MAPFRE
Madrid 2,484 EUR 0,01 (0,49 %)
Madrid 2,484 EUR 0,01 (0,49 %)

INSURANCE| 03.13.2024

How are regulatory systems for insurance companies changing?

Thumbnail user
A report released by MAPFRE Economics analyzes how financial regulation and solvency systems developed for the insurance industry are advancing towards risk-based systems. These systems make the capital requirements for insurance companies more proportional, and they provide incentives by creating comparative advantages for companies with good risk management.

All sectors of the economy are subject to public regulation to some degree, as a way of ensuring their proper functioning and protecting the public interest. The finance sector, and the insurance industry as a part of it, is subject to the highest levels of regulation because of its economic impact and the nature of its business. It’s also subject to prudential supervision, or in other words, an approach designed to ensure ongoing solvency even when difficulties arise.

The crisis that threatened some banks in the United States last year after the collapse of Silicon Valley Bank, or the problems that led to the disappearance of Credit Suisse in Europe, are good examples of these difficult situations, and they highlight the importance of imposing regulations and implementing risk management mechanisms. At the same time, the way in which those difficulties were addressed last year has demonstrated that there’s been significant progress made since the financial crisis of 2008, in terms of the response measures developed and how quickly they can be applied.

New regulations, better adapted to specific risks

As explained by Manuel Aguilera, General Manager at MAPFRE Economics, “in recent years, we’ve seen an emerging trend in the way financial systems are being regulated at the global level, with a move towards risk-based systems. These systems measure risks in a more sophisticated way, which in turn makes it possible to optimize the requirements imposed upon companies.”

Among other distinctive aspects, risk-based systems are characterized by the number of risk factors they can take into account, and by their ability to apply more complex scenario simulation techniques for calculating specific capital requirements. In some cases, those calculations can even be performed using the companies’ internal models.

This makes it possible to relax some of the rules on launching new products, for example (such as the conditions required for their structures or even their prices). This is having a positive effect on innovation and on competition in the market, while still giving the supervisor control over reviewing those products. Another new development is that these regulations no longer include a specific list of assets that insurance companies are allowed to invest in. Instead, companies have more freedom to select their preferred investments, with their solvency requirements then adjusted based upon the choices they make.

“Risk-based regulation systems allow for better proportionality with each company’s specific circumstances, and this creates competitive advantages for companies that can adequately manage the risks associated with their underwriting and their investment portfolios,” the General Manager at MAPFRE Economics pointed out.

The paradigm in the insurance industry is Solvency II, which is the European Union’s Directive that has been in force since 2016. An updating of that legislation is now pending, and a review has already received approval from European authorities. “Solvency II provides a better assessment of each company’s risk profile, which makes it possible to optimize the capital risk weights. It also encourages insurance companies to use those resources to increase their operating capacities, which in turn allows them to invest in long-term projects,” he added.

An international comparison

The report from MAPFRE Economics also provides an analysis of the regulatory systems applied in various international markets, and the degree to which those systems are advancing towards pure-risk models such as Solvency II. That analysis has been performed by classifying the elements of those systems into three groups:

  • A: Elements closest to a form of prudential regulation that’s less sensitive to each insurer’s specific risk profile.
  • B: Transitional elements, which introduce more complexity and represent a shift towards risk-based capital models.
  • C: Elements associated with the most sophisticated risk-based capital solvency systems, such as internal risk modeling, considering dependencies between risks, and stress testing.

Based on this analysis, MAPFRE Economics also creates a composite indicator, which scores the level of risk-based regulation on a scale of 0 to 10.

European Union

In this comparison, the European Union shows the most progress towards a pure-risk model with Solvency II, receiving a score of 9.2, and with most of its elements classified as type C. Although the United Kingdom has been working on its own solvency system since leaving the EU, the one currently applied there is very similar to the European Union’s and has received the same score.

United States

In the USA, there is no standardized system of solvency regulation, since regulatory authority is a decentralized matter governed by each of the country’s states. However, its National Association of Insurance Commissioners (NAIC) has developed some standards, which have been adopted by most of those states without substantial modifications.

The NAIC model has received a score of 5.9, with its elements being classified into all three groups.

Latin America

In Latin America, there’s major disparity in terms of the transition towards risk-based models. The most advanced situation can be found in Mexico, which received a score of 8.5 from the MAPFRE Economics indicator, with the majority of its regulatory elements being classified in group C. Brazil and Puerto Rico also have regulations showing significant progress in this area, both receiving scores of 5.9.

On the other hand, the Dominican Republic and Venezuela received scores of 3.0, with all of their elements classified as group A. 

Asia-Pacific

In the Asia-Pacific region, some markets are more mature and have legislation that is bringing them closer to a pure-risk system, such as Australia and Japan, which received scores of 7.8 and 5.5, respectively. The Philippines also has a more advanced regulation system, with a score of 5.1, while Indonesia (4.0), and especially Turkey (3.4), still have systems that are largely characterized by basic-risk type rules.

A system with advantages, but with some conditions too

The MAPFRE Economics report explains that in order for a risk-based regulatory system to achieve the desired effects, there are some institutional and market-related conditions that must first be met. At the institutional level, it’s of vital importance to have a supervisory framework and supervisory authority that are both well established and effective.

 

In terms of the market, there must be a certain level of maturity to ensure that there is enough statistical data available for modeling risks, along with well-trained professionals with sufficient capabilities in this area. Good governance at insurance companies is also essential, along with competitive conditions such as unrestricted pricing, and suitable mechanisms for disclosing information to the market.

“For example, small countries may not be able to meet all of these conditions, and making progress towards risk-based regulations can present certain difficulties, and even produce undesired effects,” Mr. Aguilera explained.

RELATED ARTICLES: