Risk-based Supervision
Dave Finnis, IAIS
Including Off-site analysis and On-site inspection
San Jose 6 September 2011
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Risk-based Supervision
Dave Finnis, IAIS
Basic supervisory tools – Australia as an example
The Australian Prudential Regulation Authority
San Jose 6 September 2011
2
Defining insurance
Insurance 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)
6 September 2011
Risk based supervision
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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
6 September 2011
Risk based supervision
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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
6 September 2011
Risk based supervision
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Example: Put the experts in place - Appointment of
actuary and auditor
Role of appointed actuary (AA)
Values the insurance liabilities of the general insurer
Assesses (annually) the overall financial condition of the general insurer
Role of the auditor
Annual 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 Act
They 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.
6 September 2011
Risk based supervision
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Role of a supervisor – Australian view
The role of a supervisor
• Supervision vs. regulation
• Risk vs. compliance focus
Supervisory activities
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6 September 2011
Group review
Onsite reviews
Offsite reviews
Financial analysis
Regulatory approvals and interpretations
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Industry trends
Solvency coverage ratio for the GI industry
as at 30 June 2010
6 September 2011
Risk based supervision
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Modules & Topics
Board
•Board Composition
•Fit & Proper
Module 2
Management
•Management Structure
•Fit & Proper
Module 3
•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)
•Strategic Risk
•Strategic Planning
•Business Plan
•Implementation & Execution
•Monitoring its own progress
Module 1
Risk Governance
Module 4
Strategy & Planning
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
6 September 2011
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Modules & Topics
•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
•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
•Insurance Risk
•Credit Risk
•Board and Management
•Product Design
•Pricing
•Underwriting
•Claims
•Liability Valuation
•Reinsurance
•Distribution
•Independent Review of Insurance Risk
Module 7
Operational Risk
Market & Investment
Risk
Module 10
Insurance Risk
6 September 2011
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10
Supervision Process
Risk Assessment
• PAIRS Update
Supervision Activities
• Prudential consultation
• Prudential reviews
• Offsite analysis
• Targeted reviews
•Ad hoc meetings
6 September 2011
Supervision Strategy
• Supervisory Action Plans
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Prudential Reviews of Insurers
Prudential reviews of insurers is a cornerstone of
APRA’s assessment
APRA reviews and assesses:
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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
6 September 2011
Risk based supervision
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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
6 September 2011
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Traditional supervisory considerations
Dave Finnis, IAIS
Entity-specific, and Group-wide issues
San Jose 6 September 2011
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Risk Based Supervision
Genesis and Background
Traditional/Historical Model:
• Entity-based
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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
6 September 2011
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Risk Based Supervision
Traditional/Historical Model (A Canadian Viewpoint)
CARAMELS
Capital
Asset quality
Reinsurance
Actuarial liabilities
Management
Liquidity
Subsidiaries
6 September 2011
Risk based supervision
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Risk Based Supervision
Traditional/Historical Model
CARAMELS
• Key benefit – identification of institutions that
require special supervisory attention
• Not forward looking – ratings derived from onsite 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
6 September 2011
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Risk Based Supervision
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.”
6 September 2011
Risk based supervision
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What risks are insurers exposed to?
Market Risk
Credit Risk
Concentration Risk
Asset Valuation Risk
Asset Risks
Capital Risks
Cost of capital
Mismatch Risk (ALM)
Solvency Margin Risk
Accounting Risk
Liability Risks
Operational Risks
Liquidity Risks
Other Risks
Financing Risk
Capital access Risk
Mismatch Risk (Cash Flow)
Surrender
6 September 2011
Risk based supervision
Claims Risk
Pricing Risk
Underwriting Risk
Concentration Risk
Reserving Risk
Catastrophe Risk
Reinsurance Risk
Technology Risk
Communication Risk
Business disruption
Fraud
Legal Risk
Regulatory Risk
Reputation Risk
Strategy Risk
Other business Risk
Environmental Risk
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Risk Assessment and management
London Working Group report, December 2002*
• Surveys of all recent failures and problems of EU insurers
• Identified major risks:
 Underwriting / reserving risk
 Operational risk (management / governance, business
risk, systems and controls)
 Asset risk
 External causes
 Reinsurance risk
*Source: Managing Risk: Practical lessons from recent “failures” of EU insurers,
2002, FSA UK
6 September 2011
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Risk Based Supervision
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
insurer
 prudential regulations/requirements to contain risk
 ultimate responsibility rests with Board
6 September 2011
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Risk Based Supervision
Proposed ICP 8: Risk Management and Internal Controls
Essential 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
6 September 2011
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Risk Based Supervision
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.
6 September 2011
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Risk Based Supervision
Comprehensive Risk Assessment & Ratings
Generic Features
Comprehensive 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 functions
Assessment of the inherent risks of each business unit or
significant activity
Benefits
Can be applied on a consolidated as well as solo basis
Better understanding of the risks and quality of risk
management functions at the institution
Allows for more focused and risk-based supervision
6 September 2011
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Rationale for group-wide supervision
Group
financial
position
and risks
Group risk
management
and
controls
Fill
supervisory
gaps
Rationale
Group
management
structure and
governance
6 September 2011
Increasing
prominence of
IAIGs
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Proposed ICP 23 will provide
overarching requirement
Proposed ICP 23 Group-wide Supervision
The supervisor supervises insurers on a legal entity and group-wide
basis
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:
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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.
6 September 2011
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Key issue – what is an “insurance group”
for the purpose of group-wide supervision?
Non-operating
Holding Company
(NOHC) 1
Intermediate
NOHC 2
Insurer 3
NROE 2
Insurer 1
NROE 3
Bank 1
1. Supervisors must set
the perimeter of groupwide supervision in
cooperation with other
supervisors
Insurer 2
Insurer 4
Securities
Firm 1
Non-regulated
Operating
Entity
(NROE) 1
SPE 1
3. Minimum elements
with respect to
insurance activities to
consider when
setting the scope
6 September 2011
2. The minimum types of
“relevant entities” that
should be included
Risk based supervision
• Participation, influence
• Interconnectedness
• Risk exposure
• Risk concentration
• Risk transfer
• Intra-group transactions
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Key Features of treatment of non-regulated
entities in group-wide supervision
Comprehensive
understanding
Assess risks
of group
Risk mitigation
from
measures
non-regulated
entities
Flexible
scope of
supervision
Supervisory
cooperation,
coordination,
info exchange Supervisory
review
and reporting
6 September 2011
Capital
adequacy
Key Features
Fitness and
propriety
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International recommendations on
supervisory colleges
• “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)
G20
• “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)
6 September 2011
FSB
• “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)
Joint Forum
• “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
San Jose 6 September 2011
31
“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
6 September 2011
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Contagion in banking and insurance
Coexceedance of equity prices
(in per cent of firm sample)
100%
Banks
50%
0%
50%
Insurers
100%
jul/07
jan/08
jul/08
jan/09
Daily
jul/09
jan/10
jul/10
jan/11
jul/11
Systemic
risk is
endemic –
also in
insurance
7 Day average
This chart reflects the percentage of banks and insurers that simultaneously show
an extreme decline in equity prices.
Source: Thomosn Datastream and DNB calculations
Coexceedance of CDS spreads
(in per cent of firm sample)
100%
Banks
50%
0%
50%
Insurers
100%
jul/07
jan/08
jul/08
jan/09
Daily
jul/09
jan/10
jul/10
jan/11
jul/11
7 Day average
This chart reflects the percentage of banks and insurers that simultaneously
show an extreme increase in CDS spreads
Source: Thomson Datastream and DNB calculations
6 September 2011
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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)
6 September 2011
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Macro- and microprudential approaches
Microprudential
Macroprudential
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 systemwide risk
Proximate objective
Source: Claudio Borio, 2003 “Towards a Macroprudential framework for financial stability” (BIS WP 128).
6 September 2011
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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 response
Identify 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
•
•
6 September 2011
Loss absorbency in traditional insurance
well defined by solvency requirements
Open issue remains how to include and
manage non-traditional activities
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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
•
6 September 2011
New: Collaborate closely with the Supervisory Forum
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Example: Increased systemic risk in the EU
Main risks for the EU financial system
Type of
systemic risk
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
Level and
recent change
A medium to longer term risk
Tensions related to international capital flows; asset
price increases in emerging markets
Considerable systemic risk
Systemic risk
Unwinding of
imbalances,
Potential systemic risk
Source: ECB
6 September 2011
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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
6 September 2011
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Risk-based Supervision
Dave Finnis, IAIS
Questions?
San Jose 7 September 2011
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