The Insurance Capital Standard Adds No Value to Insurance Policyholders
By Peter Skjoedt, Skytop Contributor / October 22nd, 2021
Peter’s educational background begins at Copenhagen University, where he earned his master’s degree in Economics, with an emphasis on International Economics Education. Peter worked as an Economist at both the Danish Manufacturer’s Association and Carlsberg International A/S before flourishing at the Danish Insurance Association (DIA).
During his time with the DIA, Peter worked his way from principal, to Head of Department, then Executive Director and International Advisor. While Executive Director, he was responsible for the Economic Affairs Department, dealing with prudential regulation, accounting, taxation, solvency, and investments.
Throughout his career, Peter still found time to participate in numerous working groups and committees, with both DIA and Insurance Europe. He has been a guest lecturer and an Associate Professor in International Finance and Pension Economics at Copenhagen Business School for over 20 years. Peter even spent a year as Acting Director of Economics and Finance at Insurance Europe (2006-2007), while maintaining his responsibilities as Executive Director at DIA.
Most recently, Peter sat as Director of Financial Stability and Regulation at the Geneva Association, working in Zürich.
Skytop’s readers know that the financial sector is highly regulated. We do not need to go into details on why this is the case. It is, of course, because insurers make promises into the future. And policyholders must trust that such promises will be fulfilled.
So, we all adhere to and accept that the financial sector is and should be highly regulated. Referring to the financial sector, most will think of banks. Banks do dominate the financial system and they represent an invaluable part of the value creation in modern economies. They are the oil to the engine, so to say. Nobody really thinks of why it is there, but without it…. disaster!
The Insurance and Pension Sectors
A less recognized part of the financial sector, though completely indispensable to any economy based on market principles, is the insurance and pension sector. The insurance business model is fundamentally different from the one of banking – but like banking, insurers provide financial services which are a basic precondition for economic growth and wellbeing.
Like banks, insurers are highly regulated. Very often, the motives for regulating insurers are mistakenly put forward as being the same as for banks. Insurers do not pose liquidity risk. Insurers absorb losses and look through the economic cycle. They cushion the ups and downs of the economic cycle, contrary to banks, and they do not create systemic risk to the financial system – on the contrary, they act as a buffer against systemic risk.
The case for regulating insurance is, in any case, very strong. The insurance business model implies that premiums are paid up front, while benefits are paid out later when insured events happen. The time span between premiums being paid and benefits being paid out can be decades – notably in the life insurance/pension business, workers compensation and health, etc.
The International Association of Insurance Supervisors (IAIS)
Few are probably aware that the groundwork for existing global insurance regulation – existing as well as upcoming – is prepared by the IAIS, the International Association of Insurance Supervisors. The IAIS is a standard setter – they cannot set or enforce any rules, but they set standards that all markets, emerging or mature, must, in effect, live up to. The IAIS has more than 150 members who represent supervisors around the globe. Many claim that because of this broad membership, the IAIS is weak and has difficulty in establishing strong standards.
I would claim the opposite. The IAIS is extremely powerful because of its global membership, its strong membership support, and its track record of setting high quality standards of pretty much every aspect of insurance supervision around the globe. Very few details of insurance regulation in any market based economy can be traced back to the IAIS, one way or the other.
Solvency, Capital Regulation and the IAIS Strategic Plan
During and in the aftermath of the Global Financial Crisis (GFC), the IAIS – like politicians, regulators, and supervisors around the globe – naturally had their eyes on capital regulation. How to build a capital regime which will help insurance through financial turmoil, and, not least, which will not by itself create financial turmoil?
With lessons well learned from the GFC, the IAIS has in recent years turned its attention towards emerging issues other than insurer capital. The IAIS has developed a so-called Strategic Plan which sets out the framework for the development of insurance supervision in the years to come.
This Strategic Plan will play an important role in the development of insurance regulation over the medium term. The Strategic Plan represents a move onwards from the crisis mitigating and preventive measures which were on the agenda during and just after the GFC. The IAIS Strategic Plan has its focus on the need for insurance supervisors to devote attention to new (although no longer that new) and emerging (for some time now) risks.
Core Aspects of the IAIS Strategic Plan
Technological Innovation
FinTech presents significant opportunities for financial inclusion and policyholder value, but also poses operational and underwriting risks. The rapid expansion in alternative data sources and advanced data analytics is of impact and has the potential to disrupt the insurance market.
Cyber Resilience
Insurers are not only exposed to cyber risks but are also active takers of cyber risk through their cyber underwriting activities.
Climate Risk
Insurers are exposed to both transition risk as institutional investors and physical risk from natural disasters through their underwriting but can also be key agents in the mitigation and management of climate risk.
Conduct and Culture
Technological changes to the insurance business model present new conduct challenges, such as the supervision of the use of advanced data analytics. A holistic approach to market conduct and prudential supervision is called for, recognizing that conduct and culture issues could lead to financial soundness and stability concerns.
Financial Inclusion and Sustainable Economic Development
Insurance supervision has an important role to play in insurance market development and, more broadly, sustainable economic development in the wider context of achieving the IAIS’ Mission. Policyholder protection and contributing to financial stability are fundamental to ensuring the sustainable involvement of the insurance sector in closing the protection gap, including resilience to natural disasters and security in old age, supporting inclusive insurance markets, promoting sustainable long-term investment, and the development of the cyber insurance market in support of a more resilient financial system (Report to the right of this article for downloading).
The IAIS focusing on these issues when laying the foundations for insurance regulation in the years to come perfectly makes sense. It shows that the imminent reactions to capital issues following the GFC is now being followed by a sensible and well thought through attendance towards the new risks facing insurers and, therefore, policyholders.
The Insurance Capital Standard
However, the development of the most important post-GFC supervisory initiative – the Insurance Capital Standard, the ICS, has not been given up. It is still a priority of the IAIS to develop this standard. It is supposed to be a group-wide capital standard for the approximately 50 largest insurance groups globally (the so-called IAIGs – Internationally Active Insurance Groups). While the efforts and struggles of the IAIS over some 10 years now in this area must be appreciated, the work must be simply stopped. The continuous efforts to develop an ICS make no sense.
And so, why is that? Is it not worth setting capital requirements for the biggest insurance groups in the world?
Yes, it is. Any measure to help protect insurance policyholders at reasonable costs is worth pursuing. But the ICS is flawed and will not help protect policyholders:
Capital requirements in insurance are relevant at solo level. That means individual insurers in every jurisdiction must fulfil their solvency requirement. If a US insurer has loads of capital in their mother company in the US while their subsidiary in Japan is bleeding, it is a case for the Japanese financial authorities to oversee policyholder protection in that Japanese company – not the US authorities. And the Japanese authorities cannot just call in capital from the US mother company. What insight would some group capital number bring?
Insurance is a local business. Local rules, legislation, tax requirements, insurance law, etcetera, must be respected. A person in Argentina buying insurance from a daughter company of a French insurer does not care where the mother company is located. And he or she should not care. So, what does the group picture bring about?
The group capital as measured by the ICS will inform the public, journalists, and others about some measure of the total capital strength of an insurance group (the IAIG). But they will say nothing about the willingness and capability of the IAIG to support its local operations. You can have a UK insurer with a subsidiary in Hungary which runs at the minimum level of capital – but should the Hungarian subsidiary need capital, it will flow easily from the mother company in the UK. Then again, other UK subsidiaries in Hungary may have more capital – but in the event of capital issues, the mother company will not let the money flow. What does the group capital as measured by the IAIS tell you, then?
In the discussion and negotiation on the ICS, the US has refused to accept the basic principles on which the ICS is built – and that is, basically (and very sound), a risk sensitive approach. That means, the capital requirements should reflect the underlying risk of the insurer. The US in its approach to insurance regulation has a different approach – building not on market valuation and true risk sensitivity, but on some long term approach where you hope time will allow insurers to even out short term fluctuations and survive (and respect all policyholder commitments) in the longer term. The US is developing its own so-called Aggregation Methodology (AM) instead of the ICS – and when we come closer to the ICS becoming a reality, the IAIS must decide whether this AM is a close resemblance to the ICS or not. If it is, the US can use their methodology instead of the ICS. Now, this makes no sense. If the US approach is close to the ICS (also over time in various adverse scenarios), why introduce it in the first place?
Is there no way a group capital regime could make sense? Yes, there is. But that would require politicians and supervisors to give the solo insurance supervisory approach and allow for capital to be truly an issue at the global level, allowing for diversification across markets etc. and calling on the group to support local entities. This will not happen for many decades.
Message to IAIS
It is all about politics. The US insurance and supervisory community will not accept the ICS, which is being developed and supported by almost all other important markets. The ICS will not add much value, but with the US developing its own methodology, there is just one thing to do.
Dear IAIS, stop any further work on developing the ICS. Use the resources released to support all the very reasonable and warranted initiatives you have in your important Strategic Plan.