Risk Management Contributing to Financial Stability - Case Study Example

Risk Management Introduction The normal operation of a business carries with it a level of uncertainty which poses risks to the continuing operation of the business. Risk management is therefore that process that these businesses engage in in order to identify, assess and mitigate of those risks. Over the years, all have managed to find a way to internally create a buffer for any risk inherent in the business. However, these risks have spanned from environmental to financial in the last few years. The financial crisis of 2008 was the breakthrough in realizing the massive consequences on the global economy arising from lack of strong risk management policies. This was the start of the international intervention in the risk management policies, especially for the bank and insurance companies. In this awakening, there has been improvement in the regulatory framework guiding these financial institutions in both the global (from the FSB) and the local fronts. The FSB’s risk appetite framework requirements were focused on the capital strandr5ds, accountability and global standards for insurers. However the entry of the Solvency II framework, effective since 1 January 2016, incredibly changes the risk management practices for these financial institutions. Based on the three pillars of the framework, the framework is binding upon all EU financial institutions. However, other countries are limited in its applications. The UAE have adopted part of the principles in the development of their regulatory framework on risk management. This paper will therefore analyze the Solvency II framework and other risk management measures in place based on the discussion by Nesle (2015) and offer recommendation on its applications to SMEs in UAE. Solvency II Framework and Risk Management The risk appetite framework forms the foundation for each the solvency II framework and other regulatory requirements will be effective for insurers and reinsurers. The RAF requires that each company come up with their own measure and control of their risk appetite. The FAB defines risk appetite as a cumulative of the risks a financial institution is willing to assume within its risk capacity to achieve its strategic objectives and business plan (Financial Stability Board 2013). It is this framework that Nesle (2015) asserts that is necessary for the effective application and use any risk management policy that a company adopts. The RAF is instrumental in developing a culture where the company is made aware of its risks and the contingencies that come with the risks. Furthermore, RAF ensures that the company is able to come up with a model that ensures is in within its budget limits and capability, BOD can understand the risks that the company can comfortable be able to accept in line of its operations. This is because the RAF captures all aspects of risks the company would face and bring the accountability of these risk mitigation to not only the investment department to the CEO, Chief Risk Officer and the Chief Financial Officer (Financial Stability Board 2013 Pg. 7). As much as the framework directs all forms of risk, the solvency ii framework principally deals with the solvency risks. The solvency II framework is based on three pillar: pillar I focuses on capital requirements; pillar II deals with the governance requirements and risk management; pillar III outlines the disclosure and reporting standards of the capital and risk requirements set out in the other pillars. Under pillar II companies are expected to come up with their own risk and solvency assessment (ORSA). In principle, ORSA is the solvency II FRAMEWORK IN process through risk and time dimension (Nesle 2015). For effective allocation, ORSA considers both the internal and external factors to come up with the full assessment of the company’s risk in order to inform management’s decisions. Nesle (2015) shows that as much as ORSA is strategically sufficient for guiding the company through its risk readiness, it allows the insurance companies to adopt a capital needs policies for its future business. ORSA is also preferable in the risk management practices and increasing financial stability since it is at the heart of the solvency II framework (binding upon all European insurance companies) as it encompasses all the three pillars together. The solvency assessment forms the foundation that informs the company’s BOD on the stability of the company and its ability to take further business in the future (Nesle 2015). The FAB and IAIS also binds upon all insurers listed as Global systematically important insurers (G IIs) the policy measures that apply to them. Amongst these measure Nesle (2015) identifies the systematic risk management plan (SRMP) and the liquidity risk management plan (LRMP). There is also a requirement that insurers should have a recovery plan in the event that the company becomes susceptible to either the liquidity or market risks. Nesle (2015) notes that the plan are not quite effective as they ought to be because they do not offer a concrete way in which they can be applied in the risk manage t process of companies. In particular, the article identifies that the plans are nor exhaustive of the activities that the company ought to take into consideration in order address its risk appetite. Furthermore the plans are still up for reviews by the Crisis Management Group. According to the article, the solvency II framework is best suited to be used as the risk management framework for any Organisation. This is because the framework allows an organization, and in particular insurance companies, to address their credit, liquidity and market (interest rates) risk. This is encompassed in the assessment as indicated in pillar II of the framework. Furthermore, the SCR allows for any company to deal with their credit risk sufficiently as well as meet capital requirement that are best suited for their balance sheet outcomes. The article suggests that the LRMP can be used in consolidation with the framework to advance the risk management practice of insurers. The documentation and reporting as required in pillar III of the framework and the G IIs standards allows for the full accountability o the activities of the insurance company and the fore proves to be effective in the risk management process. Enterprise Risk management in the UAE In the UAE, most insurance companies apply the enterprise risk management (ERM) to identify the investment, insurance, asset/liability risks, operational risk and the strategic risks (Rudolph 2012). In a survey of the UAE showed that 40% of those interviewed did not have a risk appetite statement in place. Further, 41% of the insurance companies found it necessary to have a risk management framework. This shows that the implementation of the effective risk management framework in the UAE is very low and hence a need to increase compliance to the regulations. The regulatory framework of the insurance companies in the UAE is developed by the insurance authority. Or those that had in, among its top priorities included risk governance, risk appetite and implementation of the ERM. In the survey carried out by earnst & young (2015) that currently 78% of UAE insurance use auditing and physical inspection as their preferred ways of identifying the risks while only 70% applied self-assessments (pg.29. ). This goes to show that the risk management practices in UAE are in its development stage. The survey also showed that thesis an assumption that ERM is best suited for the large companies. In 2015, the IA of UAE introduced new regulations that will guide insurance companies in mitigating their risks, especially the solvency risk. Article 5 of the financial regulations of insurers require that an insurance company in assessing its solvency risk should take into account (1) underwriting risk, market and liquidity risk, credit risk and operational risk . The law further requires that the company to have in place a risk management system that outlines its policies and procedures, accountability for the risk and the control of the risks. In particular the new regulations focused on: investments of the rights of the policyholders; solvency margin and guarantee fund; record keeping; accounting policies (insurance authority 2015). The foundations of these regulations targeting risk management (solvency) are the solvency II principles that guide how companies should formulate their risk management practices. Nesle (2015) clearly showed that the solvency II was more effective, Through the ORSA, than the guidelines used by FSB and IAIS. The new regulations are binding on all insurance companies hither small, medium or the large players. Therefore it will be safe to say that small insurance companies can still apply these regulations. Further, the regulations require that the ERM system will be formed dependent on the size, volume, nature and complexity of the company’s business. Asset liability management The financial regulations (2015) are also clear on the asset liability management from the investing provision provided for in section I concerning the basis of investing the rights of the shareholder. Article 3 provides for the maximum investments limits for exposure in respective assets class and the sublimit for exposures in the respective single counterparty. This increases the diversity in the assets held by the company mainly for purposes of their ALM and reducing uncertainty in investments Mei-Hwen 2015). For instance, the Regulations keep a cap of 30% investment in the real estate, which in the recent past has been the driver of volatility (Mei-Hwen 2015) while financial derivatives (hedging instruments) have maximum of 1%. Section 4 of the Regulations further provides guidelines on determining the company’s assets that meet accrued insurance liabilities. The article defines the limits and the valuation of the assets that can be used by the insurer for solvency purposes. Capital requirements and solvency Section 2 Article 1 of the financial regulations 2015 require that each insurance company (A) should have a minimum capital of AED100 million and a minimum guarantee fund (article 2 (1)) of 1/3 of the minimum solvency capital. In the same spirit as the SCR developed by solvency II, article 4(2) of the Regulations requires that each company should calculate its own solvency requirement. The new regulation gives insurance companies to options of calculating its solvency. Apart from the minimum capital requirement in article 1, companies ought to have a minimum guarantee fund and the solvency capital requirements. The MGF as stipulated in article 7 depend on the solvency capital requirement or an amount to be specified by the authority based on the type of business and the net earned premium. The SCR is calculated for each company depend ng on the risks that the insurer is exposed in compliance with the template developed by the authority. The authority also requires that each company have ‘own funds’ which includes the basic own funds and the ancillary own funds. The funds requirement is also meant to ensure the insurer meets its solvency requirements as per part I of the regulations. Risk management assessment Based on pillar II of the solvency II framework, section 3 articles 5, 6, 7& 8 provide guidelines for insurance companies in UAE on developing their own risk management framework. Article 6 requires that a company develop its own risk management framework and come up with its own assessments of the risk (similar to the ORSA). Further, the regulations require that the minimum solvency capital, minimum capital requirements and the minimum guarantee fund should be funded by the company’s own fund, as defined therein (section 2 articles 7). The SCR of each company depends on the assessment of the underwriting, market and liquidity risks, and credit risks, operational risks (section 3 article 5(1) and addendum 1). In order to fulfill this regulation, there need to be in place a risk management system inclusive of a risk appetite statement; assessments of the risks and management systems for internal and external reporting (section 2 financial regulations). Clyde & Co. (2015) recommends that in order to meet the solvency requirements, the MCR will be most used by the small insurance companies. This is mainly because of the flexibility of the requirement and the precision. The minimum guarantee fund and the solvency capital requirement will however be applicable to firms with large volumes. The MCR requirement for insurers is AED100 million while the SCR and the MGF are based on the own funds of the company and the risks that the company faces. However the Regulations require that each insurer has its own self-assessment, which will need the application of the solvency capital requirements of the firm. Most of the small companies will most likely face some difficulties that pertain to the systems to be put in place. Milliman (2007) predicted that the application of the capital requirements of the solvency II framework would cause difficulties to small insurers due to the complexities of the framework in general. though the regulations clearly state that the requirements will depend on the size, volume and nature of business of the company, the authority is yet to clearly define what these measure really mean and the extent to which they apply to the small insurance companies. The IA regulations have reduced the calculation complexities of the capital requirements by giving standard minimum capital requirements for all insurance companies. In order to fill the gap that is presented by the capital requirements rule, the regulations has the own assessment requirement. Small insurance companies can therefore be able to comply with the financial regulations 2015 through this strategy. The risk managements systems to be out in place include a risk appetite statement from the company itself. Small insurance can benefit from this as the risk appetite framework is developed by the board of directors for each company in consideration of the risks that the company faces in their daily activities. Moreover, the risk appetite framework of each company is expected, by the FSB, to be aligned to the business plan, strategy and the capital requirements of the company (financial stability board 2013). The framework also includes a measure of the company’s risk limits and risk capacity, making its formation company specifics and hence applicable to even small insurers. There is formed, within each company, an investment committee and an audit committee that ensure that the board is well informed of the risks the company is facing before decisions are made. This strategy will also be practical for the small insurance companies, given the costs of having information systems for the purpose of establishing risks. For effectiveness of the committee, the FSB and the Regulation has in place the respective roles to be taken by the CEO, CRO and CFO of the company. In an assessment of the UAE regulations, Clyde & Co (2015) posit that the new regulations could potentially prove to be costly to the small insurance companies that have to deal with the implementation, monitoring and evaluation of the risk management systems. The core issue with the risk management regulations given by IA for UAE insurance covers all the risks that pertains to the insurance companies?; Whether the regulations are sufficient to manage all the risks faced by the insurance companies, especially the small size insurers. The risks that ought to be covered in the risk management include: credit risks; liquidity and market risks (investment); operational risks; underwriting (insurance) risks; Investments risks: the management of the investment risks shall be managed by the investment committee, with their own charter and guidelines approved by BOD, which is also responsible for determining investment guidelines and monitoring the investments of the company. Financial regulations addendum (2) requires that each company coming up with their investment strategy to include the objectives of the investment, the risk and liability of the company, and strategic asset allocation: all of which ensure that the company is prepared against any investment risks. Section 1 of the Regulations further ensures that the insurer has a diversified investment risk in place through the investment caps in the asset allocation and investing. Market risks: the insurance sector is very much susceptible to market risks which include the foreign exchange risks, interest rates risks and equity risks. This is one of the risks that are captured in the risk appetite framework compiled by the BOD. Furthermore, the asset liability recognition policy of the insurer will include measures that guard the insurer against default. Liquidity risk, as noted by Nesle (2015) is not a threat to the insurance sector as it to the banking sector but the insurer is still is risk of liquidity problems. Section 1 addendum (3) 1(b) requires that the risk management developed to capture the liquidity risk of the company to include procedures to monitor liquidity of assets; uncertainty; sources of funding all in consideration of the currency in use and its volatility (1(c)) Credit risks in the insurance industry arise from failures of other party fulfilling their own financial obligations. Risk management framework of each company, according to the Regulations addendum (3) should include the credit risk limits of the company. The credit risk is further captured in the solvency margin and capital requirements: the SCR covers other credit risks exposures experienced by the insurer especially those stemming from the equity market uncertainties. Conclusions Since the financial crisis of 2008, the issue of adequate risk management has taken center stage in the international debates especially of the capital requirements of financial institutions. The IAIS in collaborating with FSB has come up with effective ways to mitigate the impact of uncertainties that occur in the financial market. The solvency II framework is a development of the solvency I framework that seek to ensure that insurance companies within the European Union are prepared for any risks. The solvency II has been since gaining popularity including in the United Arab Emirates where risk manifest practices are very low. The UAE insurers’ authority financial regulation, based on the solvency II framework, is efficient and effective in addressing the risk management problems of UAE firms and specifically the small insurers. The regulations provide the best foundation for the formulation of ERM suitable for small insurers by addressing its basic risks. References Clyde & Co. September 2015 Article Two Update Ernst & Young April 2015 MENA Insurance Enterprise Risk Management Survey Financial Stability Board Principles for an Effective Risk Appetite Framework 18 November 2013 Insurance Authority United Arab Emirates: Board of Directors’ Decision Number (25) Of 2014 Pertinent To Financial Regulations for Insurance Companies Mei-Hwen W April 2015 regulations: upgrading the UAE’s insurance market Middle East Insurance Review [online] available from: www.meinsurancereview.com/Magazine/ReadMagazineArticle?aid=36188 Milliman 2007 implications for insurers of Solvency II Nesle A How is risk management contributing to financial stability? The perspective of a European-GSII Journal of Risk Management in Financial Institutions Vol. 8, 4 358-364 19th May, 2015 Read More