ICP 14: Preventive and Corrective Measures of the Supervisor

Transcription

1 A Core Curriculum for Insurance Supervisors ICP 14: Preventive and Corrective Measures of the Supervisor Basic-level Module

2 Copyright 2006 International Association of Insurance Supervisors (IAIS). All rights reserved. The material in this module is copyrighted. It may be used for training by competent organizations with permission. Please contact the IAIS to seek permission. This module was prepared by Lawrie Savage, who is a former superintendent of insurance for the government of Ontario ( ) and is currently president of Lawrie Savage and Associates. He has 37 years of experience in the Canadian insurance sector and, in addition to his work with Ontario, was with the Canadian financial supervisory authority, OSFI, for 19 years. For the last eight years of his tenure with OSFI, he was in charge of non-life insurance supervision for Canada. He has also been chief executive officer of a Canadian life insurance company and vice chairman of a non-life insurer. The module was reviewed by Pilar González de Frutos, a specialist in both sides of insurance supervision, is president of the Spanish Insurers Association. Prior to that, she was head of Spanish insurance supervision for six years. She earned her law degree at the Autonomous University in Madrid (Spain). She also has broad experience at the international level as a member of the International Association of Insurance Supervisors (IAIS), Asociación de Supervisores de Seguros de América Latina (ASSAL), Comité Européen des Assurances (CEA), and Federación Interamericana de Empresas de Seguros FIDES.

3 Contents About the Core Curriculum v Note to learners vii Pretest ix A. Introduction: Prevention and Correction in the Supervisory Process B. Understanding Key Terms C. Importance of ICP D. Legal Framework E. The Application of Preventive and Corrective Measures in a Transparent, Consistent, and Effective Manner F. Conclusions G. References Appendix I. ICP iii

4 Insurance Supervision Core Curriculum Appendix II. Ladder of Intervention Followed by the Office of the Superintendent of Financial Institutions Canada (OSFI) Appendix III. Discussion of Case Studies and Possible Supervisory Strategies Appendix IV. Answer key Figures Figure 1: Original Situation in Which Two Brothers Own Company A and Company B Figure 2: Follow-up Situation in Which Mother Owns Corporation B Case Studies Case Study Case Study Case Study Case Study Case Study iv

5 About the Core Curriculum A financially sound insurance sector contributes to economic growth and well-being by supporting the management of risk, allocation of resources, and mobilization of longterm savings. The insurance core principles (ICPs), developed by the International Association of Insurance Supervisors (IAIS), are key international standards relevant for sound financial systems. Effective implementation of the ICPs requires skilled and knowledgeable insurance supervisors. Recognizing this need, the World Bank and the IAIS partnered in 2002 to develop a core curriculum for insurance supervisors. The Core Curriculum Project, funded and supported by various sources, accelerates the learning process of both new and experienced supervisors. The ICPs provide the structure for the core curriculum, which consists of a set of modules that summarize the most relevant aspects of each topic, focus on the practical application of supervisory concepts, and cross-reference existing literature. The core curriculum is designed to help those studying it to: Recognize the risks that arise from insurance operations Know the techniques and tools used by private and public sector professionals to identify, measure, and manage these risks Operate effectively within a supervisory organization Understand the ICPs and other IAIS principles, standards, and guidance Recommend techniques and tools to help a particular jurisdiction observe the ICPs and other IAIS principles, standards, and guidance Identify the constraints and identify and prioritize supervisory techniques and tools to best manage the existing risks in light of these constraints. v

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7 Note to learners Welcome to module 14: preventive and corrective measures of the supervisor! This is a basic-level module on preventive and corrective measures that does not require specific prior knowledge of this topic. The module should be useful to either a new insurance supervisor or an experienced supervisor who has not dealt extensively with the topic or is simply seeking to refresh and update knowledge. Start by reviewing the objectives, which will give you an idea of what a person will learn as a result of studying the module, and answer the questions in the pretest to help gauge your prior knowledge of the topic. Then proceed to study the module either on an independent, self-study basis or in the context of a seminar or workshop. The amount of time required to study the module on a self-study basis will vary but it is recommended that it be addressed over a short time, broken into separate sessions on parts if desired. To help you engage and involve yourself in the topic, we have interspersed the module with a number of hands-on activities for you to complete. These are intended to provide a checkpoint from time to time so that you can absorb and understand the material more readily. You are encouraged to complete each of these activities before proceeding with the next section of the module. You will also find questions dealing with the local situation and related to practices in your jurisdiction. These are intended to help you apply the material in this module to your local circumstances. If you are working with others on this module, develop the answers through discussion and cooperative work methods. As a result of studying the material in this module, you will be able to do the following: vii

8 Insurance Supervision Core Curriculum 1. Describe measures that a supervisory authority might take to help prevent breaches of legislation and regulations from occurring 2. Describe the instruments available to supervisory authorities to enable timely preventive and corrective measures to be taken if an insurer fails to operate in a manner that is consistent with sound business practices or regulatory requirements 3. Identify the costs and the benefits of early intervention 4. Describe possible triggers for supervisory intervention and illustrate how they can be arranged in a supervisory ladder, so that more serious breaches result in more intrusive intervention 5. Select an appropriate form of communication between the supervisory authority and an insurer, in response to a particular type of supervisory concern 6. Justify the imposition of timetables in plans of corrective action 7. Describe the oversight required once a plan of corrective action has been agreed on 8. Summarize the requirements of ICP 14. viii

9 Pretest Before studying this module on preventive and corrective measures, answer the following questions. The questions are designed to help you gauge your existing knowledge of this topic. An answer key is presented in appendix IV at the end of the module. For each of the following questions, circle the response that is correct or most relevant. 1. A supervisory authority believes there is a high probability that a recently licensed insurer is not complying with the legislation and regulations. Which of the following preventive measures might the supervisory authority take first? a. Take away the insurer s license b. Meet with the board of directors to explain the reason for the concerns c. Seek legal action through the courts for noncompliance d. Request a business plan so as to be able to assess likely future risk e. Retain an international auditing firm to carry out an investigation f. Per form an onsite inspection g. Amend the legislation and regulations. ix

10 Insurance Supervision Core Curriculum 2. Which of the following is not an advantage of using a supervisory ladder or similar scheme for assessing risk? a. It helps to ensure consistency in the way risks are assessed b. It enables staff of the supervisory authority to resolve concerns without the involvement of the authority s senior management c. It helps to ensure that insurers understand how risks will be assessed and can govern themselves accordingly d. It serves as a game plan that politicians can approve in advance, so they will not be surprised when the supervisory authority recommends a particular course of action to deal with a situation of concern. 3. In addition to the supervisory ladder and the ladder of intervention, which of the following can help to ensure that insurers are being dealt with in a consistent manner? a. A policy and procedures manual b. A regulation that prescribes penalties for the late filing of regulatory returns c. A consumer ombudsman. 4. Categorize the following preventive and corrective measures into three groups based on the order in which they are likely to be applied in other words, early measures, mid-term measures, and late-term measures: a. Assess the fitness and propriety of officers and directors b. Withdraw the insurer s license c. Increase the frequency of financial reporting d. Require a business plan e. Conduct a public hearing into the insurer s affairs f. Per form a routine onsite inspection g. Review the annual financial regulatory return filed by the insurer h. Restrict the insurer s volume of business by putting a condition in its license. 5. Which of the following are benefits that reviewing an insurer s business plan might provide to a supervisor? a. It indicates what the insurer plans to do in the future, enabling the supervisor to consider the risks involved and whether the insurer is well positioned to manage these risks x

11 ICP 14: Preventive and Corrective Measures of the Supervisor b. It enables the supervisory authority to schedule its onsite inspection at a time that will be convenient to the insurer c. It provides insight into management s ability to prepare a wellthought-out and coherent plan d. It provides insight into management s ability to control its operations and achieve its stated goals e. It better prepares the supervisor to advise the insurer s management on matters of business strategy f. All of the above, except for a and c g. All of the above, except for b and e h. All of the above. 6. Three of the actions listed below are features of risk-based supervision. Which of the following actions is not necessarily associated with risk-based supervision? a. Basing supervisory activities on the perceived risk level of each insurer b. Assessing insurers on the basis of risk c. Reviewing financial statements and calculating early-warning test ratios d. Using a supervisory ladder or some other mechanism to assess risk in a consistent manner. 7. Which of the following are important criteria with regard to the effectiveness of sanctions for noncompliance? a. The application of sanctions must require court action b. The penalties must be significant enough to be a meaningful deterrent c. Sanctions against individuals must involve imprisonment d. The penalties must actually be enforced, not merely stated in the law e. Both a and b f. Both a and c g. Both b and d. xi

12 Insurance Supervision Core Curriculum 8. A supervisory authority finds that an insurer has invested a considerable proportion of its funds in real estate. Which of the following preventive or corrective measures should be applied first? a. Require the insurer to file a more detailed listing of its investments b. Require the insurer to reduce its volume of business c. Require that the largest properties be valued by an accredited appraiser and adjust the insurer s solvency calculation to reflect any overvaluation d. Put a condition on the insurer s license, requiring that it dispose of some of the real estate within a prescribed period of time. 9. An insurer is not meeting the minimum solvency test, and the supervisory authority has just required that the insurer obtain at least $5 million of additional capital as soon as possible, but definitely within the next 90 days. At this point, which of the following preventive or corrective measures should the supervisory authority be considering? a. Require the insurer to file monthly financial statements b. Require the insurer to provide a business plan c. Prepare to withdraw the insurer s license d. Place a condition in the insurer s license indicating that the license will expire in 90 days unless it is renewed by the supervisory authority e. Retain an audit firm to carry out a special audit of the insurer. 10. Total general (non-life) insurance premiums in a particular jurisdiction grew 4 percent last year. The premium growth rates of 95 percent of the general insurers fell within a range of 10 percent and +10 percent. However, one general insurer had a premium growth rate of 49 percent. Which of the following preventive or corrective measures would the supervisory authority be most likely to consider with regard to this insurer? a. Require the insurer to file a business plan that shows expected future growth rates by line of business and the expected geographic distribution of new business b. Impose a condition on the insurer s license to limit its rate of growth in the current year to a level that appears to be reasonable relative to the availability of capital and the insurer s ability to underwrite and process business xii

13 ICP 14: Preventive and Corrective Measures of the Supervisor c. Limit the insurer s license so that it will expire in 180 days, with the intention that the license will be renewed if the insurer has reduced its rate of growth to an acceptable level in the meantime d. Require the insurer to post a deposit with the supervisory authority, so that funds will be available to protect the public if the company is unable to meet its obligations. xiii

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15 ICP 14: Preventive and Corrective Measures of the Supervisor Basic-level Module A. Introduction: Prevention and Correction in the Supervisory Process The objective of insurance supervision is to build and maintain public confidence in the financial system of the country (1) by avoiding undue monetary loss to policyholders as a result of insolvency and (2) by working to ensure fair treatment of policyholders in accordance with the terms of their contracts. To achieve these objectives, the supervisor administers the provisions of the insurance law in a professional manner, recommends such revisions to the legal structure as may be necessary to deal with changing circumstances, and works with insurers to foster the adoption of sound business and financial practices. The supervisor and the supervisory system must strike a balance between an overly conservative approach based on extensive and restrictive regulation and, at the other extreme, a permissive approach that allows excessive risk taking by insurers. The conservative approach could protect policyholders from loss but may lead to high costs (which are borne by policyholders and therefore discourage them from purchasing insurance products) and tend to stifle innovation within the industry. Such a system would not foster development of a vibrant insurance industry capable of stimulating the country s economy. The overly permissive approach could foster entrepreneurial behavior that may lead to an increase in the number of failures and undermine the credibility of the entire sector. Ideally, insurance products are available and affordable within a competitive industry that provides fair treatment to consumers. An important prerequisite for this type of environment is a supervisory agency that has the legal power to take action in a timely and effective manner when insurer actions 1

16 Insurance Supervision Core Curriculum or situations demand it and that exercises those powers in a way that is most likely to achieve system objectives. 1 Insurance core principle (ICP) 14, as its explanatory note mentions, is concerned with this area of preventive and corrective action: Where insurers fail to meet supervisory requirements or where their continued solvency comes into question, the supervisory authority must intervene to protect policyholders. To do so, the supervisory authority needs to have the legal and operational capacity to bring about timely corrective action. Depending on the nature of the problem detected, a graduated response may be required. In instances where the detected problem is relatively minor, informal action such as an oral or written communication to management may be sufficient. In other instances, more formal action may be necessary. ICP 14 further requires that: The supervisory authority takes preventive and corrective measures that are timely, suitable, and necessary to achieve the objectives of insurance supervision. While the International Association of Insurance Supervisors (IAIS) does not set out any formal definition of the terms preventive and corrective, this module defines preventive measures as actions that seek to reduce risk or avoid situations likely to weaken the insurer s position with respect to policyholders. In the case of preventive measures, the supervisor will generally take a proactive mode of response. Corrective measures are defined as measures that seek to improve an existing situation. When the system is working as it should, the supervisor will seldom have to rely on the formal application of these measures. Desirable supervisory objectives tend to coincide with the objectives of responsible managers, boards of directors, and shareholders that is, the company will generate a satisfactory return on equity and develop a strong franchise with the public. From a supervisory perspective, the best results typically are achieved when supervisors and company managers work together to ensure that risk is properly managed to protect the public interest. Supervisors who frame their comments on companies operations in terms that are both constructive and knowledgeable soon gain the respect of industry members. In addition, when the supervisor is backed up by broad legal authority to impose corrective and preventive measures of the types outlined in this module and those measures are applied in a determined manner when the situation requires them over time, it 1. Kumar, Chuppe, and Perttunen (1997) describes the regulatory framework adopted in some mature-market economies, and regulatory issues arising in some emerging markets. Part 2 of the paper examines in detail the regulation and supervision of non-bank activities and institutions, primarily in the United States, but also in many emerging markets. Das, Quintyn, and Chenard (2004) provides empirical evidence that the quality of regulatory governance and governance practices adopted by financial system regulators and supervisors matters for financial system soundness.

17 ICP 14: Preventive and Corrective Measures of the Supervisor typically becomes less and less necessary to draw on the formal authorities contained in the law. In other words, when these conditions exist, moral suasion, rather than the application of the law per se, often is the normal basis of supervision.

18 Insurance Supervision Core Curriculum B. Understanding Key Terms The essential criteria elaborate ICP 14 as follows: The supervisory authority has available and makes use of adequate instruments to enable timely preventive and corrective measures if an insurer fails to operate in a manner that is consistent with sound business practices or regulatory requirements [essential criterion a]. The supervisory authority has the capacity and standing to communicate with insurers, and insurers comply with such communications, to ensure that relatively minor preventive or corrective measures are taken [essential criterion c]. The supervisory authority initiates measures designed to prevent a breach of the legislation from occurring and promptly and effectively deals with noncompliance with regulations that could put policyholders at risk or impinge on any other of the authority s objectives [essential criterion e]. Several key phrases in the criteria are important for the concept of preventive and corrective measures: adequate instruments; capacity and standing; timely, suitable, and necessary measures; and measures to prevent a breach from occurring. Q1 Complete this exercise by referring to the wording of ICP 14. The following questions are intended to stimulate discussion. If you are working with others on this module, develop the answers through discussion and cooperative work methods. 1. What do you understand the term adequate instruments to mean? 2. What do you understand the term timely measures to mean? 3. Discuss your understanding of the term capacity and standing. 4. Consider what is meant by suitable within the context of ICP 14. What criteria might be applied to determine whether a measure is suitable or not? 5. Suggest some criteria or factors that you would use in determining whether certain supervisory measures are or are not necessary. 6. What concept is evoked by the idea of preventing a breach of the legislation from occurring? 4

19 ICP 14: Preventive and Corrective Measures of the Supervisor The supervisor must have the legal authority within the supervisory framework to carry out corrective measures, as required. Specific types of legal authorities are discussed later in the module. In addition to the country s actual insurance law, adequate instruments include written policies and procedures for the supervisory agency and an internal corporate governance system designed to ensure that the agency continues to function in an objective and professional manner. The supervisor must have capacity and standing, and this means the ability to recruit and maintain a human resource base with the experience and training required Case Study 1 An onsite inspection report for a life insurer contains the following information: During the inspection of this company, which is one of the larger companies in the marketplace, we noted the introduction of three new products in the past year. Each of these products is quite complex. We also noted that, although the systems department indicates that the internal software for processing this business will be online very soon, sales of these products are now accounting for almost 25 percent of the company s business. to assess risks within the insurance industry and to discuss those risks in a constructive manner with industry personnel. This implies that the salaries of supervisory staff have to be reasonably comparable to those of similar positions in the industry. If the supervisory staff do not have credibility with the industry, it will be difficult, if not impossible, to meet supervisory objectives in general and to conform with ICP 14 in particular. Credibility is also a function of making timely, suitable, and necessary decisions in a professional and transparent manner. Situations can change rapidly in the insurance business, and timely measures are essential. If supervisors are to have a reasonable chance of obtaining the desired results from various preventive and corrective measures, it is necessary to formulate plans and to carry them out within a time frame that is appropriate to the situation. For example, if it is clear that a company is insolvent, then rapid intervention by the supervisor provides the best chance of minimizing the depletion of assets and maximizing the resources available to protect policyholder interests. Timely action is also an important factor in maintaining credibility with the industry. Supervisory measures that are long delayed are likely to be ineffective not only because the situation has changed over time but also because they are less likely to be taken seriously by industry members. Government agencies are often criticized for their indecisiveness and slowness to act; the insurance supervisor must work to ensure that these stereotypes are not applicable to its operations Andrews and Josefsson (2003) emphasize the system costs of regulatory forbearance and argue in favor of prompt closure when circumstances dictate.

20 Insurance Supervision Core Curriculum In maintaining the credibility of the supervisory system, preventive and corrective measures must be perceived by industry members and other observers as meaningful and appropriate to the circumstances. This module discusses some of the methodologies that supervisors can employ to ensure that the measures being proposed are suitable to the circumstances. On occasion, it is necessary for the insurance supervisor to take tough measures to enforce the law, both to ensure continued respect for the legislative process and to safeguard the public interest. The supervisor, who holds strong powers, is responsible for using those powers judiciously and wisely and for using them when the situation requires it. The task of the supervisor includes more than just reacting to problems. It includes a degree of proactive attentiveness with the goal of preventing problems from arising in the first instance by working with company management and boards of directors to reduce risk when it exceeds desirable levels. This is one of the key concepts underlying the risk-based approach to supervision. See case study 1 for an example of preventive action. Q2 Complete this exercise by referring to the wording of ICP 14. The following questions are intended to stimulate discussion. If you are working with others on this module, develop the answers through discussion and cooperative work methods. 1. Do you feel that your own jurisdiction has adequate instruments to achieve its objectives? If not, what are some important changes that you would like to see and how would they improve the situation? 2. What do you understand the term timely measures to mean? Does timely always mean the same thing? 3. Do you see a connection between the need for timely measures and the need for capacity and standing? 4. How do you rate the importance of capacity and standing from a supervisory perspective? 5. Suggest some ways in which the capacity and standing of a supervisory agency might be improved. 6. Provide some examples of how a breach of the legislation might be prevented.

21 ICP 14: Preventive and Corrective Measures of the Supervisor Q3 Answer the following questions with regard to the information in case study List any concerns you might have with this situation. 2. What do you see as the timing for action? 3. Discuss some approaches to prevention and correction that might be followed in a case like this.

22 Insurance Supervision Core Curriculum C. Importance of ICP 14 In a perfect world, it would not be necessary to think about remedial measures in insurance supervision or elsewhere. But when dealing with insurance companies, the stakes are high, and there is a unique potential for abuse. These companies amass substantial amounts of funds from the public to pay for services that will not be rendered until some future date, sometimes many years in the future. Unscrupulous insurers could exploit this state of affairs by using the funds to the advantage of their managers and shareholders rather than carefully preserving the amounts required to discharge present and future obligations. International experience clearly underlines the need to have well-trained supervisors who are backed by comprehensive legal structures that provide the powers necessary to safeguard the public interest. In addition to the need to protect the public interest directly, there is also a more indirect reason for ICP 14. Over the past 15 years or so, there have been significant improvements in banking supervision. Major inconsistencies between bank supervision and insurance supervision are likely to give rise to what is termed regulatory arbitrage. For example, if in a country the laws of bank supervision are up to date and enforced by well-trained banking supervisors, but insurance supervision is largely absent, the maximum volume of financial transactions will tend to migrate to the less-supervised sector. When a transaction can be structured through an insurance company rather than a bank, this will be done. In the absence of monitoring and oversight, risk levels can become so high that the insurance sector may collapse. In some cases, this has given rise to a domino effect in which the entire financial sector, including the banking sector, has had to be restructured. This has occurred at great cost to the countries involved. In most countries, the banking sector is now subject to modern supervisory requirements, including strong powers for the supervisor to take remedial actions to protect the public and the country s financial system. In order to avoid the problem of regulatory arbitrage, insurance supervisors must have corresponding powers. In countries that have only recently been creating democratic institutions and imposing modern standards of justice, the ability to implement powerful corrective and preventive measures may be even more important than in developed countries. In these types of emerging-market situations, financial entrepreneurs have not had a long period of experience in which to gain an understanding and appreciation of the need to protect the public interest and to maintain the integrity of their financial institutions. (Developed countries also have companies and individuals who lack this appreciation!) Accordingly, emerging-market countries may have an even greater need for supervisors who have authority, confidence to use it in a timely and decisive way, and ongoing support of their ministers and other politicians.

23 ICP 14: Preventive and Corrective Measures of the Supervisor D. Legal Framework In order to have a sufficiently broad selection of preventive and corrective measures, it is important for the insurance law to include basic powers that: Enable the supervisor to monitor and understand developments in insurance companies and in the industry so that decisions can be made concerning when and what type of specific corrective measures may be required Can be exercised with varying degrees of intensity and represent important components of a program of preventive and corrective measures. These basic powers fall into two specific categories. First, there are the fundamental powers that one expects to find in almost any supervisory regime. These include the power to carry out onsite inspections, to request financial information, and to impose solvency requirements. A second category of supervisory powers includes more specialized authorities that complement the fundamental powers. These supplementary powers enhance the supervisor s ability to protect the public interest. This part of the module provides a catalogue of supervisory powers and explains their potential role as supervisory tools that can be used to reduce risk and to address existing problems. A later section focuses more specifically on techniques that can be used to apply the measures in a consistent manner and in ways that best fit the circumstances. Q4 The following questions are intended to stimulate discussion. If you are working with others on this module, develop the answers through discussion and cooperative work methods. 1. In your view, what are the five most important powers required by an insurance supervisor? In each case, explain why you consider the power to be critical to achieving supervisory objectives. 2. How do you assess the relative importance of onsite and offsite inspection (that is, the monitoring and financial analysis of insurers financial and operational results)? 3. Discuss the role of minimum initial capital requirements and minimum solvency requirements in meeting supervisory goals. In your view, what are the essential differences between these two concepts? 4. Provide some examples of supervisory powers that are not among the five most important you have listed in question 1 and explain why each of these is also important and under what circumstances this might be the case.

24 Insurance Supervision Core Curriculum Fundamental powers Certain fundamental powers should be present in every supervisory regime. They include fit and proper requirements, the power to obtain well-designed annual supervisory filings and supplementary filings, the power to carry out onsite inspections, the power to inspect business plans, the power to enforce minimum capital and solvency requirements, the power to withdraw a business license, and the power to impose sanctions and penalties for noncompliance. This section deals with each of these in turn. Fit and proper requirements Given their fiduciary powers and access to policyholder funds, it is critical that senior managers and directors of insurance companies be persons of integrity. This being the case, the supervisor must be able to block access to insurers or remove senior managers, directors, or shareholders, where documented criminal or other behavior would render the persons or corporations not fit and proper for the purposes of operating, directing, or controlling an insurance company. In keeping with the need to maintain transparent procedures, Integrity the supervisor should establish Basically it is all about people. No supervisory system will produce good results if publicly accessible criteria describing what constitutes (or at least the industry includes unscrupulous persons who lack integrity and a respect for provide examples of) situations or the law. experience that do not meet fit and proper standards. 3 The power to block a person from accepting a position or to remove someone from a position is a significant power and must be used judiciously. Nevertheless, it is a power that the supervisor must have in order to protect the public interest and to ensure that criminal elements do not gain positions of power within the country s financial institutions. The very existence of this power in the law is likely to mandate against the need to actually exercise it. This is because persons with clearly undesirable records will know that they need not apply because they will be disqualified on fit and proper grounds. ICP 7 on suitability of persons addresses fit and proper requirements more generally, while several of the essential criteria under ICP 15 on enforcement and sanctions describe remedies that should be available to deal with problems in this area IAIS (2000) describes fit and proper principles and how supervisors may apply them to individuals and corporations. Australian Prudential Regulation Authority (2004) explains how fit and proper requirements should be applied to pension trustees in Australia. The site also presents other material and information describing how the fit and proper requirements should be applied in that country. See also Risk Institute (n.d.).

25 ICP 14: Preventive and Corrective Measures of the Supervisor Power to obtain well-designed annual supervisory filings and supplementary filings Supervisors cannot assess the financial positions of insurers nor make well-considered supervisory decisions if they do not have timely, accurate, and meaningful information from the supervised insurers. In addition to complete audited financial statements and their corresponding notes, the information package that companies must submit to the supervisory authority should be sufficiently complete to enable calculation of all the standard early warning ratios and the company s solvency position. Nonfinancial material, such as information about Supervisory Assessments the company s reinsurance arrangements, Supervisory assessments and decisionmaking must be based on accurate and shareholders and related parties, off-balance-sheet items, and number of staff, is timely information. also invaluable for supervisory purposes and should be part of the formal reporting requirements. ICP 12 on reporting to supervisors and offsite monitoring provides further guidance on supervisory information requirements. Supervisors normally require a major filing on an annual basis as well as supplementary filings during the year. In today s world of electronic information and computerized systems within companies, there should be no compelling reason why the filings should not be submitted to the supervisor within 90 days of the end of the period to which they pertain. Some jurisdictions provide a slightly longer period to professional reinsurers because they have to obtain some of their information from their client insurers. Remember, insurance company management also needs timely and accurate information to guide the company s decisionmaking. In addition to the power to obtain periodic information, the supervisor should also have the legal power to impose more frequent reporting and to revise the content of reporting when particular risks need to be monitored. It is in this sense that financial reporting requirements often comprise an important part of a program of preventive and corrective measures. When the supervisor becomes aware of heightened areas of risk, in addition to any other measures that may be taken, it is often considered prudent to require more frequent reporting, often with more detailed information being provided about the area of concern. For example, suppose that a general insurance company has allowed its investment portfolio to become considerably overexposed to investments in high-risk, speculative common stock investments, many of which are not listed on any stock exchange. Such assets would be a poor match for short-term liabilities, high-liquidity needs, and volatile underwriting results, all of which are typically associated with a general insurer s underlying policy liabilities. The company may have promised the supervisor that most of these investments will be disposed of in the near future. In such a case, the supervisor may want to require, in addition to the normal statutory filings, detailed monthly information with regard to the investment portfolio so that the issue of high investment risk 11

26 Insurance Supervision Core Curriculum can be monitored closely. If improvements do not take place fast enough, the supervisor may require additional measures. Over the last few years, a growing number of supervisory agencies have found it beneficial to supplement historical financial information with information based on financial modeling, often referred to as stress testing or dynamic capital adequacy testing. One weakness of pure financial data is that they can only reflect what happened in the past. However, by using actuarially sound stochastic models (models that can incorporate many possible outcomes on a probabilistic basis), analysts can forecast a company s future solvency position. Initially, this approach required each company to develop a model that corresponded to its unique mix of product characteristics and, by extension, to possess either a highly sophisticated in-house actuarial group or to have access to significant consulting resources. Over the last few years, however, generic software has become widely available that permits models to be developed on a much more cost-effective basis. Thus stress testing is becoming more accepted as a powerful tool, not only as a preventive measure for the supervisor but, even more important, as a way for management and boards of directors to gain considerable insight regarding the impact on future solvency of various economic and business scenarios. Power to carry out onsite inspections The onsite inspection is a fundamental requirement for supervisors. Onsite inspectors are the eyes and ears of the supervisory agency. Financial information is crucial for the supervisor, but it represents a look into the past. Except when used as a basis for modeling, at best it shows what was happening during the period in question. By comparison, the onsite inspection produces a direct assessment by staff members of what is happening in the company at the present time. Also very important, it enables inspectors to discuss with Onsite Inspections senior management their plans for Onsite inspectors are the eyes and ears the coming periods and to consider the amount of risk that the com- of the supervisory agency. pany may be exposed to in these future periods. For example, a vigorous expansion plan would alert the supervisor to a possible need for heightened monitoring of the insurer in the upcoming periods and for a careful examination of the adequacy of the company s internal financial controls, including underwriting, claims handling, and accounting. The very fact that onsite inspections are going to take place serves as a preventive measure because, when people understand that their activities are going to be subject to onsite review, they tend to work hard on what they know will be of interest to the inspectors. In addition, by identifying weaknesses and bringing them to management s at- 12

27 ICP 14: Preventive and Corrective Measures of the Supervisor tention, onsite inspections encourage management to take direct preventive measures. Although not a corrective measure per se, onsite inspections typically give rise to corrective measures that are instituted in response to specific problems noted during the onsite work. An important trend in recent years is for supervisors to adopt what is generally referred to as risk-based supervision. 4 Risk-based supervision monitors areas of risk in insurers and focuses supervisory resources on the higher-risk companies, aiming to reduce risk in cases where it exceeds prudent levels. The supervisor considers that one of the main responsibilities of senior management and the board is to manage and mitigate risk by means of internal policies and procedures and high standards of corporate governance. The supervisor uses agreed techniques and measures to assess risk in a consistent manner across companies and over time. The methods of assessing risk must be fully transparent so that the insurers can be satisfied that they are addressing the proper areas of their operations. Risk-based supervision relies on both preventive and corrective measures to reduce risks. Even when a problem has materialized, one may still think in terms of risk reduction in the sense that measures will be applied in order to reduce the risk of continued deterioration. A risk-based supervisor is always evaluating the insurer in terms of the risk inherent in the various activities being carried out and the systems in place to control and mitigate those risks. This approach contrasts with the more traditional approach of having onsite inspectors verify data and check for compliance, primarily as a means of finding problems. It may be more efficient and effective to prevent problems from occurring by reducing risk before it reaches critical levels than to attempt to fix problems after they occur. In other words, in some situations, it may be more efficient to use a risk-based approach rather than a more traditional compliance-based approach. A similar issue Q5 Answer the questions with reference to the information in case study 2. If you are working with others on this module, develop answers through discussion and cooperative work methods. 1. Is the situation of ABC Life Insurance Company high risk, medium risk, or low risk? 2. What are the main risks? 3. Devise a supervisory strategy highlighting the main preventive and corrective measures that you might initiate. 4. Sparrow (2000) discusses the evolving concept of risk-based supervision and the need for the supervisor to have sufficient discretion to craft specific solutions to unique problems. Moore (1995) offers a more general look at management of organizations in the public sector and techniques for creating value. Based on analysis of actual situations, the Committee of the Conference of Insurance Supervisory Services (2002) describes the risks facing insurance firms in the European Union and evaluates how supervisors might respond to them. 13

28 Insurance Supervision Core Curriculum Case Study 2 Prior to commencing an onsite inspection, the supervisor always meets with the independent auditor of the insurer to discuss the company s situation, any issues that may have been raised with the company, and any outstanding concerns that the auditor may have. Members of the inspection team also review the auditor s working papers in order to understand the areas of focus, the tests that have been carried out, and so on. This not only provides the inspection team with many useful insights into the company s internal control systems and other aspects of its financial reporting system but also enables the team to avoid duplication of work that has been carried out by the auditor. As part of the audit review of ABC Life Insurance Company, the inspector reviews the management letter (the letter the auditor sends to the company summarizing issues for the insurer s attention prior to signing off on the audit). The letter contains the following paragraph: We note that during the year the company made a loan of $25 million to a manufacturing company that is controlled by the major shareholder of your company. We have been unable to find any documentation to support the loan or to record the details of any collateral that may have been taken as security. In view of the fact that the loan amount is considerably in excess of the company s equity base, we would like to have your assurance, prior to our signing off on the financials, that appropriate documentation will be provided for the files as soon as can conveniently be arranged. The reviewers are unable to find any evidence in the auditor s file to indicate that the company has provided the requested documentation. The audit firm is the auditor for all the companies in the shareholder group, including ABC Life and the manufacturing firm referred to in the letter. During the onsite inspection, it also becomes apparent that the company has recently retained a new actuary who has discerned that the basis on which the previous technical provisions were established was unduly conservative and that, under different assumptions, the amount of such provisions would be reduced by approximately 20 percent, or close to $15 million. The year-end financial statements reflect the new assumptions but do not address the change in actuarial bases year over year. arises in public health care, where measures to keep the population healthy are thought to be more cost-efficient than medical assistance after the individual becomes sick. There are many specific situations where increased frequency and scope of onsite inspection provide the supervisor with better intelligence on emerging risks and the additional steps that may need to be taken to ensure that they do not become unmanageable (see case study 2). 14

29 ICP 14: Preventive and Corrective Measures of the Supervisor Increased frequency and intensity of the onsite inspection work can also be a preventive or corrective measure. For example, where a company s financial position has reached a critically depleted level or where there is evidence of fraudulent behavior on the part of the insurer, supervisors may place inspectors on the company premises on a more or less continuous basis. These inspectors monitor developments closely in a particular area, and their presence encourages appropriate actions by management. More information regarding onsite inspections can be found in the module on ICP 13. Power to inspect business plans The insurance law should provide the supervisor with the authority to obtain, on a timely basis, any information required to assess the financial position and risk profile of the insurer and to assess the company s treatment of policyholders. A particularly important document in this regard is the business plan of the insurer, which is a crucial piece of information for the supervisor. First of all, it enables the supervisor to assess the risk inherent in the company s plans for the coming periods. For example, if the business plan indicates that the company is going to develop a complex new product and Ultimately, supervision is about under- Assessing Viability also commence writing business in three standing the supervised companies and new jurisdictions within the coming year, assessing their viability. then the upcoming period is judged to be of inherently higher risk than normal. The supervisor will therefore look for internal controls, budgets, management resources, board oversight, and other factors that the company should have in place to mitigate and manage the risks involved in this business plan. The insurer s business plan also enables the supervisor to assess the ability of a company to deal with issues that have been raised. For example, suppose that the most recent financial filing shows that the company has been sustaining unacceptably poor underwriting results. An onsite inspection has confirmed that the company s results in virtually all of its lines of business are significantly more unprofitable than those of companies in its peer group. In a case like this, a useful supervisory tactic is to request the company to file a business plan demonstrating the steps it will take, and over what period of time, to improve its underwriting experience. The business plan then provides a base case against which the company s performance can be monitored. Should it become evident that the plan is not bringing about the required improvement, the supervisor can follow up with the company to discuss what changes are required. Another benefit of this approach is that the business plan itself can provide considerable insight into the depth of management within the company. An unrealistic, 15