FCR changes impact insurance industry

Warren Koch (pictured), Quantitative Analyst, Centriq Insurance, reports on FCR changes and its impact on the insurance industry.

An ancient Chinese proverb says that you cannot fight a fire with water from far away. So with the emergence of the South African regulatory capital requirements standard called Financial Condition Reporting (FCR), we see short-term insurers with foresight rolling up their sleeves by pro-actively embracing a risk based solvency approach. Since Centriq’s “New capital model for short-term insurers” article in which the initial landscape of FCR implementation was explained (September 2007), the Financial Services Board (FSB) has been considering commentary received from various respondents on the FCR Discussion Paper. They’ve been reviewing their approach, especially with regards to the Prescribed and Internal Models, with the Certified Model (seemingly) taking a back seat.

The FSB has also commissioned Deloitte SA to re-calibrate the Prescribed Model to take into account the short-term insurance industries data from 2006. Hopefully, this will improve the accuracy of the modeling framework as more up-to-date data is collated.

In addition to other refinements, it is expected that the calibration will integrate the impact of non-proportional reinsurance, hopefully resulting in more appropriate capital requirements, especially for smaller insurers. One wishes that the end result will be the Prescribed and Internal Models approximate.

It remains uncertain as to whether the re-calibration will result in an easier application of the model. Regardless, Centriq is welcoming the changes as any stress-tested innovation can only lead to more stable and reasonable outputs.

The FCR (replacing the historic 25% solvency with requirements to reserve past the 99, 5 percentile) is currently being drafted into the Short-term Insurance Act (“The Act”).

Insurers have noted that this risk-based capital approach, especially as calculated by the initial prescribed model, is dictating that significantly higher volumes of capital are required than previously. Smaller companies that do not enjoy as much diversification as their larger competitors are particularly unfavorably affected. This includes niche insurers and the cell captive market. These insurers, it would seem, have little option but to make use of robust stochastic methods i.e. the smaller the company, the more likely the use of the Internal Model, which we expect will be more robust, and therefore more flexible and less stringent.

It is still unclear at this point what, if any, the impact of the FSB’s review will be on the Internal Model. However, certain aspects like the importance of prudent catastrophe modeling and the parameterization (accurate and relative statistical variables) of the attritional loss levels are coming to the fore as a significant determinant of capital in the smaller markets.

How recalibrated FCR requirements compare globally

As we start to unpack the methodology, principally we see the FSB following an approach similar to the Financial Services Authority (FSA) in the United Kingdom. The Individual Capital Adequacy Standard (ICAS), implemented in 2005, was globally recognised as a benchmark for measuring qualitatively and quantitatively capital adequacy.

It seems as if the FSA’s approach for determining capital adequacy is based on an Internal Model that is in line with specified European Union’s (EU) standards that use a prescribed formula. Solvency II - the EU’s answer to capital adequacy which commenced in 2001, has recently issued more questionnaire surveys that will have an expected impact on their calibration. Solvency II is due for implementation in 2012.

Broadly speaking, Solvency II, ICAS and now FCR will be similar in design, all encompassing a risk based capital approach. That said, the Australian regulatory authority and the Australian Prudential Regulation Authority have a stricter approach, with the proposed Internal Model being very onerous and stringent, leading most Australian firms to use the Prescribed Model.

It would be unreasonable to compare between the USA and Canada as the capital requirement methodology differs between the various states.

The FCR, ICAS and Solvency II in principle all follow a three pillared approach:

- The organisation analysis

- Risk governance analysis

- Regulatory and disclosure requirements

In summary, it seems that a correctly “manicured” Internal Model is the most prudent measure in terms of solvency requirement, optimal reinsurance structuring and the like. The big step in selecting an Internal Model is achieving model approval from the regulator. This is expected to entail consideration of model design and theory, an understanding of the test used, capital allocation, statistical quality tests, calibration and validation etc.

Whichever approach is used, it’s clear that to evolve in the most efficient way we need to gain the best understanding of the requirements. This translates to working with the FSB from the outset with regards to what is in line with best practice and what is best for that specific organisation. We need to embrace this process with open arms.