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Over recent years, ERM has begun to leave an indelible mark on actual and proposed changes to regulation in many international jurisdictions.

Solvency II in Europe has become something of a gal-vanising force. If everything stays on track, 30 European countries will be united in late 2012 by a single set of rules governing what constitutes an acceptable level of solvency.

Its ambition, both in terms of scale and scope, is acting as a catalyst, spurring regulators in other jurisdictions to re-view their supervisory policies – not least because Solvency II encompasses the concept of judging the “equivalence” of regulatory regimes in other territories. The global conver-gence of risk and principles-based regulation and ERM is growing as a result.

Does this mean that we are heading for a world where prudential regulation of the industry is identical in all major centres? Not quite. There is no doubt, however, that traditional rules-based solvency standards are widely viewed as inadequate. They bear no relation to the actual risk profile of any given business. They mean that capital may be tied up unnecessarily. And they can encourage an attitude of box-ticking regulatory compliance.

Convergence of objectivesRisk-based regulation moves the onus of assessing a firm’s explicit level of solvency from the regulator to the company management. As a result, firms are expected to become much more risk-aware in their management and culture.

This is consistent with the idea that ERM is not separate from the business: it is a way of doing business. One regula-tory implication, therefore, is that risk management has to be – and seen to be – part of everyone’s day job. For many companies, this entails a significant culture shift, one that only senior managers can bring about.

What does such a culture shift involve? There are numer-ous definitions of ERM that would suggest a whole range of areas where understanding and performance might need to be improved, including internal environment, objective setting, event identification, risk assessment, risk response, control activities, information and communication, and monitoring.

In combination, tackling these (and others could well be advanced) represents a lot of work for most companies. Regulation, in itself, is not necessarily an incentive to do so. The bigger carrot for the ERM-led approach is the opportu-nity for competitive advantage and for firms to manage not

Where erM goes, regulation will followThe principles of enterprise risk management (ERM) have become a driving force in international insurance solvency regulation. It will pay companies in developing markets – such as MENA – to anticipate changes ahead, says Mr Mike Wilkinson, Head of Risk Management Consulting at international actuarial and business consultancy EMB.

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Cover story – regulation

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just their capital, but their entire business, more effectively in order to improve returns.

But an increasing number of regulators around the world are set on pushing companies within their jurisdictions towards that carrot.

europe and africaSolvency II is a major testing ground for regulatory moves towards ERM. However, the inherent complexity of the exercise is compounded by the tremendous diversity of companies and countries within today’s European Union. The decision to offer firms a choice between a standard formula and an internal model for capital calculations is a practical approach to dealing with this diversity, as is the inclusion of a “proportionality” principle so that smaller, less complex companies are not treated in exactly the same way as multinational giants.

Included in the three pillars of the Directive, however, is a requirement for an “own risk solvency assessment” (ORSA). This will force even those companies which choose the standard formula to submit an objective assessment of capital sufficiency for all the risks to which they are exposed. And whichever route they take, Solvency II requires them to consider all their business risks, not just the insurance risks.

Various country regulators and market bodies (including Lloyd’s of London) within Europe have actively encouraged firms within their jurisdiction to pursue the internal model option so that capital is more closely aligned to the risks within the business. A key component for regulatory ap-proval of such models is the “use test” whereby companies must demonstrate that the model is being used to support important decision-making, not just calculate capital.

In South Africa, which operates as an insurance hub for sub-Saharan Africa, the regulator has issued draft regula-tions to be implemented by 2014 (with interim measures to be applied by 2012). The regulations are structured to be consistent with Solvency II. According to the draft regula-tions, all companies are expected to move towards a full internal model within five years of implementation.

asiaThe Australian regulator was a very early pioneer of a risk-based regulatory framework. This, again, is based on a choice between an internal model or a formula approach to calculating capital.

Many Asian regulators are watching the Solvency II pro-cess closely. Japan, with the biggest insurance industry in Asia, currently has a formula system, although the regulator has demonstrated a growing interest in exploring a regional equivalent to Solvency II within the last year. The Chinese regulators are also experimenting with internal models and risk-based solvency regulation.

Throughout the Middle East, there is an increasing drive towards ERM. The influence and demands of rating agencies are also significant factors within the region. Consequently, the region as a whole and certain countries in particular, such as Bahrain, have invested considerable time and effort in moving towards world-class regulation.

The next step will be wider supervisory enforcement. Currently, the emerging regulatory bodies are preoccupied with more fundamental issues, such as ensuring that people moving into the industry are suitably qualified to meet the growing demand for insurance products.

the americasState-by-state supervision of the insurance industry has led to a more fragmented approach in the US. However, in the wake of the financial crisis, the Obama administration has made a more unified approach to financial regulation a priority with the result of the proposed creation of the Federal Insurance Office. The National Association of In-surance Commissioners has had a Solvency Modernisation Initiative (SMI) Task Force in place since 2008 and earlier this year released a SMI roadmap which sets out plans for an ERM/ORSA type tool by the end of 2011 and the devel-opment of model law and group-wide supervision rules by the end of 2012.

The Bermuda Monetary Authority has been pursuing the phased introduction of risk-based capital requirements since 2008. Recent activity has included the release of a consultation paper on the approach to an insurer’s own risk and solvency assessment regime (similar to Solvency II), to be referred to as the Commercial Insurer’s Solvency Self-Assessment.

In Latin America, Brazil is leading the drive towards risk-based solvency regulation with rules regarding underwriting risk becoming effective in 2008 and credit risk by the end of 2010. While an internal model cannot yet be used to determine an insurer’s capital requirement, any company that has such a model receives a discount. The other major markets in Central and South America, such as Mexico, have also developed proposals for new solvency regulations.

What next?From all this activity, it is clear to see the direction in which global solvency regulation is moving.

While some Middle East insurers are already familiar with the ERM expectations of rating agencies, the need to prepare for ERM-inspired regulation also seems almost inevitable. Concentration on a few key areas of ERM will stand the industry in good stead as it gets on with growing capacity and market penetration:

• Governance – Allocate clear senior responsibility and authority for risk management, ideally at board level. Start creating an environment for effective communica-tion and data capture.

• Decision-making – Align risk management to the busi-ness strategy and the interests of stakeholders.

• Risk modelling – Aim to model key risks and the de-pendencies between them. In tandem, be aware of the need to be able to stress test the key assumptions and scenarios within models.

• Integration and resourcing – Organise the capital management function so that it is working closely with other departments such as reinsurance, reserving, pricing and asset management. Experience from those countries where risk-based regulation is being implemented also shows a growing demand for risk professionals and actuaries.

• Benchmarking – Build in external benchmarks to verify internal views of risk.

Since the discipline involved in complying with emerging insurance regulations and implementing ERM are increas-ingly overlapping, such forward planning is likely to prove a worthwhile investment in any case.

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