Financial Institution Supervision: Insurance Companies
Introduction
Insurance, in the simplest terms, means a transference of risk from the insured to the insurer. Around the world, individuals, families and businesses take advantage of the provisions of insurance so as to protect the possibilities of catastrophic losses that could occur due to loss of life or failure of a business. Over a period of time, the insurance industry has matured to throw up a multitude of products, and has grown into a multibillion-dollar industry.
The management of risk is the key to the operations of the insurance industry. While insurance agencies have necessary internal checks and balances to manage risk, it is important for the government to lay down rules and regulations within the ambit of which insurance agencies operate. At the same time, it is necessary for the government to assess how the insurers are following laid down rules and regulations. It is in this context that supervisory agencies are incorporated in the insurance sector.
Key Components of Risks
While preparing models of risk faced by insurance companies, actuaries pay attention to certain key components of risk, which are discussed below.
Volatility. Volatility is a measure of the uncertainty about the value of a security. Higher volatility would imply that a security’s value may change by a larger margin in a given period of time. Seen in the context of insurance companies, they are uncertain about the quantum of claims that would be proffered by clients. Random variations in claims increase once the size of businesses gets smaller. Therefore, the more the retail clients for an insurance company, larger the volatility in terms of claims (Neha et al.)
Uncertainty Uncertainty refers to the inability to predict the future with confidence. Insurance companies face uncertainties as to the outcome of businesses already written. At any point of time, there would be a number of claims preferred on the insurance companies. There would be a modicum of uncertainty regarding when these claims would be settled. At the same time, insurance companies are uncertain about the premium rates to charge from customers. Insurance companies need to be profitable overall, but are unsure as to how past experience of premiums charged and profits made would translate to the future. They are also uncertain about whether they need to cater for exceptional claims that occurred or failed to occur (Neha et al.).
Types of Risk
Taking volatility and uncertainty into account, insurance companies face numerous risks in their business, which are discussed below.
Underwriting Risk. Underwriting is a process through which an insurance company evaluates the risks and exposures of prospective clients, and decides the extent to which it would cover the risk and how much premium the client would need to pay for the coverage. In effect, the insurance company underwrites a potential loss to the client to the extent agreed upon. Underwriting decisions flow out of an assessment of the ‘probable maximum loss’, which is lesser than a catastrophic maximum possible loss wherein all safety features would have failed. Insurance companies need to ensure that they remain financially viable even after incurring losses from the occurrence of ‘probable maximum’ events. Outliers such as the attack on the Twin Towers create situations that are out of the calculus of insurance companies, and cause them to go bust. The uncertainty regarding the losses incurred by the client and the financial viability of the insurance company after paying for all possible losses constitutes underwriting risk (Neha et al.).
Credit Risk. Credit risk refers to the uncertainty in a counterparty’s ability to meet its obligations. Insurance companies would have lent funds to institutions. In their calculus, they would take into account that such funds would be recouped with interest over a period of time. However, credit risk occurs over the probability that the counterparty would default over its obligation to repay. In such a case, the insurance company would have to factor in credit exposure it has to the counterparty, and the recovery rate that stipulates the fraction of the credit exposure the insurance company is likely to recover through pursuing bankruptcy proceedings (Neha et al.).
Market Risk. The volatility of market prices of interest rate instruments, equities and currencies would constitute market risk for insurance companies, which would have invariably deployed funds in the market to gain profits. Market risk includes equity risk, interest rate risk and currency risk. Equity risk refers to the risk of depreciation of equities due to the dynamics of the stock market. Interest rate risk refers to the risk that the relative value of an interest-bearing asset, such as a loan or a bond, would worsen due to an increase in interest rates. Currency risk relates to the uncertainty arising over the relative price of one currency as compared to another. As insurance companies invariably operate across national borders, being multinational in nature, they would have to settle claims in different currencies. The relative prices of currencies would thus affect their overall profitability (Neha et al.).
Operational Risk. Operational risk occurs when internal processes, people, systems and external events trigger losses to a company. Insurance companies stand to lose if employees make errors, if there are system failures, if there are fires, floods or losses to physical assets, and if there is fraud or criminal activity. The challenge for an insurance company is to separate operating risk from underwriting risk, credit risk and market risk, so as to holistically analyze such a risk and take measures to minimize it. It is important for insurance supervisors, the insurance industry and the actuarial profession to work in harmony to reduce operational risks to the industry (Neha et al.).
Liquidity Risk. Liquidity risk emanates from the difficulty in selling an asset. Institutions may lose liquidity if credit ratings fall, or if they experience sudden cash outflows, or if events occur that result in counterparties refraining from trading with or lending to an institution. In the context of insurance companies, liquidity risk refers to the possibility of the insurance company not having necessary funds to honor claims and policy obligations when due (Neha et al.).
Measures for Risk Mitigation by Insurance Companies
Insurance companies, aware of the risks they face, take a number of steps to mitigate and transfer this risk. The measures are discussed below.
Reinsurance. Through reinsurance, the insurance company does its own insurance, and passes on some of its risks to a reinsurer. Reinsurance is primarily a method to reduce the underwriting risk of a company. The cost of transferring risk to a reinsurer is lower than the solvency capital the insurer would bear if it retained the risk in its portfolio, because the reinsurer benefits from better risk diversification than the primary insurer (Neha et al.).
Hedging. Hedging is an investment that is used to cancel out the risk in another investment. Insurance companies use this option in many of their practices. For instance, writing life insurance policies as well as life contingent annuities for similar groups of policyholders would provide a hedge against the prospects of improving mortality (Neha et al.).
Participating. In a participating policy, the insurance company shares its profits with the policyholder in the form of bonus or dividends attached to their policy. In this manner, the policyholder also shares the risk of the investments made by the insurance company in the market (Neha et al.).
Supervision of Insurance Companies
Though insurance companies try to mitigate risk, the element of risk is not totally eliminated. Failure of insurance companies has a considerable impact on the well being of society. Therefore, governments put in place a slew of regulatory and supervisory mechanisms for the insurance sector. The basic rationale for supervising insurance operations is to protect the insurance consumer, ensure the safety and soundness of insurance companies and to facilitate the insurance industry in its contribution to the overall economic growth of the nation. In addition, supervision helps in improving the market efficiency of insurance companies and preserves the stability of the financial system. Supervision also ensures that the informative obligations of insurance companies are met, regulations are observed and the overall professionalism of the insurance industry is improved (UNCTAD).
Responsibilities of Insurance Supervisory Authorities
Insurance supervisory authorities have a large scope of responsibilities. According to UNCTAD, the relative priorities of their responsibilities can be listed as under: -
Powers to grant licenses to insurance companies.
Licensing of intermediaries.
Powers to withdraw authorization.
Approval of insurance policies.
Ensuring that insurers maintain acceptable financial records.
Authorize the requirement of additional capital by insurance companies.
Examine the insurer’s books of records.
Authority to examine the records of affiliated companies or agents.
Determine the minimum standards, liabilities and reserves that insurance companies must maintain.
Evaluate the quality of insurer’s assets.
Ensure that the insurer maintains a diversified investment portfolio to reduce market risk.
Determine the nature of admitted, authorized or allowed investments for insurance companies to create assets.
Grant approval for premium rates charged by insurance companies.
Control management expenses and acquisition costs.
Control reinsurance transactions done by insurance companies to mitigate risk.
Registration of reinsurance companies.
Impose reserves for reinsurance with non-registered reinsurers, to ensure that risk mitigation avenues for insurance companies are safe.
Impose management fitness requirements.
Make sure that insurance is available and affordable.
Educate consumers on all matters of insurance.
Make reliable information on insurers available publicly.
Methods of Financial Analysis by Supervisory Agencies
Supervisory agencies responsible for assessing the performance of insurance companies of their task through two methods- desk analysis and on-the-spot inspections.
Desk Analysis. The basic tool for analyzing an insurer’s financial soundness consists of checking mandatory and other returns from the company. These comprise balance sheets, operating accounts, revenue accounts, profit and loss accounts, detailed reporting of technical reserves, asset statements with their valuations and solvency ratios. Supervisory agencies lay down necessary rules to ensure that the insurers submit their returns timely so that the monitoring is effective and relevant. The format of the returns is designed to make the analysis efficient in terms of time and resources (UNCTAD).
On-the-Spot Inspections. In most countries, supervisory authorities are empowered to carry out on-site inspections in the offices of the insurers. This method is valuable as it provides the authorities the means to verify the information provided to them through returns. Further, supervisory authorities are able to obtain additional up-to-date information from the insurer (UNCTAD). The key advantage of onsite inspections is that such inspections provide supervising agencies information and data that could not be discovered or obtained through regular monitoring. Inspectors are able to identify cases where insurance companies have problems with management of assets or have irregularities in their accounting information system. It is also possible to assess whether insurers are correctly calculating premium rates. Onsite inspections also enable the supervisors to make direct and personal contact with the directors of insurance firms. This is useful for the conduct of proper analyses in conformity with laid down criteria for management of insurance and reinsurance activities. Further, onsite supervision enables the supervisors to assess the management policies and internal controls and audits in the insurance companies. During such inspections, it is possible to directly influence the insurers to give up performing certain activities that may be contrary to the existing law and regulations in the insurance industry. As a corollary, onsite inspections also enable supervisors to conduct analyses on the influence of certain regulations that are applied industry-wide (AIS).
On-site inspections may be carried out periodically or without forewarning. For such inspections to be effective, it is important that supervisory authorities are vested with the powers to access all documents that the insurer possesses. The inspections could be comprehensive, to cover all aspects of operations of the insurer, or could be focused on a specific aspect of the insurer’s operations. The results of such inspections are kept confidential, and provided to the head of the supervisory agency. After review by the supervisory agency, the results of such inspections may be made public for the purpose of transparency and guidance. Supervisory agencies need to plan carefully before carrying out such inspections. They need to have identified the insurer’s problem areas prior to the inspection, so that they are aware of what aspects to look for during the inspection. During the actual inspection, the inspectors should be careful not to waste time on easy aspects of monitoring, so that they do not need to subsequently rush through the more complex aspects (UNCTAD).
Problems Faced by Supervising Agencies
While the supervision agencies have a vast charter and have sufficient regulatory power, they often hampered by a lack of sufficiently experienced and trained analysts to assess the information on the financial position of companies. Many supervisory agencies are unable to deploy their resources optimally, and this creates a gap between their goals and their effectiveness. Certification of accounts by external auditors is not a universal practice, leading to opacity in the books of insurers in some countries. A substantial proportion of countries lack certified actuaries to help in supervisory tasks. Financial solvency remains a challenge in developing countries (UNCTAD).
The key to effective supervision is the expertise and professionalism of the staff of supervisory authorities. In a number of countries, supervisory authorities find it difficult to hire, train and retain the required quantum of qualified staff. Lack of available qualified people, uncompetitive employment conditions, inadequate budgets, and attractiveness of the private sector are factors explaining the deficit in experienced supervisory staff. Often, supervisory bodies are unable to convince their governments about their role in securing the stability of the financial markets. To fully meet their charter, supervisory bodies would require a proper human resource strategy to include hiring criteria, formal and continuous training and ensuring job satisfaction (UNCTAD).
Conclusion
Insurance companies manage considerable risk on behalf of their clients. Given the quantum of money invested by clients, the insurance industry is a major component of any country’s financial system. To safeguard the health and stability of the financial system, it is important that insurance companies are well regulated and supervised. In this regard, the role of supervisory agencies becomes critical. It is important that supervisory agencies have the necessary expertise and analytical tools to carry out their function. Within the ambit of the charter of supervisory agencies, onsite inspections have a special place toward ensuring that insurance companies reflect their books and conduct their activities in the true spirit of the law.
Works Cited
Agency for Information Supervision (AIS). “Manual on Performance of Supervision on Insurance Companies and Insurance Market Subjects in Macedonia.” ASO.Mk. n.d. Web. May 21, 2016.
Neha, Birla, et al. “Risks Faced by General Insurers.” ActuariesIndia.org. 2008. Web. May 21, 2016.
United Nations Conference on Trade and Development (UNCTAD). “Regulation and Supervision of Insurance Operations: Analysis of responses to a Questionnaire and Possible Elements for Establishing an Effective Insurance Supervisory Authority.” UNCTAD.org. August 30, 1995. Web. May 21, 2016.
