Global capital standard raises calibration and consistency questions

International efforts to develop a global capital standard are gathering pace, but the plans are controversial, raising fears that the competitiveness of international insurance groups could be damaged. There are also questions over how any global standard could be calibrated and applied. Louie Woodall reports

Plans to enhance the supervision of internationally active insurance groups (IAIGs) have taken a disturbing turn of late. The International Association of Insurance Supervisors (IAIS) originally embarked on this project in the interests of fostering supervisory convergence and closing regulatory gaps. But over time it has morphed into something that closely resembles a whole new layer of regulation for IAIGs, much to the alarm of national supervisors, think-tanks, and the internationally active insurers themselves.

Earlier this year, whispers from Basel, the headquarters of the IAIS, hinted that the common framework (ComFrame), as the project is known, may enclose a new global capital standard for IAIGs, whipping industry participants into a frenzy of speculation. At Insurance Europe’s annual conference in June, one supervisor warned that such a standard would not be the “silver bullet” that killed systemic risk in the insurance industry, and should not be seen as such by regulators.  

But this summer, a global capital standard came one step closer to reality. On July 18, tucked away in its policy measures for global systemically important insurers (G-Siis), the IAIS wrote: “[We] will prepare by October 2013 a work plan to develop a comprehensive, group-wide supervisory and regulatory framework for IAIGs, including a quantitative capital standard”. In that one sentence, ComFrame switched from being a principles-based toolkit for insurance supervisors into a potentially burdensome new layer of regulation for internationally active firms.  

While the rumours had been doing the rounds for months, there was no official tip-off from the IAIS that this change was taking place. “Up until [the G-Sii] release by the IAIS, ComFrame did not have a quantifiable global capital standard embedded in it,” says John Fitzpatrick, Geneva-based general secretary of insurance industry think-tank the Geneva Association.

One possible reason for the IAIS’s silence is that it is no longer the organisation calling the shots in the field of global insurance regulation. Fitzpatrick suggests that pressure from the Financial Stability Board (FSB), the international coordinating body for financial regulators, may have forced the IAIS’s hand. “The FSB starts from a position that what is good for the banks is good for the insurers. It seems clear that the FSB does not understand why the banks have a global capital standard [in the form of] Basel I, II, III, and insurers do not,” he argues.

This sentiment is shared by some national regulators as well. They see ComFrame as a game of tug-of-war between the IAIS and the FSB – a game the latter is winning. While the IAIS’s instincts may be to retain ComFrame as a high-level framework to aid supervisors and foster regulatory convergence, the FSB has a grander goal in mind: namely, bringing insurance supervision in line with that for banks.

Thomas Leonardi, Connecticut’s state insurance commissioner, says: “My concern is that the IAIS is pandering to what the FSB wants and is resetting its direction based on the FSB, as opposed to what the IAIS feels is appropriate [for insurers]”. The danger is that by kowtowing to the wishes of the FSB, the IAIS risks being made to look weak and irrelevant.

But, Leonardi adds, the situation might be more complicated than it appears from the outside. In fact, the IAIS may have effectively been coerced by the FSB into developing this quantitative capital standard (QCS). “The suggestion I have heard is that if the IAIS doesn’t do it the FSB will go and do it,” he says.

The commissioner makes no bones about the fact that this would be a disaster for the insurance industry. “The FSB does not have the insurance expertise or the credibility of an international insurance standard-setter. For the FSB or anyone else to try and step in to develop a capital standard for insurers is disingenuous,” he argues.

Unanswered questions
Whatever the truth of the situation, the IAIS now has a race on to develop the QCS in time to be implemented as part of ComFrame in 2018. But just what form will this new standard take? Nothing on this scale has been attempted before for insurers, and there are several big questions the IAIS will have to answer before firms and supervisors can get on board with the plans.

The first concerns the actual calibration of the standard. IAIGs by nature operate across multiple jurisdictions, with each operating company conforming to different regulatory standards as determined by each host regulator.

It seems the calibration is up in air for now. “We do not know what it will look like: how risk-based it will be, whether it will be outcomes based, if it will allow for some degree of internal models, or whether it will be based on a common valuation,” says Leonardi.

What is suspected is that the QCS will act as a definitive backstop capital level to the patchwork of requirements international firms have to adhere to at present. In order to do this, the calibration needs to be sensitive to these regional differences, but at the same time simple to calculate.

It’s a tall order, admits Stephen Zielezienski, Washington-based head of the Global Federation of Insurance Associations’ (GFIA) ComFrame working group and senior vice-president of the American Insurance Association. “It’s a real balance that needs to be struck. If we start viewing ComFrame as a series of additional requirements for insurance groups, simply because they happen to be internationally active, then in a perverse way you are thwarting the ability of those groups to compete on a level playing field with insurance groups that may write the same line of business but don’t operate in a global environment,” he says.

“If, on the other hand, the development of the quantitative standard is not so focused on trying to achieve a separate metric, but instead is flexible enough to be adapted by each different supervisor according to their own national standard, [then] that’s the only way it works.”

Some have suggested that if the standard was based on well-defined stress tests, consistently applied to IAIGs and used on firms’ existing balance sheets, then it could gain traction within the industry.

“The use of stress tests as a supervisory tool is well accepted and, as a first step towards any longer-term objective, comparable stress tests can probably be done quickly and efficiently,” says Tom Wilson, chief risk officer at Allianz in Munich.

However, such an approach isn’t without complications of its own. Stress tests are by nature subjective tools, their calibrations determined by risk assumptions that may not capture each and every eventuality. In addition, they can only provide a snapshot of a company’s capital strength at a specific time, so naturally they reflect the current risk environment rather than accounting for future developments.  

Nico Esterhuizen, Johannesburg-based manager at the South African Insurance Association (SAIA), fears stress tests are too inflexible to work as the basis for a global capital standard. “It would have to be something that is frequently updated because of the changing environment in different jurisdictions. If you do use that method I think it will probably require an annual or biannual review, depending on the criteria you are stress-testing.”

He adds that the sheer number of factors that could be incorporated in a stress test is a problem. Depending on which ones are selected, the capital numbers could vary drastically between firms, reflecting their different exposures.

Accounting challenges
This links in with the second question the IAIS needs to address: how can it ensure the standard is applied fairly across different IAIGs, with different business profiles, operating in different jurisdictions?

The lack of an internationally accepted accounting standard is a particularly thorny problem in this context. While there are efforts by both the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) to harmonise the array of systems used around the world, these remain works in progress and cannot hope to be adopted by firms before ComFrame’s 2018 implementation date.

The only way a global capital standard has a chance of being adopted by regulators is if it uses existing accounting standards as a base, argues the GFIA’s Zielezienski. “If you’re able to develop a quantitative standard that can be applied in the US according to US GAAP and statutory accounting principles, in Japan according to Japanese GAAP, in Europe according to Solvency II and in Switzerland according to the SST, then I think there’s hope,” he says.

This need not prove an insurmountable challenge either, suggests Kerry Reinke, vice-president, enterprise risk management at Manulife Financial in Toronto. He says a common capital standard could be arrived at through standardised adjustments to insurers’ balance sheets.

“The differences between the various accounting standards are fairly well known, and when you zero in on them, the QCS probably can be done in terms of saying here’s a number of adjustments we want to make to various balance sheets. While the specifics are currently being discussed with regulators, certain items may be added to an IFRS balance sheet, and/or subtracted from a US GAAP balance sheet, to get to a common solvency measurement,” says Reinke.

But making the range of accounting standards comparable will not guarantee the QCS is uniformly applied. That depends on each national regulator choosing to adopt it in the form the IAIS intends, says Zielezienski.

“One of the problems is that even if you are able to develop a global group capital standard, there is no way you’re going to be able to ensure that different regulators in different countries are not going to apply their own regulatory philosophies in enforcing that standard in their own jurisdiction,” he says.

Supervisors might be encouraged to adopt an international standard, though, if it conforms with, rather than conflicts with, their domestic regimes. In South Africa, for example, supervisors are hard at work updating their regulatory framework as part of the Solvency Assessment and Management (Sam) programme. The domestic industry’s European links also means they have one eye on winning Solvency II equivalence status as part of the revamp. What they do not want is ComFrame to swoop in and undermine the system they have spent years setting up.

Ian Marshall, the Financial Services Board’s head of Sam, based in Pretoria says: “I think it is important to, as far as possible, get alignment. There was a consultation last year on ComFrame, and it is expected there will be another version of the document that will go out for a further consultation soon. If you look at the concepts included in there, what I’ve heard is they are very closely aligned with the ICPs [Insurance Core Principles, developed by consensus within the IAIS], which have also been a key input into the Sam framework.

“One key question is on the level of detail and flexibility in ComFrame. That will have a big impact in terms of how easy it would be to for Sam to align with the ComFrame regime.”
Marshall admits, though, that supervisors’ consideration for the IAIS’s projects has its limits. Inevitably they will look to their own interests first.

“Everything is working to a different timeline. It is not our intention to wait and delay our development of Sam until there is certainty on all other developments.

“Theoretically, we could wait until the IAIS has finalised ComFrame and for the IASB to finalise its view on the valuation of insurance contracts before developing Sam. However, we have already made good progress with the Sam project, so it is important to keep up this momentum rather than stopping now and waiting for all international developments to be finalised,” he adds.
 
Manulife’s Reinke thinks ComFrame will be a mixed blessing for firms. “Thinking about the objectives of ComFrame, and Osfi’s [the Office of the Superintendent of Financial Institutions, Canada’s financial regulator] supervisory approach, I think Manulife’s position would largely be that they are more or less aligned. That said, when there’s a new layer of regulation there is always going to be an increased cost and complexity.”

Cost burden
It is inevitable that the introduction of the QCS will cost firms one way or another. IAIGs’ primary concern is that being burdened with additional capital requirements could skew the market against them. The SAIA’s Esterhuizen remarks: “You can put groups at a disadvantage because spare capital won’t go back to shareholders in the form of dividends and can’t be used to expand the business. Instead it is used to create additional loss-absorbing capacity.”

The IAIS, Esterhuizen adds, also needs to provide clarity on which entities within an IAIG have to hold the capital requirement. “These groups are much larger than most and contain a range of insurance and non-insurance companies, so is every single entity in the group going to carry a portion of the cost?” he asks.

It is expected though that the QCS will be considerably less onerous than those in force at the domestic level. The requirement is meant to serve as a sensible backstop for international groups rather than an add-on charge, helping to alert supervisors of potential capital shortfalls before policyholders are put at risk.

However, to some insurers it does seem the IAIS is developing tunnel vision when it comes to regulation. To the association capital is king, but firms are conscious that when it comes to risk management, it is but one aspect of the overall framework.

“Thinking about what is the best way to address systemic risk, my answer would be that there is no one best way,” Reinke says. “I absolutely agree with the statement that the foundational component has to be a very strong risk culture that is capable of identifying issues on both the downside and the upside. Capital is certainly one of those tools, [but] I’m not sure I would necessarily say it’s the best tool,” he adds.

But if the amount of capital required of IAIGs is not onerous, the cumulative effect of a new capital framework certainly will be.

Allianz’s Wilson believes the introduction of a new capital standard, whatever form it takes, will require firms to adopt a new reporting framework too. This would be particularly unwelcome news to the largest firms, which might also qualify for enhanced supervision as G-Siis or domestic systemically important insurers (D-Siis).

The accretion of regulatory layers on the largest firms is a particular concern of the GFIA.  The IAIS is running multiple work streams at the moment – some focused on the regulation of G-Siis, some on ComFrame, and others rumoured to be looking at D-Siis. With all this activity under way, the GFIA can be forgiven for wanting to apply the brakes.

“There is a danger that all the regulations will just pile on top of one another, and if you’re a large insurance group that does business in more than one country, there’s great danger that regulatory accumulation results in an inability to compete with domestic groups that may not be subject to the same types of prudential oversight,” says Zielezienski.

Unfortunately for the GFIA, few answers can be gleaned from the IAIS on how it will coordinate these various projects. A spokesperson says the relationship between the loss-absorbency capital requirement for G-Siis and QCS for IAIGs is still under discussion, but does not rule out the possibility that they could be combined at some point in the future.

Commissioner Leonardi thinks this outcome is likely: “I do think the [G-Sii] backstop could be used as a basis [for the QCS], but I think it’s very much in the early stages right now.” He also cites the “aggressive” timeframe for implementation of the QCS as a good reason for the IAIS to go down this route. Otherwise, the association would have less than five years to develop three separate capital standards: the QCS, G-Sii loss absorbency and G-Sii higher loss absorbency.

Whatever route to a QCS the IAIS chooses, it will be hard pressed to finalise the calibrations in time for ComFrame’s launch in 2018. The association noted in July that it had already begun work on the loss-absorbency requirement for G-Siis, but remained silent on whether similar efforts were under way for the QCS. All that is known for certain is the IAIS will unveil its plans in October, including details on how the QCS will coordinate with ComFrame and G-Sii measures.

Until then, the true nature of the new global capital standard remains a mystery. Few doubt, however, that this will remain a harmless pipe dream, confined to the imaginations of international standard-setters.

“My opinion is that we will continue to move into the direction of a global capital framework as long as the political will is there, and that we will get a better idea of how this new standard will work when ComFrame undergoes field testing in 2014,” Marshall says.

With the FSB snapping at the IAIS’s heels, it is unlikely that the QCS will be frozen in committee. A group-wide, globally applicable capital framework will soon be part of insurers’ reality.