Early-warning Indicators, Supervisory Intervention and Cross-border Resolution of Insurance Groups

1. Early-warning Indicators, Supervisory Intervention and Cross-border Resolution of Insurance Groups Regional Seminar on Supervision of Insurance Groups Santiago, Chile, 19-21 November 2013 Gunilla Löfvendahl Senior Financial Sector Specialist

2. Agenda • On a legal entity and group-wide level • Learn from past crises - typical problems and possible solutions • Identifying problems early, responding with adequate supervisory tools • Supervisory ladder of intervention, cooperation and resolution, and orderly exit from the market

3. HIH failure (2001) - Findings • New supervisory methods and structure, with loss of corporate memory and industry expertise • Assumption that most large and complex groups were well managed and controlled, with concentration on exceptions • Mismanagement of HIH • Under-pricing and provisioning • Creative reinsurance arrangements • Bad corporate culture • Blind faith in an ill-equipped leadership consisting of dominant personalities • Risk not properly identified and unpleasant information hidden or sanitised • Lack of independence and critical analysis • Aggressive accounting practices and lack of audit independence • Fraud, extravagance and questionable transactions

4. Palmer Report recommendations (2002) • Powers and quality of the supervisor • High degree of supervisory independence and ability to act quickly and decisively • Strengthen intervention powers, using them vigorously, also informally • Reasonable degree of senior management and board involvement in important decisions • Broader mix of expertise, including from the outside • Capacity to review sufficiency of reinsurance arrangements and adequacy of liabilities, such as outstanding claims • Planning for future contingencies (creation of business cases, training etc)

5. Palmer report continued • Supervisory process • Strengthen supervisory risk-rating process and more frequent meetings to review institutions • Amend methodology to acknowledge that apparently well-managed groups can experience financial problems – early detection • Regular meetings with boards and relevant board committees of supervised entities (discuss expectations and findings) • Regular meetings with approved actuaries and auditors • Review relationship with foreign regulators and, where necessary, establish MoUs • Focus • Group-wide supervision, looking at the legal entities, including non-regulated • Monitor intra-group transactions • Move from high-level on-site inspections (discussions) to more detailed reviews of evidence

6. Royal Commission recommendations (2003) • Corporate governance • Look at remuneration policy and disclose benefits • Clear definition of duties and functions of board and senior management • Capital adequacy • Minimum solvency requirements on entity as well as group level • Require approved actuary reports of financial condition • Greater disclosure of information about financial positions, and risk- and reinsurance management strategies • Supervisory capacity, methodology and focus • Build supervisory competency and review competitiveness in the labour market (salaries etc) • More sceptical questioning and aggressive approach to prudential supervision • Preparedness to enforce compliance (also timely returns) • Continual questioning of assumed financial viability of institutions • Random but frequent investigations of reinsurance arrangements

7. European failures(2002*) – Findings • Main apparent causes: underwriting and reserving risk • Root causes: management or governance issues - more focus on the underlying causes makes it easier to detect the effects early • Indications of lax risk management or systems and control should generate a search for a potential deeper malaise • Enough autonomy for insurers belonging to groups • Appropriate experience and skills of board and management • Performance assessment and bonus policy that do not encourage excessive risk taking • Not only rely on quantitative factors • Anticipate how risks can interact in complex ways, including causal links between different types of risk and unexpected correlations – large exposures on a group-level • Move to risk-based approaches, with more forward-looking tools and greater international cooperation *Joint work of 15 countries in the European Union: Report on 20 out of 270 cases of failed insurers or near misses, looking at causing risks and existing supervisory practices on prevention and early detection

8. Great Financial Crisis - Findings • Insurers mainly affected on the asset side - life insurers predominantly hit (higher asset/equity ratio) and greatest problems in guaranteed products • Credit-related non-life lines more hit due to business insolvencies (monoline/financial guarantees) • Pro-cyclicality of capital risk charges (reduction of available capital, sale of risky assets, aggravating the asset prices in a downward spiral) • Pro-cyclicality of accounting standards (fair value) • Gaps in the supervision of groups, egAIG • Systemic risk (risk seriously impairing the overall economy) – insurers systematically risky? • Risk of run on insurers - no significant increase in lapse rates although in principle possible for life insurers • Liquidity risk management – claims normally well-managed but securities lending, collateral requirements (triggered by downgrade), and redeemed policies could pose such risks • Safeguards in case of troubled insurance groups – possible simplification of group structure, orderly resolution process, orderly exit and guarantee schemes

9. IMF recommendations (May 2010) The Making of Good Supervision: Learning to Say “No“ • Sceptical but proactive: Question also in good times (counter-cyclical) • Comprehensive: Identify emerging risks at the edge of the regulatory scope (unregulated entities, off-balance sheet structures, systemic risk) • Adaptive: Be in constant learning mode (new markets, services, products and risks) - form views on how changes will affect institutions • Conclusive: Follow-up findings (on- and off-site) – take sanctions if not remedied

10. IMF recommendations continued - How • Ability to act • Legal authority, including operational independence • Adequate resources, including skilled staff • Clear strategy regarding the approach to supervision • Robust internal organisation, including well-defined decision making, oversight and accountability • Effective working relationships with other agencies • Will to act • Constant dialogue with industry, including boards • Take action and fulfil the supervisory role

11. Insurance Core Principles – the tools are there • ICP 17 Capital Adequacy: The supervisor establishes capital adequacy requirements for solvency purposes so that insurers can absorb significant unforeseen losses and to provide for degrees of supervisory intervention. • ICP 10 Preventive and Corrective Measures: The supervisor takes preventive and corrective measures that are timely, suitable and necessary to achieve the objectives of insurance supervision. • ICP 11 Enforcement: The supervisor enforces corrective action and, where needed, imposes sanctions based on clear and objective criteria that are publicly disclosed. • ICP 12 Winding-up and Exit from the Market: The legislation defines a range of options for the exit of insurance legal entities from the market. It defines insolvency and establishes the criteria and procedure for dealing with insolvency of insurance legal entities [ ] the legal framework gives priority to the protection of policyholders…..

12. Solvency control levels and other triggers • Regulatory requirements should be at a sufficient level so that insurers’ obligations to policyholders continue to be met as they fall due • Capital resources reduce the probability of insolvency and loss to policyholders - increase capital or reduce risk if not sufficient • Solvency control levels provide triggers for action by insurers and supervisors • Should be at least two control levels: • Prescribed capital level (PCR): above which intervention would be on other grounds than capital adequacy • Minimum capital level (MCR): strongest supervisory action if corrective action is not taken promptly • Should allow for intervention at a sufficiently early stage for a realistic prospect of being rectified in a timely manner • Group solvency levels – PCR and MCR?

13. Early-warning indicators • Capital is not everything – have a range of early-warning indicators, both quantitative and qualitative that should trigger action • Examples of indicators? • How could they be identified?

14. Supervisory monitoring tools • ICP 9 Supervisory review and reporting • ICP 4 Licensing • ICP 6 Changes in control and portfolio transfer • Acquisitions and mergers • Portfolio transfers • ICP 23 Group-wide supervision

15. ICP 10 Preventive and Corrective Measures • Legal and operational capacity to act timely • Decision-making lines of the supervisor should be structured so that action can be taken immediately in the case of an emergency situation • Detect vulnerability in the insurer’s ability to protect policyholders • Prevent a breach of legislation • Deal with non-compliance or where an insurer enters into unsound practices • Require insurer to develop an acceptable plan for prevention and correction of problems • Ensure that the measures are taken

16. Early prevention and detection tools • Activities subject to prior approval • Continual fit and proper requirements • Requirements of sound corporate governance, internal control and risk management • Prospective reporting and analysis • Business plan and strategy for new business • Established contacts with other involved supervisors • Informal contacts with management • Public disclosure/transparency

17. Preventive and corrective supervisory measures • Increased supervisory activity or reporting • Independent review by auditors or actuaries • Correction of reporting errors • Capital and business plan for restoration of capital resources • Measures to reduce risk (eg reinsurance) • Strengthen or replace the insurer’s management and/or risk management framework and governance

18. ICP 11 Enforcement • Formal directions to take (or desist) actions - failure to comply should have serious consequences (combine with fines and punitive actions) • Should at a minimum include • Restrictions on business activities • Measures to reinforce the financial position of the insurer • Consequences when failing to provide information in a timely fashion, withhold information or provide information that is intended to mislead • Should not delay necessary preventive or corrective measures to be taken • Powerful supervisory tools that should be used in a fair and equal manner • Not sufficient to have powers delegated under legislation (powerful tools are only powerful if used) – will to act • Issues related to groups? • Determine that the insurer is complying with the measures once action has been taken or measures have been imposed

19. Enforcement or sanction measures • Restrict business activities • Stop the writing of new business • Withhold approval for new activities or acquisitions • Restrict the transfer of assets • Directions to reinforce financial position • Require capital levels to be increased or measures that reduce or mitigate risks • Restrict disposal of insurer’s assets • Restrict/suspend dividend or other payments to shareholders • Remove directors and managers - bar individuals from acting in responsible capacities in the future • Compulsory portfolio transfer or conservatorship • Revoke the licence – require the company to wind-up • Direct a company to stop unlicensed business

20. Resolution and G-SIIs • Define insolvency and the limit when it is no longer permissible to continue business • Resolution could be used for cross-border groups before that point is reached – should be used for G-SIIs, which need to be resolvable • Orderly resolution requires appropriate actions prior to the non-viability stage – on-going cooperation and information sharing • Normal resolution tools that can be used on all insurers (enough for G-SIIs?): • Portfolio transfer • Run off • Establish resolution authorities and cross-border management groups (CMGs) – top level or resolution powers in more than one part of the group • Appropriate powers to intervene at holding company level • Powers to terminate large volumes of financial contracts – insurance policies? • Ensure continuation of non-insurance operational business that is significant to the systemic function • Temporary public financial support may be needed

21. ICP 12 Winding-up and Exit from the Market • Procedure for dealing with winding-up and insolvency • Appoint administrator or liquidator to take over the roles and duties of board and senior management • Run-off with supervisory involvement • Liquidation in court procedure • Protect the rights and entitlements of policyholders/beneficiaries in the event of insolvency • Protection scheme/guarantee fund • Preferential rights

22. Conclusions • Independence and resources • Comprehensive supervision, including group and macroprudential level • Early identification and intervention • Power and will to actusing adequate tools