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    The Energize Insurance in India Essay

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    For Immediate Release India Insurance Industry Essay Writing Competition Winner Announced Ms Megha Asnani, Business Analyst with Accenture Service Private Limited was declared winner of the 2nd India Insurance Industry Essay Writing Competition organised by Asia Insurance Review in conjunction with the India Rendezvous. Ms Asnani’s essay on the topic: ‘An Indian Solvency II’stood out for its originality and in-depth analysis of the subject. Ms. Asnani will receive a cash prize of S$5,OOO and she will also make a presentation of the winning essay at the 5th India Rendezvous in Mumbai on 20th

    January 2012. The “Energise Insurance in India” essay competition drew entries from some of the best insurance writers in India and was Judged by a distinguished panel of top industry professionals and chaired by Mr Yogesh Lohiya, Chairman and Managing Director of GIC Re. Others in the Judging panel included: Mr Jan Mumenthaler, Head- Insurance Services Group, Business Risk Department, IFC; Ms Joan Fitzpatrick, CEO, ANZIIF; Mr Michael J Morrissey, President & CEO, I’S; Mr Dezider Stefunko, Chief, Insurance Unit, UNCTAD; Mr Jawaharlal Upamaka, Editor, IRDA Journal; Mr A K Roy,

    General Manager, GIC Re; Mr K Raghunath, Vice President, Reinsurance, Bharti AXA General Insurance Co; and Mr G V Rao, Chairman & CEO, GVR Risk Management Associates. More details at wrww. asiainsurancereview. com For enquiries, please contact: Asia Insurance Review Ms Ann Tay, DID +65 6224 5583 or email: [email protected] com OR Mr Jimmy John, DID +91 98302 46752 or email: [email protected] com An Indian Solvency II? Word count : 4552 Megha Asnani Business Analyst Accenture Service Pvt. Ltd. Pune megha. [email protected] om megha. [email protected] com Years in Insurance – 4. Years Pagel of 18 Insurance is the business of selling commitments of transfer of risk to the policy hold ers. Thus financial health of an insurerl is of utmost importance if it were to honor its commit ments to policy holders in form of insurance policies or treaties. However, no catastrophe is in control of any insurer thus it becomes important for the risk carriers2 to keep their claim payin g capacity at much higher levels than its liability, at any point of time.

    A solvency for an insurer corresponds to its claim paying ability. An insurer is insolvent if its assets are not adequate over indebtedness) or cannot be disposed off in time (illiquidity) to pay the claim. The solvency of an insurance company (financial strength) depends mainly on whether sufficient technical reserves have been set up for the obligations entered into and wh ether the company has adequate capital as security.

    It can be described by the following formu la: Solvency = Ability to pay the claims of policyholders = (Policyholders assets – Policyholders liabilities) In 1970s the life insurers of Europe were required to maintain the size of their assets more than the size of their liabilities by a margin. This margin was known as Solvency Marg in. This margin takes care of unanticipated claims that have potential to make an insurer insolvent thereby creating an awkward situation for the insurance company, regulator as well as the government. The solvency margin is thus aimed at preventing such a crisis.

    Nowaday s solvency margins have become norm in Insurance Industry globally. Indian Solvency Norms In 1994, the Union Ministry of Finance constituted an expert group to formulate solvency margin requirements for Indian insurance companies. The regulations of many countries before framing the current regulations. As per the IRD A (Assets, Liabilities, and Solvency Margin of Insurers) Rules 2000, both life and general insurance Insurer here refers to Direct Insurers and Reinsurers operating in life and non- life domains Insurers or Reinsurers 2 Page 2 of 18 companies need to maintain solvency margins.

    India’s solvency regulation is a hybrid of the I-JK and Canadian norms. The regulation follows the UK model while the regulator’s admi nistrative fiat to maintain a 50% extra margin is taken from Canada. This 50% extra capital cush ion is to make sure that a breach is never reached by insurers or has a very low probability. It also nsures that a fraudulent insurer is caught much earlier. According to IRDA (Assets, L ‘abilities and Solvency Margin of Insurers) Regulations, 2000, all insurance companies are required to maintain the solvency ratio of 150% at all times.

    It also mandates all insurers to file the Statement of Solvency Margin (General Insurers) as on March 31 every year. But post relaxation of controls on the tariffs for the general insurance industry, there was a need to moni tor the solvency position of all insurers at shorter intervals. The regulator mandated all insurance companies to file their solvency position as at the end of each quarter. It was expecte d that the stipulation would enable insurance companies to lay down their business plans and be in a position to meet their capital requirements in a timely manner.

    Challenges/ issues in the present solvency norms in India Solvency is a part of prudential norms and as risks increase across markets, the solve ncy margin also needs to go up tangentially. In order to satisfy the solvency margin requirements, companies have to systematically build up reserves by transferring a part of the surplus to a special reserve called “Solvency Margin Reserve. ” However, transferring the surplus w ll result in a reduction in bonus rates declared and make insurance unattractive vis- a-vis other financial instruments.

    Therefore, only a part of the amount needed to meet solvency margin requirements can come from the surplus held back. The balance requirement has to be met by other sources for capital, which include: Share capital Free reserves in the shareholders’fund Difference between the market value and book value of assets Page 3 of 18 This coupled with the FDI restrictions in private insurers and mandatory majority gov ernment shareholding in public insurers constrains capital raising and poses significant challenges for nsurers to maintain 150% solvency margins in a fast growing industry scenario.

    What is Solvency II’solvency II is an European Union (ELI) legislative programme to be implemented in all 27 Member States, including the I-JK. It introduces a new, harmonized EIJ-wide insurance regulatory regime. The legislation replaces 13 existing EIJ insurance directives. The o bJectives of implementing Solvency II are: Improved consumer protection: It will ensure a uniform and enhanced level of policyholder protection across the ELI. A more robust system will give policyholders greater confidence in the products of (Re)insurers.

    Modernised supervision: The “Supervisory Review Process” will shift supervisors’ focu from compliance monitoring and capital to evaluating (Re)insurers’ risk profiles and t he quality of their risk management and governance systems. Deepened EU market integration: Through the harmonization of supervisory regimes. Solvency II framework has three main pillars Pillar 1 framework sets out Qualitative and Quantitative Requirements such as the a mount of capital alan (Re)insurer should hold/ capital requirements, calculation of Technical provision and investment rules.

    Technical provisions comprise two components: the best estim te of the liabilities (i. e. the central actuarial estimate) plus a risk margin. Technical provisions are intended to represent the current amount the (re)insurance company would have to pay for an immediate transfer of its obligations toa third party. Page 4 of 18 Pillar 1 broadly sets Two thresholds: (1) Solvency Capital Requirement (SCR) – The SCR is the capital required to ensure that the (re)insurance company will be able to meet its obligations over the next 12 months with a probability of at least 99. 5%.

    SCR is calculated using either a standard formula given by the regulators or and nternal model developed by (re)insurance company with regulatory approval. (2) Minimum Capital Requirement (MCR) – In addition to the SCR capital, a Minimum Capital Requirement (MCR) must be calculated which represents the threshold below which the National Supervisor (regulator) would intervene. The MCR is intended to correspond t o an 85% probability of adequacy over a one year period and it cannot fall below 25%, or exceed 45% (Re) insurers SCR For supervisory purposes, the SCR and MCR can be regarded as “soft” and “hard” floors respectively.

    That is, a regulatory ladder of intervention applies once the capital holdi g of the (re)insurance undertaking falls below the SCR, with the intervention becoming progressively more intense as the capital holding approaches the MCR. The Solvency II Directive provides regional supervisors with a number of discretions to address breaches of the MCR, in cluding the withdrawal of authorization from selling new business and the winding up of the co mpany. Pillar 2 emphasizes on Governance & Supervision majorly focusing on Effective Risk Management Systems, Own Risk & Solvency Assessments (ORSA) and Supervisory Rev iew and Intervention.

    Pillar 3 focuses on disclosure and transparency requirements. Under this pillar the in surers are required to publish details of their exposure to various risks, risk management activities and capital adequacy. Transparency and open information are intended to assist market forces in imposing greater discipline on the industry. Page 5 of 18 Theories Against Implementation of Solvency II Solvency II is modeled on the Basel II Prudential rule for banking sector – now incorporated into capital requirement directive. However in spite of Basel II financial crisis could not be predicted or controlled and Basel II itself is undergoing revision.

    This raises questions on the e fectiveness of Solvency II which is inspired by Basel II. Solvency II and Basel II appears to distort the competition between large insurance companies who see a huge reduction in their capital requirements compared to small and medium sized companies. Life insurance comp antes gain in capital saving due lower risk linked to life insurance companies resulting from poli cyholder’s participation in future profits. This is an improper estimate of risk exposure, as the co mpanies can share the profits with the policy holders however they would never be able to share the losses with policyholder.

    However the capital equirement significantly increases for Non-Life insurance companies, unlike the case of life insurance sector. This implies that a Non-life company of Small-medium size would have increased capital requirement compared to large and life insurance companies. This fund could be better used in product development or reducing the premium rate. The Pillar 1 of Solvency II in base on calculating capital r equirement based on Value at Risk (VAR)3 method over 1 year period is a complex method with t heoretical shortcoming with unclear outcomes.

    This estimate ignores the duration of policy periods of shorter than a year or longer than a year. Solvency II standard formula prohibitively overestimate the requirement for long terms risk. The formula also takes in account a II balance sheet risks. Thus the insurers who today match their long- term liabilities with long-term assets would be at disadvantage forcing them to cut down on long terms risk business. This behavior would have direct negative impact on third party liability business, which has significant contribution in growth of Insurance business in European markets.

    Asset valuation rule associated with capital requirement would penalize companies who have made huge 3 Value-at- Risk (VaR) is a commonly used measure in financial services to assess the risk associa ted with a portfolio of assets and liabilities. VaR answers the question how much money would be lost, if Risk (VaR) measures the worst expected loss under normal conditions over a specific time interval at a given confidence level. Page 6 of 18 investments in Shares or real estate.

    Such companies would either tend to withdraw their investments from share/ real estate further reducing the liquidity in capital markets or retaining the investments and increase premiums to compensate for higher capital charges for these investments. It also involves handing over of sensitive and confidential company dat a to team of actuaries and IT professional. Increased capital requirement, restructuring of organization and huge investments in IT for risk modeling, governance, data management and risk management would put pressure on bottom line forcing insurer to increase the prem ium rates.

    The increase in premium rates could result in shrinking of Top-line/ demand. Compliance to Solvency II is a costly and time consuming affair. Perceived Benefits of Implementing Solvency II Benefits expected out of implementing Solvency II in spirit with which it was onceptualized, can result in greater transparency into their capital holdings and risk exposure, insurers will offer better sightlines into their operations for both investors and customers. Solvency II also provides an opportunity for a positive business transformation.

    As ins urers take steps to better manage their capital, theyll generate more operational data, which in turn will enable more informed and improved decisions. A study conducted by SunGard’s found that “more progressive organizations, typically large companies with more than E25 billion in assets, see Solvency II as a real opportunity to create business advantage. They are likely to commit management resources to understanding the scope of the work involved and are gearing up their people and processes accordingly. Solvency II is an incentive for both insurers and reinsurers to adopt a risk- based management approach that is based on properly measuring and managing their risks. Solvency II would break the departmental silos as it would require Senior executives, risk, actuarial and IT de partments would require to work together to develop the reporting practices, management reports and other internal MIS necessary for building a risk aware corporate environment thereby providing Page 7 of 18 ctive on other business opportunities that the company should be exploring.

    As they optimize their governance structure and enhance their reporting standards with statuary reports and public disclosure, the business as a whole will benefit. By implement new risk management processes and systems, insurers will improve their ability to track and report their exposure to r isk. Asa result, they will be in a much stronger position as they plan for business developmen t, manage their liquidity and risk appetite to optimize their return on capital reserves.

    To summarize, Solvency II promises to bring greater transparency to insurance ompany operations along with more and better information for improved operations and competitive advantage. By addressing the wider ERM issues raised by Solvency II, companies can minimize operational risk, potentially minimize the IT cost base, implement enhanced processes that create a more flexible organization and so potentially lower their capital requirements.

    Companies who imbibe the principles and purpose of solvency II would also get competitive advantage apart from maintaining good financial health of the organization. Challenges to implementing Solvency II norm Data Collection for timely risk assessments Collation of accounting, risk and actuarial information Systems process and data need to be streamlined Solvency II directives shall affect monocline insurers and benefit the large diversified groups as they would avail the benefits of diversification credits. This can discourage the specialist insurers such as Health insurers.

    Page 8 of 18 Challenges before IRDA and an ‘Indian Solvency II’ Initiative The IRDA was founded, “to protect the interests of the policyholders, to regulate, pro connected therewith or incidental thereto. ” Since opening up of Insurance Industry IRDA continues to refine t e Indian regulatory environment and address India- specific problems and purposes like 0 Increase insurance penetration Extend the insurance services to rural areas of country Improve financial literacy Create conducive environment to attract more new players in market.

    Regulations for curbing malpractices and set up systems and process to protect inter est of policy holders. Ensure overall growth of the sector by following ‘Inclusion Philosophy. Today, there are 2 dozen general insurance companies and an equal number of life i nsurance companies operating in India, and the insurance sector is a ignificant piece of the Indian economy, growing at a rate of 15 to 20 percent annually. Most companies are Joint ventures with foreign partners thus close attention is being paid to how Solvency II will play ou t in this marketplace.

    The European Union’s Solvency II regulations promise to be a huge catalyst for change within the insurance industry. Though it is not expected that IRDA would exactly replicate the model of Solvency II in India however it can learn many new and better ways to regulate the sector. Solvency II has had its own share of appreciation and criticism, and considering both, IRDA can formulate norms and guidelines or systematic and exponential growth of the industry adopting some of the guidelines relevant to Indian Insurance industry from Solvency II.

    IRDA has initiated some action on these lines. The recent guidelines issued by IRDA to Indian insurers broadly suggest alignment with the Solvency II regime that in Page 9 of 18 Beginning with the initial IRDA Regulation in 2000, IRDA has issued ongoing updates and guidelines both for company activities within India as well as for compliance with Inte rnational Financial Reporting Standards (IFRS).

    Some of the key areas touched upon by IRDA in an ndeavor to prepare Indian Insurance sector for an Indian Solvency II regime are: Capital Management The IRDA Regulation 2000 – a set of regulations for valuation of assets, liabilities and solvency margin and the minimum capital requirement for setting up of insurance companies, ensure s that the capital with each insurer is large enough to withstand any eventuality. At present, the Indian insurance industry follows a simple formulaic approach and is related to the total amount of business that an insurer transacts.

    The minimum solvency capital that insurers are required to hold is 150% of Required Solvency Margin (RSM) calculated a per the guidelines. No ratios have been prescribed for assets, and the solvency margin is sim ilar to EIJ Solvency l. Recently, IRDA has asked the companies to calculate economic capita14 and submit their calculations along with the Appointed Actuaries’ Annual Report beginning with their actuarial valuation.

    IRDA has published a report on calculation of economic capital as a reference for Indian insurers. Insurers are required to conduct a calculation of economic capital an d submit a report every year starting from 31st March 2010. The EC calculation recognizes the capital requirement for specific risks a non- ife insurance company is exposed to, as opposed to a formula approach based on simple proportion of premium or claims.

    The EC is calculated as the sum of EC for: Underwriting Risk, Market Risk and Other Risk. 4 Typically, Economic Capital is calculated by determining the amount of capital that th e insurer needs to ensure that its realistic balance sheet stays solvent over a certain time period with a pre- specified probability. E. g. The EC may be determined as the minimum amount of capital required to make 99. 5% certai n that the insurer remains solvent over the next twelve months Page 10 of 18

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