The impact of implementation of Risk Based Capital (RBC) for insurance companies in Sri Lanka, from January 2016 was discussed at the International Insurance Congress on 8 October 2015. I was delighted to be a panelist for the first session of the conference on Legislative Developments. My comments on this topic are summarized below:
Key questions on readiness would be:
Does the insurer have a clear corporate governance framework in place to address the new regulatory requirements?
Is there a robust risk management framework with the necessary components to meet the requirements ?
Do you have adequate actuarial capabilities to perform these assessments?
Risk-taking is an essential element of being an insurer. Insurance is a business that, itself, requires the management of risk. As a result, most insurers tend to view risk management as a regulatory compliance procedure rather than an integral part of the business. RBC should fundamentally change the way business is run, to realize the benefits.
Companies will initially struggle to find the right focus between compliance with RBC and value for their business. The pilot run should help but its not the same as reflecting the actual impact. Finding the right balance between business benefits and compliance (Capital- Risk- Profit) will produce the best results.
The implementation of ICP 16 to have a proper Enterprise Risk Management process is essential to fully benefit from RBC. The principle set out below should fundamentally change the way insurance business is conducted.
“The supervisor establishes enterprise risk management requirements for solvency purposes that require insurers to address all relevant and material risks.”
Regulators should be aware of what effects solvency requirements and accounting standards may have on the behavior of insurers. They will need to decide to what extent such behaviour or any side-effects are acceptable. For example; Regulations and accounting may drive insurers to divest from riskier assets at times of negative investment performance, putting further downward pressure on prices and contributing to financial distress. This may give credence to the myth that accounting caused the financial crisis! Whereas, poor risk management should have been cited as the cause.
Accounting rules can also introduce volatility into the level of assets versus the level of liabilities, reflected in the insurer’s balance sheet and statement of profit and loss. This so-called accounting volatility can arise when assets and liabilities are treated differently; for example, if assets are valued on an amortised cost basis, but liabilities are measured at fair value.
A good governance mechanism is fundamental to avoid manipulation of results and fair values. Therefore, the regulator should consider implementing ICP 7 to ensure the governance aspects of insurers and their duty to protect policyholders. The principle states:
“The supervisor requires insurers to establish and implement a corporate governance framework which provides for sound and prudent management and oversight of the insurer’s business and adequately recognizes and protects the interests of policyholders.”
Under RBC, the net premium valuation method using prescriptive valuation assumptions will be replaced. Discounting of liability will be done on gross cash flows using the risk free discount rate.
• IBSL may have to publish quarterly risk free interest rate curve for valuation purposes.
• At inception use of Gross Premium method of valuation may cause some concerns.
To fully realise the benefits of RBC, insurers will need to demonstrate that they have a robust risk management framework and that their board understands and challenges the outputs of their risk framework.