Enterprise risk management could help insurers in Brazil as they strive for increased capital efficiency in a climate of decreasing returns from financial assets, higher regulatory, risk-based, capital requirements and growing competition. Nuno Vieira explains
Growing interest in enterprise risk management among larger Brazilian firms has embraced measures ranging from explicit and clear risk appetite statements emanating from the top of the organisation to the reinforcement of internal audit, actuarial and risk management functions.
Two main factors are driving this need. First, a historical reduction of interest rates has been depressing the return on invested assets and shifting attention to measures that could effectively enhance underwriting profit on a sustainable basis.
Second, the market consolidation to around a half-dozen strong insurance providers with well-established distribution channels has sharpened competition, thus creating pressures against "transferring" operational inefficiencies and rising capital cost to premiums. The following example is illustrative of this trend.
The supply of life insurance in Brazil is heavily concentrated in two basic product designs: life insurance guarantees, which are short-term with non-levelled (age-dependent) premiums and include lump-sum payments upon death, accident and disability; and pension products, which are mostly investment contracts with (very unattractive) guaranteed annuity options.
The view from São Paulo
Nuno Vieira is senior manager, financial services, at Ernst & Young Terco in Brazil. Armed with a first degree in economics, a master's degree in operations research and a post-graduate diploma in risk management, he has spent 12 years advising clients in Portugal, Brazil and Poland. His experience includes managing a Solvency II programme for a large Portuguese insurance group and many other risk-related projects for insurers and pension funds.
What's your personal involvement with Brazil?
I'm currently living and working in Brazil, after spending several years working in Europe, mainly in Portugal. I'm a consultant advising financial institutions in the risk and regulatory arena.
What's been your involvement with the insurance industry there?
I've been supporting insurance companies in Brazil to develop and enhance their risk management systems and practices, particularly on risk gap analyses against best practices; risk modelling and quantification; risk reporting; and integration of risk within business strategy, performance and processes.
How big is the foreign participation in the local insurance industry?
The Brazilian market is highly concentrated both in theproperty/casualty and life business (with the five biggest companies having about 65-70% of total market share) and dominated by local Brazilian companies.
Most major foreign insurance companies have a presence in Brazil, through joint ventures and associations with local companies or independent operations. Foreign companies have higher market share of more complex products or specialised segments, but we can also see a trend of growth in traditional products such as motor, given the dynamics of the market (the Brazilian insurance market is growing fast – about 15% each year.)
Are local insurers and regulators following the moves in the US towards solvency modernisation and an ORSA, as well as Solvency II?
Major insurance providers in Brazil are showing a growing interest in implementing modern enterprise risk management techniques, and establishing a corporate structure with well-embedded and useful risk management functions may become an indispensable condition for surviving and succeeding in the Brazilian insurance market. Strategies based on sheer volume, product homogeneity and short-term profits offer increasingly limited opportunities for success.
This conclusion applies equally to property and casualty insurers. For instance, the automobile insurance market is characterised by strong players, fierce competition and a trend toward high combined ratios, for which the high frequency of fraud and litigation claims are major contributors. Therefore, in this business, success requires a constant improvement of data governance, combined with well-informed risk-evaluating intelligence and technology throughout the processes of underwriting, risk classification, pricing and reserving.
On the regulatory front, there is some convergence of SUSEP rules with the Insurance Core Principles of the International Association of Insurance Supervisors, so expect more regulation in Brazil consistent with new standards of risk and capital management in insurance. A similar approach is expected on the ORSA-like regulatory requirements, under which insurers design, develop and implement formal processes to achieve a deeper integration of risk management (and internal models when applicable) with their business plans. A more pragmatic and less demanding framework than Solvency II may be a feasible regulatory strategy for Brazil.
On the other hand, products that are actuarially more complex from a risk management point of view – such as life annuities, endowment insurance, long-term life insurance with levelled premiums or life insurance contracts with participation features – represent a very small percentage of life insurance industry liabilities. As a result, the market volume in these lines has been growing at a slower pace.
The big challenge for life insurers in Brazil, then, is how to increase capital efficiency in the context of decreasing returns from financial assets, higher regulatory (risk-based) capital requirements and growing competition with strong market players.
Benefits and challenges of implementing pillar 2
The strategic path seems to go through one (or both) of the following alternative landscapes.
In one approach, survival may require merging, purchasing existing portfolios or entering new partnerships in order to explore existing distribution channels and maintain profitability through potential economies of scale and stronger market position.
Another approach may be to invest in riskier assets aiming to achieve higher returns and to supply more sophisticated and appealing life and pension products with longer-term guarantees, for example, whole life insurance with levelled premiums and (affordable) life annuities.
The option for mergers, acquisitions and partnerships may reach a saturation point if the market suppliers become too concentrated. In that case, the alternative of innovating through product design may be a good strategy and will require correspondingly more robust enterprise risk management (ERM). On its own, ERM could deepen technical capabilities to venture into new, unexplored market niches or offer better commercial conditions for insurance consumers in consolidated markets.
As a corollary, establishing a corporate structure with well embedded and useful risk management functions may become an indispensable condition for surviving and succeeding in the Brazilian insurance market. Strategies based on sheer volume, product homogeneity and short-term profits offer increasingly limited success opportunities.
These may lose out to strategies oriented towards product diversification, innovation and sustainable yields where the assumption of riskier positions in search for higher profits is secured by a solid risk management framework.
For quite similar reasons, this conclusion applies also to property and casualty insurers.
For instance, the automobile insurance market is characterised by strong players, fierce competition and a trend towards high combined ratios, for which the high frequency of fraud and litigation claims are major contributors. Therefore, in this business, failure or success requires a constant improvement of data governance, combined with well informed risk-evaluating intelligence and technology throughout the processes of underwriting, risk classification, pricing and reserving.
In Brazil, detailed monthly reporting requirements of individual policy and claims data for the Brazilian regulatory authority, Superintendência de Seguros Privados (SUSEP), were introduced in 2004. Insurers have been encouraged to make greater investments in data governance in order to comply with the new requirement. However, as a consequence, they need to be careful when reconciling the outputs of operational systems with accounting records.
In summary, sound and effective risk management may be the best strategy for Brazilian insurers to gain a competitive edge in saturated markets and venture in new market niches through innovation. The benefits may far surpass the gains from "volume" strategies such as mergers and acquisitions.
Pillar 1 initiatives in Brazil
In a consistent and gradual path towards risk-based supervision, SUSEP has implemented the following pillar l measures during the last 10 years:
- Valuation of liabilities. A defined set of principles and rules was established for determining technical provisions in order to cover all expected losses and expenses inherent in insurance contracts, including those liabilities arising from embedded options and guarantees. Furthermore, pursuant to the adoption of International Financial Reporting Standards (IFRS) as Brazilian generally accepted accounting principles (GAAP) in 2010, the SUSEP established detailed guidance on how to perform liability adequacy tests in order to verify the sufficiency of the official technical provisions.
- Standard risk-based capital requirements. In 2007, the SUSEP introduced a solvency capital requirement based on underwriting risks for short-term insurance contracts, aiming to protect insurers against unexpected losses arising from provision and premium deficiencies. Two years later, the capital charge was extended to include protection against default risk. The effect of this new risk-based standard was generally an increase in the required capital for operating in the Brazilian insurance market.
- Maximum retention limits. Regulatory retention ceilings per type of risk were fixed based on percentages of a fair-value measure of net asset values.
Adopting new measures for pillar 3
In 2004, the SUSEP introduced the requirement that each insurance company should produce an annual actuarial valuation report demonstrating the adequacy of all technical provisions as of the financial closing date. This included making statements about data quality, methodological approaches and historical consistency of best estimates. The collateral effect of this requirement was to reinforce the actuarial function within the governance structure in insurance companies.
In 2010, the Brazilian insurers adopted IFRS as the guiding accounting standard for producing statutory financial statements. This moved Brazilian GAAP towards a more fair value-oriented approach and required more disclosure about the financial condition of insurance companies.
The way forward
The agenda for the SUSEP in the next few years appears to be consistent with risk-based supervision. The implementation of standard risk-based capital requirements for longevity, mortality and disability and expense and benefit revision risks arising from long-term life and pension contracts is planned for this year. Simultaneously, initial proposals are being drafted for the standard formula for capital charges based on operational risk. Also, a technical commission was created within SUSEP to study a standard formula for market risk.
There is some debate about the feasibility of allowing insurers to substitute risk-based capital charges (as determined by standard formulas) with insurers' internal models of economic capital.
Consolidation and competition
The Brazilian market has witnessed a series of mergers, acquisitions, strategic alliances and joint ventures of insurance providers since 2000, and particularly after 2005. These events have been driven both by regulatory activity and market dynamics. Increasing capital requirements and higher operational standards – promoted by regulatory and supervisory authorities – as well as declining capital supply in the wake of the international financial crisis since 2008, have led to market consolidation and takeovers.
This development coincides with a sharp increase in the participation of banks and international insurance companies in the Brazilian insurance market. As a consequence, there is concern among market agents that the implementation costs and capital requirements associated with the new risk-based supervision paradigm may induce additional consolidation waves in the insurance industry and may even hamper the growth of small and mid-sized companies.
In the years to come, after regulating all risk-based capital charges, it is expected that the regulator will allow internal models for regulatory purposes, but the degree of allowance is still unclear.
Will the regulator accept the amount of capital charge given by the internal model as regulatory capital (as in Solvency II?) Or a different set of parameters applicable to a standard formula considering some regulatory capital gain (more aligned with Basel II?)
A similar approach is expected on regulatory requirements like the own risk and solvency assessment (ORSA), i.e. that insurers design, develop and implement formal processes to achieve a deeper integration of risk management (and internal models when applicable) with their business plans. A more pragmatic and less demanding framework than Solvency II may be a feasible regulatory strategy for Brazil.
Nevertheless, the more rules-based approach that SUSEP adopted for the Brazilian business environment may not be understood. There is growing demand for improved ERM from both regulators and managements of insurance companies.