Regulation | On the road to Basel III

Insurance companies watching from the sidelines as banks wrestle with the complexities of the controversial Basel II capital Accord may catch a glimpse of their own future. Financial regulators are already discussing how to apply common risk-based rules to non-bank financial institutions, and they are targeting the insurance sector first.

Supervisors at the UK’s Financial Services Authority (FSA), the country’s principal financial watchdog, are looking to harmonise the regulation of all financial institutions – banks, investment firms and insurance companies – under a single, risk-sensitive regime based on the principles adopted in the Basel II banking Accord, says Paul Sharma, the FSA’s head of operational, insurance and group risk. Some in the financial services industry have already dubbed the process “the road to Basel III”.

Two main forces are at work: the FSA’s desire to modernise insurance sector regulation, and the growth over the past few years of large financial conglomerates that provide a range of banking, investment and insurance services. Recent UK insurance industry scandals – the collapse in 2001 amid suspicions of fraud of the non-life group Independent Insurance and the troubles that engulfed mutual life assurer Equitable Life after it fell foul of legal risk – have given urgency to the task. The regulation of insurance companies now lags far behind that of banks, says Sharma.

The aim of the new approach is to accurately measure the assets and liabilities of insurance companies as they actually are, and to move away from the concept of ‘implicit prudence’ that characterises traditional methods of regulation.

It would be difficult for the FSA to pursue its aims unilaterally. Sharma says internationally over the past few months there has been a shift in regulatory opinion towards the FSA’s view, although there is still a fair amount of opposition.

The European Commission, the ruling body of the European Union, has already taken an important step by developing common accounting principles for insurance contracts under the aegis of the International Accounting Standards Board, the privately funded London-based body set-up to devise global accounting rules.¹

Regulation of insurance companies currently comes in two primary frameworks: the risk-based capital approach used in the US, Canada, Japan and Australia, for instance, and the index-based insolvency regime used in the European Union and elsewhere. Both approaches, despite the epithet ‘risk-based’ associated with the US approach, are traditional in form, says Sharma.

But the problem with traditional approaches to insurance regulation is that they generally involve crude and unscientific overestimations of liabilities and undervaluations of assets, he says. That may sound like a prudential thing to do, rough and ready though it may be, and it is one reason why some supervisors treat arguments for change with caution. However, Sharma says traditional rules create a false sense of security. Insurers assume bad news can be absorbed easily by the inherent prudence of the rules but, too late, learn otherwise.

Equitable, for instance, had liabilities of around £1.5 billion ($2.2 billion) after losing a legal case. Some 1 million people face less-than-planned-for retirement incomes as a result.

The collapse of Independent, now under investigation by the UK Serious Fraud Office, meant hundreds of firms and local authorities had to scramble for accident cover at soaring premiums with other companies.

An aspect common to several insurance failures around the world, including Independent’s demise and Equitable’s problems, was the existence of financial reinsurance treaties of doubtful value with unregulated insurers. The conclusion is that, paradoxically for an industry that 250 years ago pioneered the mathematical analysis of risk, risk management within insurance companies must be brought into line with best practice elsewhere in the financial services industry. Insurance industry accounting practices, which differ widely around the globe and are sometimes quaintly archaic, must also be reformed and unified, says Sharma.

In the UK, FSA managing director John Tiner is leading a team reviewing insurance regulation, and expects to issue an interim report in September.

FSA chairman Howard Davies told insurance and risk managers at the annual Association of Insurance and Risk Managers’ lecture in January that the insurance industry needed to increase its capital base, and reiterated the FSA’s intention of bringing the industry under a Basel II-like regime.

Such a regime would be more forward-looking and, as with the bankers’ Basel II, insurance firms would make their own specific assessment of the overall level of financial resources they need to meet their liabilities, Davies said. There would be regular stress and scenario testing. He added that the FSA would envisage setting capital requirements for higher risk firms, and would provide a consistent set of guidance on systems and controls.

Davies noted that there are currently 39 general insurers in formal insolvency in the UK, most having failed in the 1990s, with gross liabilities of £12.5 billion, far outweighing the cost of all bank failures in the UK in the past decade. “Insurance companies must play catch-up in terms of Basel II,” says Sharma, “but in the longer term, regulation of both sectors will need to change if harmonisation is to be achieved.



“In some respects, insurance regulatory reform may even leap-frog Basel II by, for example, placing greater emphasis on newer techniques such as fair-value accounting and internal capital models. It will then be the bankers’ turn to play catch-up.” Insurance regulatory reform may prompt further banking reform.

Traditional formula-based capital rules will increasingly become obsolete as firms develop their own internal capital models rather than select from a list of regulator-approved models as proposed under Basel II, says Sharma.

The Basel II bank capital adequacy Accord will determine from 2005 how much of their assets major banks must set aside as protective capital to guard against banking hazards, including credit and market risk as well as operational risk.

Basel II’s aim is to improve the safety of the world’s banking system by aligning regulatory capital – the capital charges required by banking supervisors – with economic capital, the capital that banks set aside on the basis of their own assessment of the risks they face. That’s in contrast to the one-size-fits-all minimum 8% capital-to-asset ratio regime of the current Basel I Accord. Basel I, which dates back to 1988, has nevertheless made the world’s banking system a lot safer, say regulators.

Under Basel II, Banks with sophisticated computerised internal models for measuring and managing their business risks won’t have to set aside as much protective capital proportionately as those using simpler methods.

The Basel II Accord, designed by the Basel Committee on Banking Supervision, has three interdependent pillars. Capital charges will be required under pillar 1. Under pillar 2, regulators will monitor banks to ensure their risk management practices are rigorous. Pillar 3 exerts market discipline on banks by requiring them to publish more information about their risk management practices.

Risk-based regulation should only underpin what smart firms are doing anyway by developing integrated enterprise-wide risk management based on statistical analysis of all the risks businesses face, says Sharma.

But the road to Basel II is not smooth. The Accord’s complexity has already delayed its coming into a force by a year to 2005, and many bankers think it won’t come into effect before 2006.

But how will a set of risk-based rules designed for banks be applied in practice to insurance companies? Sharma says the difference between banks and insurance companies is not fundamental from a regulation viewpoint. “There is more in common between the two than is generally given credit – a difference in language often disguises the common factors,” he says.

The greatest hazard faced by most commercial banks is generally credit risk – the risk of loss arising from the default or failure of a borrowing customer. And the largest risk facing both non-life and life insurance companies is of miscalculating their so-called technical provisions – the amount of premium and investment income needed to cover future payouts. As a recent joint study by international financial regulators of the prospects for harmonised regulation points out, technical provisions represent funds the insurers expect to pay out to claimants rather than funds reserved against future losses.²

For the non-life insurer, although technical provisions also form the main category of liabilities, they represent a lower proportion of liabilities than they do for a life company. Capital makes up between one-fifth and two-fifths of liabilities for a non-life company compared with only a few percent for a life assurer.

But both life and non-life companies, like banks, also face credit, market, interest and operational risks, for example, against which protective capital can be set aside. Credit risk lies in the large bond portfolios held by insurers and in their reinsurance deals. Market risk arises from their extensive investment of premiums in equity markets. Interest rate risk for life assurers arises from any product with guaranteed interest rates of the sort that first gave rise to Equitable’s problems. Equitable’s plight and Independent’s collapse also illustrate the nature of operational risks faced by the insurance industry.

Sharma says the three-pillar structure of Basel II-type regulation could easily be adapted to regulate insurance companies. The FSA is considering whether to require pillar 1 capital charges from insurers against credit, market and operational risks arrived at through internal modelling, he says.

Tough regulator supervision under pillar 2 would help ensure the rigorousness of risk management and modelling by the companies. The management of some risks, like interest rate risk for banks under Basel II, could be monitored under pillar 2 and capital charges required if necessary. Improved modelling of technical provisions could be regulated under pillar 2.

Pillar 3 would require, as with banks, greater public disclosure of the insurance industry risk management principles. However, the insurance industry has no global body of regulators with the clout of the Basel Committee, which largely comprises senior banking supervisors from the Group of 10 leading economies. Basel I has been adopted in more than 100 countries, and some 30,000 banks around the world could eventually come under a Basel II regime.

The International Association of Insurance Supervisors brings regulators together for discussions on topics of mutual interest, but doesn’t legislate for the international insurance industry. Nevertheless, there’s a gathering momentum for changing the way insurance companies are regulated, and Basel II points the way.


¹Draft Statement of Principles: Insurance Contracts, by the International Accounting Standards Board and available on the board’s website (www.iasc.org.uk)
²Risk Management Practices and Regulatory Capital – Cross-Sectoral Comparison, by the Joint Forum of the Basel Committee on Banking Supervision (www.bis.org), the International Organisation of Securities Commissions (www.iosco.org) and the International Association of Insurance Supervisors (www.iaisweb.org)