Today’s complex risk-based capital approaches aim to ensure that the capital needs of a company are specifically tailored based on the risks inherent in the types of business underwritten. The Insurance Regulatory and Development Agency of India (IRDAI) has announced its intention to adopt an RBC system by 2021 and is part of an evolving global phenomenon.
The EU’s Solvency II regime is probably the most famous implementation of risk-based capital (RBC) regulation in an insurance context; however, the RBC concept is not new to Asia. Indeed Japan, Taiwan and Singapore were amongst the earliest adopters of RBC in the late 1990s and the early 2000s. A second wave of advancement saw Thailand, South Korea and Malaysia introduce similar RBC requirements. More recently, a third wave of countries recently updated their rules, namely Sri Lanka and China in 2016 and the Philippines in 2017.
Processes and transition
To guide and oversee the implementation of RBC and its later compliance, companies and supervisory authorities generally need to make considerable investments in the form of systems and process upgrades, while also strengthening their resources. A clear understanding of the impact of an RBC regime on an insurer’s balance sheet, solvency ratio and capital requirement is therefore of vital importance. To aid a smooth transition, regulators typically mandate several dry-runs or Quantitative Impact Studies (QIS). These QIS exercises help companies build their processes gradually and provide an early insight into the financial impact of the new rules ahead of their implementation.
Forewarned is forearmed
While India is yet to launch its first QIS, companies in the Hong Kong insurance market are getting ready to compile their responses to the third such study (QIS 3) this August.
In June 2019, Peak Re held its inaugural CEO dialogue session for the Indian market, which was hosted in Mumbai by our CEO Mr. Franz Hahn. During this event, we presented a case study in which we modelled data drawn from the public disclosures of 32 Indian direct non-life insurers using a modified version of Hong Kong’s previous RBC template (QIS 2). In addition, we included in our simulation a series of high-level assumptions to assess the potential impact of introducing an RBC regime in India.
India’s non-life insurers assess their regulatory solvency ratio by comparing their “available solvency margin” to their “required solvency margin” as specified by the IRDAI. However, in an RBC world, this will evolve:
- First, the required solvency margin will be replaced with output from the RBC template. This change is expected to drive a material increase in the required capital. Based on our case study, we estimate that the industry’s required capital level will be around 2.72 times larger than today’s levels on an as-is basis without factoring in growth. This increase is significant, but perhaps unsurprising as the range of risks considered under RBC frameworks (e.g. investment market volatility, credit defaults and reserve deteriorations) are much broader than those contemplated under India’s existing rules, which use profit-and-loss quantities (e.g. incurred claims) that essentially only capture the risk exposure during single financial year.
- Under RBC rules, we also expect that the available solvency margin to support these risks will change. In other regimes, the available capital to support the RBC typically reflects a firm’s net asset value on a market-consistent and economic basis. Right now, the solvency rules in India contain prudent adjustments to an insurer’s net assets. However, there is a reasonable chance that these adjustments will be diminished or removed entirely as the regulator seeks to apply an economic lens and to align its rules to emerging international practice. If our expectation is borne out, these revisions will push-up the available capital and offset some of the impact from the rise in required capital indicated above.
Taken together, our case study analysis suggests that the combined industry solvency ratio in India will drop from just over 200 percent now to around 140 percent under RBC. As with all regulatory changes, some insurers may see an increase in their solvency ratios while many players in our case study saw substantial declines in their solvency ratios.
In the case study, we also considered the implications on insurers’ return on equity. This is a broad topic, but for simplicity we solely analysed the impact on companies if they elected to inject funds as a means of stabilizing their solvency ratio before and after the new rules’ introduction. Our case study suggests that under such actions, insurance companies’ return on equity might reduce from approximately 8 percent currently to 5 percent, although we recognise that multiple actions are available to management as they steer through an RBC headwind.
Moving forward
Aside from the quantitative outcomes of an RBC introduction, we understand that India will follow international practice, with the new regime being based on three pillars, with the second and third focusing on governance and public disclosures, respectively.
IRDAI already requires insurers to provide comprehensive public disclosures in the NL forms used to support our case study. As such we think that companies are likely to see only a small evolution in meeting the likely requirements under RBC Pillar 3 rules. The bigger challenge will arise once the numbers are understood. This challenge is likely to come in the form of Pillar 2 requirements, which will put a strong burden on the management and boards of insurance companies to increase their focus on risk-management, including understanding scenarios and capital requirements over the medium term.
The impact of introducing RBC goes beyond direct effects on equity and solvency. IT systems may also need to undergo changes, in the way that data is both organised and managed, not just for reporting, but also for risk-management purposes.
With changes in the measurement metrics of exposures, the ability of an insurance company to precisely define its exposures will play a key role in managing this exercise. While this is not a case for pre-emptively managing the situation, companies need to be cognisant of this today as well.
Even though there are a variety of solutions available – rannging from reinsurance to raising capital – companies will need to start planning the various scenarios and combinations when considering how to strengthen their solvency position. Reinsurance and raising capital both have their own challenges and merits in managing an insurer’s financials and in meeting the expectations of shareholders.
Typically, the management team of insurance companies will be aware of the challenges in raising additional capital, both for listed and unlisted companies. This requires planning as building these scenarios is a time-consuming and laborious exercise. Company boards should be informed as to what is coming, because once India’s insurers start to compete the likely QIS templates, what is required could be intense and yield surprising results.
We expect the IRDAI to strive for an appropriate balance that allows the Indian insurance market to remain competitive while meeting the security needs of policyholders. The regulator is also likely to tip its hat to the observable convergence in solvency standards across jurisdictions, as promulgated by supranational bodies including the International Association of Insurance Supervisors and the International Monetary Fund.
