Climate change risk and transmission channels
UK’s Insurance Supervisory Body PRA just published a very interesting paper describing it’s purpose and it’s working principles. Even if Bexit will exclude PRA from EIOPA associated supervisory bodies, this paper should be considered as being landmark as most of the EIOPA associated bodies didn’t go this way of transparency and methodology yet, despite EIOPA having set a framework at least for some of these issues, crucial for insurers to manage thair risk and capital requirements.
« We, the Prudential Regulation Authority (PRA), as part of the Bank of England (‘the Bank’), are the UK’s prudential regulator for deposit-takers, insurance companies, and designated investment firms.
This document sets out how we carry out our role in respect of insurers. It is designed to help regulated firms and the market understand how we supervise these institutions, and to aid accountability to the public and Parliament. The document acts as a standing reference that will be revised and reissued in response to significant legislative and other developments which result in changes to our approach.
This document serves three purposes.
- First, it aids accountability by describing what we seek to achieve and how we intend to achieve it.
- Second, it communicates to regulated insurers what we expect of them, and what they can expect from us in the course of supervision.
- Third, it is intended to meet the statutory requirement for us to issue guidance on how we intend to advance our objectives.
It sits alongside our requirements and expectations as published in the PRA Rulebook and our policy publications.
Our approach to advancing these objectives will remain the same as the UK withdraws from the EU. Our main focus is on trying to ensure that the transition to our new relationship with the EU is as smooth and orderly as possible in order to minimise risks to our objectives.
Our approach to advancing our objectives
To advance our objectives, our supervisory approach follows three key principles – it is:
- forward-looking; and
- focused on key risks.
Across all of these principles, we are committed to applying the principle of proportionality in our supervision of firms.
Identifying risks to our objectives
The intensity of our supervisory activity varies across insurers. The level of supervision principally reflects our judgement of an insurer’s potential impact on policyholders and on the stability of the financial system, its proximity to failure (as encapsulated in the Proactive Intervention Framework (PIF), which is described later), its resolvability and our statutory obligations. Other factors that play a part include the type of business carried out by the insurer and the complexity of the insurer’s business and organisation.
Our risk framework
We take a structured approach when forming our judgements. To do this we use a risk assessment framework. The risk assessment framework for insurers is the same as for banks, but is used in a different way, reflecting our additional objective to contribute to securing appropriate policyholder protection, the different risks to which insurers are exposed, and the different way in which insurers fail.
Much of our proposed approach to the supervision of insurers is designed to deliver the supervisory activities which the UK is required to carry out under Solvency II.
The key features of Solvency II are:
- market-consistent valuation of assets and liabilities;
- high quality of capital;
- a forward-looking and risk-based approach to setting capital requirements;
- minimum governance and effective risk management requirements;
- a rigorous approach to group supervision;
- a Ladder of Intervention designed to ensure intervention by us in proportion to the risks that a firm’s financial soundness poses to its policyholders;
- and strong market discipline through firm disclosures.
Some insurers fall outside the scope of the Solvency II Directive (known as non-Directive firms), mainly due to their size. These firms should make themselves familiar with the requirements for non-Directive firms.
This section describes how, in practice, we supervise insurers, including information on our highest decision-making body and our approach to authorising new insurers. As part of this, it describes the Proactive Intervention Framework (PIF) and our high-level approach to using our legal powers. For UK insurers, our assessment covers all entities within the consolidated group.
Proactive Intervention Framework (PIF)
Supervisors consider an insurer’s proximity to failure when drawing up a supervisory plan. Our judgement about proximity to failure is captured in an insurer’s position within the PIF.
Judgements about an insurer’s proximity to failure are derived from those elements of the supervisory assessment framework that reflect the risks faced by an insurer and its ability to manage them, namely, external context, business risk, management and governance, risk management and controls, capital, and liquidity. The PIF is not sensitive to an insurer’s potential impact or resolvability.
The PIF is designed to ensure that we put into effect our aim to identify and respond to emerging risks at an early stage. There are five PIF stages, each denoting a different proximity to failure, and every insurer sits in a particular stage at each point in time. When an insurer moves to a higher PIF stage (ie as we determine the insurer’s viability has deteriorated), supervisors will review their supervisory actions accordingly. Senior management of insurers will be expected to ensure that they take appropriate remedial action to reduce the likelihood of failure and the authorities will ensure appropriate preparedness for resolution. The intensity of supervisory resources will increase if we assess an insurer has moved closer to breaching Threshold Conditions, posing a risk of failure and harm to policyholders.
An insurer’s PIF stage is reviewed at least annually and in response to relevant, material developments. (…) »
If implementation of the forthcoming insurance contracts standard is to reach the best possible outcome for your organization, we believe it needs to be seen as more than just a compliance exercise. This will entail
- combining multiple strands into a common program,
- identifying linkages
- and addressing dependencies
across the business in a logical sequence and thinking strategically about possible effects on the organization and its stakeholders. A well-developed and ‘living’ plan assigns clear accountabilities and breaks down objectives into manageable tasks for delivery to realistic time-scales in order to establish an effective blue-print for success.
Our methodology groups activities into four manageable phases:
- assess the change
- design your response
- implement your design
- sustain your new practices, securely embedding them in business as usual.
Key success factors
Our experience shows us there are many factors that will contribute to successfully implementing insurance accounting change, including:
- Dedicated staff: In our experience the single biggest factor contributing to program success is the presence of full-time staff dedicated to the project, with a wide range of skills including data management, IT implementation and project management and who know your business.
- Spend sufficient time and energy on the initial impact phase: It is essential that an insurer plans for this critical phase and allows for sufficient time to perform a gap analysis on a line-by-line basis through the income statement and balance sheet and supports disclosures.
- Consider fundamental questions surrounding core business drivers: earnings trends, growth opportunities and target operating models. The earlier effects are identified, the more time an insurer will have to develop and implement a strategic response.
- Training staff: Many organizations underestimate the amount of personnel training required. Designing a comprehensive training strategy and program is highly complex and requires careful planning.
- Robust project planning: The plan must be achievable and continuously refined with formal tracking and monitoring.
- Clear communications: Communication needs to be both formal and informal and applied throughout the life of the program.
- Careful change management: IFRS conversion will lead to significant changes in how people do their jobs. Some of the biggest challenges have arisen when the cultural issues have not been acknowledged and addressed.
- More than just an accounting and actuarial project: Implementing the forthcoming insurance contracts project will undoubtedly be a multi-disciplinary effort.
- IT specialists consider the functionality of source systems and enterprise performance management (EPM) systems;
- Change management specialists focus on behavioral change and communication;
- specialists in commercial functions (tax, data management, executive incentives, etc.) bring a holistic approach to the program.
Robust project management helps to bring everything together coherently.
Assessing what the forthcoming standard will mean for you
Accounting, actuarial, tax and reporting
Q1. What are the key accounting, actuarial, tax and disclosure differences between our current generally accepted accounting principles (GAAP) and the new standards? What are the key decisions that need to be made by management regarding the alternative treatments that are available?
Data, systems and processes
Q2. What will the impact be for our data requirements, and on the systems and processes used for
- data collection,
- actuarial projections,
- calculating and accruing interest on the contractual service margin
- and consolidation and financial reporting systems?
Are there quick fixes that we can use? Can we leverage recent investments in infrastructure or will we need a major overhaul?
Q3. How will the group‘s close and other processes be impacted?
Q4. What is the estimated directional impact on profit and equity and what are the key decisions and judgments that this will influence?
Q5. What are the key impacts for my business and how will these be influenced by the choices open to us? Who will need to understand results and metrics on the new basis?
People and change management
Q6. Who will be impacted by the conversion, what skills and resources are likely to be needed and what training needs can we identify?
Q7. What would a high-level conversion plan look like and what is its likely impact on resources?
The International Financial Reporting Standard 17 (IFRS 17) was issued in May 2017 by the International Accounting Standards Board (IASB) and has an effective date of 1st January 2021. The standard represents the most significant change in financial reporting for decades, placing greater demand on legacy accounting and actuarial systems. The regulation is intended to increase transparency and provide greater comparability of profitability across the insurance sector.
IFRS 17 will fundamentally change the face of profit and loss reporting. It will introduce a new set of Key Performance Indicators (KPIs), and change the way that base dividend or gross payments are calculated. To give an example, gross premiums will no longer be recorded under profit and loss. This is just one of the wide-ranging shifts that insurers must take on board in the way they structure their business to achieve the best possible commercial outcomes.
In early 2018 SAS asked 100 executives working in the insurance industry to share their opinions about the standard and strategies for compliance. The research shed light on the sector’s sentiment towards the regulation, challenges and opportunities that IFRS 17 presents, along with the steps organisations are taking to achieve compliance. The aims of the study were to better understand the views of the industry and how insurers are preparing to implement the standard. The objective was to share an unbiased view of the peer group’s analysis of, and approach to, tackling the challenges during the adjustment period. The information garnered is intended to help inform insurers’ decision-making during the early stages of their own projects, helping them arrive at the best-placed strategy for their business.
This report reveals the findings of the survey and provides guidance on how organisations might best achieve compliance. It provides a subjective, datadriven view of IFRS 17 along with valuable market context for insurance professionals who are developing their own strategies for tackling the new standard.
SAS’ research indicates that UK insurers do not underestimate the cost of IFRS 17 or the level of change it will likely introduce. Overall, 97 per cent of survey respondents said that they expected the standard to increase the cost and complexity of operating in insurance.
Companies will need to
- introduce a new system of KPIs
- and make changes in management information reports
to monitor performance under the revised profitability metrics. Forward looking strategic planning will also need to incorporate potential volatility and any ramifications within the insurance industry. To achieve this, firms will need to ensure the main parties involved co-operate and work together in a more integrated way.
The cost of these measures will, of course, differ considerably between organisations of different sizes, specialisms and complexities. However, the cost of compliance also greatly depends on
- the approach taken by decision-makers,
- the partners they choose
- and the solutions they select.
Perhaps more instructive is that 90 per cent believe compliance costs will be greater than those demanded by the Solvency II Directive, aimed at insurers retaining strong financial buffers so they can meet claims from policyholders.
The European Commission estimated that it cost EU insurers between £3 and £4 billion to implement Solvency II, which was designed to standardise what had been a piecemeal approach to insurance regulations across the EU. Almost half (48 per cent) predict that IFRS 17 will cost substantially more.
Respondents are preparing for major alterations to their current accounting and actuarial systems, from minor upgrades all the way to wholesale replacements. Data management systems will be the prime target for review, with 84 per cent of respondents planning to either make additional investment (25 per cent), upgrade (34 per cent), or replace them (25 per cent). Finance, accounting and actuarial systems will also see significant innovation, as 83 per cent and 81 per cent respectively prepare for significant investment.
The use of analytics appears to be the most divisive area for insurers. While 27 per cent of participants are confident they will need to make no changes to their analytics systems or processes, 28 per cent plan to replace them entirely. A majority of 71 per cent still expect to make at least some reform.
Risks originating from the macroeconomic environment remained at a high level in Q4 2017, although most indicators improved slightly comparing with Q3. Positive developments in forecasted real GDP growth and increased expected inflation closer towards the ECB target contributed somewhat to a decrease in risk, as well as a slight reduction in the accommodative stance of monetary policy. Swap rates recently increased but remained low by historical standards. The credit-to-GDP gap was the only indicator to deteriorate since the previous assessment, moving further into negative territory.
Credit risks remain constant at a medium level in Q4 2017. Since the last assessment spreads have decreased across all bond segments, except for unsecured financial corporate bonds. Concerns about potential credit risk mispricing remain.
Market risks were stable at a medium level in Q4 2017. Most market indicators changed only little when compared to the previous risk assessment, except for investments in equity. Volatility of equity prices increased, with a temporary peak in February. A slight decline was reported for the price-to-book value ratio (PBV). In addition, Q4 Solvency II data seems to indicate a slight increase in median exposures to bonds and property and an increase of exposures to equity for insurers in the upper tail of the distribution.
Liquidity and funding risks remained constant at a medium level in Q4 2017, with most indicators pointing to a stable risk exposure.
Profitability and solvency risks remained stable at a medium level in Q4 2017. Annual figures for some profitability indicators show a slight deterioration when compared to annualised Q2 indicators, but are broadly at the same level as in Q4 2016. Solvency ratios remain well above 100% for most insurers in the sample. A slight increase in the quality of own funds has also been observed.
Risks related to interlinkages and imbalances remain stable at a medium level in Q4 2017. Main observed developments relate to a slight decrease in median exposures to domestic sovereign debt and to a mild increase in the share of premiums ceded to reinsurers. Investment exposures to banks, insurers and other financial institutions remained broadly unchanged.
Insurance risks remained stable at a medium level when compared to Q3 2017. The impact of the catastrophic events observed in Q3 on insurers’ technical results still weights on the risk assessment.
Market perceptions remained stable at a medium level since the last assessment. Positive developments related to the performance of insurers’ stock prices relative to the overall market and a decrease in the upper tail of the distribution of price-to-earnings ratios contributed to decreased risk, but this was partially compensated by a deterioration of some insurers’ external rating outlooks. Other indicators, such as insurers’ CDS spreads and external ratings remained largely unchanged.
Risks originating from the macroeconomic environment remained stable and high. Improvements have been observed across most indicators, but were not sufficient to change the overall risk picture. The improving prospects for economic growth still contrast with the persistence of structural imbalances, such as fiscal deficit. The accommodative stance of monetary policy has been reduced only very gradually, with low interest rates continuing to put a strain on the insurance sector.
Credit risks remained constant at a medium level whereas observed spreads continued to decline. The average rating of investments has seen some marginal improvements. Concerns on the pricing of the risk premia remain.
Market risks remained stable at a medium level despite a reduction of the volatility on prices was observed. Only price to book value of European stocks moved in the direction of risk increase.
Liquidity and funding risks were constant at a medium level in 2017 Q3 and remained a minor issue for insurers. Catastrophe bond issuance significantly decreased when compared to the record high registered during the previous quarter. The low volume of issued bonds made the indicator less relevant.
Profitability and solvency risks remained stable at a medium level. A deterioration of the net combined ratio was observed in the tail (90 percentile) of the distribution mainly populated by reinsurers in this quarter. SCR ratios have improved across all types of insurers mainly due to an increase of the Eligible Own Funds. This has been especially marked for life solo companies.
Interlinkages & imbalances: Risks in this category remained constant at a medium level. Investment exposures to banks and other insurers increased slightly from the previous quarter.
Insurance risks increased when compared to 2017 Q2 and are now at a medium level. This was essentially driven by the significant increase in the catastrophe loss ratio resulting from the impact of the catastrophic events observed in Q3 mainly on reinsurers’ technical results. This is also reflected in the loss ratio. Other indicators in this risk category still point to a stable risk exposure.
Market perceptions remained constant, with the improvement in external rating outlooks outweighing the observed increase in price to earnings ratios. Insurance stocks slightly outperformed the market, especially for life insurance, and CDS spreads reduced.