New Risk-Based Capital Requirements for the Brazilian Insurance Market
New Risk-Based Capital Requirements for the Brazilian Insurance Market
Brazil is set to become a major world economy. Find out how large a part the opening of the reinsurance market has played in this.
As part of a year-end flurry of activity, the Brazilian Insurance Regulatory Body, SUSEP, via the National Board of Private Insurers (CNSP) released several new regulations, one of which revises reserving guidelines and four of which establish new capital requirements for the insurance (excluding pensions) industry.
Resolution 155 establishes the minimum capital required to operate. This capital is composed of Base Capital, which is a fixed amount per region in which the insurer operates, and Additional Capital, which is variable and meant to reflect the risks inherent in the business of insurance. The regulation states that additional capital requirements will be promulgated for credit, market, legal, underwriting and operational risks. The Additional Capital for Underwriting Risk has been defined in Resolution 158, the fourth of the regulations published on December 29 regarding capital.
Brazil is on the verge of being a major world economy and with inflation apparently under control (approximately 3 percent for 2006), investment-grade status will not be long in coming. As a result, there has been consistent pressure from the international community for Brazil to make necessary reforms in its insurance market, such as the opening of the reinsurance market, which was finally signed into law in January. The Brazilian primary insurance market, with over US$15 billion in premium, has been open since the mid-1990s and there are currently over 20 multinational players, five of which are in the top 10 companies and 13 of which are in the top 20.
As part of this focus on improving insurance regulation, SUSEP has proposed or implemented a series of measures with the goal of increased self-regulation and a stronger risk management culture. Solvency II is a clear inspiration for their initiatives and the role of the actuary in Brazil will likely have a new level of visibility within the insurance company environment. This is a significant advance over the current regulatory regime and quite different from other markets in the region.
Minimum Capital Requirements
Current capital requirements have been fairly simple—basically the greater of 1/3 of average net incurred losses over the last three years or 1/5 of net written premium. The new regulation has four main points: 1) the definition of minimum capital and of the levels of Base Capital required by region, 2) defined action for varying levels of capital insufficiency (shown in Table 1 on page 12), 3) transition rules, and 4) the effective date of Jan. 1, 2008, or one year after publication, with calculations to be made on a monthly basis.
The regulation states that additional capital requirements will be promulgated for credit, market, legal, underwriting and operational risks and that until all five risks have Additional Capital regulations in place, the transition rules apply, with the adjusted policyholder surplus compared to the greater of the current solvency margin calculation and the new minimum capital required. Further, there is a period of three years in which an insurer has to raise the Additional Capital due to that particular risk. In other words, if a company is found to be R$100 million1 deficient in January, 2008, it will have to cover R$30 million within one year, another R$30 million the following year, and the remaining R$40 million by the end of the third year. What is unclear is how any deficiency calculated in January 2009 (or any point in time after January 2008) will be coordinated with the capital infusions defined by this transition rule.
Additional Capital Due to Underwriting Risk
Resolution 158 defines the Additional Capital required for insurers based on their underwriting risk. The key points of this regulation are: 1) portfolios exempt from the legislation; 2) the formula (and parameters) to be used in calculating a company's Additional Capital; and 3) the definition of an "internal model," which allows companies that have one to use lower parameters to calculate their capital.
The formula to calculate the Additional Capital is not complex mathematically, although it looks fairly daunting (See below). There are 12 classes of business (which apply to net written premiums and net case-incurred losses, or sin) and three regions (which apply only to premiums). Each of these segments has factors, as well as a correlation factor between them.
What is inconvenient about this formula is that due to its non-linearity and the presence of correlation factors, the marginal impact on capital due to an increase in premium in a given segment is not easy to determine solely from the factors in the tables, as it depends also on a company's volume in each of the segments.
Pension companies are not subject to this regulation. Further, industry pools and life insurance savings products with minimal risk embedded in the policy relative to the savings component (most non-term life insurance products in the Brazilian market) are excluded from the Additional Capital calculation. (In other words, these requirements apply to companies that operate in P&C and Group Life.) However, as an insurer's surplus is not segregated by product, this exemption creates the impression that capital is not required to support these products.
Consolidating Brazil's entire Group Life and Personal Accident portfolio into one company (which does not write any other business) results in a calculated Minimum Capital of R$4.9 billion to support R$8.5 billion of net written premium, implying a leverage ratio of 1.7. Further, an additional 100 Reais of premium demands similar leverage, requiring an additional R$50 to R$63 of capital, depending on the region.
SUSEP, as part of their program to encourage companies to have a more risk-oriented view towards their business, is permitting companies with an "internal model" to use reduced factors in calculating their Additional Capital, resulting in a discount of approximately 15 percent. This model must be a dynamic financial capital adequacy model with at least one macroeconomic variable. Further, although not explicit in the regulations, it is the regulator's intention that the model must be used as part of the company's decision-making processes. Again, it is important to reiterate that the results of a company's model will not be used to determine its capital level, but only to determine which tables of industry factors it can use in calculating its Additional Capital based on the regulator's formula.
As mentioned above, various actions will be required depending on the level of capital deficiency of an insurance company. These are described in the following table.
Simulations of the market using November, 2006 data show that more than 20 of the 110 companies in the market will be subject to Regulatory Supervision and a similar number will need to present Solvency Recovery Plans.
Impacts on Brazil's Life Insurance Market
According to Brazilian Regulation, life insurance can be underwritten by an insurance company or by a life insurance and pension company. As this Additional Capital is not currently required for pensions or Individual Life products (as mentioned earlier), the Life/Pension companies will appear to have a significant excess of capital. The concern is that companies may make strategic decisions without considering this and once these portfolios have their own capital requirements, they may find themselves significantly undercapitalized (See Table 2).
Besides the significant increase in capital requirements across the board, we can see from Table 2 that Group Life Insurance Companies (defined as those with Group Life and Personal Accident net written premium making up more than half of their total) are more than 30 percent deficient while Pension and Individual Life insurers (defined as having more than 80 percent of their premium in these lines) show a tremendous excess in capital. This is likely a distortion due to the fact that these premiums continue to not be included in the Capital calculation.
Sensitivity analysis shows that there are some diversification opportunities that allow greater leverage for life insurers. However, these opportunities are typically in more obscure lines of business (Liability, Hull, Bonds, Credit, etc.) that require specific expertise. Geographic diversification allows for some slight improvement in leverage, but not a great deal, and these benefits disappear fairly quickly as the portfolio balance shifts. The most obvious form of capital relief, especially given current events, is greater reliance upon reinsurance. However, it seems somewhat counter-intuitive that insurance companies should enter in large-scale quota share treaties with reinsurers on mature, frequency-driven portfolios.
As the non-regulated capital will allow life insurers to possibly avoid capital infusions in the near-term, this could provide an opportunity for the market to practice greater discipline and build up the necessary capital through retained profits. The need for this discipline and an improved ability to analyze books of business for true underlying profitability will be particularly key given the continued fall in interest rates.
It is likely that these increased capital requirements will lead to further consolidation in the Brazilian insurance market. (The regulator has even stated that they hope that this will be a result of these changes.) However, given the increased level of capital necessary, and the spectre of further additional capital requirements in the future due to the other risks (credit, asset, operational, legal), the reduced Return on Equity resulting from these acquisitions may make them unattractive. But for the few companies that are truly over-capitalized, this could be a significant opportunity.
With a population closing in on 200 million, a strengthening economy and a growing awareness of the need for insurance and a greater offering of low-price, high-penetration products, the Brazilian market has significant potential for those companies that can operate in an efficient, disciplined manner. And with the new capital regulations, the weaker players will need to exit the market, perhaps opening space for more strongly capitalized entrants.
David Sommer, FCAS, is managing partner at EMB Consultores America Latina.
"Brazil is on the verge of being a major world economy. ... As a result, there has been consistent pressure from the international community for Brazil to make necessary reforms in its insurance market."
"With a population closing in on 200 million, a strengthening economy and a growing awareness of the need for insurance ... the Brazilian market has significant potential for those companies that can operate in an efficient, disciplined manner."