Risk-based capital and governance in Latin America: Emerging regulations

1Risk-based capital and governance in Latin America: Emerging regulations

Risk-based capital is in the limelight as one of the most significant regulatory regimes to affect insurance companies. The countries we discuss in this paper (Argentina, Brazil, Chile and Mexico) each have a distinct view of the proposed single standard and the implications for insurers to drive their organizations to business and regulatory compliance.

Latin American (LatAm) markets are in various stages of sophistication, with each facing a different journey to a risk and economic value-based solvency framework. Countries such as Brazil are showing a growing interest in implementing modern enterprise risk management techniques. In contrast, for the Argentine life and pension insurance market, applying Solvency II methodology does not appear to be feasible in the near future.

Of the four countries, Mexico is one of the most advanced in pushing to apply certain aspects of Solvency II. Proposed law advocates stronger corporate governance and risk management within a well-defined and integrated organizational structure. This includes establishing effective and permanent internal control, audit and actuarial functions that promote regulatory compliance. The risk management infrastructure is less sophisticated in Chile. However, there is evidence of a shift from the present regulatory framework to risk-based regulation that better captures current industry risks. Adopting a Pillar II type approach would have numerous benefits for Chilean insurers through improved governance and greater consistency in linking decision making to risk appetite.

As for investment in Solvency II, some countries are taking a wait-and-see approach. In Brazil, however, companies recognize that failure or success requires constant improvement of data governance, combined with well-informed risk-evaluating intelligence and technology through underwriting, risk classification, pricing and reserves. This may be their strategy to gain a competitive edge in saturated markets and apply innovation to venture into new ones.

Our LatAm review of Argentina, Brazil, Chile and Mexico addresses the current state of play in each country, and the benefits and challenges of implementing capital requirements, corporate governance and risk management. It is our belief that countries can learn from the experiences of others in introducing a risk and economic value-based solvency framework.

Executive summary

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Risk-based capital is in the limelight as one of the most significant regulatory regimes to affect insurance companies. The countries we discuss in this paper (Argentina, Brazil, Chile and Mexico) each have a distinct view of the proposed single standard and the implications for insurers to drive their organizations to business and regulatory compliance.

Latin American (LatAm) markets are in various stages of sophistication, with each facing a different journey to a risk and economic value-based solvency framework. Countries such as Brazil are showing a growing interest in implementing modern enterprise risk management techniques. In contrast, for the Argentine life and pension insurance market, applying Solvency II methodology does not appear to be feasible in the near future.

Of the four countries, Mexico is one of the most advanced in pushing to apply certain aspects of Solvency II. Proposed law advocates stronger corporate governance and risk management within a well-defined and integrated organizational structure. This includes establishing effective and permanent internal control, audit and actuarial functions that promote regulatory compliance. The risk management infrastructure is less sophisticated in Chile. However, there is evidence of a shift from the present regulatory framework to risk-based regulation that better captures current industry risks. Adopting a Pillar II type approach would have numerous benefits for Chilean insurers through improved governance and greater consistency in linking decision making to risk appetite.

As for investment in Solvency II, some countries are taking a wait-and-see approach. In Brazil, however, companies recognize that failure or success requires constant improvement of data governance, combined with well-informed risk-evaluating intelligence and technology through underwriting, risk classification, pricing and reserves. This may be their strategy to gain a competitive edge in saturated markets and apply innovation to venture into new ones.

Our LatAm review of Argentina, Brazil, Chile and Mexico addresses the current state of play in each country, and the benefits and challenges of implementing capital requirements, corporate governance and risk management. It is our belief that countries can learn from the experiences of others in introducing a risk and economic value-based solvency framework.

IntroductionThe status of the Argentine insurance market in light of Solvency II differs significantly from the situation in other Latin American countries. In fact, far from being a priority, the issue has only been included superficially in the list of initiatives of the regulatory agency, the Superintendencia de Seguros de la Nación (SSN), over the past few years.

In general, Argentine insurance policy has been consistent with the economic measures taken by authorities in charge of Argentine economic policy. Thus, the most significant measures taken in the past few months relate to the nationalization of reinsurance (reinsurance transactions may only be accepted by government-owned companies, mutual societies and branches of foreign entities established in Argentina, with certain exceptions), the repatriation of almost all funds that insurers had invested abroad as of 27 October 2011, and the subsequent obligation of placing their funds and financial assets in Argentina.

Current state of play in ArgentinaInsurance activity is significantly impacted by conditions that could be deemed as traditional within the Argentine economic framework. For one, the high inflation rate has a strong influence on the increase in costs of material damages and in compensation claimed for personal damages. It also renders more complicated the assessment of sufficient rates and the interpretation of statutory gains (losses) and financial income (loss) disclosed by insurers. Another issue to consider is the large number of lawsuits in the overall market, particularly in automobile and workers’ compensation insurance. Most companies’ loss reserves arise from lawsuits filed against them. These are very difficult to value based on the wide range of claims and the diversity of treatments that apply in different districts and court proceedings.

The insurance industry is tightly regulated in Argentina. SSN resolutions cover most aspects of insurance company activity, including unearned premiums and methods of mathematical reserve valuation. The agency establishes minimum valuation methods arising from formulas used to value out-of-court, mediation and lawsuit payables, as well as incurred but not reported (IBNR) claims reserves. Most insurance companies use these mechanisms to value their payables. Their sufficiency should be certified by an independent actuary in each quarterly set of financial statements filed with the SSN.

ArgentinaImplications of risk-based capital for Argentine insurers

3Risk-based capital and governance in Latin America: Emerging regulations

Benefits and challenges of implementing capital requirementsThe current solvency system in Argentina is based on traditional measurement methods and works with historical information; controls are mostly ex post. It is not sensitive to risk and requirements are consistent for all lines and coverage. The system applies indicators and assumes that risks are minimized by prudent payable valuation criteria and limitations in allowed investments.

Under current local regulations, insurers should evidence compliance with minimum capital requirements on a quarterly basis. This technical requirement, called “capital to be credited,” results from the largest of the following three elements:

• A nominal capital amount allocated on the basis of each insurance line in which the entity operated or a group thereof. The amounts required may vary from line to line, with values periodically adjusted by the regulatory agency. In general, they are significantly exceeded by the other two parameters, except in the case of companies in a start-up phase.

• An amount assessed by virtue of a certain portion (16%) of total premiums issued over the past 12 months in all of the business lines, adjusted by the risk-withholding percentage for the past 36 months (calculated on the basis of the claims paid in such period), which may not be less than 50% of the risk-withholding percentage which is calculated as (net claims paid/gross claims paid).

• An amount calculated on the basis of a certain portion (23%) of total claims accrued over the past 36 months in all of the business lines, adjusted by the risk-withholding percentage mentioned above.

The largest of these amounts is compared against the entity’s computable capital, which results from revising shareholders’ equity against the application of the criteria established by the regulatory agency and relates to the possibility of whether to compute certain asset accounts. The excess or shortfall in computable capital against capital to be credited indicates whether the entity yields surplus or deficit, respectively. In case of a deficit in minimum capital, the entity should file a regularization plan with the regulatory agency. Under current regulations, this may include: capital contributions, a merger into another entity, intervention by authorities, portfolio assignments, or transfer to another insurer and/or trust of certain assets and liabilities.

As of 30 June 2011 (last fiscal year-end), all insurance companies in the market calculated their capital to be credited based on the issued premiums indicator. Of 155 insurers, only 4 carried minimum capital deficit as of this date.

Adopting Solvency II or its equivalentOver the past few years, the SSN only mentioned the adoption of Solvency II in Argentina through public statements at seminars or in insurance industry publications, without defining any clear initiatives. The only exception relates to Resolution No. 35,058, issued in May 2010, whereby the SSN encouraged “insurance entities and the different business associations representing them to analyze, reflect on, discuss and submit proposals.” These were aimed at reviewing and, possibly, establishing new capital requirement criteria and a good corporate management practice code to consider the basic principles of corporate governance. The background mentioned to support the request was the “Basel II” Accord. The terms set by the regulation were met without any news release or announcement. Subsequent measures by the agency have not addressed the issue.

The way forward in Argentina In recent months, the SSN announced the launch of a strategic plan of insurance, inviting all industry participants to bring their vision to define the insurance policy to be used during the period 2012–2020. Some players, especially entities held by European insurance companies, believe that the plan should include, among other issues, adopting a risk-based capital system. So far, this initiative has not made any significant progress. The rest of the market would be willing to accept a model that takes into account and is adapted to local market conditions.

Upon trying to trace major elements of the Solvency II methodology, we should mention that certain SSN resolutions cover corporate governance issues in a scattered fashion. It is possible to find regulations related to the prevention of harboring and laundering assets from criminal activities, investment procedures and policies, administrative procedures and internal controls and monitoring the sufficiency of premium rates. These cases also include the role of the regulatory agency in providing the minimum methodology to meet such requirements.

In summary, the current framework does not seem to indicate that an extended application of the Solvency II methodology will be feasible in the near future, except for the offices and branches of European–based insurance companies.

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BrazilImplications of risk-based capital for Brazilian insurers

IntroductionThe Brazilian market has witnessed a series of mergers, acquisitions, strategic alliances and joint ventures of insurance providers since 2000, and particularly after 2005. These events have been driven both by regulatory activity and market dynamics. Increasing capital requirements and higher operational standards — promoted by regulatory and supervisory authorities — as well as declining capital supply in the wake of the international financial crisis since 2008, have led to market consolidation and takeovers.

This development coincides with a sharp increase in the participation of banks and international insurance companies in the Brazilian insurance market. As a consequence, there is concern among market agents that the implementation costs and capital requirements associated with the new risk-based supervision paradigm may induce additional consolidation waves in the insurance industry and may even hamper the growth of small and mid-sized companies.

Current state of play in BrazilIn this challenging environment, the major insurance providers in Brazil are showing a growing interest in implementing modern enterprise risk management (ERM) techniques. These include measures ranging from explicit and clear risk appetite statements emanating from the top of the organization to the reinforcement of internal audit, actuarial and risk management functions.

Two main factors are driving this need: first, a historical reduction of interest rates has been depressing the return on invested assets and shifting attention to measures that could effectively enhance underwriting profit on a sustainable basis. Second, the market consolidation around a half-dozen strong insurance providers with well-established distribution channels has sharpened competition, thus creating pressures against “transferring” operational inefficiencies and rising capital cost to premiums. The following example is illustrative of this trend.

The supply of life insurance in Brazil is heavily concentrated in two basic product designs: life insurance guarantees, which are short-term with non-leveled (age-dependent) premiums and comprehensive lump-sum payments upon death, accident and disability; and pension products, which are mostly investment contracts with (very unattractive) guaranteed annuity options. On the other hand, actuarially more complex products — from the point of view of risk management — such as life annuities, endowment insurance, long-term life insurance with leveled premiums or life insurance contracts with participation features, represent a very small percentage of life insurance industry liabilities. As a result, the market volume in these lines has been growing at a slower pace.

5Risk-based capital and governance in Latin America: Emerging regulations

One great challenge is then posed to life insurers in Brazil: how to increase capital efficiency in the context of decreasing return of financial assets, higher regulatory (risk-based) capital requirements and growing competition with strong market players?

Benefits and challenges of implementing Pillar llThe strategic path seems to go through one (or both) of the following alternative landscapes. On one side, survival may require merging, purchasing existing portfolios or entering new partnerships in order to explore existing distribution channels and maintain profitability through potential economies of scale and stronger market position. An alternative survival strategy may be to invest in riskier assets aiming to achieve higher returns, and to supply more sophisticated and appealing life and pension products with longer-term guarantees (for example, whole life insurance with leveled premiums and (affordable) life annuities).

The option for mergers, acquisitions and partnerships may reach a saturation point if the market suppliers become too concentrated. In that case, the alternative of innovating through product design may be a good strategy and will require correspondingly more robust ERM. On its own, ERM could deepen technical capabilities to venture in new, unexplored market niches or offer better commercial conditions for insurance consumers in consolidated markets.

As a corollary, establishing a corporate structure with well-embedded and useful risk management functions may become an indispensable condition for surviving and succeeding in the Brazilian insurance market. Strategies based on sheer volume, product homogeneity and short-term profits offer increasingly limited success opportunities. These may lose to strategies oriented toward product diversification, innovation and sustainable yields where the assumption of riskier positions in search of higher profits is secured by a solid risk management framework.

For quite similar reasons, this conclusion applies as well to property and casualty insurers. For instance, the automobile insurance market is characterized by strong players, fierce competition and a trend toward high combined ratios, for which the high frequency of fraud and litigation claims are major contributors. Therefore, in this business, success requires a constant improvement of data governance, combined with well-informed risk-evaluating intelligence and technology throughout the processes of underwriting, risk classification, pricing and reserving.

In Brazil, detailed monthly reporting requirements of individual policy and claims data for the Insurance Supervisory Authority (Superintendência de Seguros Privados) were introduced in 2004. Insurers have been encouraged to make greater investments in data governance in order to comply with the new requirement. However, as a consequence, they need to be careful when reconciling the outputs of operational systems with accounting records.

In summary, sound and effective risk management may be the best strategy for Brazilian insurers to gain a competitive edge in saturated markets and venture into new market niches through innovation. The benefits may far surpass the gains from “volume” strategies such as mergers and acquisitions.

Pillar l initiatives in BrazilIn a consistent and gradual path toward risk-based supervision, the Brazilian Regulatory Authority for Insurance has implemented the following Pillar l measures during the last 10 years:

• Valuation of liabilities. A defined set of principles and rules was established for determining technical provisions in order to cover all expected losses and expenses inherent in insurance contracts, including those liabilities arising from embedded options and guarantees. Furthermore, pursuant to the adoption of International Financial Reporting Standards (IFRS) as Brazilian generally accepted accounting principles (GAAP) in 2010, the Regulatory Authority established detailed guidance on how to perform liability adequacy tests in order to verify the sufficiency of the official technical provisions.

• Standard risk-based capital requirements. In 2007, the Regulatory Authority introduced a solvency capital requirement based on underwriting risks for short-term insurance contracts, aiming to protect insurers against unexpected losses arising from provision and premium deficiencies. Two years later, the capital charge was extended to include protection against default risk. The effect of this new risk-based standard was generally an increase in the required capital for operating in the Brazilian insurance market.

• Maximum retention limits. Regulatory retention ceilings per type of risk were fixed based on percentages of a fair value measure of net asset values.

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Adopting new measures for Pillar lllIn 2004, the Supervisory Authority introduced the requirement that each insurance company should produce an annual actuarial valuation report demonstrating the adequacy of all technical provisions as of the financial closing date. This included making statements about data quality, methodological approaches, and historical consistency of best estimates. The collateral effect of this requirement was to reinforce the actuarial function within the governance structure in insurance companies.

In 2010, the Brazilian insurers adopted IFRS as the guiding accounting standard for producing statutory financial statements. This moved Brazilian GAAP toward a more fair value-oriented approach, and required more disclosure about the financial condition of insurance companies.

The way forward in BrazilThe agenda for the Superintendência de Seguros Privados (SUSEP) in the next few years appears to be consistent with the paradigm of risk-based supervision. The implementation of standard risk-based capital requirements for longevity, mortality, and disability, expense and benefit revision risks arising from long-term life and pension contracts is planned for later this year or 2013. Simultaneously, initial proposals are being drafted for the standard formula for capital charges based on operational risk.

In 2010, the SUSEP announced the creation of a special commission to assess, debate and propose actions and solutions regarding the technical and legal nature for improving enterprise governance in the insurance industry in Brazil. However, this special commission was dissolved one year later. Therefore, it is still not clear how the Insurance Supervisory Authority will move forward with this initiative.

There is some skepticism about the feasibility of allowing insurers to substitute risk-based capital charges (as determined by standard formulas) for an insurer’s internal models of economic capital. This will not likely be the case in Brazil, at least for some years to come.

A similar approach is expected concerning the Own Risk and Solvency Assessment (ORSA)-like regulatory requirements; i.e., that insurers design, develop and implement formal processes to achieve a deeper integration of risk management (and internal models when applicable) with their business plans. A more pragmatic and less-demanding framework than Solvency II may be a feasible regulatory strategy for Brazil.

Nevertheless, the more rules-based approach that SUSEP adopted for the Brazilian business environment may not be understood. A growing demand for improved ERM is increasingly present on the agendas of both regulators and managements of insurance companies.

7Risk-based capital and governance in Latin America: Emerging regulations

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IntroductionThe Chilean insurance market has proved to be quite stable throughout the years. Despite some loss in equity value during the 2008 – 2009 financial crisis, companies were able to withstand the event without any government intervention. The same endurance prevailed after the massive earthquake that hit Chile in February 2010.

This stability is primarily the result of several factors, including tight controls over insurance products and asset portfolios. At the present time, most supervision is based on a product-by-product basis, without a holistic approach to risk management.

Companies run their business from a commercial point of view, complying with regulations. Most do not have a well-defined risk appetite or risk function and use supervisory limits as their own. The local regulator, Superintendencia de Valores y Seguros (SVS), is working to change this – moving from its current regulatory framework to a risk-based regulation that better captures current risks faced by the industry. One of the biggest challenges is the change from a commercial point of view to one that will measure return against risks.

Current state of play in ChileIn Chile, a new law that would require insurance companies to withhold risk-based capital was sent to Congress for approval on 30 September 2011. It is expected that it will take one year to be approved, and then companies will have two to five years to implement changes and prepare for risk-based supervision. Meanwhile, the local regulator, SVS, published two regulations in 2011 regarding corporate governance (NCG 309) and enterprise risk management (NCG 325). The first regulation became effective 31 December 2011 and the latter on 30 April 2012. Both regulations fall under what is known as Pillar II of the Solvency II framework.

Currently, capital is calculated as a factor of reserves, premiums or claims, depending on the product. In terms of risk management initiatives, the regulator assesses an insurer’s exposure to risks arising from its business and risk management activities.

In terms of level of sophistication, most insurance companies do not possess a robust risk management infrastructure. In most cases, the chief risk officer does not exist. Furthermore, some insurers lack proper segregation of duties between risk takers and risk control. Risk processes are viewed as a way of complying with regulatory requirements, with value primarily driven by commercial activities. The regulator recognizes this, and in order to move the industry to a more sophisticated state, has been working on implementing a Solvency II-type framework since 2005. The most recent steps are the new regulations NCG 309 and NCG 325.

Benefits and challenges of implementing Pillar ll Benefits of adopting a Pillar ll-type approach in Chile Adopting a Pillar ll-type approach would have numerous benefits for Chilean insurers through improved governance, more informed decision making and enhanced risk management information. Some of the benefits include:

• Management and other stakeholders would have more confidence in understanding the sources of risk.

• There is a “single version of the truth” within the business. Different individuals responsible for making (or averting) risk-taking decisions will not be using different metrics and information to make their decisions. This should drive a greater consistency of decision making that is better linked to risk appetite.

• While Pillar l in the Solvency II framework looks at a 12-month time frame, insurance companies (especially life insurers) run their businesses on a much longer cycle. It is management’s

ChileImplications of risk-based capital for Chilean insurers

9Risk-based capital and governance in Latin America: Emerging regulations

responsibility to demonstrate a deeper understanding of risks than they have in the past, which can be done through the Own Risk and Solvency Assessment (ORSA) process. Recent events (such as the global financial crisis in 2008) have highlighted the importance of understanding business risks over the long term.

Furthermore, there would be numerous implications for the way in which insurance companies are managed. Some aspects of business might transform significantly as a consequence of changes to the relative importance of performance measures.

In December 2011, the Chilean Insurance Regulatory Commission issued guidance on implementing an enterprise risk management (ERM)system, which aims to embed ERM into the governance structure, day-to-day operations and corporate culture of insurance companies. This framework should enable risk profiling, risk quantification and assessment, risk warning, and risk supervision and disclosure.

Some of the challenges The current state of risk management among Chilean insurers suggests that there would have to be a cultural shift to adopt the Pillar ll initiatives. Insurance companies would also have to invest significant time and resources to educate the board and the senior management around these initiatives. Furthermore, there is a limited pool of talent from which to hire risk professionals who understand insurance.

Shortages may also be apparent at the most senior levels of companies given the prominence assigned to the role of governance. A change in the mindset of top management is also required. Very few Chilean insurers have a chief risk officer; however, many have identified the need for such a role and are actively looking to fill that position.

Historically, risk management activity has often been backward-looking, which is contrary to the essential feature of Pillar ll that companies must be forward-looking in their risk assessments. This touches on all key functions from product pricing to reinsurance, effective management decisions, performance management, mergers and acquisitions, portfolio management and business planning. These and other activities need to be informed by a Pillar ll-compliant view on the risk exposure levels of the business.

There is also often insufficient stress testing support. In particular, there is room for more forward-looking stress tests around the business strategy to help drive contingency planning. This would have to undergo a major transformation for Chilean insurers to benefit from Pillar ll-type initiatives.

Pillar l in ChileThe methodology for calculating risk-based capital in Chile has yet to be made public. We are expecting it to be very similar to Solvency II. However, the local regulator has made it clear that, for the time being, they intend not to adopt a full economic framework for annuity products.

It is expected that the Chilean regulator will publish a consultative white paper with details around the calculation of risk-based capital in the third quarter of 2012. The SVS has demonstrated interest in performing the first Quantitative Impact Study (QIS) by the end of 2012.

One of the major challenges of implementing Pillar l-type elements will be the availability of skilled resources. Another hurdle will be getting the appropriate granularity of data to perform credible analysis. Furthermore, to successfully implement Pillar l, Chilean insurers and the local regulator will need to invest significantly in IT, finance and actuarial systems.

The way forward in ChileThe release of NCG 325 caught many companies off-guard. The regulation not only requires companies to adopt and implement various risk management practices that reach beyond their local technical expertise, but also to adopt a risk culture that would turn their organizational structures inside out.

Insurance company efforts will be focused on developing a risk policy which must be submitted to the SVS by the end of September 2012. Subsequently, for the next few years, many companies will start implementing initiatives to improve their risk management practices in order to achieve a more robust risk strategy.

The local regulator has communicated intentions to reward companies that have implemented better risk management practices. Such rewards will be reflected indirectly in capital requirements. The SVS has also communicated the consequences of having a poor solvency assessment, which is directly correlated to the soundness of the company’s risk management practice.

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Mexico

IntroductionAs of December 2011, the Mexican insurance market reached a volume $277,001 million of Mexican pesos in direct premiums (approximately US$19,860 million), which is equivalent to 1.89% of GDP. Growth was 9.5% in real terms: 39.8% of premiums correspond to life business; 5.7% to pensions related to social security; 15% to accident and health; and 39.8% to property and casualty. Mexico has a total of 102 insurance companies; in 58% of them, the major stockholder is a foreign company.

In the regulatory arena, in the second half of 2008, the Mexican regulator (Comisión Nacional de Seguros y Fianzas, or CNSF) shared with the Mexican association of insurance companies (Asociación Mexicana de Instituciones de Seguros, or AMIS) a draft of a project of insurance law (the proposed law) in which a Solvency II-type regime was incorporated. The draft considered an initial date for this proposed law of January 2012. Since that time (end of 2008) through 2009 and the beginning of 2010, the proposed law was discussed and reviewed between CNSF and AMIS. The actual initial date is January 2014; however, the proposed law has not yet been approved by the Mexican Congress.

Current state of play in MexicoIn the last decade, the insurance business in Mexico has been moving toward a higher level of sophistication. The regulator has pushed for stronger corporate governance and has been very strict with solvency requirements. For example: companies must annually submit a dynamic solvency test and an independent opinion on their financial risk management; actuaries must be certified by their professional organization; technical reserves are subject to adequacy tests and for life operations, in addition to such tests, a minimum reserve calculation must be performed. Furthermore, capital requirements are determined for underwriting, market and credit risks with a factor-based procedure applied to premiums and claims. The proposed law is intended to take the business to a further level of sophistication that is aligned with international trends.

Given the uncertainty of when the proposed law will be approved, some have concerns about the initial date. Larger companies are still preparing for the new regulation, but have slowed the pace significantly and are very cautious about where and how much to invest. European subsidiaries are leveraging on what their headquarters are asking and doing, with the expectation that the approved local requirements will be equivalent. Mid-sized and smaller companies are reluctant to continue their efforts. Many have made some progress, but are delaying until there is more clarity on when this new regime will start.

Notwithstanding the above, there is also the view that even if the approval of the proposed law is delayed, there may be some changes in level 2 regulation (Circular Única de Seguros) in order to strengthen several Pillar ll aspects related to corporate governance, internal control and risk management.

Benefits and challenges of implementing Pillar ll The proposed law states that insurance companies should establish an effective system of corporate governance and enterprise risk management (ERM) that is integrated into the corporate structure of the organization. This includes decision-making processes that are supported by efficient internal controls, with implementation and monitoring by management and the board of directors.

The corporate governance system must consider an organizational structure that is well defined, with clearly assigned responsibilities that follow proposed law and current regulations. There should be a mandatory code of conduct for all employees and officials of the insurance company to maintain a prudent and appropriate management structure. Consistent application of standards, policies and procedures throughout the organization is critical.

Implications of risk-based capital for Mexican insurers

11Risk-based capital and governance in Latin America: Emerging regulations

Furthermore, the system should correspond to the volume of an insurer’s operations and the nature and complexity of its activities. This includes establishing and verifying policy performance in risk management, internal control, internal audit, actuarial functions and outsourcing activities.

The ERM components in Pillar IIThe risk management system must include the risks set forth for calculating the Solvency Capital Requirement (SCR), as well as other risks identified by the insurance company that are not included in this calculation. To operate efficiently, the system should be integrated into the insurer’s organizational structure and its decision-making processes, and be supported by effective internal controls.

The area responsible for the risk management system should identify, measure, monitor and report the risks to which the insurance company is exposed— including determining whether they are quantifiable. They should also monitor that the operational implementation of the limits, objectives, policies and procedures for risk management is performed as approved by the board of directors.

Management and the board must review the insurance company’s risk management activities at least once a year. To do so, they have to consider the results of the Autoevaluacion de Riesgos y Solvencia Institucionales, or ARSI (Mexican equivalent of the Own Risk and Solvency Assessment, or ORSA) and periodic reports of risk management compliance. The document containing the ARSI must be submitted to the regulator as part of a corporate governance regulatory report.

The ERM framework must also include maximum risk limits for different types of risks, tests and validations of the internal model and adequate analysis procedures. The insurance company must be able to understand and control the origin and nature of the risks identified using qualitative and quantitative analyses. The framework must include documentation of the internal model and a performance analysis.

Other key functions in Pillar llAs part of the corporate governance system, insurance companies should establish an effective and permanent internal control system. This requires insurance activities related to the design, establishment and update of measures and controls that promote compliance with internal and external regulations. It must include a written policy for the internal controls that is proposed by the audit committee and approved by the board. An assessment of the implementation and operation of their corporate governance system must be submitted to the regulator on an annual basis.

Insurers must also have a permanent and effective system of internal audit in order to review and verify compliance with internal and external standards. This function should be objective and independent of the company’s operations. Furthermore, insurers need to define policies and procedures related to procurement of services with third parties.

Insurance companies must have an effective actuarial function, performed by persons with sufficient knowledge and experience in financial and actuarial mathematics and statistics. The main tasks of this function are to: (a) perform actuarial work related to product design and the feasibility of those products; (b) provide valuation of technical reserves; (c) verify the adequacy of methodologies and assumptions used for calculating technical reserves, perform back-testing procedures and communicate an opinion to the board regarding technical reserves; (d) issue an opinion on the reinsurance program and underwriting policy; and (e) support development of methodologies for measuring insurance risk.

Some of the challengesEmbedding the risk culture will be a big challenge. Most insurance companies lack a process for identifying risks other than those for underwriting. In some cases, even multinational insurers have not established a global methodology within their various organizations to support this process. There is a lack of risk culture and few insurance companies have a formal risk appetite statement.

Another big challenge will be to have sufficient and updated documentation that can be used as evidence of the compliance of the Pillar II requirements.

Pillar l in Mexico Under this proposed new regulation, the unearned premium reserve (UPR) and benefit reserves are calculated to cover the expected value of future obligations from claims, benefits, cash values, dividends, acquisition costs, administrative expenses and other obligations related to insurance contracts in force. The reserves must be the best estimate, plus a risk margin (calculated separately). This must be the expected value, considering the term structure of the cash flows using market risk-free rates provided by the regulator. The best estimate must be based on homogeneous, trustworthy, sufficient and timely information (similar to data quality requirements of Solvency II), and the projection should include all gross inflows and outflows (no effect of reinsurance should be subtracted).

The risk margin is the net cost of capital (considering the remaining term of each policy and must be calculated by line of business). The cost of capital rate will be above the risk-free rate and will be provided by the regulator.

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The valuation of the technical reserves should include the time value of options and guarantees, and must be accompanied by a documented back-testing analysis in order to identify and evaluate any systematic deviation.

Claims reserves must cover the expected value of the obligations once the claim has occurred, and must be calculated based on the best estimate, plus a risk margin for unpaid claims.

Other topics related to technical reservesThe actuarial methodologies used to calculate the reserves must be approved by the regulator. Insurance companies must demonstrate (hypothesis test) that the methodology can estimate (with a high level of confidence) the future obligations. Annual back-testing will be included in a Pillar lll report that must be presented to the regulator annually.

Capital requirementsThe proposed capital regime will include all risks, such as underwriting, operations, credit (including counterparty for reinsurers), market, ALM risk and concentration, and will consider a one-year horizon with a 99.5% confidence level. Insurance companies will have the option to develop an internal model, which must be approved by the regulator.

Internal model approvalInternal models are expected to be embedded in the ERM framework. The insurance company must demonstrate that it has taken the necessary steps related to the structure and complexity and that the internal model has been used consistently in the last year for measuring and controlling risk.

The insurance company must document: (a) board approval of the model; (b) an adequate organizational structure and internal controls based on the nature and complexity of risks; (c) evidence of systems, mechanisms and internal procedures that allow the board to monitor internal models in a manner that reflects the risk profile of the insurance company; (d) the technical note (modules, sub-modules, assumptions, statistical distributions, correlations, etc); (e) calibration standards; and, (f) profit and loss attribution (the insurance company analyzes the causes of P&L).

The documentation must include an independent validation of the internal model. Calculations under both the internal and standard models must be performed simultaneously two years after the internal model has been approved.

Benefits and challenges of implementing Pillar lTechnical reservesFew insurance companies have robust actuarial systems for reserve calculation. In most cases, they use a variety of tools, “in house” and other solutions that operate without synergies. The measurement of options and guarantees embedded in insurance contracts will demand knowledge and additional tools that are currently unavailable. The amount of reserves for these products can be onerous to many companies.

Capital requirementsThe CNSF regulator will provide the standard formula for capital requirements, and has indicated that the level of complexity and sophistication of such a formula will be greater than the complexity of the Solvency II standard model.

Data qualityMost insurance companies do not know which information they will be using for measuring risks. The level of granularity of available information is lacking and few companies have performed serious data quality analysis. In many cases, management does not have sufficient information for the decision-making process.

The way forwardStrong steps, agreements and actions have been taken toward a Solvency II- type regime in Mexico. Currently, there is no certainty on when the proposed law will be approved. However, there is a major consensus that different aspects of Solvency II will be applied in one way or another. Even if the law is not approved in the short term, stronger requirements on topics such as corporate governance and risk management are expected.

Finally, as part of a greater picture, it should be mentioned that the Mexican insurance sector is very interested in the development of the market. The goal has been set for premiums to surpass the threshold of 2% of GDP. So a greater challenge for the industry will be to have new regulation and a co-existing market growth strategy.

13Risk-based capital and governance in Latin America: Emerging regulations

Contacts

ArgentinaFernando Conesa +541145102212 fernando.conesa@ar.ey.com

Guillermo Diaz +541145102396 guillermo.diaz@ar.ey.com

BrazilPedro Subtil +3459498444 pedro.subtil@ky.ey.com

Gregory Gobetti +551125733262 gregory.gobetti@br.ey.com

Ricardo Pacheco +551125733579 ricardo.pacheco@br.ey.com

Chile Rodrigo Leiva +5626761282 rodrigo.leiva@cl.ey.com

MexicoJose Mendez +525552831455 jose.mendez@mx.ey.com

Fernando Belaunzaran +525511016468 fernando.belaunzaran@mx.ey.com

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