In some cases – for example hedge funds – the policy response has been that they should be brought within the framework of regulation despite strong arguments that they played little role in creating the crisis. In the case of insurers, the debate has taken a different course, questioning whether insurers could in principle ever be classified as SIFIs, presenting systemic risks comparable to those of major global banks.
The bases of the argument that insurance is different are familiar: fundamentally different business models, capital structure, maturity profiles, liquidity characteristics and so on.1 Nevertheless, there are routes by which insurers could in principle generate systemic risks and the G20 and Financial Stability Board (FSB) have made it clear that, in some circumstances, insurers may be classified as SIFIs and subjected to similar banks. These could include constraints on non-core insurance activities such as credit protection and asset leverage, but in particular the requirement to develop recovery and resolution plans (RRPs) or so-called ‘living wills’.2
However, leaving aside the possible regulatory drivers, there are strong reasons why insurers should be looking seriously at the principles behind RRPs and developing appropriate plans. The financial crisis did expose deficiencies in risk management in the insurance sector and it is no more than prudent and responsible risk management for insurance companies – SIFIs or not – to look seriously at recovery and resolution planning as part of an integrated risk management structure.
Recovery and resolution plans
As the name suggests, RRPs are designed to address two distinct phases of crisis which may affect an institution:
- Recovery: In the event of capital or liquidity stress, the plan provides for a strategy to prevent organizational failure. This may involve restructuring, sale of assets and certain non-core business lines, raising new capital from the market and other activities that may mitigate the risk of failure.
- Resolution: If failure cannot be avoided, the RRP offers the regulatory authorities a mechanism to take control of the situation and resolve the organization by implementing a pre-determined strategy, minimizing the harm and cost to creditors and public funds.
The necessary planning needs to be integrated into an institution’s risk management framework, not bolted on separately or treated as a formal compliance exercise. One of the best routes forward may be to expand the requirements of the Own Risk and Solvency Assessment (ORSA), which requires insurers to undertake an assessment of their own risks, complemented by an assessment of the capital required to meet such risks:
“Every insurer should undertake its own risk and solvency assessment (ORSA) and document the rationale, calculations and action plans arising from this assessment. The ability of an insurer to reflect risks in a robust manner in its own assessment of risk and solvency is supported by an effective overall ERM framework, and by embedding its risk management policy in its operations.”3
By expanding the ORSA requirements, the conceptual framework of RRPs could be practically applied as part of the ORSA analysis that insurers would be expected to review and include, applicable to all firms.
Extending the ORSA
Extending the role of the ORSA to satisfy the needs of effective recovery and resolution planning would involve a number of complementary strands:
Potential economic impact considerations
The ORSA assessment in future would need to consider explicitly risks posed to the wider economic environment. Such macro considerations do not currently feature heavily in most insurers’ ORSA assessments. Insurers would be required to have mechanisms in place to restore the group in the case of solvency and/or going concern issues – or at least to consider such scenarios within their ORSA or internal model analysis – and in a worse case situation, to deconstruct the group in an orderly manner. To be in a position to effect appropriate mechanisms, insurers will need insight into the potential triggers. These are likely to require scenario analysis to understand the pressure points and the likely sequence of events.
Risk appetite and strategy
One of the lessons of the crisis was that supervisors and a number of insurance groups, did not fully understand those inherent underlying risks with potential systemic relevance. How risk appetite is effectively used and monitored is less well understood by supervisors – in particular, how the risk appetite of an insurer fits with the strategic direction of the company. Formalizing such analysis and extending it to, for example, instances of mergers and acquisitions may also assist regulators to better assess the systemic relevance of firms, as well as enabling insurers to articulate potential impacts on the business model.
Greater focus on non-core insurance activities and off-balance sheet items
Part of the ORSA analysis needs to examine the impact that non-core insurance activities and off-balance sheet items may have on the business. Failure to recognize the risks such activities can pose to a group creates a material weakness in the overall risk management capabilities and functions of a group. Special purpose vehicles, hedge funds, derivatives, private equity, structured credit products, insurance linked instruments and hybrid instruments that embed derivatives and dynamic hedging programs all require additional scrutiny. A first step would be to require firms to undertake specific analysis of such instruments within their ORSA assessments, with particular regard to whether such assets lead to an increased systemic risk scenario.
Mandatory use of reverse stress testing
The use of reverse stress testing or test-to destruction analyses (which identify scenarios that are most likely to cause an insurer to fail) should also form part of a firm’s overall risk management analysis and assessment and could therefore form part of the ORSA. This can assess the adequacy of management actions proposed in order to avoid business failure. In relation to resolution, insurance failures are typically resolvable through an orderly runoff, but exceptions to this have occurred and remain plausible. There may therefore be a case for putting in place arrangements to ensure an orderly conclusion to various scenarios.
Improving risk management
In reviewing the ORSA requirements and the draft Pillar 3 requirements of Solvency II, the European Insurance and Occupational Pensions Authority (EIOPA) laid stress on “what is to be achieved by the ORSA rather than on how it is to be performed.”4 Whether or not the ORSA itself forms the context for recovery and resolution planning, such analysis can contribute a valuable and distinct perspective to insurers’ overall risk management frameworks. And in the end, improved risk management is the core aim of both insurance companies and supervisors alike. Insurers are not banks. Rather than facing banking model for recovery and resolution planning, insurers should engage with regulators to shape the discussion to include recovery and resolution planning as part of an integrated risk management structure.
KPMG in the UK
Tel: +44 20 76948818
US Head of Insurance Regulatory, Financial Services
Regulatory Center of Excellence, Americas Region
KPMG in the US
Tel: +1 212 954 5861
1. See for example Recovery and Resolution Plans for Insurers: The need for a broader debate, KPMG, August 2011
2. cf. Evolving Insurance Regulation: Time to get ahead... KPMG, February 2012
3. International Association of Insurance Supervisors, ICP 16 Enterprise Risk Management for Solvency Purposes
4. Consultation Paper On the Proposal for Guidelines on Own Risk and Solvency Assessment, EIOPA-CP-11/008, 7 November 2011