Risk Based Capital- Issues, Challanges and Opportunities
A Stable insurance sector is encouraging various insurance regulators around the world adopting Risk-Based Capital (“RBC”). In Asia, many insurance markets have moved to RBC or moving towards more advanced RBC 2 regimes, the latest being China implemented RBC in 2016, Philippines is getting ready for RBC 2 in 2017, Singapore implementing RBC 2 sometimes in 2017-18, Hong Kong time frame 2017-22 is under way besides, Malaysia, South Korea, Thailand, Indonesia and Taiwan have already implemented RBC.
The purpose of RBC is to bring insurance sector more responsive to changes in both local and global economic and demographic environment. Many failures have been witnessed in the past in the financial sectors particularly in banking and insurance and need was observed to have solvency regime that can withstand some financial turmoil.
So instead of having a static solvency regime where solvency capital remains more or less static despite changes in the demographic and economic environment, the world has moved and is moving towards an era where the solvency capital will be dynamic to the changes in various internal and external risk factors.
Recent RBC Entrants
Recently in 2017, Philippines which is getting ready to implement RBC 2 regime. Philippines has adopted three pillar approach to RBC where Quantitative calculation in Pillar-1, Governance in Pillar-2 and Disclosure in Pillar-3. The risk charges applied under Pillar-1 for the year 2017 is at 95.5% of confidence level increasing to 97.5% in 2018 and finally 99.5% in 2019 and beyond.
The Hong Kong Market is also working towards RBC with consultation starting in 2017 and full implementation by 2022. They are also adopting the three pillar approach similar to other markets, wherein the pillar-1, the quantification of risk capital is performed by using Market Risk, Credit Risk, Life Underwriting risk and operational risk for life insurers. For non-life companies, GI underwriting risk is in place of life underwriting risk. The Pillar-2 is Enterprise Risk Management and ORSA requirement and Pillar-3 is disclosure.
China implemented the RBC is very quick time within four years between 2012 to 2016 with three pillars approach.
Key Issues, Challenges, and Opportunities
Implementation of RBC is not free from challenges, different stakeholders such as regulatory, insurance players, shareholders etc faces a different level of challenges. The section below discusses some of the issues, challenges, and opportunities that these stakeholders may face.
Regulators are to stay proactive and ahead of the market in spotting emerging risks along with collaborating with international agencies in sharing knowledge and learning from each other.
The role of the Regulator is not just concerned about the protection of the policyholders but also instilling confidence in the customers to have faith in the financial system of the Country. The regulator is not also free from challenges; they may find challenges putting in place all the regulation along with monitoring mechanism. They have to ensure that their own resources are in place, up to date with skills, systems etc. Implementation of RBC is a key challenge for the regulator
Impact on Market
There is a far-reaching impact on the insurance industry by the implementation of RBC which may change the competitive landscape. The RBC may split financially strong players with the weaker ones; in such situation, consolidation in the market is not ruled out. In China, it was observed that smaller players required more capital to support their business model.
Such situation is addressed by altering the strategy of the Company for investment, product, sales, and marketing. Players may select target market based on their risk appetite and ability to withstand volatility rather than present everywhere.
It has been observed in many markets moving to RBC adopting lesser guaranteed products and focusing more on protection products. Where low-interest rate regime is prevailing, there is a focus on risk management in the lapse, expense, and mortality to generate a surplus from these risks. Moving to unit-linked products are other options as it requires lower capital.
More successful players have a better implementation of risk management; they derive direct value both in terms of capital and profit. In the China, there is a reward of the lower capital requirement for better risk management.
In the different insurance markets in Asia, there are areas of convergence and divergence related to RBC. The convergence areas are risk framework - definition of risks and risks events, diversification of risks, economic balance sheet etc. The areas of divergence are - country specific features in the calibration of risk factors, the liquidity of financial markets, accounting standards, product specific features, methodology etc.
Many of the regulatory regimes around the world are treating cyber risk in a crude way, though it can have a catastrophic impact because there is a shortage of data, cyber insurance is limited and many insurers do not provide such protection, blurring of territorial boundaries proving difficult to pinpoint the fault increases the complexities. Currently, cyber risk sits in the operational risk category and does not gain enough importance whereas its impact could be very high; therefore, there is a need to have a separate category for cyber risk similar to catastrophe risk to allow for appropriate risk change. It should attract more regulatory focus in RBC.
Interest rate risk
Companies selling long-term traditional products with guarantees face high capital charge due to interest rate risk. Many Asian economies are lacking long-term risk-free assets to back long-term liabilities, this makes difficult to match the assets and liabilities in long terms products.
The interest rate shocks result in higher capital requirement where there is a mismatch between assets and liability duration.
To manage this risk, the Companies need to focus on assets liability management, reduction in duration gap between assets and liability and hedge the risk from derivatives.
There is a need to realign the investment strategy based on the available capital and focus on the customer target segment matching with the investment philosophy. For example, a more capital constrained Companies may invest in relatively secure assets to save capital and make product strategy that consumes lesser capital such as protection or unit-linked business.
Bigger and well-capitalized players may have a competitive advantage of investing in riskier assets to give a higher return to policyholders as compared to smaller players. Their investment strategy and risk appetite will have more powers to absorb shocks.
In order to sustain in such environment, the Companies have to keep their long-term strategy agile while focusing on the implementation of RBC.
Risk and Capital
In an RBC regime, capital is based on risk, so risk and capital become synonymous; there is a direct relationship between the better management of risk and capital management. There is a need to invest in a risk management. In the China insurance market, there is an allowance to keep lower capital for better risk management. Risk management also allows benefits of risk diversification due to the negative correlation between the risk factors.
Many countries with risk-based capital regime have adopted three line of defense model, where the first line is the front line function, the second line is risk and compliance function and the third line is audit function
Many countries who have implemented risk management, the key challenges are the development of risk culture within the organization.
The role of CRO is becoming very important where he is to do a balancing act of helping to identify risks to meet business objectives.
In the coming times, the role of CRO will be very challenging as he will be on firing line both from management and shareholders. He should be a critical friend rather than policing.
Sri Lankan market implemented RBC in 2016, some of the learning from this market are that actuarial competency is very important in the successful implementation of RBC, Sri Lankan market has felt some challenges in garnering the actuarial resources. Senior Management involvement is very important in the implementation of RBC. Use of scenario testing and risk appetite is important in decision making. Employing disciplined process of setting actuarial assumption helps in reducing future volatility in profit emergence and capital requirement.
Strengthening Customer Experience
Better customer experience helps in improving the customer’s loyalty; this also brings more loyal customer through family and friends. In the western market, it has been found that the lapse rate of loyal customers is half of rest of the population. Such initiatives help in optimizing capital and profit.
Better expense management with lower operating expense helps in releasing the capital. This can be performed by improving IT capabilities, better fraud management, enhancing front line sales training, error free processing etc.
The quantification of operational risk is challenging for most of the markets, however many markets have developed Risk Control Self Assessment process and created a probability and loss amount grid as a part of Common materiality framework to address the operational risk issues.
In the end, we need to ask some fundamental questions, whether the implementation of capital as a function of risk would make solvency dynamic with changes in the risk factors for which the regulatory changes are implemented around the world. Will it able to spot Bank Swan?
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