The insurance industry is following the banking sector in implementation of risk-based capital (RBC), which is known as Solvency II and is scheduled to be implemented in Europe by the end of 2012.
In India, the life insurance industry is following rule-based capital requirement, known as solvency ratio. The companies are required to maintain assets at 1.50 times the discounted value of policyholders liabilities and any shortfall is met by infusion of capital by the shareholders.
As per Irdas annual report for 2010-11, as on March 31, 2011, it ranges between 1.54 to 6.70 among the companies. Maintaining too much capital leads to chasing undesirable business and low return on capital. But lower capital base is risky in volatile conditions and the companies run the risk of ruin. It also fails to provide a feeling of security to its customers.
Solvency II is a principle-based approach and calculates RBC through internal models. While the rule-based approach focuses on capital adequacy, the principle-based approach focuses more on capital efficiency. Under Solvency II, the capital requirement will be calculated taking into consideration the various risks faced by the company, i.e, insurance risk, credit risk, market risk, interest rate risk and operational risks. The better the risk management in the company, the lower will be the capital requirement. Once RBC is introduced, the companies will be constrained to improve the risk management systems. But RBC in the insurance sector in India will take more time since it awaits implementation of IFRS, which needs to address market consistent valuation of liabilities.
In the initial phase of the opening of the life insurance sector, there were vast opportunities for business growth and, coupled with a booming capital market, the sector witnessed tremendous growth.
But with the financial crisis of 2008 and the subsequent market downturn, business growth has been affected. Uncertainties have increased and the companies have been caught unawares.
The response requires strong risk management and governance through Enterprise Risk Management(ERM). The objectives of ERM are continued growth, earnings stability, continuity of operations, survival, reduction in anxiety, meeting externally imposed obligations, good citizenship and social responsibility. The companies can protect and create value for their stakeholders, including owners, employees, customers and the regulator by identifying and proactively addressing risks and opportunities. There are costs for not managing the risks adequately. It results in variable business performance, increase in customer grievances, tarnished brand, regulatory penalties, attrition, increased cost of capital and reduction in enterprise value.
The mandate for ERM should start from the top management and the risk aware culture should percolate down the whole organisation. There should be a common risk language. The roles and responsibilities must be clearly prescribed for the board, committees of the board and senior management. The chief risk officer should be independent in functioning. Risk ownership must be clearly defined and aligned with roles and responsibilities. The incentives and compensation should be consistent with the desired risk behaviour at all levels. The board and top management should communicate the risk profile and ensure that it is integrated with the companys strategy. The process for reporting and monitoring risks should be clearly defined. The board must be kept informed of major risk developments.
The challenges for implementing ERM comes from organisational resistance to change, business units reluctance to implement risk-adjusted results, decision-making driven by top line growth, lack of understanding of the key interdependencies of various functions, lack of mandate for risk function and viewing risk management function as a mere control function. In the current scenario, it will be costly for the companies to defer implementation of ERM and wait for Solvency II.The companies can adopt a top-down approach in identifying risks and sensitise the organisation in mitigating them. The major visible risks are reputation risk, regulatory risk and strategic risk.
The writer is chief financial planner, Max Secure Financial Planners