Background
Insurance Companies in India are to keep reserves to meet the future liabilities, these reserves are kept based on prudential regulatory norms. However, regulators also prescribe additional money that the insurance companies must keep aside in a form of solvency capital to meet the contingency if it arises. Such money cannot be used for any other purpose.
This Solvency capital in India is currently calculated based on a two-factor approach, which however does not take into account all the risks that insurance companies face. There is a shifting world over on the calculation of capital based on all the risks that a company faces as opposed to the two-factor approach currently used, commonly known as Risk-Based Capital (RBC) Approach.
Introduction
This write-up assesses the high-level likely impact on the Indian Insurance Industry when Risk-Based Capital (RBC) regime will be implemented in India, expectedly by 2021. The Committee on RBC set up by the Indian Insurance Regulator (IRDA) in June 2016 has given its report in
July 2017 and has recommended the introduction of the RBC regime by March 2021. The report is available on the IRDA website.
The key highlights in the report are:
1. The RBC approach may be based on factor-based model as compared to internal model used in some markets
2. Qualitative Impact Study (QIS) will be performed which will help in determining the approach and assessment of parameter value
3. Recommendation on the implementation of Enterprise Risk Management (ERM)
The impact of this change in the capital calculation will be on key stakeholders and the way insurance companies operate. Some of these changes discussed below are my personal opinion based on the studies available from those markets where RBC has been implemented.
Shareholders
The solvency capital directly comes from the shareholders which cannot be used for any other purpose than supporting the solvency. The investment norms on solvency capital money are much stricter which means that the Shareholder earns a return on this money by around equivalent to return on G-Sec and therefore loses the right to earn market return. This means that shareholders bear the cost of locking this money which otherwise could have earn higher return. Therefore, shareholders would like to lock lesser solvency capital and therefore reduce the risk; however, the current solvency regime does not provide this opportunity as the capital is not a function of all the risks.
The introduction of risk-based capital will provide this opportunity to the Shareholders to optimize the return on capital by suitably managing the risks that the Company will undertake. This will enhance the focus of shareholders on the enterprise risk management which provides a tool to manage risks. Such tools not only help in optimizing the capital position but also help in taking risk-based decisions to stay within the risk appetite. This means that on every penny spent on the Company risk can be adjusted to provide a better return than the market return. This may change the strategic focus of the Company on the investment that it makes rather than just following the competition because the risk appetite of different players of the same size could be different.
Product Design
Due to the risk-based capital requirement, the Companies may shift the focus of product design based on their risk appetite. For example, those companies who have constraint capital position may move away from designing high capital-intensive products such as products with high-interest rate guarantee which consumes higher interest rate risk capital to protection based products which are less capital intensive. The key risk in the protection product is a mortality risk which can be hedged by purchasing the reinsurance cover as compared to the higher capital requirement for interest rate risk in the absence of interest rate risk hedging tools. Similarly, other options of moving to lower capital intensive products are to move towards linked products where the customer bears the investment risks. However, such expected change in the product designs must be driven by customer’s need rather than just capital requirement. The emerging economic condition will also be a factor for the customer’s choice of financial products. Some bottom rung players may need additional capital to manage the needs of the customer and their own risk appetite.
It would be useful for the insurance players to re-look into their product strategy based on currently available capital and future risk-taking ability. Such change now will help in the smooth transition from the current capital regime to the RBC regime.
Mergers
In the western market when they were moving to the RBC regime, it was observed that the risk-based capital had a higher capital requirement as compared to their earlier regime. The impact on the Indian insurance players in terms of their capital position will only be known in the industry go through the Quantitative Impact Study (QIS); if the results of other markets that moved to RBC is used, there could be challenge to some bottom rung companies in terms of their available capital to back solvency.
So they may require either additional capital injection or they may take the route of mergers with stronger players. Some players may take the IPO route to fetch additional capital but their other financials will be the key in taking this route for the public to invest money to get a suitable return. Post implementation of RBC, consolidation in the insurance industry may not be ruled out.
Investment
The introduction of RBC may bring new investment norms which will impact different players based on their capital position in leveraging competitive advantage. Players with higher capital and higher risk appetite may have a more competitive advantage in investing into the more risky assets thereby giving customers better return products based on their needs. The exact nature of investment norms will only be known when the parameter values for investment are known. There will be a linkage of investment norms, products design, and risk appetite while setting the strategy for the future. Those players who will be managing the risks better will be in a better competitive position in terms of satisfying customer’s need as well as Shareholder’s required return. The key in this direction is build up of risk culture.
Enterprise Risk Management
The RBC committee has exclusively recommended a parallel implementation of Enterprise Risk Management (ERM). The ERM in a simple sense is a Company-wide application of risk management where all functions contribute to identification and management of risk. This is opposed to the silo approach where risk management is focused and limited to few functions. The implementation of ERM is likely to bring a change in the mindset of all the employees in relation to how they perceive risk and risk management. This is because shareholders will be keen to optimize the return on capital. The ERM will also help in choosing the risks so that they get a diversification effect when they aggregate the risks. The aggregation of risks is not summed total of all risks because different risks are correlated, so overall risk gets reduced.
Risk diversification may be used smartly to lower the overall capital requirement. In some countries such as China where implementation of ERM reduces the overall capital requirement.
Policyholders
Policyholder’s need and managing their expectation will determine the leaders in the market; this is represented by Conduct Risk which is defined as the risk of not delivering good customer outcomes. In some countries, managing conduct risk is one of their key requirements of success apart from financial results. The future of risk management will have a very important component of conduct risk apart from other standard risks.
Though the conduct risk separately, may not demand the additional capital but it could be a key driver of new business generation. In this direction, recently, IRDA, the Indian Insurance Regulator has prescribed a Claim ratio mandatorily in the advertisement to help customers in choosing the right player. The price of the products may not be the key pull factor, so the companies may have to focus on services and claim payment to attract and retain customers than just worrying about price.
Summary
The final details of RBC implementation will be known later by the IRDA, however initial assessment of moving to risk-based capital suggests that the insurance companies may work on their strategy to place themselves better when finally it gets implemented. The areas where the players can work on are
1. ERM may be proactively implemented in conjunction with the Board, which will not only help in optimizing the Capital but also help in developing and implementing the ERM model within the Company.
2. Such ERM implementation will also help in building the risk culture across the organization.
3. Focusing on the product design which optimizes the capital given the risk appetite of the Company. Because there will be a diversification effect of different risks, product classes and risks may be chosen which provide this advantage. For example, annuity and term product portfolio will bring down overall risk as longevity risk and mortality risks are negatively correlated.
4. Improving the customer satisfaction level
5. Once the details of the parameter values are known, there will be players who can take advantage of investment norms based on their product design. The investment norms may also drive the choice of product design.
It is imminent that the landscape of the Indian Insurance industry is bound to change in next five years if RBC is implemented as scheduled.
