Solvency II – Lessons for MENA Markets
The insurance sector is a core pillar of the global financial system covering a wide span of the economy from savings, investment and risk protection. The insurance industry differs from other industries by having the technical feature to buy and manage risk through variable maturities. Simply said, the core business model is built on pricing based on probability of risk being incurred; sharing part of the risk with (re)insurers, and then serving the customers through proper claim management practices when the risk is incurred.
Due to the important role in the economy, the insurance market is among the most heavily regulated sectors.
The insurance regulator or the supervisory authority intervenes in the insurance process for two fundamental roles: reduce the risk of insolvency of insurance companies, and protect policyholders’ rights.
Insurance companies' financial health and long term sustainability is assessed by their capital adequacy - as an ultimate residual buffer reflecting the company's asset liability management practice and ability to meet claims. They should therefore have sufficient capital to sustain their risk retention and maintain enough liquidity to match their liabilities towards policyholders. The approach for assessing risk capital is nevertheless rapidly changing given the macroeconomic, financial/market, and regulatory changes in both mature and developing markets.
Traditional capital requirements of insurance companies, known as Solvency I within the European Union’s single market, were originally "static" and calculated simply as a function of gross written premiums or claims incurred.
Solvency I did not develop to cope with the changes in the economy and rising of new risks. The 2007-2008 financial crises showed the weaknesses of the existing regulations due to its insensitivity to risks and to the absence of scientific risk management and economic transparency.
This was an opportunity for regulators to continue and speed their already started discussions on economic solvency principles.
Solvency II introduces market-consistent valuation of assets and liabilities, enhanced quality of capital, risk-based capital requirements, improved governance and risk management, a rough approach to group supervision, and strengthened market discipline through firm disclosures. Solvency II focuses on the risk profile of each insurance company in order to promote comparability, transparency and competitiveness.
The main purpose of solvency II is to assess the minimum amount of capital that insurance companies must hold to reduce the risk of insolvency and promote confidence in the financial stability of the insurance sector.
A capital falling below the minimum required level generates an early warning to supervisors to interfere.
The major benefits of Solvency II are enhancing risk and capital management, which in return can decrease operational costs, strengthen product offerings, and provide support for more optimal management decisions such as planning and strategy. The valuation of economic capital plays an important role in assessing credit ratings; therefore, using Solvency II capital model increases faith in a company’s creditworthiness and helps reduce the cost of raising capital.
Now, looking closer in our regional markets – the Middle East – the insurance sector is considered to be in its niche stages with low penetration and density compared to mature markets. Products and distribution channels are classical, and driven by the local cultural and economic aspects in the region. Some challenges that the insurance sector faces include high level of competition, political instability, un-optimal investment levels, operational challenges, increasing reinsurance prices and low credit environment.
A huge gap exists between the various regulations across the MENA region
Most of insurance players and regulators in the Middle East have adopted simple capital regimes and risk management practices, mainly, similar to Europe’s solvency I,
where the regulatory capital requirement is calculated as a percentage of premiums and reserves. Only few countries, such as UAE, have implemented a risk sensitive model for the calculation of the minimum required capital. Other countries such as Lebanon and Oman have flat solvency requirements, while Yemen has none. Most of the GCC countries are still in the early stages of regulatory development. The same applies to the North African market, where countries are pushing for improved regulations. Qatar and Morocco are already adopting new prudential guidelines similar to international regulations. In addition, other measures are also being adopted such as board members accountability and asset-liability management processes. Saudi Arabia has implemented as well a similar approach of a modified EU solvency formula. In 2015, the UAE insurance authority introduced several actions such as risk management, improved financial reporting standards and a modified solvency model.
Lack of risk based capital requirements does not allow accurate risk assessment and timely intervention by regulators, and does not help to allocate capital optimally.
In addition, the current regulations allow companies to freely state their risk appetite that is defined by common practices or shareholder preferences rather than a logical and analytical process.
The existing regime focuses on the financial risks rather than risk management. Therefore, there is a consensus for the need of more risk based capital regimes and, in several countries, the possibility of adopting regulations similar to solvency II is being discussed. However, any new regulatory regime has to be easily understandable and adaptable to the local market. Europe for instance faced similar difficulties in implementing Solvency II in spite of more harmonized cross borders laws and capital markets within EU. This is driven by local sensitivities to equity markets, credit spread, and internal company operational assumptions.
A first step towards change is to understand the need to create a new corporate culture that recognizes the importance of identifying and managing risks. This helped launch new employment roles for all risk and capital management decisions such as chief risk officer in parallel with detailed procedures or risk reporting.
Companies should put in place proper procedures to incorporate risk management in the decision making process. Measures taken in this respect can go from setting risk management processes for key risks, such as underwriting market and operational, to having a specialized team supervising the implementation of the new regulation.
Establishing a new regulatory regime in the region is challenging due to inadequate resources, low level of capitalism, lack of historical data, and poor insurance awareness in addition to political, economic and social problems.
Insurance regulators in the region are recommended to use a risk-based capital as a steering tool for insurance companies, and as an approach to protect the insurance sector from risks
(i.e. political, investment diversification, reinsurance optimization, credit, etc.). The use of a customized capital model can therefore be more efficient than the EU solvency model. All solvency calculations might serve the ultimate purpose of helping management to direct the company and take economic decisions reflecting the underlying risks. As such, management should use the Solvency tools not as a regulatory requirement to satisfy the regulators, but as a regular internal tool embedded in the daily processes of the company's risk management framework and as a business enabler rather than a control function.
Responsible risk management departments can powerfully also disclose very transparently the underlying assumptions, deviations compared to previous period and to budget, and the key rationale behind each risk factor. Furthermore, a common community between insurance players and regulators will be established to implement a customized risk based capital model that is light in terms of complexity and solid in terms of covering the local market exposure, being in line with Global solvency II regulations.
Middle East regulators are invited to cooperate together to share best practice lessons learned, and facilitate a smooth transition into a customized risk based framework that is part of the daily processes of insurance companies.
As a concluding note, the main challenge for the MENA region will be to find the right balance between extending insurance coverages while maintaining a financially stable insurer/reinsurer at an acceptable compliance cost. Encouraging transparency and openness is also another concern. As such,
the future performance of Middle East insurance industry strongly depends on the success of the future reform measures.
A stable and reliable regulatory framework is therefore essential for the business activities of insurers and for sustainable results in the insurance markets. The ambition is to have a healthy Middle East insurance sector that protects and meets the expectations of policyholders, shareholders, distribution partners, and governments.