Chapter 8: Regulation

Question 1

Examples of regulation

Mnemonic - SAD ADVERT PROMPTS ACIDIC CALM

Answer 1

Solvency level
Amount/type of business written
Disclosure
Auditing
Deposit assets to meet liabilities
Valuation basis (Assets and liabilities)
Equalisation reserve
Risk based capital calculations
Type/amount of assets for demonstrating solvency
Publish premiums
Reinsurance requirements
Offer required cover
Mandatory restrictions on cover
Premium rates
Treating customers fairly
Statement of ACtuarial  Opinion 
Authorization of companies/agents/management
Cooling off period
Illegal products
Discounting of liabilities
Information used in underwriting
Compensation scheme
Countries where business is written
Anti -competitive behaviour
Levies to consumer protection bodies
Mismatching requirements

Question 2

Objectives of regulation

Mnemonic - CREAM HEMP

Answer 2

Create liquidity
Reduce transaction costs
Efficiency of the financial system
Allocate resources efficiently
Manage risk
Help growth and competition
Economies of scale in investment
Mobilize long-term savings
Protect policyholders

Question 3

Disadvantages of regulation

Mnemonic - EPIC BLOC

Answer 3

Economies of scale (fewer) - the inability of companies to benefit from economies of scale and cost reductions due to anti-competitive legislation

Premiums increased - the increased premium cost to the public arising from levies and the general increase in insurer expenses

Investment return lower - the inability to maximise investment returns when there are controls on investment decisions

Costs - the cost in terms of resource and finance to comply with and supervise the rules

Barriers to entry - the amount of regulatory bureaucracy deterring new entrants

Less insurance coverage - the failure of insurance to reach certain sectors of the population due to the increased cost of and restrictions on methods of distribution

Opportunity cost - the loss of business opportunities that arise from any restriction on a free market
the

Complex capital calculations - the difficulties and hence potential inaccuracies in complying with complex (risk-based) liability and capital calculations

Question 4

The aims of regulation

Answer 4

• correct market inefficiencies and promote efficient and orderly markets
• protect consumers of financial products
• maintain confidence in the financial system
• help reduce financial crime.

Question 5

list the direct and indirect costs of regulation.

Answer 5

Direct costs arise in:

• administering the regulation
• compliance for the regulated firms, ie maintaining appropriate records, etc.

Indirect costs arise from:

• an alteration in the behaviour of consumers, who may be given a false sense of security and a reduced sense of responsibility for their own actions
• an undermining of the sense of professional responsibility amongst intermediaries and advisors
• a reduction in consumer protection mechanisms developed by the market itself
• reduced product innovation
• reduced competition

Question 6

3 forms of regulation

Answer 6

1. Regulation can be prescriptive, with detailed rules setting out what may or may not be done.
   Recall that the detailed nature of prescriptive regulation can reduce the likelihood that things go wrong, but often with greater costs.
2. Alternatively, it can involve freedom of action but with rules on publicity so that third parties are fully informed about the providers of financial services.
3. Finally, the regime can allow freedom of action but prescribe the outcomes that will be tolerated.
   This last form of regulation is sometimes called ‘outcome-based’ regulation.

Question 7

5 types of regulatory regimes

Answer 7

1. Unregulated markets
   It has been argued that the costs of regulation in some markets, especially those where only professionals operate, outweigh the benefits.
2. Voluntary codes of conduct
   These operate effectively in many circumstances but are vulnerable to a lack of public confidence or to a few ‘rogue’ operators refusing to co-operate, leading to a breakdown of the system.
3. Self-regulation
   A self-regulatory system is organised and operated by the participants in a particular market without government intervention. The incentive to do so is the fact that regulation is an economic good that consumers of financial services are willing to pay for and which will benefit all participants. An alternative incentive is the threat by government to impose statutory regulation if a satisfactory self-regulatory system isn’t implemented.
4. Statutory regulation In statutory regulation the government sets out the rules and polices them.
   This has the advantage that it should be less open to abuse than the alternatives and may command a higher degree of public confidence. A disadvantage of statutory regulation is that outsiders may impose rules that are unnecessarily costly and may not achieve the desired aim. It is claimed that attempts by government to improve market efficiency usually fail and that financial services regulation is an economic good that is best developed by the market.
5. Mixed Regimes
   In practice many regulatory regimes are a mixture of all of the systems described above, with codes of practice, self-regulation, and statutory regulation all operating in parallel

Question 8

list the advantages and disadvantages of self-regulation

Answer 8

Advantages: 
 
The system is implemented by the people with the greatest knowledge of the market, who also have the greatest incentive to achieve the optimal cost benefit ratio.
Self-regulation should, in theory, be able to respond rapidly to changes in market needs.
It may be easier to persuade firms and individuals to co-operate with a self-regulatory organisation than with a government bureaucracy.
Disadvantages: 
The regulator may be too close to the industry it is regulating. There is a danger that the regulator accepts the industry’s point of view and is less in tune with the views of third parties – ie the consumers of financial services.
  This can lead to low public confidence in the system.
Self-regulatory organisations may inhibit new entrants to a market, eg by imposing very exacting capital adequacy requirements

Question 9

What is the key objective of regulation and supervision

Answer 9

to promote efficient, fair, safe and stable insurance markets and to benefit and protect policyholders.
A sound regulatory and supervisory system for insurance helps sustainable growth and healthy competition in the insurance sector.
A well-developed insurance sector also helps to enhance overall efficiency of the financial system by: 
 
reducing transaction costs, creating liquidity, and
facilitating economies of scale in investment.

Question 10

Explain how a well-developed insurance sector helps facilitate economies of scale in investment.

Answer 10

An efficient, competitive insurance industry is likely to have a good understanding of the risks it takes on, and to allocate capital to these risks appropriately. This is in contrast to individual policyholders, who would be less likely to hold appropriate reserves (if any) for these risks, had they chosen to retain them.
By pooling these risks, an insurance company can (a) hold a more appropriate amount of capital than the sum total held by individuals, and (b) achieve economies of scale in the investments it holds to back this capital.

Question 11

Why must the insurance sector operate on a financially sound basis?

Answer 11

The insurance sector must operate on a financially sound basis in order to: 
contribute to economic growth 
allocate resources efficiently 
manage risk
mobilise long-term savings.

Question 12

What is IAIS and when was it established?

Answer 12

Established in 1994, the IAIS represents insurance regulators and supervisors of more than 200 jurisdictions in nearly 140 countries, containing 97% of the world’s insurance premium income.
The IAIS has more than 135 observers comprising industry associations, professional associations, insurers and reinsurers, consultants and international financial institutions.

Question 13

3 main committees in IAIS

Answer 13

An executive committee, whose members represent different geographical regions, heads the IAIS. It is supported by three main committees:
1. the technical committee
2. the implementation committee
3. the budget committee.
These committees form subcommittees and working parties (working groups, task forces and groups) to accomplish their objectives.

Question 14

What does IAIS do?

Answer 14

The IAIS:

1. issues global principles, standards and guidance papers
2. provides training and support on issues related to insurance supervision, and
3. organises meetings and seminars for insurance supervisors.

Question 15

What are the objectives of IAIS?

Answer 15

The objectives of IAIS are to:

1. promote effective and globally consistent supervision of the insurance industry in order to develop and maintain fair, safe and stable insurance markets for the benefit and protection of policyholders
2. contribute to global financial stability.

The IAIS works closely with other organisations to promote financial stability. It holds an annual conference where supervisors, industry representatives and other professionals discuss developments in the insurance sector and topics affecting insurance regulation.

Question 16

What are IAIS Insurance Core Principles (ICPs)?

Answer 16

The IAIS has worked with a number of supranational financial bodies to produce recommendations for insurers and regulators alike. Thus, the global insurance community has been presented with a set of insurance principles that hold significant implications for company operations.
These have been set out in the Insurance Core Principles (ICPs) that the IAIS adopted in October 2011 and last updated in 2015. The ICPs comprise an internationally developed set of standards and guidance for insurance regulators.
The ICPs have the support of global financial organisations such as the IMF and World Bank.
Insurers are not obliged to follow this guidance (unless the regulator has adopted the ICP standards themselves), although it is recognised best practice for them to do so.

Question 17

What is Solvency II?

Answer 17

Solvency II governs the capital requirements for insurance companies in the European Union.
Solvency II is a risk-based approach to prudential requirements which brought harmonisation at the EEA level

Question 18

Suggest reasons why, under a risk-based approach, one insurer may have a higher capital requirement than another, despite having a lower written premium income.

Answer 18

The insurer may have written the same volume of business but at lower rates, so it has a higher insurance risk.
It may have purchased reinsurance from reinsurers with a lower credit rating.
It may have written more risky business,
eg:
more long-tail
more heterogeneous risks.

Question 19

What are the key objectives of solvency II?

Answer 19

The key objectives of introducing Solvency II were to:

1. increase the level of harmonisation of solvency regulation across Europe
2. introduce capital requirements that are more sensitive to the levels of risk being undertaken
3. provide appropriate incentives for good risk management
4. improve consumer protection.

Question 20

Examples of regulatory proposals

Answer 20

1. Restrictions on underwriting
2. Capital requirements
3. Investment requirements
4. Reporting requirements
5. Authorization requirements
6. Other requirements to protect PH

Question 21

Examples of regulatory proposals

1. Restrictions on underwriting

Answer 21

1. Restrictions on the type / amount of business a general insurance company can write / classes of business it is authorised to write. An authority could prevent an insurer from writing volatile classes of business or classes where it has little expertise.
   - Ensures companies have appropriate expertise / sufficient capital to write the business classes.
2. Limits on contract terms and premium rates that can be charged. For example, we saw earlier that some US states prescribe the level of personal motor premium rates. An authority could also set a maximum or minimum premium or restrict the way in which the premiums are calculated. For example an authority could set a maximum allowance for expenses defined as a percentage of the gross premium.
   - Ensures premium rates are sufficient to meet future claims / ensures policyholders not overcharged.
3. Restrictions on information that may be used in underwriting and premium rating, eg restrictions on rating factors used, or on the ability to decline cover.
   - For ethical / anti-discrimination reasons.
4. Requirement to file / publish premium rates before they can be used.
   - Prevents anti-competitive practices and therefore protects policyholders.
5. Restrictions on countries a general insurance company can write business in. – Prevents exposure to volatile risks and unfamiliar legal systems and regulations.
6. Mandatory restrictions on cover, eg no deductible on employers’ liability. –
   Prohibiting illegal products from being sold.
   – To discourage illegal practices.
7. Requirements to offer cover, eg even in high-risk flood areas / motor third party liability.
   – For social responsibility and helps economy as a whole.
8. Statutory requirement to purchase certain cover, eg employers’ liability and motor third party liability.
   – For social responsibility and helps economy as a whole. To

Question 22

Examples of regulatory proposals

2. Capital requirements

Answer 22

1. The requirement to deposit assets to back claims reserves.
   – To ensure the company has sufficient funds to pay claims.
2. Requirement to hold a claims equalisation reserve (if allowed).
3. The requirement to maintain a minimum level of solvency, ie a minimum level of free assets. This might, for example, be calculated as a proportion of premiums written.
   – To ensure if claims are significantly worse than expected the company will remain solvent.
4. The use of prescribed bases to calculate premiums, asset values and liabilities to demonstrate solvency.
   – To ensure accurate / consistent estimates of liabilities and uncertainty. 
5. The requirement for risk-based capital calculations and capital assessment analyses.
   – To ensure accurate estimates of liabilities and uncertainty.

Question 23

Examples of regulatory proposals

3. Investment requirements

Answer 23

1. Restrictions on the type or amount of certain assets allowed to demonstrate solvency.
   – To prevent high-risk assets from backing liabilities, or to encourage diversification.
2. Restrictions on the currency, domicile and duration of assets allowed to demonstrate solvency (or mismatching reserves).
   – To ensure that assets match liabilities by term and currency so that short-term changes in exchange rates will not have an impact on solvency margins
3. Other regulations concerning investments could include:
   - requirements to hold prescribed assets, eg government securities
   - restrictions on holding certain assets, eg foreign securities
   - restrictions on the amount of investment in any one company / group custodianship of assets.

Question 24

Examples of regulatory proposals

4. Reporting requirements

Answer 24

1. Disclosure / transparency of reporting requirements, eg a requirement to provide detailed reports and accounts at prescribed intervals.
   – To help regulators, investors, capital providers and policyholders assess the soundness of the company.
2. Requirement for a Statement of Actuarial Opinion to be produced by an approved actuary.
   – Promotes confidence in the level of reserves and helps to prevent the failure of a general insurance company.
3. Restrictions on the type of reinsurance that may be used.
   – To prevent exposure to risky reinsurers or reinsurance products.
4. Restrictions on discounting of liabilities and discount rates that can be used. –
   To ensure consistency and that reserves are sufficient.
5. Requirement for general insurance companies to be audited.
   – To give regulators and investors confidence in the company and to prevent fraud.

Question 25

Examples of regulatory proposals

4. Authorization requirements

Answer 25

1. Initial authorisation of new insurance companies.
   – Ensures companies have appropriate expertise / sufficient capital to write the business classes.
2. Licensing agents to sell insurance and requirements on the method of sale.
   – To ensure company has necessary expertise and that insured is well informed.
3. Requirements for management to be fit and proper, eg restrictions preventing specific individuals from holding key roles in companies.
   – Promotes confidence in the industry and helps prevent fraud.

Question 26

Examples of regulatory proposals

5. Other requirements to protect PH

Answer 26

1. Requirement to purchase reinsurance.
2. Legislation to protect policyholders should general insurance companies fail, eg Financial Services Compensation Scheme in the UK.
   – To protect policyholders and maintain faith in insurance market.
3. Requirement to pay levies to consumer protection bodies.
   – To protect policyholders and maintain faith in insurance market.
4. Cooling off period, eg fourteen-day cancellation rules on policies issued.
   – To protect policyholders and promote confidence in the industry.
5. Advertising restrictions.
6. Regulations with respect to treating customers fairly.
   – To protect policyholders and promote confidence in the industry.
7. Restrictions with respect to anti-competitive behaviour.
   – Prevents formation of cartels, concentrations of risk, and protects policyholders.