governance since 2002 and Comprehensive Risk Management Regulation since Based on Decreto No of August 2010 and Circular Externa 045 of November Based on: Reglamento sobre la Solvencia de Entidades de Seguros y Reaseguros, SGUESE, September 2008, and Lineamientos Generales Para La Aplicación del Reglamento sobre la Solvencia de Entidades de Seguros y Reaseguros, SUGESE, July Based on Ley General del Sistema Financiero y del Sistema de Seguros y Orgánica de la Superintendencia de Banca y Seguros (# 26702). 33 To determine net premiums, gross premiums are multiplied by the retention rate (net claims/gross claims), which cannot be less than 50%. 34 See Article 12 of Ley Reguladora del Mercado de Seguros (#8653) of August SFC Circular Externa 028 of 2007 and SFC Circular Externa 007 of See Reglamento de Gobierno Corporativo, Superintendencia General de Valores, July See Código de Buen Gobierno Corporativo para las Sociedades Peruanas, Superintendencia del Mercado de Valores, November 2013; and SBS Resolution No. 037 of Swiss Re Insurance solvency regulation in Latin America : modernizing at varying speeds 11

14 Solvency regimes in Latin America Figure 5 Solvency regimes in the main Latin American markets as of November 2014 Country Risk category Argentina Solvency margin Bolivia Solvency margin Brazil Underwriting Market Credit Operational Chile Underwriting Market Credit/asset Operational Colombia Solvency margin Market* Asset* Costa Rica Solvency margin Market* Credit* Ecuador Solvency margin Mexico Underwriting Market Credit/asset Operational Panama Solvency margin Peru Solvency margin Market* Credit/asset* Operational* Uruguay Solvency margin Venezuela Solvency margin Solvency margin Underwriting Market Credit/Asset Operational *Stripped patterns indicate transition to economic risk-based solvency regimes. Note: expectations of future changes in solvency regulation are based on latest information and are subject to change. Source: IFRS, IMF, National Superintendencies of Insurance, AXCO. Economic risk-based solvency regulation will have implications for four key areas. The model design process is ongoing and fluid but capital requirements are ultimately expected to increase. Implications of solvency regime changes The net effect of the new solvency regulations in their respective countries will vary depending on the country-specific model designs and market circumstances. Nevertheless, some general inferences about the potential impact on (1) capital requirements; (2) insurance product mix; (3) industry concentration; and (4) reinsurance demand can be drawn from current trends and past precedents. Capital requirements It is too early to say what the impact of new solvency rules on solvency capital requirements will be. The model design process is ongoing and fluid, with many methodological aspects still to be determined. Moreover, several features of the respective economic risk-based solvency regimes or RBC models should help mitigate the impact of additional capital charges. The sequence and pace of regulatory reform will also determine the ease of adjustment for insurers. Regarding the overall level of capital required, there is broad consensus that the balance of risks lies to the upside. 38 The results of the fifth and latest European Insurance and Occupational Pensions Authority (EIOPA) quantitative impact study, which estimated an increase in the solvency capital requirement of around 140% 38 See for example: Mexico Insurers: March 2014 Financial Ratios, Fitch Ratings, July 2014; 2014 Outlook: Chilean Insurance Sector, Fitch Ratings, December 2014; Insurers predict rise in premiums from changes to supervision model, BNamericas, April Swiss Re Insurance solvency regulation in Latin America : modernizing at varying speeds

15 with the introduction of Solvency II in Europe, may influence this view. 39 In the case of Mexico, the authorities have yet to reveal the technical details of their QIS 3 concluded in August 2014, although they have highlighted significant challenges to implementation. 40 Also, much of the adjustment will be front-loaded since Pillars II and III will still be implemented in April 2015 unlike most provisions of Pillar I which have been pushed back to January 2016 and will entail significant costs. Sequencing and pacing should facilitate adjustment for insurers. Diversification will help mitigate the impact of new capital charges. Reinsurance can be an effective and efficient form of capital relief. The more gradual approaches adopted by Brazil and Chile should soften the impact for insurers in those markets. In Brazil, the piecemeal introduction of an economic risk-based solvency regime from 2007 does not appear to have put undue pressure on insurers capital positions or bottom lines. Rather, insurers have been granted considerable time to make necessary adjustments, such as raising capital, derisking balance sheets or diversifying their product mixes. The phase-in of market risk capital, likely by the end of 2014, is thus not expected to create a major shock. There are also early indications of pre-emptive measures by insurers in Chile in anticipation of the forthcoming economic risk-based solvency regulation, despite the still uncertain timeframe of the legislative agenda. 41 Diversification and risk mitigation are integral to economic risk-based solvency regimes and will help mitigate additional risk capital charges. Diversification applies to risk categories (ie, underwriting, market, operational and credit) and to lines of business. In the fifth QIS of the EU s Solvency II framework, diversification effects were shown to be between 20% and 36% of the SCR for non-life and life insurers, respectively. Brazil, Chile and Mexico s economic risk-based solvency models allow for diversification effects between lines of business and risk types. If the latter are demonstrated to be weakly or negatively correlated, substantial capital savings may result (see Box 4 for an illustration). Similarly, reinsurance offers significant capital relief under Standard Formulae of the new economic risk-based solvency frameworks, and often at a lesser cost than other financing tools such as equity or subordinated debt. 42 The trade-off between alternative capital management tools is summarized in Figure 6. Compared to other forms of capital-raising, reinsurance reduces the SCR and also frees up own funds for alternative uses. Further, the new rules imply that reinsurance will be more closely linked to risk transfer than under previous regimes, these having been generally based on book value accounting rather than market-consistent valuations. Figure 6 Solvency capital management tools Assumed underwriting and market risks Sources Example Impact Raise capital New capital Retained earnings Shares Hybrid capital Own funds Unlock hidden capital Exit exposures Cut dividends Share buyback Reinsurance Sale of assets Exit businesses Own funds Own funds Own funds ( SCR) SCR Reduce risk exposures Risk mitigation Reinsurance Hedging SCR Source: Swiss Re. Emphasis on increasing own funds Emphasis on reducing SCR and stabilizing own funds 39 EIOPA Report on the fifth Quantitative Impact Study (QIS5) for Solvency II, European Insurance and Occupational Pensions Authority March Informe Sectorial del Estudio de Impacto Cuantitativo 2, CNSF, June For example, see: Consorcio Seguros raises capital ahead of new regulations, BNamericas, February For a discussion of the economics reinsurance capital solutions, see: E. Gurenko and A. Itigin, Reinsurance as Capital Optimization Tool under Solvency II, World Bank, Also: O. Mayo and B. Heinen, Reinsurance as a capital management tool under Solvency II, Swiss Re, Swiss Re Insurance solvency regulation in Latin America : modernizing at varying speeds 13

16 Solvency regimes in Latin America Reinsurance can help a life insurer with an average risk profile... Box 4: Example applying the Standard Formula to a Mexican life insurer A stylized example illustrates the potential impact of diversification effects and reinsurance relief on the solvency capital requirements using the EU s Solvency II standard formula. The life insurer in Mexico is assumed to mirror the market average, with the following characteristics: Annual premium revenue of MXN 8.2 billion and assets of MXN 12 billion; Product mix consists of individual and group life products; and Investment portfolio comprises 95% A-rated Mexican sovereign bonds and 5% cash. The insurer enters into a 50% quota share on all risk insurance products for a 7% margin and 60% profit participation.... realise substantial capital relief. Based on Solvency II standard RBC model formula, the insurer could reduce its SCR for life underwriting risk by 36% from MXN 16 billion to MXN 10 billion, with the largest impact on mortality risk. Diversification between risk categories generates capital savings of between 30 40%, depending on whether reinsurance cover is purchased. In the final SCR, the RBC model adds MXN 3 billion of market risk capital, MXN 300 million of operational risk capital and, assuming reinsurance, MXN 60 million of counter-party default risk capital, for a total of ~MXN 3.3 billion of additional capital requirement. Diversification between modules subtracts MXN 2 billion (MXN 1.9 billion with reinsurance). Figure 7 Life solvency capital requirement (LHS) and overall solvency Capital requirement (RHS), in millions of pesos Without reinsurance With reinsurance Diversification across risk segments Diversification across modules Mortality Disability Lapse Expense Cat Diversification Reinsurance capital savings = = = 5.5 Life SCR Life SCR Market Default Non-Life Diversification Operational SCR Final Source: Swiss Re. The industry product mix may shift towards capital light products... Product mix The differential capital treatment of risk categories and/or business lines may influence the demand and supply of certain insurance products. On the supply side, insurers may be incentivized to concentrate on less capital-intensive products. For example, market risk capital add-ons favour unit-linked products over those that contain financial guarantees since the former pass the market risk exposure on to policyholders A. Al-Darwish, M. Hafeman, G. Impavido, M. Kemp, and P. O Malley, Possible Unintended Consequences of Basel III and Solvency II, International Monetary Fund, August Swiss Re Insurance solvency regulation in Latin America : modernizing at varying speeds

17 as seen in Brazil and Mexico. The higher underwriting risk capital associated with more actuarially complex products such as life annuities, may also discourage their development. 44 The introduction of RBC models could therefore trigger or reinforce a shift away from pension schemes with mostly defined benefits to those that rely on policyholder contributions. In Brazil, such a trend has been manifest in the displacement of traditional defined benefit plans by unit-linked pension and life insurance products known as PGBL (Plano Gerador de Benefício Livre) and VGBL (Vida Gerador de Benefício Livre), which do not offer a minimum rate of return or a lifetime income (see Figure 8). Mexico has experienced a similar trend with the share of defined benefit plans falling from 93% in 1995 to 27% in Figure 8 Pension schemes in Brazil (LHS) and Mexico (RHS) 100% 80% 60% 40% 20% 0% 100% 80% 60% 40% 20% 0% VGBL PGBL Traditional plans Hybrid Defined contribution Defined benefit Source: FenaPrevi (for Brazil) and Consar (for Mexico). High capital charges will translate into higher prices for consumers. Smaller carriers and mono-line insurers may be disadvantaged by the new rules. On the demand side, high capital requirements and/or costs associated with new regulations could be passed on to consumers in terms of higher prices. 45 In a region where affordability is a key driver of spending decisions, higher costs could have a significant impact on insurance demand. 46 Industry consolidation Tighter capital regulation will impact insurers differently. Some will be better placed to absorb the additional costs of meeting the new capital requirements. In general, larger multi-national carriers will have an advantage by being able to call upon parent or affiliated companies for capital and operational support. In contrast, smaller- and medium-sized firms may find it harder to raise capital and achieve cost savings through scale. Mono-line insurers will be at an added disadvantage because they will reap fewer diversification benefits. Faced with such pressures, smaller or weaker firms may be forced to exit the market or merge with others. Less diversified insurers may seek to acquire non-correlated businesses in order to gain some diversification benefits or to accelerate a shift in their product mix. 44 In Brazil and Mexico, pension funds are subject to the same capital requirements as insurance companies. 45 This is a concern of the Chilean insurance industry association, the A.A.C.H. See: Insurers predict rise in premiums from changes to supervision model, BNAmericas, 4 April A customer survey conducted by Swiss Re in 2013 found affordability to be the main reason why Latin Americans do not take out savings products for retirement. See: Latin America Customer Survey Report 2013: Capturing future opportunities, Swiss Re, Swiss Re Insurance solvency regulation in Latin America : modernizing at varying speeds 15