Regulations and responses – seeing the big picture - Insurance Market Update - June 2005

Swamped with a surge of regulatory changes, companies need to be strategic in their responses. Taking an integrated portfolio approach and adapting your infrastructures to the new requirements will position you to use regulatory change as a driver of value and competitive advantage. We review the key regulatory drivers and make the case for a strategic response.

Insurers are dealing with a plethora of regulatory change which is being imposed on an unprecedented scale with different drivers generating significant overlapping and interdependent impacts on various functions of the business. Each regulatory driver has significant costs associated with it, with real impact on the business and its infrastructure. There may also be effects on the business strategy including the core markets which are serviced. The changes arising are too numerous to cover in this article but some of the key changes including the Integrated Prudential Sourcebook and International Financial Reporting Standards are amongst those considered. Figure 1 lists some of the key impacts on insurance firms, and the timeline in Figure 2 following shows that many of them have concurrent or overlapping implementation periods.

Many organisations are managing the approach to this change in silos, with a focus on compliance rather than the business impact and strategic implications. Insurance businesses need to adopt a more holistic approach to these changes, which may involve more fundamental re-thinks than have previously been required. They need to re-evaluate business strategy and take the opportunity to challenge and in some instances transform current infrastructure and embrace the change to create real competitive advantage and drive shareholder value.

One of the key regulatory drivers is the new Integrated Prudential Sourcebook, which represents a fundamental change in the approach to the regulation of financial strength and capital adequacy, including impacts on the systems and controls within all financial firms.

From a systems and controls perspective the greatest areas of change for insurers are likely to be the new and sharper focus on operational risk and formalisation of the expectations for the management of credit risk, in particular with respect to reinsurance. The teams dealing with these risks will need to monitor key risk indicators, have consistent event and loss reporting processes and provide meaningful risk information to support decision making. Furthermore, rating agencies are increasingly looking at operational risk as an important element in assessing firms. This focus on better risk management is consistent in many ways with other risk focused legislation such as Sarbanes Oxley. This indicates a need to consider these changes in a holistic manner.

From a capital adequacy perspective the key for many insurers will be the extent to which credit for any diversification benefits across classes of business will be allowable by the regulator. Diversification benefits are a significant component to many insurer’s individual capital assessment, but are difficult to quantify. Models can be used, but a holistic scenario based approach to back-test the model should give further confidence to the regulator. An independent review of the model and process could also be of benefit in this regard.

Insurance is an increasingly global business and insurance accounting varies considerably across jurisdictions. Most listed UK insurers are now well advanced in the production of the IFRS financial statements processes.

IFRS will have a number of significant impacts both to the way that insurance (following any revision to IFRS 4) and non-insurance transactions are accounted for, but also to the way they are disclosed which will be especially significant for companies wishing to access the capital markets. In the long term, this will have the potential both to harmonise accounting practice and thus make accounts more consistent, but it may alter perceptions of the industry as a potential investment.

Recent changes to insurance and mortgage intermediation regulation have been numerous including the adoption of insurance and mortgage distribution regulation by the FSA. These changes are at the heart of some fundamental restructuring occurring across the industry such as:

• transition by many distributors from one regulatory model to another (such as single tie to multi tie);

• in some cases the separation of manufacturing from distribution and the move towards a multi-tie model for large networks;

• major investment from insurers into distribution and networks of distributors.

One area of commonality with these changes and other "risk focused" regulation is that Principals supporting Appointed Representatives (ARs) will now be responsible for advice of their ARs for mortgage and general insurance. This creates a need for insurers to assess and understand this new operational model.

Sarbox is yet another driver of the need to enhance a firm’s control environment. This is to ensure that management is responsible and accountable for, the accuracy and integrity of accounting records procedures and controls.

A synergy of this regulation with PRU is that some of these control related drivers will help to manage and reduce the risk of fraud, error and mis-statement in the financial statements, thereby helping reduce operational risk.

In addition, other major areas of imposed regulatory changes are Pensions Act 2004 and good practice measures advocated by the FSA such as "treating customers fairly".

Tax is an area that will be affected by regulatory change. The new Enhanced Capital Requirement may lead to increased tax charges in relation to allocated investment income for UK branches of overseas insurers. The interaction of regulation and tax demonstrates the need for a multi disciplinary approach with both disciplines being aware of the wider potential impact.

In summary, regulatory timetables are generally business critical as non compliance could result in licenses being withdrawn to write business. Therefore regulatory programs need to focus on ensuring that execution risk is minimised. It is likely that the increased awareness imposed by the consultation processes and subsequent implementation of some, will have assisted in enabling insurers to be better able to manage these changes. However, tackling the above changes would be challenging enough without mentioning other regulatory pressures such as financial crime, market abuse and anti-money laundering legislation to name just a few.

One of the key challenges facing insurance firms is getting the financial implications of internal capital assessment, intermediation regulation and International Financial Reporting Standards aligned with strategy.

In order to maximise risk adjusted return, make best use of capital and minimise the probability of insolvency, insurers may find themselves considering a number of strategic actions, for example:

• reducing exposure to high risk lines/adjusting product mix where the returns do not justify the risk or additional capital burden of certain lines;

• withdrawing from some product lines permanently;

• merger and acquisition activity, taking into account the new capital requirements and the potential diversification benefits therein;

• transforming operational strategy to both avoid significant operational risk exposures but also rebuild infrastructure both to deliver the regulatory change but also to improve efficiency. This could include significant reinforcement/overhaul of control environments;

• restructuring reinsurance strategy based on internal risk models rather than waiting for a ratings downgrade to be published.

Each of these would suggest that a company is better informed and able to take decisions based upon the increased risk based analysis they have performed.

Many analysts have often perceived the insurance market as "worth a punt", but "not a long term investment"; in particular because of earnings volatility caused by the insurance cycle including competitive pressures such as price and depressed investment returns, thus placing pressure back on cost control.

Regulatory change is frequently seen as a necessary cost of doing business which reduces margins. Whilst the cost implications cannot be avoided an integrated portfolio approach should minimise the costs and assist in identifying commercial opportunities and benefits arising from the imposed change. Overall however the costs will erode margins and therefore this will devalue this industry relative to non-regulated industries.

In some cases improved risk management procedures may have a number of significant impacts on shareholder value such as:

• where credit rating agencies take a favourable view of new risk management processes, this may result in a rating upgrade. For business to business insurance, reinsurance, fronting, affinity and white-labelling, this may increase the likelihood of securing new contracts or distribution deals;

• increase expected profit by setting up a cost efficient risk management framework which avoids overlaps in activity and strips out excessive or obsolete controls and avoids unnecessarily constraining the business;

• reducing volatility in earnings by reducing both expected and unexpected losses through an early warning mechanism to highlight change in the operating and external environment or changes in the effectiveness of controls;

• effective use of capital by allocating capital to business units and measuring their performance on a risk adjusted basis;

• establish a strategic competitive advantage by enhancing outsourcing and risk transfer decisions and factoring all risk classes into the pricing of products and services.

Many insurers are dealing with these changes in a tactical, rather than a strategic manner and some do not yet have an integrated programme approach responsible for delivering all regulatory change. In addition there should be a clear link from overall business strategy to the risk strategy which should be at the heart of the regulatory change program.

An integrated portfolio approach should be employed which will address these changes holistically. This should reduce implementation costs and address business and systems impact issues. Part of the integrated portfolio approach will encompass the consideration of the interactions of these different imposed regulatory and legislative changes. In particular there is a need to:

• consider commonalities such as drivers under PRU, Sarbox and COBS to improve control environment and risk management;

• understand that improved risk management under PRU may stabilise some earnings patterns;

• pre-empts pitfalls such as deploying team resources in silos, implementing multiple technological or architectural solutions where one may suffice, or implementing tactical/short term solutions with no migration path to get to strategic solutions in a sensible time frame.

When constructing an integrated approach to the regulatory drivers the programme should be structured to:

• provide senior management with a clear view of the aggregated position and interaction across a series of mandatory change programmes to determine issues and priorities, and support decision making;

• ensure appropriate and adequate resources and skill sets are obtained to meet the requirements within the timescales and balancing the availability and scheduling of these across operational needs and different parts of the programmes;

• assist in managing stakeholder relations, explaining the impact on capital requirements and earnings, and managing the relationship with the regulator.

In addition where businesses are long overdue in upgrading financial and management information processes, structures and systems these changes will provide an ideal time to maximise on the investment in new infrastructure and develop areas such as accounting and risk systems, improving automation and data integrity as well as making access to this information more efficient through best practice in management information.

The portfolio approach will be a major challenge; therefore it is essential to attain the right balance between project management/process and technical knowledge. In order to neutralise these issues effective communication is essential, also careful selection and allocation of resources will be paramount. Delivery will in most cases need to be accelerated by augmenting existing resources and capabilities where necessary with external resources, methodologies and tools thereby benefiting from the experience of others and reducing timescales and delivery risk.

Overall insurance firms who address these changes effectively will be able to drive towards competitive advantage both through cost effectiveness but also risk effectivenes

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.