The PRA and Insurer Business Model Analysis - emerging risks into capital add-ons?

A rather revealing "topical article" was pushed out by our pals at the PRA this week, mouthwateringly titled "The role of business model analysis in the supervision of insurers".

I obviously threw my Woman's Weekly professional reading materials to one side in order to see how much juice there was in this particular fruit, and it is certainly worth a glance for anyone in the risk management game, if only for the idiot's guide to Life and General insurer business models it provides!

Ironically, in the Life Insurer case (where they have chosen 'non-standard annuities' as a paradigm-changing product offering), they weren't able to forecast yesterday's scuppering of the UK annuities market in its entirety in their business model analysis!

It actually reads as quite a good case study in how we should be conducting emerging risk assessment against one's prevailing strategy, walking through specific changes in the operating environments of Life and General Insurers driven by both exogenous and endogenous factors.

With the price comparison website example, it is a good example of how a strategic risk filters down into second order risks which require reconsideration. The annuity example shows how the impact of competitors can impact both existing new business streams and the risk profile of one's existing book.

There is evidently an enormous emphasis being paid in the regulator's BMA activity to those grim business school concepts no doubt already permeating your emerging risk assessment processes such as SWOT and PESTLE analysis, as well as what (in future) will be supplied under Solvency II, most notably Profit and Loss Attributions and ORSA supervisory reports. I'm sure we will see over the next couple of years how the PRA's demand for these very sensitive in-house outputs materialises into supervisory action!

What perhaps Risk and Capital Management functions should be particularly cautious of is the leitmotif of the PRA "responding pre-emptively" where they feel that profits are not aligned with the risks insurance firms are taking. The following quote is of particular concern, as I can't see how this and the ORSA supervisory report aren't sharing the same womb (my emphasis)!;

"...the results of a BMA exercise help to inform the PRA's expectations of a firm's financial and non-financial resources. For example, the PRA might raise capital requirements, or require a firm to improve its governance process, to address weaknesses identified by BMA"

Bearing in mind we are months away from the first glut of ORSA material being delivered to Moorgate's finest, is the industry about to fertilise an expensive new world of capital add-ons via supplementary business model disclosure?

I appreciate that it has been emphasised by the PRA (p8) that ORSAs, and their supervisory reports, simply cannot be used to set regulatory capital, but in the context of what is being stated by the BMA team here, would they really be ignored?

UK's "new" Prudential Regulatory Authority - Approach to Insurance Supervision

So a magical thing happened over the weekend: a venerable institution disappeared on Friday, only to come back reborn on Monday...

...that's right, the FSA is no more, being replaced by two more focused entities in the Prudential Regulatory Authority (PRA) and Financial Conduct Authority (FSA). This is part of the UK-specific fallout from the financial crisis, where a perceived lack of focus from the former tripartite system which housed the FSA allowed for both systemic risk (Northern Rock, RBS) and conduct risks (PPI, Interest Rate swaps) to emerge largely unchecked.

Rather excitingly, this means a new website with some natty logos from the Bank of England (which

PRA - emperor's new clothes
or Solvency II aperatif?

has rehoused the PRA side of the FSA), as well as a statement on the new supervisory approach that the PRA will be taking.

For anyone in the ERM/Solvency II/Corporate Governance space, this gives us a chance to pick up on the kind of regulatory interrogation one might expect when writing/upgrading system of governance-related materials in preparation for both full Solvency II implementation in 20??, as well as how they are accommodating EIOPA's interim measures from 2014.

Remembering that the PRA's two statutory objectives are to promote safety and soundness of the firms it regulates, as well as specifically providing appropriate protection to insurance policyholders, I thought it wise to make some notes on how they have catered for Solvency II and deference (when due) to EIOPA, as well as the general content around expectations of governance systems. I found the following worthy of note;

Control function-specific

Section 82 - "[PRA] wants to be satisfies in particular that designated risk management and control functions carry real weight within insurers"

Section 117 - Should have separate risk management and individual control functions in place (dependent on nature scale and complexity etc)

Section 118 - the PRA "expects these functions to be independent of an insurer's revenue generating functions"

Section 120 - expectation of an "operationally independent Actuarial function", which the PRA consider to be "integral to the effective implementation of a firm's risk management framework"

Section 182 - "Actuaries can play an important part in supporting prudential supervision"

Section 119 - an effective Risk function on the other hand merely "ensures that material risk issues receive sufficient attention from the insurer's senior management and Board" - just because I'm paranoid, doesn't mean the Risk profession isn't being made something of a gooseberry here, particularly as the FSA/Actuarial profession love-in started some time ago!

On Risk Appetite

Section 110 - a firm's risk appetite "[is] to be integral to its strategy, and the foundation of its risk management framework"

Remuneration

Section 84 - "remuneration and incentive schemes should reward careful and prudent management" - just like Prudential's and Standard Life's did this week!

Section 194 - Hint at potentially restricting pay in firms if intervention is warranted

Stress/Reverse Stress Testing

Section 109 - the AMSB must have "...an explicit understanding of the circumstances in which their firm might fail"

Section 145 - with regards to Reverse Stress Testing, "...management should consider the reliability of the output of the internal model compared with the results of these tests"

Section 106 - "competent, and where appropriate, independent control functions" should oversee risk management and internal control frameworks

Internal Models

Section 116 - On Internal Models, the AMSB should understand;

• extent of reliance on models for managing risk;
• limitations of their structure and complexity;
• Data used;
• key underpinning assumptions

Section 140 - "PRA expects internal models to be appropriately prudent"

Section 144 - firms may not choose the lowest capital requirement to determine whether or not to model internally

Regulatory Capital

Section 135 - for capital adequacy, firms "...should not rely on regulatory minima", and also "...should not rely on aggressive interpretations of actuarial or accounting standards"

Proportionality

Sections 212-215 - touches on treatment of "low impact" firms - is this effectively where aggressive approaches to proportionality interpretation should be expected (combined control functions, limited documentation, passive acceptance of Standard Formula etc)?

p43 - table covering the allocation of supervisory staff - 10 staff to 1 firm for the 25 largest insurers, versus approaching 10 firms to 1 supervisor at the small end.

Solvency II-specific references

• In the PRA's view "[Solvency II technical detail should] leave scope for supervisors of individual insurers to make informed judgements around risks posed"
• Confirms that elements of the Directive such as Prudent Person Principle, ORSA, Control Function requirements and Pillar 1 are all aligned with the new Threshold Conditions
• Model approval will be dependent on "adequate" risk identification, measurement, management, monitoring and reporting throughout the modelling process
• Will impose capital add-ons when necessary "to ensure insurers meet the required standards"

EIOPA's Montalvo on the Solvency II impasse - "more complex than it was originally foreseen"

EIOPA published a transcript of Carlos Montalvo, their Executive Director, speaking with Risk Universe magazine about the current state of play in the Solvency II/Omnibus II world. Always nice to hear from the horse's mouth, and he had a fair amount to say (with not all of it regurgitation!);

• "The objective of Solvency II is not to reduce risks, but to allow companies to properly understand, price and manage the risks they face" - we frequently hear from the EU institutions on what the 'objective' of Solvency is, so I might do a clean-up post on this, particularly as the scare stories on the impact of the LTG assessment outcome on granny and grandad's pensions are increasing the prominence of the topic (the Advisory world being a prime example). 
• "Solvency II is more complex than it was originally foreseen" - early contender for understatement of the year...
• Credible timeline is "a must have".
• Insurers should "make sure that Boards of firms keep considering Solvency II a priority" - after  4 years of phoney war, easier said than done Señor!
• EIOPA's interim measures "...an excellent way for all parties to use the extra time of the delay as a way to be better prepared for implementation".
• Internal Models are "a fundamental management toolkit" - quite the opposite take of the wonderful blog post from one of Willis's finest last week, writing that actuarial models "take combinations of assumptions and torture them to come to conclusions"!
• "The ORSA Process must be owned by the company" - without any useful elaboration on what 'ownership' entails and how it should be documented from a system of governance perspective. I would add that the questioner's view that firms are still "struggling" with ORSA feels a touch dated, otherwise what has industry been spending its money on for the last 3 years

The standout comment on p4, for all the wrong reasons, is around the potential use of ORSA supervisory reports for the calculation of capital add-ons, stating "...if we would do so, it would be a one and done exercise". Can't work out if this is a misquote, mistranslation, or if I need a trip to the optician, but if there is any threat of ORSAs being used by national supervisors for this purpose, a direct, plain-English statement to that effect would be appreciated by all.

Listed Insurers and capital adequacy - Generali

Onto the home straight with these now, as most of the UK Tier 1's and the larger mainland European have already presented their preliminaries for 2011, but Generali kindly pushed their disclosures out yesterday, which made for interesting reading on the capital adequacy/transition to Solvency II front. I had blogged last summer that these guys may be stretching it on the capital front on the basis of some numbers touted by the FT, so I have been looking forward to these!

In the main report, they draw out the following;

• Solvency I coverage down to 117% at 2011 year end (from 132% at end 2010) - similar to Aviva, they throw together a pro-forma estimate for end-February to show that the year-end number was something of an "exceptional volatility" fluke, and suggest it is back around 130% again (p76).

In their analyst presentation, they are a lot more forthcoming on both regulatory and economic capital, and cover the following;

• "Restoring capital adequacy" slide on p5 shows the need for the pro-forma capital recovery mentioned above.
• Same slide shows economic capital was as low as 124% before the post-year end recovery (not disastrous bearing in mind they are calibrated to 1 year VaR at 99.95%, the same as Aviva and Zurich, and the same ballpark as Old Mutual).
• Analysis of change in the Solvency 1 Margin (p33) shows how both the ratio and the amount have been decimated y-o-y - relatily small dividend element, so that should be safe I guess.
• Economic Capital ratio change (p35) sees them also reference a more generous area of the PDF in order to give context to the level of coverage (only 124% covered at year end using AA rating as the calibration, but 159% covered using BBB rating). I'm guessing things look rosier at 99.5% for everyone else as well though fellas!
• A slide covering the Solvency I change between 2010 year end and the improved pro-forma number at the end of February 2012. They gain €1.1bn from "Italian anti-crisis legislation", which I'm guessing is bond-related, and amplifies why the economic issues in that area of the Eurozone have to be catered for.
• Some stress tests on the Solvency I ratio on p74 - useful for consideration

You might also get some use out of their EEV report if you are knee deep in sensitivity/scenario testing, and they go to the trouble of defining some of the terminologies we know and love in their methodology section (particularly nice effort on internal capital on p30)