Address by Director of Insurance Supervision, Sylvia Cronin, at DIMA Conference on 14 May 2015

‘The Changing landscape in Global Regulation’

Introduction

Good morning ladies and gentlemen. I would like to thank DIMA for the opportunity to share my thoughts with you today on the changing landscape in global regulation. The financial turmoil of recent years and the resultant cost imposed on societies has rightly resulted in unprecedented and on-going change in the financial services area. Within the insurance sector specifically, we have the: 

• Imminent implementation of Solvency II.
• Evolution of Conduct regulation and the EU Consumer Package.
• The development of Global Capital Standards.
• The designation of some (re)insurers as systemically important, to name but a few.

Given the work required to develop and implement all of the above, you can be forgiven for feeling overwhelmed. However, it is important to recognise that the cost of failure can and does result in unacceptable financial hardship for households. It is incumbent upon industry and regulator alike to ensure that new regulations are carefully designed and implemented so as to address the underlying weaknesses in the financial system.  We need to prevent the accumulation of unmanageable risk, I will outline the new regulatory initiatives with you this morning. We need to explore how we can collaborate more effectively to protect consumers and safeguard financial stability.

Solvency II

January 1st 2016 will see the introduction of a new capital standard across the EU with the introduction of solvency II. The new capital standard is economic and risk-sensitive in nature. It is designed to ensure that the regulatory capital requirement is commensurate with the underlying risk you are taking in your business. Solvency II also sets out clear standards and expectations around your internal control and risk management. All of this represents a very positive step forward for insurance supervision across the EU. However, in many respects, I sometimes feel that the hard work relating to the new directive is only the beginning.

As we move from the design to the implementation phase of Solvency II, there are a number of challenges that need to be overcome in order for the insurance directive to deliver on its promise. We will need:

• A harmonised and consistent implementation of the directive by National Supervisory Authorities (NSAs). On the one hand, it’s necessary for the regime to have regard to the nuances of each local market, but equally, we must work together towards implementation in a way that prevents regulatory arbitrage across jurisdictions. The risk of a fragmented or uneven application of the new standards is very much on the radar of EIOPA, but there is scope for subjective judgment within the new regime. It will take a number of iterations to achieve the required level of consistency across Europe.
• We expect to see an increase in cross-border activity as firms seek capital synergies. This will present challenges for me and my fellow regulators across Europe where an increasing percentage of the business in our jurisdiction may or not be within our prudential remit. A necessary minimum step to safeguard against any unintended consequences of this shift will be enhanced cooperation and information exchange between regulatory authorities to increase awareness of the emerging trends and developments in the various markets. While there has been significant progress in this area in recent years, the challenges for individual NSAs and EIOPA in this regard are not insignificant.
• The third dimension that I highlight is for firms to wholeheartedly embrace the Pillar II aspects of Solvency II. In particular, you need your firm to recognise that the ‘Own Risk and Solvency Assessment’ (ORSA) is at the heart of Solvency II and is a critical component to the success of Solvency II. Your Board must use the ORSA to more fully align business strategy and capital planning.  You also need to use it as a lever to discharge your core responsibility not to take on risks and exposures which the capital base does not support. In doing so, you can embed greater risk awareness throughout the organisation and foster the development of a strong risk culture. My team in the Insurance directorate recently conducted a review of the ORSAs submitted to the Central Bank   - I note that there is a lot of work yet to do by firms to get this element of the new regime embedded to the extent that we require. 
• There is a significant increase in the data reporting requirements for firms. The Central Banks conversations with Industry and Industry surveys show this as a key risk for companies. We have found that some firms have faced significant challenges in the external user testing for the preparatory phase. I urge you to pay particular attention to your readiness in this area. 

It is important to remind ourselves of the compelling reasons that led to the Solvency II project and the need for reform of the existing regulatory framework for insurance.

• Solvency II differentiates solvency charges based on the inherent risk of different lines of business. 
• Solvency II takes account of asset risks in an insurance company. 
• Better governance and risk management is encouraged.  
• Enhanced disclosure of the health of insurance companies is provided. 

While there are challenges in Solvency II, the benefits of moving ahead far outweigh the costs and risks of retaining the existing EU framework and the development of a myriad of competing national regimes.

Having spoken about some of the challenges we face as we move into the implementation phase of Solvency II, I now turn my attention to the area of conduct supervision and consumer protection.

Consumer Protection

In turning to the conduct agenda, it is worth remembering that the basic tenet of the insurance business model is the provision of a product or service that meets a genuine consumer need at a fair and reasonable price through the pooling of similar risks. In running your business, you must ensure that you have sufficient capital to meet the commitments made to your customers. You must also ensure that customers receive the information they need regarding the suitability of the product, the costs and risks of the product, that customers are treated fairly, and that they get value for money. All of this is well known to you already. As a result of the financial crisis, regulators and financial market players have been mainly focused on ensuring financial market stability. In the meantime and also prompted by the crisis, there is a clear need for fundamental change in the behaviour of financial services providers towards consumers.

A multitude of factors can give rise to poor consumer outcomes: many of the products are complex and hard for a consumer to fully understand; many are long-term in nature and judging fairness for a consumer can be difficult; consumer understanding can be poor; there can be substantial consumer inertia; consumers have behavioural biases; some markets are not sufficiently competitive; and the list goes on and on. These are the reasons why a regulator is needed to act on behalf of consumers and investors to ensure that the financial services market operates fairly and, by so doing, redress the balance that is otherwise biased against the consumer.

The media is full of mis-selling cases that have occurred in the financial services sector in recent years. You need to examine whether changes are needed to the way you operate in your business. Do you ensure that you put the consumer and the integrity of the market at the heart of your business models and strategies? This includes making strategic cultural changes which promote good conduct, establishing oversight around the design and innovation of products and services, and ensuring that you are transparent in your dealings with consumers. I believe that much greater emphasis is needed on clearly articulating your vision and values to drive a cultural shift within your firm.

How should conduct risk be managed?

Let me take a moment to outline my expectations of insurers in this area.

Fair treatment of customers is not, in my view, something that can be reduced to a risk to be managed – that way leads conduct to be treated as a compliance question with ever-expanding armies of compliance personnel checking that a process has been followed – in other words a tick-box compliance exercise.  We expect insurers to build or reinforce a culture of good conduct, and to enhance product oversight and governance.

Development of a conduct culture

You need to pro-actively align your strategy with good consumer outcomes, and sustainable profit. To best achieve this you should seek to build a culture, from the top, that delivers this strategy, tackling potential structures that reinforce negative behaviours such as incentive structures. 

Our expectations in this regard are and must be high –We are not expecting the board to approve every product, as that is both unrealistic and confuses the role with that of executive management. However, I do think that boards should understand how and where the firm makes money, what the conduct implications of that are and how customer outcomes are tracked across the product life-cycle. You must be able to demonstrate to your supervisor that the board is actively engaged with the conduct agenda and placing sufficient emphasis on embedding a culture that promotes good consumer outcomes.

Product Oversight and Governance

Let me draw your attention to a recent publication by EIOPA on product oversight and governance. This sets out high-level principles and best practice on the product approval process for use by the boards of financial institutions. It sets out your responsibilities in organising processes, functions, and strategies aimed at designing, operating, and bringing products to market. The EIOPA initiative is very much designed to complement on-going work on forthcoming EU directives on the distribution of and disclosure of information pertaining to insurance products. The sort of principles EIOPA have envisaged, include the need for boards to ensure:

• Identification and analysis of the characteristics and objectives of the target market.
• Senior management involvement in developing product oversight and governance processes.
• Product testing is conducted to assess how a product operates in different scenarios.
• Information is provided about product features and charges that are relevant for the target market.
• Appropriate distribution channels are selected that are adequate for the target market.
• Products and the target market are monitored on an on-going basis to ensure that distribution channels are still appropriate for future offerings.
• Appropriate action is taken when challenges in the product oversight and governance processes are identified. 

I have spoken in detail about the conduct agenda. I believe it is important to use every opportunity possible to reiterate our expectations of firms in this area. The advent of Solvency II as I mentioned previously is leading to greater cross-border activity and will lead to a greater proportion of business transacted in markets which is prudentially supervised elsewhere in Europe. Ireland is already a significant exporter of the so-called freedom of establishment and freedom of services model. In looking ahead over the next number of years, you can expect to see more convergence across Europe on the conduct agenda. Better information exchange and sharing of examples of good practices between supervisory authorities will drive convergence of conduct of business rules and consistency of supervision, which in turn will deliver an increased level of protection for consumers. You have the opportunity to properly reflect on this direction of travel and to play your role in building greater trust in the financial services sector.

Global Regulation

I’d now like to turn my attention further afield and examine some of the more international regulatory developments. The change in the regulatory standards in insurance globally has been remarkable. In many countries all over the world, risk/based regulation and supervision is already being enacted, with different nuances, but with lots of commonalities. In each continent, there are some countries which evidence good practices being implemented. These include risk based capital requirements, stronger emphasis on good governance and risk management as well as improvements in public disclosure.

In many respects, Solvency II has been a catalyst for the international movement towards risk based regulation and supervision. The Solvency II equivalence process has played a role in this regard. Furthermore, the EU/US dialogue project has been essential in reinforcing the mutual understanding of the solvency regimes on both sides of the Atlantic. This paves the way to more effective supervision and to the development of a global capital standard.

Towards a Global Capital Standard

There are many reasons why a global standard would be good for the insurance industry. A key lesson of the financial crisis is that there are certain key financial institutions that play extremely significant roles within the global financial services industry and, the entire global economy. On the insurance front, these organisations are referred to as Global Systemically Important Insurers (G-SIIs).While there is much debate on whether insurance is really systemic or not, there is certainly much greater interconnectivity with the wider financial system than has historically been the case. 

The crisis exposed many shortcomings in the areas of cooperation, consistent application of supervisory measures, and trust between supervisors.  The introduction of global capital standards should help prevent regulatory arbitrage, increase financial stability, facilitate a level playing field, and strengthen international supervisory coordination. 

Furthermore, global capital standards will reinforce the supervisory network by providing competent authorities with a common system. Global capital standards will facilitate the work of the colleges of supervisors that play an important role in an increasingly globalized market. With global capital standards, supervisory authorities will obtain a common understanding of qualitative and quantitative requirements for insurance groups, which is fundamental for the college’s efficient, effective, and consistent functioning.

The work of the International Association of Insurance Supervisors (IAIS) has been instrumental in the progress on the development of group level regulation of the largest institutions globally. We now have in place a methodology allowing assessment and ultimately identification of, G/SIIs. The development of the Common Framework for the Supervision of Internationally Active Insurance Groups (ComFrame) is also well underway. 

There is however, much to be resolved.

The areas that I would draw attention to are: 

• Transparency and comparability are key where we seek to enhance public confidence in the insurance sector’s capital adequacy. Ensuring comparability of IAIGs’ capital adequacy will require comparable measurement of the insurance liabilities which is challenging to say the least where there are many variations of generally accepted accounting principles (GAAP). Increased convergence over time of accounting standards would be desirable. 
• Designing a “one size fits all” rules-based capital standard that generates the right risk management incentives for all I AIGs is extremely challenging. Challenges also remain on finding a consensus on issues such as the definition of contract boundaries, valuation of options, sovereign credit risk, realistic allowance for (deferred) taxation, and the calibration of market-adjusted yield curves. These issues were debated for years in European circles before a compromise was eventually found.  
• It is also worth mentioning the work underway in many jurisdictions by group supervisors as part of recovery and resolution planning to better understand the constraints within insurance groups to capital fungibility and transferability. While we rightly advocate for the recognition of diversification in the new standards, we must also find a way to reflect the barriers to capital movement (and hence diversification) that exist in each group structure arising through local regulatory, accounting and tax regimes. Greater emphasis on the appropriate principles to underpin this assessment will be required as the ICS proposals are developed further. 

It goes without saying that the development of ICS will have implications for how you run your businesses. It is safe to assume that the parallel running of Solvency II and the ICS would present challenges as differences in capital and risk management incentives will inevitably arise unless the regimes are identical. At a European level, we cannot simply expect to export Solvency II to the rest of the world. While not attempting to play down the importance of the remaining items to European IAIGs, the central role that the ORSA will play in the new capital framework must be seen as a significant step and may yet facilitate the finding of common ground on the some of the remaining issues. Furthermore, it’s worth noting that the Solvency II directive requires that the calibration be revisited in 2020, which would provide a natural opportunity to reflect on the initial period of implementation and to potentially align the requirements of Solvency II with the ICS.

Low Interest Rate Environment

On a macro environmental level, the continuing low interest rate environment is making it increasingly difficult for insurance companies to compensate for poor underwriting results with investment income. The combined impact of the current low interest rates with the incentives that SII brings towards less risky investment strategies is of particular interest.  This dynamic will be carefully considered by regulators to ensure that firms through their own risk and solvency assessments take the opportunity to assess the impact of the difference between the risk of holding assets over a one-year period compared to the risk of holding them to the point of maturity of the policy.

The impact of suppressed investment yields brings more attention from a regulatory perspective to the increased driver of profitability within the non-life industry of underwriting profitability and the ability to withstand periods of poor investment returns.  The low interest rate environment will not only impact the financial performance and resilience but also the change in products within the industry as guaranteed investment bonds are no longer viable and annuities become much less attractive.

Much of the changing focus of regulation as a consequence to the low interest rate environment has yet to come. The regulatory focus will evolve further when quantitative easing ceases, nominal values of bond portfolios adjust downwards and the knock on effects of increasing lapse rates and a different inflationary environment are considered.

The last area I want to refer to is the regulatory landscape in the new digital world

The increased usage of the internet and the increasing “social economy” is presenting opportunities for the insurance industry in the form of big data, using social media for increasing brand awareness and customer loyalty, as well as threats in the form of cybercrime. The ever increasing social economy is bringing a wave of new trends for insurance industry in the form of online peer-to-peer insurance. Online peer-to-peer insurance is the purchase of insurance by social networks rather than individuals, and increases the collective buying power of individual customers when they act collectively as social networks. This wave of new trends is likely to present significant challenges for insurance companies directly, and reinsurance companies indirectly, by putting significant pressures on premiums. These new trends will likely heighten supervisory focus and scrutiny on insurance companies’ business models, product development and distribution processes.

The shift towards digitalisation poses new risks to the insurance industry such as cyber risk.  But in the increasingly hyper-connected present and future, the number of cyber risk incidents will increase as well.   SEC Commissioner Luis A. Aguilar stated that “Cyber threats are a particular concern due to the potential for widespread and severe impact they could have on investors, firms and the integrity of capital markets.” In 2014, 33% of financial industry survey respondents ranked cyber-attacks as the number one systemic risk to the broader economy.

Conclusion

In recent times in the financial services sector we have come to rely upon the constant change in the regulatory sphere. It is clear that challenges remain to ensure that greater convergence in global regulation is achieved, and that the failings of the last financial crisis are not repeated.

However, progress has been made in the area of insurance regulation, both in the EU and further afield. I would like to take this opportunity to commend the insurance industry in Ireland for its pro-active and constructive engagement on these issues. It has been a key component of the progress achieved to date, and I look forward to continuing this dialogue in the future.  

Click here to see interview given by Sylvia Cronin to World Risk and Insurance News at the same conference.