Insights – Annuity Risk India

Solvency II

gsinghal@annuityrisk.com — Tue, 08 Aug 2023 07:23:38 +0000

Annuity Risk India - Life Insurance and Annuity Risk Management

Solvency II is the latest set of regulatory requirements and risk management standards developed by European Union (EU) that aims to enhance the level of policyholder protection, ensure the long-term stability of the insurance industry, and create a more consistent and risk-sensitive framework for insurance supervision and regulation across the EU.

In 1999, the European Commission introduced a pivotal document titled “The Review of the Overall Financial Position of an Insurance Undertaking”, This marked the initial step towards modernizing the prudential oversight framework in the insurance sector. The subsequent global financial crisis in 2008 underscored the urgency of this endeavour, shedding light on the susceptibility of insurers, alongside banks, to inadequate governance practices. As a response to these evolving challenges, the European Union (EU) meticulously formulated Solvency II. This comprehensive framework is tailored to guide and regulate insurance companies and reinsurers within EU member states, ushering in a new era of stability, resilience, and effective risk governance in the insurance industry.

Solvency II is structured around three main pillars, each serving a specific purpose in the regulatory framework for insurance companies within the European Union. These three pillars

Pillars of Solvency Framework

Solvency II is structured around three main pillars, each serving a specific purpose in the regulatory framework for insurance companies within the European Union. These three pillars are designed to work together to ensure solvency, risk management, and regulatory oversight. Here are the three pillars of Solvency II:

Pillar I: Quantitative Requirements and Capital Adequacy

At its core, Pillar I is the foundation of Solvency II, focusing on the quantitative aspects of insurance regulation. It revolves around determining how much capital an insurance company should hold to safeguard against risks. This is done through two key metrics:

The Minimum Capital Requirement (MCR)
The Solvency Capital Requirement (SCR)

The MCR acts as a safety net, ensuring insurers have a minimum level of capital to remain operational even under adverse scenarios. On the other hand, the SCR is a more dynamic and risk-sensitive measure. It requires insurers to assess and quantify various risks they face, including market, credit, underwriting and operational risks. By calculating their SCR, insurers tailor their capital reserves to their unique risk profiles, ensuring they have an adequate buffer to weather unforeseen challenges.

Pillar II: Supervisory Review Process and Governance

Pillar II shifts the focus from numbers to oversight and governance. It underscores the importance of effective risk management and robust internal governance within insurance companies. The Own Risk and Solvency Assessment (ORSA) is the key concept here, where insurers conduct an in-depth self-assessment of their risk exposure and evaluate their ability to manage those risks.

Moreover, Pillar II emphasizes the need for insurers to establish a strong governance framework. This encompasses clear roles and responsibilities, robust internal controls, and transparent communication channels. Supervisors play a critical role by conducting a comprehensive review of an insurer’s risk management practises and overall governance to ensure they align with regulatory expectations.

Pillar III: Reporting and Disclosure

Pillar III puts transparency and accountability in the spotlight. It requires insurers to disclose detailed information about their financial health, risk management practises, and corportate governance. This information is intended for regulatory authorities, policyholders, and the broader public, fostering market discipline and informed decision-making.

Insurers must provide regular reports to regulatory bodies, shedding light on their financial position and risk exposures. Additionally, they are obliged to make specific information accessible to the public, enhancing market confidence and holding insurers accountable for their actions.

In essence, the three pillars of Solvency II collectively form a robust framework that harmonizes quantitative requirements, effective risk management, and transparent reporting. This synergy enhances the stability and resilience of the insurance industry, safeguarding policyholders and promoting a well-regulated financial landscape.

Annuity Risk India - Life Insurance and Annuity Risk Management
Solvency II

Economic Capital

gsinghal@annuityrisk.com — Mon, 31 Jul 2023 09:49:03 +0000

Annuity Risk India - Life Insurance and Annuity Risk Management

Economic Capital

Life insurers protect policyholders from mortality risk, longevity risk, and investment risk. Consequently, life insurers need a far more comprehensive risk management than, say, banks.

Economic Capital for Life Insurance companies simply means the amount of surplus capital that is sufficient to cover potential investment (credit) losses in the future. The insurer’s management decides the extent of protection to seek, i.e., the duration and extent of market stress that the insurer should prepare for. The regulator typically does not help here, and in fact, can increase the strain with newer and stringent reserving standards.

Economic Capital just cannot be replenished at a time of crisis.

Can lower rates boost economic capital?

Lower rates will not be able to rescue insurers. Credit sress is typically the main precursor of lower rates. Therefore, a lower-rate environment will cause their existing asset book to experience some mark-to-market gains. But let’s not forget the mark-to-market losses due to capital losses on their riskier debt.

Moreover, insurers will reinvest at a lower yield, while liabilities remain locked at a higher rate. Such liabilities (policies that offer above market yields) tend to be stickier, i.e., they exhibit lower lapse and disintermediation risk. Lower rates also tend to push insurers into riskier assets – eventually leading to capital losses in future.

Can product discounts help boost economic capital?

Theoretically, steep discounts on life insurance and annuity products can bring in a lot of new money into an insurance company. That cash can be crucial life support and a solvency aid in the very short term. However, we realize that insurance products in India are already selling at greatly discounted levels on an actuarial basis, with insurers looking up to the investment profits to realize any gains. Any more discounts are unfeasible, if not outright impossible, in a scenario where investment profits turn into losses.

Measuring Economic Capital

Traditional measures fall short: There is a lot of empirical evidence that suggests that simple measures such as standard deviation, VaR or Conditional Tail Expectation, are not sufficient to adequately measure economic capital.

We think that the most practical framework of measuring Economic Capital is using stochastic economic scenarios. The framework must allow the various risks to have covariance. Interest rate risk (asset-liability), mortality risk, and lapse risk are going to be the primary drivers of economic capital for a life insurance company.

And although economic capital tends to focus on investment outcomes, operational risk cannot be ignored. For instance, if an insurance company faces risk in its distribution channels, such as with commissions, or with marketing (branding), then such risk needs to be modeled as well. The model risk with respect to the valuation of assets must be assessed. Policyholder behavior is another key risk, particularly around unit-linked products. As insurers race to innovate and create more attractive and unique policy features, the risks of those features will not be captured anywhere other than economic capital.

At Annuity Risk, we are eager to assist insurers in developing a robust framework for measuring economic capital. There are great many uses of such a framework, all of which greatly strengthen the insurer and add to its competitive advantage.

Annuity Risk India - Life Insurance and Annuity Risk Management
Economic Capital

Risk Based Capital

gsinghal@annuityrisk.com — Sun, 09 Jul 2023 07:23:19 +0000

Annuity Risk India - Life Insurance and Annuity Risk Management

Risk Based Capital : As it applies to life insurers in the US

Is RBC applicable to Indian Life Insurance Companies?

Although, as of this writing (August 2023), Risk Based Capital (RBC) is not yet applicable to Indian life insurers, IRDAI is collecting data from Indian insurers (via QIS1), and making a concerted effort towards implementing RBC in India.

What is RBC and how does it work?

Risk Based Capital simply represents an expected dollar amount of loss that the insurer may suffer due to asset risk (defaults), insurance risk (underwriting losses), interest rate risk (asset-liability mismatch) and other operational risks. The credit risk within the asset portfolio, i.e., risk of default of corporate bonds and loans, is the primary driver of RBC for a life insurer, provided that the insurer is solvent and is operating normally.

Risk Based Capital = Book value x RBC Factor

Let us assume that an insurer holds 100 different high-quality investment-grade bonds (from 100 issuers) each worth Rs. 1 crore book value, and the RBC factor is 1.5%. In that case, the expected loss from defaults can be approximated to be around Rs. 1.5 crores (total). RBC = Rs. 100 crores X 1.5% = Rs. 1.5 crores. So, the RBC for this portfolio is Rs. 1.5 crores.

As is evident, RBC is a formula-based approach where RBC factors play a key role. RBC factors increase with increasing asset concentration (opposite of diversification). The RBC factors are calculated using cash flow analysis and historical default rates. The exact methodology and parameters of calculation (percentile risk, time horizon, size of portfolio, covariance adjustments, etc.) are determined by experts.

RBC factors

How many different RBC factors are available?

Using cash flow testing devised by experts, RBC factors have been determined for most asset classes – such as for different grades of bonds and most types of asset-backed loans, including mortgages, preferred and common stocks, etc. RBC factors are regularly updated. The higher the default risk, the higher will be the RBC factor. For instance, a home loan in good standing may have an RBC factor of just 0.14%, while a defaulted farm loan (non-performing asset) may have an RBC factor of 20%. RBC factors have also been determined for other sources of risk besides asset risk, such as insurance (underwriting) risk (~0.2%), interest rate and market risks (~ 1%-3%), and other business risks (~3%). The RBC factors for the assets are much higher in comparison to these other risks, hence asset portfolio drives much of the RBC calculation.

By applying the prescribed RBC formula to the asset book value and business details, and using the updated RBC factors, RBC calculation becomes (somewhat) straightforward.

Consequences : Regulatory Action

What could happen if the life insurance company’s surplus falls below the prescribed level of RBC?

A life insurer in the US is expected to hold an amount of capital greater than 3 x RBC. If the capital falls below 1.5 x RBC, the regulator will take action. Once RBC is implemented in India, we expect such a situation (of surplus falling below a threshold level of RBC) to automatically trigger a set of interventional events to be overseen by IRDAI.

How can an insurer decrease its RBC requirement?

An insurer can either raise capital or reduce its RBC requirement. It can a) reduce asset risk by replacing low-grade bonds with high-grade (less risky) bonds; b) raise capital by issuing stocks; c) free-up reserves by reinsuring policies; d) redesign policies in order to have lower RBC requirement.

Here at Annuity Risk, we are ready to assist you with assessing the impact of RBC implementation and making all preparations for its future implementation.

Annuity Risk India - Life Insurance and Annuity Risk Management
Risk Based Capital

Risk Based Supervision

gsinghal@annuityrisk.com — Thu, 09 Jul 2020 07:23:47 +0000

Annuity Risk India - Life Insurance and Annuity Risk Management

Risk-Based Supervision for Life Insurance Companies in India

IRDAI is looking to adopt a new risk assessment framework called Risk-Based Supervision (RBS). In a nutshell, the new Risk-Based Supervision framework:

Is risk-focused, as opposed to compliance-focused existing framework.
Is principles-based, as opposed to rules-based existing framework.
Is forward-looking and focused on outcomes.
Assesses risks emanating from within the insurer, as well as from outside, including the business environment.

How to implement RBS framework?

Designate a Supervisory Manager (SM), who will act as a single point of contact between the regulator and the insurer. SM will draft a Supervisory Action Plan and update it annually. SM will take the following steps:

Identify significant business activities as per criteria of materiality (as per revenue, income, capital allocation, reserves, strategic, etc.)
Identify inherent risks in conducting such significant business activities. For example, a large proportion of non-linked annuities may expose the insurer to large investment risks.
Assign a level of risk (rating) to each significant business activity.
Document appropriate measures and policies for control and mitigation of such inherent risks.

Working Example

Let’s understand by example. Assume that IndiaLife is a life insurer with a significant business volume in both annuities and life insurance.

The significant business activities of IndiaLife will be

Investment Management
R&D: Designing new policies and features.
Managing existing policy features and rates.
Underwriting and Claims Management.
Marketing and Selling annuities and life insurance policies
Customer Service and Retention
Policy Data Management – IT and MIS

The inherent risks in the significant activities, as per impact/magnitude may include:

Investment Risk
Distribution Risk
Interest Rate Risk (Lapse and Disintermediation Risk)
Liquidity / Cash Management
Mortality and Longevity Risks
Risk to Marketing and Brand Value
Risks to Operations and Business Continuity
- Customer Service and Claims Management
- Credit Rating, Litigation, etc.

Based on the inherent risks identified, the Supervisory Manager will then deliver the following outcomes.

Document various control measures for the risks listed above.
Document appropriate risk appetite and risk limits, and capital cushion.
Assess the quality of oversight/control for each inherent risk.
Assign a risk rating (low/moderate/substantial) for each inherent risk.
Assign forward-looking guidance with respect to the level of risk (stable/decreasing/increasing).
Prescribe a level of oversight (low/enhanced/intensive oversight), or intervention, if necessary.

Annuity Risk India - Life Insurance and Annuity Risk Management
Risk Based Supervision

IFRS 17 for Life Insurers

gsinghal@annuityrisk.com — Thu, 09 Jul 2020 07:23:22 +0000

Annuity Risk India - Life Insurance and Annuity Risk Management

IFRS 17 for Life Insurance Companies in India

IFRS 17 is the new principle-based reporting standard implemented by the International Accounting Standards Board (IASB) for insurance (and reinsurance) contracts. This new standard will warrant dramatic changes in the data management and operational workflows of life and annuity insurance companies.

IFRS17 will change how profit emerges from a book of business, and will accelerate recognition of losses on contracts that are expected to be onerous. In addition, a tremendous amount of new data inputs and experience assumptions will be required. New models, new valuation processes and new visualization setup will be required. Audits will require greater granularity of record-keeping, model validation, and experience monitoring. A holistic revaluation of internal and external risk reports, audit trails, and controls will be required.

Implementation

The most important choices regarding IFRS 17 implementation for life insurance and annuity contracts in India are the level of aggregation, and the accounting policy choices (configurations) related to risk adjustment and contractual service margin. Another key choice will be the model used to calibrate discount curves as per the requirement of market consistency.

At Annuity Risk, we are ready to assist with an end-to-end implementation of IFRS 17 accounting standard, or in any customized capacity. We will work closely with your enterprise risk team and your external auditor to choose the right valuation and accounting approaches that will lead to the best outcomes and timely implementation. Our proprietary analytics allow us to forecast significant financial reporting KPIs, and then track them as we progress through the implementation towards actual metrics. Expected impacts on equity and income patterns, including the effect of derivatives, on regulatory capital and key solvency metrics are tracked at multiple stages, and communicated with all stakeholders and auditors.

At Annuity Risk, we deliver the full IT infrastructure that goes well beyond the requirements of IFRS 17, and allows key decision-makers to extract powerful insights from their financial data. We ensure every calculation is auditable and every batch of analysis is properly stored and archived, preserving the greatest level of granularity possible. Our financial and regulatory reporting templates are designed specifically for the new IFRS 17 data schema while preserving the management’s viewpoints and style of risk management.

Annuity Risk India - Life Insurance and Annuity Risk Management
IFRS 17 for Life Insurers