Risk-based Supervision

1. Risk-based Supervision Dave Finnis, IAIS Including Off-site analysis and On-site inspection San Jose 6 September 2011

2. Risk-based Supervision Dave Finnis, IAIS Basic supervisory tools – Australia as an example The Australian Prudential Regulation Authority San Jose 6 September 2011

3. 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 uncertainfuture 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) Risk based supervision

4. Example: APRA’s powers and responsibilities under the Insurance Act 1973 Risk based supervision 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

5. Example: Legislative framework for General Insurance Risk based supervision

6. Example: Put the experts in place - Appointment of actuary and auditor Risk based supervision 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.

7. Role of a supervisor – Australian view The role of a supervisor Supervision vs. regulation Risk vs. compliance focus Supervisory activities - Group review Onsite reviews Offsite reviews Financial analysis Regulatory approvals and interpretations Risk based supervision

8. Industry trends Risk based supervision Solvency coverage ratio for the GI industry as at 30 June 2010

9. Modules & Topics 9 Risk based supervision

10. Modules & Topics Risk based supervision 10

11. Supervision Process • Risk Assessment • PAIRS Update • Supervision Strategy • Supervisory Action Plans • Supervision Activities • Prudential consultation • Prudential reviews • Offsite analysis • Targeted reviews • Ad hoc meetings 11 Risk based supervision

12. Prudential Reviews of Insurers 12 Risk based supervision • Prudential reviews of insurers is a cornerstone of APRA’s assessment • APRA reviews and assesses: • Reinsurance • Pricing • Underwriting • Claims • Independent review • Liability valuation • Product design • IT and business continuity management • Operational risk • Investment risk

13. 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 Risk based supervision

14. 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 Risk based supervision

15. Traditional supervisory considerations Dave Finnis, IAIS Entity-specific, and Group-wide issues San Jose 6 September 2011

16. Risk Based Supervision • Genesis and Background • Traditional/Historical Model: • Entity-based • 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 Risk based supervision

17. Risk Based SupervisionTraditional/Historical Model (A Canadian Viewpoint) • CARAMELS • Capital • Asset quality • Reinsurance • Actuarial liabilities • Management • Liquidity • Subsidiaries Risk based supervision

18. Risk Based SupervisionTraditional/Historical Model • CARAMELS • Key benefit – identification of institutions that require special supervisory attention • Not forward looking – ratings derived from on-site 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 Risk based supervision

19. 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.” Risk based supervision

20. What risks are insurers exposed to? Market Risk Credit Risk Concentration Risk Asset Valuation Risk Claims Risk Pricing Risk Underwriting Risk Concentration Risk Reserving Risk Catastrophe Risk Reinsurance Risk Cost of capital Mismatch Risk (ALM) Solvency Margin Risk Accounting Risk Technology Risk Communication Risk Business disruption Fraud Legal Risk Regulatory Risk Reputation Risk Strategy Risk Other business Risk Environmental Risk Financing Risk Capital access Risk Mismatch Risk (Cash Flow) Surrender Risk based supervision

21. 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 Risk based supervision

22. 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 Risk based supervision

23. 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 Risk based supervision

24. 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. Risk based supervision

25. 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 Risk based supervision

26. Rationale for group-wide supervision Risk based supervision

27. 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: • 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. Risk based supervision

28. Key issue – what is an “insurance group” for the purpose of group-wide supervision? Non-operating Holding Company (NOHC) 1 1. Supervisors must set the perimeter of group-wide supervision in cooperation with other supervisors Intermediate NOHC 2 Insurer 1 Bank 1 Insurer 2 Securities Firm 1 Non-regulated Operating Entity (NROE) 1 2. The minimum types of “relevant entities” that should be included Insurer 3 NROE 2 NROE 3 Insurer 4 SPE 1 3. Minimum elements with respect to insurance activities to consider when setting the scope • Participation, influence • Interconnectedness • Risk exposure • Risk concentration • Risk transfer • Intra-group transactions Risk based supervision

29. Key Features of treatment of non-regulated entities in group-wide supervision Risk based supervision

30. 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) • “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) G20 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) Risk based supervision

31. Macroprudential Supervision Dave Finnis, IAIS An additional dimension San Jose 6 September 2011

32. “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 Risk based supervision

33. Contagion in banking and insurance Systemic risk is endemic – also in insurance Risk based supervision

34. 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) Risk based supervision

35. Macro- and microprudential approaches Source: Claudio Borio, 2003 “Towards a Macroprudential framework for financial stability” (BIS WP 128). Risk based supervision

36. 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. Risk based supervision

37. Workplan for the Macroprudential Policy and Surveillance Working Group (MPSWG) Risk based supervision

38. Considerable systemic risk Systemic risk Potential systemic risk Example: Increased systemic risk in the EU Source: ECB Risk based supervision

39. 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 Risk based supervision

40. Risk-based Supervision Dave Finnis, IAIS Questions? San Jose 7 September 2011