03_D Finnis_Risk-based supervision.ppt

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Risk-based Supervision

Dave Finnis, IAIS

Including Off-site analysis and On-site inspection

San Jose 6 September 2011

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Dave Finnis, IAIS

Basic supervisory tools – Australia as an exampleThe Australian Prudential Regulation Authority


Risk based supervision 36 September 2011

Defining insuranceInsurance contract

“means a contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder” (AASB)

General insurance contract“means an insurance contract that is not a life insurance contract” (AASB) (see Insurance Act 1973)

Life insurance contract“means an insurance contract…regulated under the Life Insurance Act 1995” (AASB)


Example: APRA’s powers and responsibilities under the Insurance Act 1973

Authorisations Granting authorisation for eligible insurers to carry on an insurance business

Prudential Standards Applying the prudential regime to the authorised entities.The prudential standards are legally enforceable under section 32 of the Act


Example: Legislative framework for General Insurance

LEGISLATION DESCRIPTION

Corporations Act 2001 Financial Services Law

Insurance Act 1973 Regulation of general insurance businesses, including •authorisation •prudential requirements

• Prudential Standards• FCR• REMS

•Enforcement

Insurance Contracts Act 1984 • Regulation of information provided to consumers. • Defines duty of disclosure for consumers and limits areas in which

a claim may be denied or policy cancelled

Australian Securities and Investments Commissions Act

• Misleading and deceptive conduct and • Unconscionable conduct

Australian Accounting Standards Board (AASB)

• An Australian Government agency that develops and maintains the financial reporting standards for private and public sector organisations.

• Powers and functions set out in the ASIC Act 2001


Example: Put the experts in place - Appointment of actuary and auditor

Role of appointed actuary (AA)Values the insurance liabilities of the general insurerAssesses (annually) the overall financial condition of the general insurer

Role of the auditorAnnual audit of the statutory accounts Reviews other aspects of the general insurer’s operations on an annual basis.

Both auditor and actuary May be requested to conduct special purpose reviews relating to operations, risk

management and the financial affairs of the insurer

Auditors and actuaries provision of information under the ActThey must provide information to APRA if they believe the insurer is likely to

become insolvent or has contravened the Act or Prudential Standards, or face disqualification.


Role of a supervisor – Australian view

The role of a supervisor• Supervision vs. regulation• Risk vs. compliance focus

Supervisory activities- Group review• Onsite reviews• Offsite reviews• Financial analysis• Regulatory approvals and interpretations


Industry trendsSolvency coverage ratio for the GI industryas at 30 June 2010

Risk based supervision 96 September 2011 9

Modules & Topics

Module 1

Board

•Board Composition•Fit & Proper

Module 2 Management

•Management Structure •Fit & Proper

Module 3

Risk Governance

•Role of Board•Risk Governance of Board•Board Committees•Decision Making Process – Risk Management

•Compliance Framework•Management Information System•Independent Review – Internal Audit (IA)•Independent Review – External Audit (EA)

Module 4

Strategy & Planning

•Strategic Risk•Strategic Planning•Business Plan

•Implementation & Execution•Monitoring its own progress

Module 5 Capital

•Coverage / Surplus•Earnings•Access to Additional Capital

Module 6 Liquidity Risk

•Liquidity Risk•Board and Management Awareness•Liquidity Risk Management•Independent Review of Liquidity Risk


Modules & Topics

Module 7

Operational Risk

•Nature & Complexity•Internal & External Fraud•IT Systems•Business Disruption•Board & Management Awareness•Operational Risk Management Framework•Outsourcing Arrangements

•Administration•Information Technology•Business Continuity Management•Project Management (IT)•New & Varied Products•Independent Review of Operational Risk

Module 8 Credit Risk

•Portfolio Composition•Strategy & Appetite•Bad Debts/ Arrears Experience•Board & Management•Credit Risk Framework & Architecture•Origination/ Approval Process

•Portfolio/ Account Management & Monitoring•Governance & Controls around Credit Risk Grading System/ Scorecards•Problem Asset Management•Independent Credit Review Process

Module 9

Market & Investment Risk

•Traded Market Risk•Non-traded Market Risk•Board and Management

•Traded Market Risk Management•Non-traded Market Risk Management•Independent Review of Market & Investment Risk

Module 10

Insurance Risk

•Insurance Risk•Credit Risk•Board and Management•Product Design•Pricing•Underwriting

•Claims•Liability Valuation•Reinsurance•Distribution•Independent Review of Insurance Risk

Risk based supervision 116 September 2011 11

Supervision Process

Risk Assessment• PAIRS Update

Supervision Activities• Prudential consultation

• Prudential reviews• Offsite analysis

• Targeted reviews•Ad hoc meetings

Supervision Strategy• Supervisory Action Plans


Prudential Reviews of InsurersPrudential reviews of insurers is a cornerstone of APRA’s

assessmentAPRA reviews and assesses:

− Reinsurance− Pricing− Underwriting− Claims− Independent review− Liability valuation− Product design− IT and business continuity management− Operational risk− Investment risk

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Offsite review – Obtain the trust!

Do the homework:• Current filings• Additional filings• People history• (proposed ICP 9)

Focus on other key documents and structures:• Business plan• Financial condition report• Management structure• Peer review• SWOT


On-site review - Verification

Support from primary legislation (ICP 9 again)• flexibility in scope and frequency• review effect of regulatory change and market

developments

Follow up on questions from off-site review• tangible balance sheet issues• intangible balance sheet issues

Confirm the plans are put into practice• HIH example• risk management practicalities

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Traditional supervisory considerations

Dave Finnis, IAIS

Entity-specific, and Group-wide issues



Risk Based Supervision

Genesis and BackgroundTraditional/Historical Model:• Entity-based • Revalidation of financial statements• Significant transaction testing• Largely compliance based• No reliance on the work of third parties (external auditors) or

on Internal Audit, Appointed/Responsible Actuary – redo their work

• Point-in-time – not dynamic • Looking for problems

• extensive investigation of almost every aspect of an institution’s operations; heavy demand on supervisory resources


CARAMELS CapitalAsset qualityReinsuranceActuarial liabilitiesManagementLiquiditySubsidiaries

Risk Based SupervisionTraditional/Historical Model (A Canadian Viewpoint)


CARAMELS• Key benefit – identification of institutions that

require special supervisory attention• Not forward looking – ratings derived from on-site

examinations, not designed to track changes• Based on the last on-site examination, which may

have been several years ago• Provide ex post indications of problems.• Usefulness depends on the frequency of

examinations and stability of institution’s financial condition

Risk Based SupervisionTraditional/Historical Model



ICP 18 Risk Assessment & Management“The supervisory authority requires insurers to recognize the range of risks that they face and to assess and manage them effectively”

Proposed ICP 8 Risk Management & Internal Controls“ The supervisor requires an insurer to have, as part of its overall

corporate governance framework, effective systems of risk management and internal controls, including effective functions for risk management, compliance, actuarial matters, and internal audit.”


Liability Risks

Other Risks

Operational Risks

Liquidity Risks

Capital Risks

Asset Risks

Claims Risk Pricing Risk

Underwriting RiskConcentration Risk

Reserving RiskCatastrophe RiskReinsurance Risk

Market RiskCredit Risk

Concentration RiskAsset Valuation Risk

Cost of capital Mismatch Risk (ALM)Solvency Margin Risk

Accounting Risk

Financing RiskCapital access Risk

Mismatch Risk (Cash Flow)Surrender

Technology RiskCommunication RiskBusiness disruption

Fraud

Legal RiskRegulatory RiskReputation RiskStrategy Risk

Other business RiskEnvironmental Risk

What risks are insurers exposed to?


London Working Group report, December 2002*

• Surveys of all recent failures and problems of EU insurers• Identified major risks:

Underwriting / reserving riskOperational risk (management / governance, business

risk, systems and controls)Asset riskExternal causesReinsurance risk

*Source: Managing Risk: Practical lessons from recent “failures” of EU insurers, 2002, FSA UK

Risk Assessment and management



Proposed ICP 8: Risk Management and Internal Controls• the supervisor requires the insurer to establish, and operate within, effective

systems of risk management and internal control • risks specific to insurance sector

e.g. underwriting risk, risks related to evaluation of technical reserves (ICP 19)• supervisors participate in risk management process by reviewing the monitoring

and controls of the insurerprudential regulations/requirements to contain riskultimate responsibility rests with Board



Proposed ICP 8: Risk Management and Internal ControlsEssential Criteria

• supervisor requires/checks that insurers have in place comprehensive risk management policies/systems

• risk management policies/risk control systems are appropriate to the complexity, size and nature of insurer. Appropriate risk tolerance limits are in place

• risk management system monitors/controls all material risks• insurers regularly review the market environment and take appropriate actions to

manage adverse impacts of environment on insurer’s business



Key benefits of Risk-Based Supervision:Systematic assessment within a formalized framework both at the time of examination

and in between examination through off-site monitoring (a continuous process).Identification of institutions and areas within institutions where problems exist or are

likely to emerge.Cost effective use of resources through greater emphasis on risk – regulatory

resources are focused on areas of highest risk (by FI and by sector)Allows for prompt intervention and timely action.



Comprehensive Risk Assessment & RatingsGeneric FeaturesComprehensive and detailed assessment of the risk profile of the institution – overall assessment score/rating.Assessment of qualitative and quantitative risk factors and risk management oversight functionsAssessment of the inherent risks of each business unit or significant activityBenefits Can be applied on a consolidated as well as solo basisBetter understanding of the risks and quality of risk management functions at the institutionAllows for more focused and risk-based supervision


Rationale for group-wide supervision

Group riskmanagement

andcontrols

Group managementstructure andgovernance

Increasingprominence of

IAIGs

Fill supervisory

gaps

Groupfinancialposition and risks

Rationale


Proposed ICP 23 will provide overarching requirement

Have a clear definition of “insurance group”.Supervisors cooperate and coordinate to avoid regulatory gaps and

avoid unnecessary duplication.At a minimum, group-wide supervision covers:

• Group structure• Capital adequacy• Intra-group transactions and exposures• Governance and risk management

Put in place adequate supervisory reporting requirements.Deny or withdraw license when effective supervision is hindered.

Proposed ICP 23 Group-wide SupervisionThe supervisor supervises insurers on a legal entity and group-wide

basis


Key issue – what is an “insurance group” for the purpose of group-wide supervision?

Non-operatingHolding Company

(NOHC) 1

Insurer 1 Bank 1 SecuritiesFirm 1

Non-regulated Operating

Entity (NROE) 1

IntermediateNOHC 2

Insurer 3 NROE 2 Insurer 4NROE 3

Insurer 2

SPE 1

2. The minimum types of “relevant entities” that should be included

1. Supervisors must set the perimeter of group-wide supervision in cooperation with other supervisors

• Participation, influence• Interconnectedness• Risk exposure• Risk concentration• Risk transfer• Intra-group transactions

3. Minimum elements with respect to insurance activities to consider when setting the scope


Key Features of treatment of non-regulated entities in group-wide supervision

Risk mitigationmeasures

Flexiblescope of

supervision

Supervisorycooperation,coordination,info exchange Supervisory

reviewand reporting

Fitness and propriety

Capital adequacy

Assess risks from

non-regulated entities

Comprehensive understanding

of group

Key Features


International recommendations on supervisory colleges

G20

FSB

Joint Forum

• “Supervisors should collaborate to establish supervisory colleges for all major cross-border financial institutions, as part of efforts to strengthen the surveillance of cross-border firms.” (Washington D.C. Summit, Nov 2008)

• “We remain focused on the medium term actions, and make recommendations to the London Summit to ensure strengthened international cooperation to prevent and resolve crises, including through supervisory colleges…” (London Summit, Apr 2009)

• “Substantial progress has been made in strengthening prudential oversight, improving risk management, strengthening transparency, promoting market integrity, establishing supervisory colleges, and reinforcing international cooperation.” (Pittsburgh Summit, Sep 2009)

• “The use of international colleges of supervisors should be expanded so that, by end-2008, a college exists for each of the largest global financial institutions.” (Apr 2008)

• “The BCBS, IOSCO, and IAIS should work together to enhance the consistency of supervisory colleges across sectors and ensure that cross-sectoral issues are effectively reviewed within supervisory colleges, where needed and not already in place.” (Jan 2010)

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Macroprudential Supervision

Dave Finnis, IAIS

An additional dimension



“Macroprudential regulation” – a definition

“Regulatory policy that uses primarily prudential tools to limit systemic or system-wide financial risk.” (IMF)

Effectively macroprudential regulation provides a “top down” approach to regulation that complements standard, “bottom up” (or microprudential) regulation


Contagion in banking and insurance

100%

50%

0%

50%

100%

jul/07 jan/08 jul/08 jan/09 jul/09 jan/10 jul/10 jan/11 jul/11

Daily 7 Day average

Coexceedance of equity prices (in per cent of firm sample)

This chart reflects the percentage of banks and insurers that simultaneously show an extreme decline in equity prices.Source: Thomosn Datastream and DNB calculations

Banks

Insurers

100%

50%

0%

50%

100%

jul/07 jan/08 jul/08 jan/09 jul/09 jan/10 jul/10 jan/11 jul/11

Daily 7 Day average

Coexceedance of CDS spreads(in per cent of firm sample)

Banks

Insurers

This chart reflects the percentage of banks and insurers that simultaneously show an extreme increase in CDS spreadsSource: Thomson Datastream and DNB calculations

Systemic risk is endemic – also in insurance


Where we start from

The guiding principle… “…no source of systemic risk should be left unattended.”

(IMF, March 2011)

…and its consequences…

“In principle, macroprudential policy should capture all systemically important providers [of risk] … and where relevant, appropriate prudential instruments and regulations should be applied to institutions and market activities that may pose systemic risk. This would require redefining the perimeter of reporting and regulation to include all firms that may contribute to systemic risk.”

(IMF, March 2011)

…are recognized in our mandate

“…to develop a macroprudential policy framework …to identify, assess, monitor, and mitigate the adverse consequences of any systemic risk…” (IAIS, February 2011)


Macro- and microprudential approachesMacro- and microprudential approaches

Microprudential Macroprudential

Proximate objective Limit distress of individual institutions Limit system-wide distress

Ultimate objective Investor/depositor) protection Avoid macroeconomic costs linked to instability

Risk characterisation

Exogenous—independent of individual behaviour

Endogenous—dependent on collective behaviour

Correlations and common exposures Irrelevant Important

Calibration of prudential controls

Bottom up, risks of individual institutions

Top down, in terms of system-wide risk

Source: Claudio Borio, 2003 “Towards a Macroprudential framework for financial stability” (BIS WP 128).


Implementing the G-20 agenda

At the 2009 Pittsburgh Summit G-20 leaders called on the Financial Stability Board to develop for systemically important financial institutions “possible measures including more intensive supervision and specific additional capital, liquidity, and other prudential requirements.

Challenge IAIS responseIdentify systemically relevant insurers • G-SIFI project; results by 2012

• Macroprudential surveillance in insurance established

Promote consolidated supervision that accounts for all risk activities undertaken in a group and its entities

• ICP 23 in effect by October 2011• ComFrame for 50 large IAIGs

Establish resolution regimes for failed financial institutions

• Traditional supervisory approaches to insurers in failure and run-off

• IGSC work on resolution

Enhance loss absorbency • Loss absorbency in traditional insurance well defined by solvency requirements

• Open issue remains how to include and manage non-traditional activities


Workplan for the Macroprudential Policy and Surveillance Working Group (MPSWG)

Analysis / diagnosis• Develop analytical tools for macroprudential surveillance• Analyse gaps that could give raise to regulatory arbitrage• New: Analyse systemic issues of sovereign debt• New: Analyse systemic role of Credit Rating Agencies (CRAs)

Operational issues / standard setting• Further develop KIRT (internal) and GIMAR (external) reports to strengthen

comprehensive analysis of insurance sector• Develop measures to close regulatory arbitrage• Develop macroprudential tool kit to be used by national supervisors

Institutional set-up• Internal: Report to FSC and TC• External: Work closely with IMF, World Bank, OECD, FSB and Joint Forum

• New: Collaborate closely with the Supervisory Forum


Example: Increased systemic risk in the EU

Main risks for the EU financial system Type of systemic risk

Level and recent change

Interplay between public finances and financial sector; potential for adverse contagion

Macro shock, unwinding of imbalances

Bank funding vulnerabilities leading to contagion Contagion

Losses for banks in residential and commercial real estate markets of certain EU countries

Unwinding of imbalances, contagion

New: Sudden rise in global long-term interest rates with adverse impact for financial institutions

Macro shock

A medium to longer term riskTensions related to international capital flows; asset price increases in emerging markets

Unwinding of imbalances,

Considerable systemic risk Systemic risk Potential systemic risk

Source: ECB


KIRT

“Key Insurance and Risk Trends” Initial survey of insurers and reinsurers• Type of risk

• Insurance risk• Financial market risk

• Potential systemic risk implications• Trends in profitability and pricing

adequacy

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Dave Finnis, IAIS

Questions?


Documents

03_D Finnis_Risk-based supervision.ppt