Free and open International Insurance Markets
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1 Free and open International Insurance Markets European Financial Forum Michael Koller Head Group Regulatory Affairs London, 12 November
2 Objective of the presentation Economic rationale and need for open international insurance markets Reasons for having regulation Impediments for having open international insurance markets Transparency and risk management Conclusion Page 2 2
3 History: From collegia funeratica to global Reinsurance Poor people could not afford their funerals in the ancient Rome Therefore they agreed to help each other in the case of death in order to finance the costly funeral ceremonies This is diversification (raison d être of insurance) But did they need regulation and supervisors? No, because the whole was based on trust But now the insurance industry has become a global play and there is a need for a efficient regulation which does not destroy the underlying principle of diversification Page 3 3
4 Diversification benefit Sum of locally required capital Globally required capital Page 4 Insurability of extreme losses depends on global risk sharing: disastrous flood losses in China are shared within a global pool 4
5 Objective of the presentation Economic rationale and need for open international insurance markets Reasons for having regulation Impediments for having open international insurance markets Transparency and risk management Conclusion Page 5 5
6 Why do we need regulation at all? To protect the clients in a B2C business Because the industry is not sufficiently transparent and very complex Because the wealth stored in life insurance policies represents usually the biggest asset for a retired person and needs to be protected adequately Because of abuses, misses and near misses And finally that the industry as such becomes even more efficient and transparent Page 6 6
7 How good is risk management in insurance companies? Ironically, risk management in insurance companies does not have a very good reputation. Mostly because of investment losses depleting huge amounts of capital major insurer insolvencies or almost insolvencies public scandals related to accounting (not only insurers) Some of the weaknesses that have been mentioned are lack of clearly formulated risk policy lack of formalised risk governance structure and processes unclear responsibilities for risk taking and risk controlling inadequate Asset & Liability Management Page 7 As a result regulators worldwide are requiring companies to strengthen their risk management processes and capabilities 7
8 Stock markets crashed and remained low for a prolonged time Period Share prices % % % % % Due to the high equity holdings, the stock market downturn destroyed a vast amount of capital in the insurance sector. In the non-life market, reduced availability of capacity led to increased premiums and profitability. The life sector continues to struggle with minimum return guarantees. 0% -20% -40% -60% Note: Basis - S&P 500, values per year-end -80% 9/11 resulted in one of the largest insurance losses ever. Although 9/11 was not the beginning of terrorism, the event increased the awareness for how vulnerable modern society has become to actions of extremist groups. Page 8 8
9 Post mortem Analysis Top 5 Life Insurers in CH: Revaluation reserves P/L. Capital injections in 2002 Swiss Life: CHF 1.20 bn. Zurich: CHF 3.70 bn. Winterthur: CHF 3.75 bn. (via Credit Suisse) Page 9 9
10 Objective of the presentation Economic rationale and need for open international insurance markets Reasons for having regulation Impediments for having open international insurance markets Transparency and risk management Conclusion Page 10 10
11 Statutory Accounting true and fair? IFRS Economic Equity Securities Liabilities (longterm) Equity Securities Liabilities (longterm) Equity Securities Liabilities (longterm) Real estate Real estate Real estate Fixed maturities (mid-term) Statutory Fixed maturities (mid-term) IFRS Equity Fixed maturities (mid-term) Economic Equity Equity No impact Equity decreases Equity increases Page 11 11
12 Form chaos to cosmos or rather overregulation? Single European Prudential Regulator Second Basel Accord Solvency II/SST International Financial Reporting Standards Right to underwrite e.g. gender equality Firms Age Discrimination in Employment Directive Harmonisation of European Contracts Products Various pensionsrelated initiatives Investment Services Directive Distribution Insurance Mediation Directive Consumer Protection Green Paper Money Laundering Directive 2nd wave Distance Marketing of Financial Products Page 12 12
13 Global standards? USA FASB Global IAIS IASB IAA collateral RBC EU Solvency II Regulatory landscape Applied corporate finance Page 13 Asia APR A 13
14 Trust and Insolvency Diversification and Capital fungibility are twins Not allowing for it results in higher capital costs for the insurance product leading to either higher prices for the end-user or to a less profitable insurance sector for the shareholder, resulting in withdrawal of capital in the longer term Therefore it is imperative To enable utmost capital fungibility by corresponding harmonisation of local insolvency laws Page 14 14
15 Objective of the presentation Economic rationale and need for open international insurance markets Reasons for having regulation Impediments for having open international insurance markets Transparency and risk management Conclusion Page 15 15
16 New solvency framework based on three pillar approach Solvency II addresses several key areas of regulatory compliance: Assets and liability valuation Risk management / risk models Risk disclosure issues Financial Resources Quantitative standards Solvency II European solvency system for insurance Supervisory Review Qualitative standards Market Discipline Disclosure standards Page 16 Minimum capital requirements Investment rules Technical provisions Regulators capabilities and discretion Areas of activities Transparency Competitionrelated elements 16
17 Why do insurers need risk management? To provide confidence to their shareholders that the company will protect their investment and engages in controlled risk taking To provide confidence to clients/policyholders and regulators that the company will be able to meet its obligations, (re)insurers need to be financial strong, and build up a solid risk management reputation Robust internal risk management processes are key not only to the sustainability of an insurer but also to its value proposition Additional regulatory requirement can distort the internal processes Therefore the full allowance of internal risk models and processes is essential Page 17 17
18 Regulation prescribes risk quantification on an economic basis Illustrative Economic balance sheet Market value of assets Market consistent value of in-force liabilities Risk-bearing capital + Economic P&L distribution Risk-bearing capital is the total economic capital available to absorb risk Risk is quantified over a one-year horizon Page 18 An economic perspective is necessary since accounting rules may distort the measurement of available capital and financial market risk 18
19 Regulatory trends: risk disclosure and risk transparency Capital standards and supervisory review form the basis of the new regulation but public disclosure will be required to promote market discipline imposing strong incentives on insurers to conduct their business in a well-defined, sound and efficient manner, and promoting safety and soundness in insurance markets and the financial system Page 19 Providing stakeholders with meaningful, timely and transparent risk information is a key check and balance 19
20 Risk transparency is the basis for establishing trust with all stakeholders External risk disclosure and dialogue will intensify in the future shareholders, rating agencies, clients, and regulators, but risk transparency and dialogue among business units, corporate center, Executive Board and Board of Directors is also key transparent operational structure, business activities, and risk exposures clearly defined responsibilities and robust processes Page 20 An open risk culture and general risk transparency is key for risk management to be effective and credible 20
21 Challenges: risk disclosure and risk transparency Lack of standards makes comparability problematic and may lead to wrong conclusions Overloading the public with too much data may ultimately lead to less transparency Companies could be forced to disclose trade secrets thus jeopardising their competitive position Use of internal models may put optimistic modelers at an advantage Page 21 The (re)insurance industry needs to agree on meaningful disclosure standards with the relevant international bodies 21
22 Objective of the presentation Economic rationale and need for open international insurance markets Reasons for having regulation Impediments for having open international insurance markets Transparency and risk management Conclusion Page 22 22
23 Do the right things and do the things right We do not need a lot of regulation but relevant one Transparency is not the art of producing telephone books full of information, but rather concise and relevant information for transparency Beware of the principal agent problem of regulators It is key that the new regulation is developed in coordinated efforts between regulators and industry. Only by this Regulation becomes relevant and applicable Is accepted by all parties Can enhance the value creation of the sector Replace old regulation by new and better one do not pile up regulation on regulation Page 23 23
24 6 Axioms for good and successful regulation 1. It must be anticipatory 2. It must be nimble 3. It must have integrated and coordinated systems for developing company positions 4. it must cultivate dependable relationships with regulators 5. it must be capable of implementing strategies to accomplish corporate goals 6. it must be able to manage a crisis to minimise negative impacts and reputational harm Page 24 24
25 Different levels for protection Life Insurance P&C Insurance Re-Insurance Product Savings Old age - annuities B2C Risk B2B Risk Capital Protection Main Risk Individual Wealth after Retirement Claim paying ability in case of event Counterparty risk Possible Supervision Solvency calculation Risk governance Transparency Capital requirements Policyholder protection Solvency calculation Risk governance Transparency Capital requirements Policyholder protection Solvency calculation Risk governance Transparency Page 25 ALM requirements Ring fenced assets 25
26 5 Key Design Principles for Risk Based Supervision (1/3) 1. A realistic assessment of all risks following economic principles Swiss Re has published on this basis For life insurers options and guarantees are critical Internal models are the solution: Solvency II should encourage their development 2. The recognition of diversification The fundamental concept of insurance (= raison d être). Central to the risk management of global reinsurers ( e.g. California earthquake and European windstorm) Significant in determining the capacity a reinsurer can supply to the markets Page 26 26
27 5 Key Design Principles for Risk Based Supervision (2/3) 3. Credit for appropriate risk transfer Reinsurance is a key risk management tool for insurers It is essential that the capital impact of reinsurance reflects a proper assessment of the effective transfer of risk Failure to give full recognition to effective arrangements introduces artificial charges on risk, rating and regulatory capital, and fails to incentivise good risk management The system needs to allow for innovation (e.g. securitisation) One challenge for regulators, and the industry, is to devise capital requirements that can deliver this full recognition whilst remaining practicable for those who most need effective reinsurance Page 27 27
28 5 Key Design Principles for Risk Based Supervision (3/3) 4. Risk Management has to be at the core of Solvency II Quantification will be the focus of much of the debate but is only part of the picture and no substitute for proper risk management The key to understanding all the potential sources of risk to the delivery of policyholder expectations. As management, we have a wider brief; to deliver shareholder expectations. These are closely linked When we understand risk we can then manage it by controls and mitigation, and assess the potential impacts via scenarios and comprehensive (internal) models 5. Fungibility/ capital mobility The ability to access resources to meet benefit payments Localisation of capital works against this, increasing total capital requirements We need an open-minded examination of the quantum of capital required and how it can be held; an integrated regime for the internal market Page 28 28
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