CONFIDENTIAL FOR RESTRICTED USE ONLY (NOT FOR USE BY THIRD PARTIES) FINANCIAL SECTOR ASSESSMENT PROGRAM RUSSIAN FEDERATION INSURANCE SECTOR TECHNICAL NOTE JULY 2016 This Technical Note was prepared in the context of a joint World Bank-IMF Financial Sector Assessment Program mission in the Russian Federation during April, 2016, led by Aurora Ferrari, World Bank and Karl Habermeier, IMF, and overseen by Finance & Markets Global Practice, World Bank and the Monetary and Capital Markets Department, IMF. The note contains technical analysis and detailed information underpinning the FSAP assessment’s findings and recommendations. Further information on the FSAP program can be found at www.worldbank.org/fsap. THE WORLD BANK GROUP FINANCE & MARKETS GLOBAL PRACTICE CONTENTS Acronyms .................................................................................................................................. 4 I. INTRODUCTION ......................................................................................................... 6 II. EXECUTIVE SUMMARY ........................................................................................... 6 III. INSTITUTIONAL, REGULATORY AND MARKET STRUCTURE OVERVIEW . 8 A. Institutional and Regulatory Overview ............................................................. 8 B. Market Structure and Sector Performance ...................................................... 13 IV. MAIN FINDINGS AND CHALLENGES .................................................................. 20 A. Regulatory and Supervisory Key Findings ..................................................... 20 B. Market Key Findings ....................................................................................... 26 C. Insurance Sector Key Challenges .................................................................... 31 V. RECOMMENDATIONS ............................................................................................ 33 TABLES Table 1: Minimum capital requirements ...................................................................................................... 11 Table 2: Insurance penetration and density .................................................................................................. 13 Table 3: Insurance market size and structure ............................................................................................... 14 Table 4: Non-life insurance premiums ......................................................................................................... 15 Table 5: Non-life insurance market profitability .......................................................................................... 16 Table 6: Agricultural insurance .................................................................................................................... 17 Table 7: Life insurance premiums ................................................................................................................ 18 Table 8: Number of insurance companies .................................................................................................... 19 Table 9: Insurance sector concentration ....................................................................................................... 19 Table 10: Key performance indicators ......................................................................................................... 26 Table 11: Key challenges of insurance sector in the Russian Federation ..................................................... 31 Table 12: Mapping credit quality steps with ECAI ratings .......................................................................... 40 Table 13: Types of insurance risks ............................................................................................................... 42 Table 14: Credit risk monitoring .................................................................................................................. 43 Table 15: Operational risks .......................................................................................................................... 44 FIGURES Figure 1: CBR insurance supervision functions ............................................................................................. 9 Figure 2: Macroeconomic impact on insurance development ...................................................................... 14 Figure 3: Non-life insurance solvency ......................................................................................................... 16 Figure 4: Impact of normative coefficients to solvency ratios ..................................................................... 22 Figure 5: BF method results’ reliance upon static assumptions ................................................................... 23 Figure 6: Impact of potentially understated reserves to solvency ................................................................ 24 Figure 7: Development of reinsurance premiums in Brazil ......................................................................... 29 Figure 8: NCR’s capacity vs. commercial reinsurers ................................................................................... 31 Figure 9: Insurer’s electronic dosier ............................................................................................................. 34 Figure 10: Early warning system phases ...................................................................................................... 35 Figure 11: A sample of key tests and ratios for non-life insurance .............................................................. 36 Figure 12: IMF FSAPs and completion of insurance stress tests ................................................................ 47 Figure 13: Characteristics of intermediaries’ licenses and registrations ...................................................... 52 Figure 14: Training of intermediaries........................................................................................................... 53 Figure 15: EU insurance group definitions .................................................................................................. 54 Figure 16: Group solvency ........................................................................................................................... 55 Figure 17: EU Solvency II pillars................................................................................................................. 55 Figure 18: Intermediate steps to risk based supervision .............................................................................. 55 3 Acronyms ADR Alternative dispute resolution ALM Asset liability matching AML Anti-money laundering ARIA All Russian Insurance Association BAFIN Federal Financial Supervisory Authority in Germany BF Bornhuetter-Ferguson CBR Central Bank of Russia CDF Claims development factor CEO Chief executive officer CFO Chief financial officer CFT Combating the financing of terrorism CIO Chief investment officer CMTPL Compulsory motor third party liability CRO Chief risk officer Delegated Regulation Delegated Regulation (EU 2015/35 of 10 October 2014)1 EIOPA European Insurance and Occupational Pensions Authority ERM Enterprise risk management EU European Union EU SI EU Solvency 1 EU SII EU Solvency 2 EWS Early warning system FFMSR Federal Financial Markets Service of the Russian Federation FMA Financial Markets Authority in Austria FSAP Financial Sector Assessment Program GDP Gross domestic product GWP Gross written premiums IAIS Insurance Association of Insurance Supervisors IBNR Incurred but not reported ICP Insurance core principle IFRS International financial reporting standards ILS Insurance linked security IMD Insurance Market Department Insurance Law Law N 4015-1 "On the organization of insurance business in the Russian Federation" IRB Brazil Re (Instituto de Resseguros do Brasil) IT Information technology MCR Minimum capital requirement MIS Management Information System MoCE Margin over the current estimate Motor CASCO Voluntary own motor vehicle insurance 1 http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32015R0035&from=EN 4 NMER Net maximum event retention NRC National Reinsurance Company NWP Net written premiums OECD Organisation for Economic Cooperation and Development ORSA Own risk and solvency assessment OSFI Office of the Superintendent of Financial Institutions in Canada PCR Prescribed capital requirement PLR Premium leverage ratio PML Probable maximum loss RBNS Reported but not settled RoE Return on equity RR Receivables ratio RUB Russian Rouble S&P Standard & Poors SCR Solvency capital requirement SMR Solvency margin ratio SRO Self regulated organization SUSEP Superintendence of private Insurance in Brazil ULR Ultimate loss ratio USD American dollar VAT Value added tax 5 I. INTRODUCTION 1. This technical note covers the insurance sector supervised by the CBR. The analysis was carried out as part of the 2016 Financial Sector Assessment Program (FSAP) of the Russian Federation, and was based on the regulatory framework, supervisory practices and other conditions as they existed in March 2016. Relevant information including laws, by-laws and regulations as well as responses to a questionnaire sent out in advance were provided by the CBR before and during the mission. 2. The assessment has been supported by discussions with the CBR and the insurance market participants. The assessors are thankful for the full cooperation and support received from the CBR and the Russian insurance market in carrying out the assessment. II. EXECUTIVE SUMMARY 3. With about RUB 988bn (USD 26bn) in gross premium written, in 2014, the Russian insurance industry ranked 27th in the world.2 Non-life insurance premium accounted for 89 percent of GPW while life insurance for only 11 percent. The ratio of insurance assets to GDP amounted to 2 percent, which is far below the EU average of more than 50 percent. The insurance sector has shrunk in the past two years on account of several factors. In 2013-14, gross written premium in the non-life sector grew by only one percent in real terms, but declined by 12 percent in 2015 due to declining demand for voluntary insurance products in the context of deteriorating macroeconomic environment. The downgrade of Russia’s sovereign rating from BBB - to BB+ with a negative outlook (S&P, 2015) reduced the ability of large Russian insurers to write inward foreign reinsurance business. With combined ratios close to 100 percent over the last five years, the non-life insurance sector realized only marginal profits which were mainly due to the investment income. The current macroeconomic conditions significantly reduce consumers’ saving capacity and have an adverse impact on the development of life endowment products and credit life insurance which closely follows the downward trend in new loan originations in the banking sector at large due to the increasing inflation and bank interest rates. 4. Another factor that further undermined the profitability of the insurance industry in 2013-2015 has been the raising claims inflation in the MTPL segment of the market. The 2012 decision of the Supreme Court to extend consumer protection law to insurance claims enabled consumers to file insurance claims directly with the courts bypassing the insurance companies. In the absence of claims settlement guidelines for lower courts, this led to millions of arbitrarily high court awards to consumers. As a result, 2013-14, witnessed a major increase in MTPL claims although the situation considerably improved in 2015 due to some changes 2 http://www.swissre.com/media/news_releases/Stronger_advanced_markets_performance_boosts_insurance_indust ry_growth_in_2014.html 6 introduced in the Insurance Law and the proactive stance taken by the All Russian Insurance Association on that issue with the government and the Supreme Court. 5. In 2015, the industry also faced with the consequences of the Western economic sanctions which effectively closed access to the high quality Western reinsurance capacity for the Russian insurers that provide coverage for 1500 large Russian companies that were put on the sanctions list. In the past, the Western reinsurers provided over 80 percent of reinsurance capacity for such risks. To address the problem, the government intends to establish a national reinsurance company (NRC) to be capitalized by the CBR, which will provide reinsurance capacity for large industrial and commercial risks emanating from these companies and will assume other difficult risks which are difficult to place in the commercial reinsurance markets (e.g. developers’ third party liability). While understandable, this approach may not be the most effective solution to the problems created by the sanctions regime for the Russian insurance. International experience with national reinsurance companies has been by and large negative, as most of them have been eventually privatized at a considerable cost to the state. In addition, the creation of the NCR will also have adverse effects on the market competition and the long-term stability of the Russian insurance market as the company is likely to emerge as the largest reinsurance player in the Russian Federation not constrained by market competition or even regulatory requirements. 6. The further consolidation of the sector will lead to a better performing insurance market. Since 2013, when the CBR took over supervision of the sector, the industry has been under increasing pressure to increase its solvency capital and liquidity of assets, improve the quality of regulatory compliance, internal controls and financial management. These tightened regulatory requirements have led to a major industry consolidation. In 2015 alone, 70 insurers lost their licenses. The introduction of planned new regulatory requirements in 2017 – such as the IFRS-like accounting rules, including the system of IFRS internal financial accounts, and actuarial valuation of insurers’ liabilities – is likely to reduce the number of companies even further. With the first 20 largest insurers already accounting for 77.5 percent of the gross written insurance premium in 2015, further consolidation is unlikely to have negative effects on market competition. 7. In the case of Russia, the main objective of insurance supervision is to ensure that insurers fully comply with core regulatory norms fixed by the law in the following four areas of insurance operations: (a) solvency (capital adequacy); (b) insurance reserves; (c) assets covering own funds; and (d) assets covering reserves. As a consequence, the main efforts of off- site and onsite supervision are focused on ensuring compliance of insurers with these four regulatory norms, which also determine the allocation of CBR regulatory resources. 8. The most profound implications of the current rule-based insurance supervision is a likely underestimation of the sector’s solvency. Even though the CBR requires insurers to submit actuarial assessments of reserves as part of their regular reporting, such estimates play no role in determining companies’ legal compliance with the insurance solvency requirement, which instead relies on a normative formula-driven assessment universally applied to all lines of insurance business regardless of insurers’ size and claims performance record. Such an approach 7 may materially underestimate the real solvency of the sector. As of 2017, with the introduction of IFRS reporting standards companies will be required to present actuarial assessments of their reserves on their solvency reporting forms. However, it is still unclear whether these risk-based assessments of insurance liabilities will be fully reflected in the calculation of insurers’ solvency ratio due to the lack of appropriate legislation. 9. While the dispersion of insurance supervisory functions among numerous CBR departments with various reporting lines carries certain advantages (such as a reduced potential for the conflict of interest), it also has a potential for major drawbacks. These include the (a) potential for insufficient coordination among different departments, (b) shortage of necessary insurance expertise within departments universally dealing with a wide range of financial services, and (c) impaired ability of the regulator as a whole to systematically detect problems with compliance in such a technically complex industry as insurance at an early stage. The rule-based supervisory framework and the current infrastructure do not fully support the implementation of the early warnings system which is designed to (a) detect and prevent negative solvency trends, (b) require insurers to take measures at an early stage of such negative trends and (c) report more frequently until the warning has been addressed. 10. Despite the negative macroeconomic outlook for 2016, due to the still very low personal insurance consumption ($179/per capita in 2014) and insurance premiums amounting only 1.4 percent of GDP, the Russian insurance industry is poised for further growth which can be encouraged by selected legislative and regulatory reforms. The most pressing issues to be addressed include but are not limited to: (a) introduction of actuarially set reserves for solvency assessment purposes and enhancing the role of supervision actuaries; (b) setting up an effective insurance supervision approach with automated data storing and processing capabilities that would ensure the optimization of contributions from all involved CBR departments; (c) development of an effective Early Warning System (EWS), with clearly set benchmarks to determine the topics and companies which require close attention; (d) introducing sound requirements on corporate governance and risk management; (e) developing sound CMTPL claims reserving standards as a prerequisite for the tariff liberalization; (f) introducing minimum requirements regarding the insurers' net retentions on per risk and aggregate level; (g) introducing agricultural insurance requirements for farmers receiving agricultural subsidies from the state; and (h) considering an alternative market-based approach to secure additional reinsurance capacity instead of creating a national reinsurer. III. INSTITUTIONAL, REGULATORY AND MARKET STRUCTURE OVERVIEW A. Institutional and Regulatory Overview The Supervisor 8 11. The CBR as a mega regulator. From 2013 the Central Bank of the Russian Federation (CBR) has become the single mega regulator for both credit and non-credit financial institutions. In the case of insurance supervision, the CBR has fully assumed the functions of the national insurance supervisor from the now abolished Federal Financial Markets Service of Russia (FFMSR). With the transfer of insurance market oversight to the CBR the quality of insurance supervision has markedly improved. In only two years, the CBR has greatly contributed to the development of national professional insurance market, strengthened its capital base, brought about noticeable improvements in the market conduct and facilitated the much needed consolidation of the industry by withdrawing licenses of almost 200 non-performing companies. Figure 1: CBR insurance supervision functions Source: CBR 12. Several departments of CBR are responsible for insurance supervision. Departments involved in supervision include: (i) Financial Market Access Department (in charge of licensing and conducting the public register), (ii) Department of Non-bank Financial Institutions’ Statements Collection and Processing (in charge of data collection); (iii) Financial Market Development (iv) Chief Inspection (in charge of onsite inspections for all financial institutions, including banks), (v) Department for Protection of Financial Services Consumers and Minority Shareholders (in charge of consumer protection), (vi) Financial Monitoring and Foreign Exchange Control (in charge of anti-money laundering), and (vii) Insurance Market Department (IMD) in charge of off- site monitoring of insurance market. The later acts as the core insurance supervision department which performs the overall market monitoring and coordinating role on all insurance supervision matters in cooperation with other CBR departments. 9 13. The IMD conducts its operations through its Headquarters in Moscow and three regional branches. The IMD currently employs 90 staff including 47 insurance experts and 32 curators with professional background in insurance acquired through either several years of work in insurance regulatory bodies, the insurance industry or insurance service companies (e.g. rating agencies or auditors). The IMD staff displays a high level of technical competence. However, the current organizational setup of insurance supervision does not fully provide for the efficient use of this expertise. Supervision 14. The CBR applies a rule-based supervisory approach which enables it to assess whether insurers comply with the relevant legislation and rule-based regulatory requirements. Its primary concern is to ensure that insurers fully comply with core regulatory norms fixed by the law in the following four areas of insurance operations: (a) solvency (capital adequacy); (b) insurance reserves; (c) assets covering own funds; and (d) assets covering reserves by the means of off-site monitoring and on-site inspections of insurance operations. 15. To carry out market off-site monitoring and review, the CBR has established frequent (monthly, quarterly and annual) reporting requirements for all insurers. In accordance with the Insurance Law and the Law on Bankruptcy, insurers should submit information on their financial and solvency position comprising: balance sheet, profit and loss statement, cash-flow statement, structure of assets, a solvency report, as well as information on premiums and claims by lines of business and regions. In addition, the insurers are required to submit external audit reports and technical reserves certified by responsible actuaries on an annual basis. The reporting of financial statements is currently done based on the national accounting standards but as of January 2017 it is expected to be fully compliant with the IFRS. The off-site monitoring and review is carried out by the Insurance Market Department. 16. The on-site supervision operates as a separate function under the Chief Inspection Department which supervises the overall financial sector. The onsite inspections can be full- scale or thematic and initiated upon request from the IMD planned or unplanned basis. The onsite inspections mainly involve checking insurers’ compliance with the supervisory (and legal) norms, which does not require specific insurance qualifications from the onsite inspection team. 17. To ensure the necessary level of supervision for systemically important insurers, the CBR has implemented a system of individual curators for the top 100 companies. The largest 22 companies, which have designated as systemically important, have been assigned individual curators, while those within the 21-100 group have one curator per two or three companies. Licensing 18. The legislation sets out requirements and procedures with regards to licensing of insurance companies (Articles 25, 32 & 32.1 of the Insurance Law and Regulation of the CBR №3316-Y of July 10th, 2014) which is administered by the Financial Market Access 10 Department. The requirements consist of a) minimum capital amounts which were recently increased (see Table 1); b) the necessary list of documents required by the CBR from the applicant of the authorization; c) information on the source of capital invested by shareholders holding 10 percent or more of the shares of the prospective insurer, as well as d) criteria applying to supervisory board, executive management, accounting, internal audit and actuarial functions. Table 1: Minimum capital requirements Scope of insurance license Amount in mm RUB Health insurance 60 Non-life insurance 120 Life insurance 240 Accident and health insurance 240 Reinsurance 480 Source: Article 25 of the Insurance Law 19. There are no regulatory requirements for the applicant to submit a business plan describing products, distribution channels, projected business volumes and financial projections that reflect the projected risk profile of the business. The licensing decisions are based on the applicant’s ability to meet the minimum capital requirements, requirements for the completeness of the list of documents concerned and educational qualifications for senior management, chief accountant, internal auditor (or the Head of the Internal Audit Department) and actuary required by the Insurance Law. 20. There are specific licensing criteria for insurance brokers, which require them only to have no criminal record, to have no administrative sanction in the form of disqualification, to have no fact of being an individual executive body in the financial company that has committed an infraction and for that CBR has withdrawn license from and to have a minimum bank guarantee or another document proving the fact that the broker maintains the minimum amount of own funds required by the Insurance Law. The regulation is however silent on the need for relevant insurance expertise or insurance experience as a pre-requisite for licensing. There are no licensing requirements for insurance agents. Corporate governance and risk management 21. The current legislation has only generic corporate governance provisions, which establish the main objectives of the internal control systems to provide assurance for (a) effectiveness of insurance operations and risk management; (b) reliability of financial information; c) compliance with the laws and regulations; and (d) systems for detecting criminal activities including anti-money laundering and counter-terrorism financing. 22. The current legislation has limited suitability criteria for shareholders and Board members who are not required by law to comply with such essential requirements as reputation and professional competence. There are no specific legal requirements on the level of knowledge, skills and expertise at the Board level, which should be commensurate with the 11 governance structure and the nature, scale and complexity of the insurer’s business , and remuneration policies and practices covering senior staff positions whose actions may have a material impact on the risk exposure of the insurer. 23. The Insurance Law requires identification, measurement and monitoring of risks through internal audit and actuarial functions which should assess (i) the company's performance, (ii) adequacy and efficiency of the internal control system, (iii) compliance with regulations and internal guidelines, (iv) adequacy of technical reserves and (v) irregularities. Based on legal requirements, audit reports have to present irregularities and violations and their estimated impact on the solvency margin, liquidity and other business performance. 24. The current rule-based regulation also does not provide for the use of (ORSA) own risk and solvency assessment to assess the adequacy of insurers’ risk management, and current and likely future of their solvency position. Capital adequacy 25. Capital adequacy requirements are by and large in line with the EU Solvency I framework and hence are not risk sensitive. The Insurance Law (Article 25) requires insurers to meet at all times the solvency requirements which are monitored by the CBR on a quarterly basis. The Insurance Law clearly, and in line with best international practices, specifies the types of assets which can be taken into account for the calculation of available capital. Insurers are required to calculate the normative solvency ratio as a ratio of available capital to the required solvency margin (EU S1 – like approach) and ensure that it does not fall below 1. Non-compliance with solvency and capital adequacy triggers a supervisory request for the plan of measures to restore own capital. Failure to comply with an order to increase capital gives grounds for the CBR to suspend and in some cases even revoke the insurer’s license. 26. The mathematical reserve is calculated for each individual contract based on actuarial methods. Life insurance reserving regulation requires life insurers to use a maximum technical interest of 5 percent for the purpose of calculating their mathematical reserve, and makes allowance for guarantees offered through rather short-term life insurance contracts (mostly up to five years). 27. The capital adequacy of non-life insurers (and hence solvency) may be materially underestimated due to the rule-based calculation of the IBNR claims reserves based on the Bornhuetter-Ferguson method, which is universally applied to all lines of insurance business. The CBR has recently required insurers to carry out alternative actuarial calculations of their technical reserves. However, as of now the actuarial estimates of reserves are not taken into account in assessing insurers’ capital adequacy. 28. The current regulation does not require insurers to have a reinsurance policy that would define the objectives of reinsurance arrangements in line with the company’s ris k appetite, risk concentrations and its net capacity for risk retention. There are no regulatory 12 requirements with regard to insurers’ per-risk or aggregate net risk retentions relative to their net capacity. 29. The regulations spell out clear and strict requirements for the investment of insurers’ assets, which absolve them from the need to have an explicit investment policy. Anti-Money Laundering and Combating the Financing of Terrorism 30. The legislation clearly regulates (a) the operation of the AML/CFT system, (b) the list of entities subject to the AML/CFT legislation, which includes insurance entities and (b) their obligations. The CBR has a thorough and comprehensive understanding of the ML/FT risks and uses available information to assess the ML/FT risks to the insurance sector on a regular basis. The regulatory framework has been extensively amended to enhance the AML/CFT practices of insurers and insurance brokers. B. Market Structure and Sector Performance Insurance penetration 31. With insurance penetration of 1.4 percent of GDP and about USD 179 insurance consumption per capita, the Russian Federation lags far behind the OECD countries (Table 2). Table 2: Insurance penetration and density Insurance penetration Insurance density (GWP as % of GDP) (GWP per capita in USD) YEAR Russian Federation OECD Russian Federation OECD 2011 1.2 8.7 159.2 3,294 2012 1.3 8.4 183.8 3,204 2013 1.4 8.3 198.7 3,148 2014 1.4 8.7 179.0 3,329 Source: CBR and OECD publications (https://stats.oecd.org) 32. The development and growth prospects of the insurance sector have been adversely affected by the macroeconomic environment, which has been steadily deteriorating . As a result, in 2014, the the gross written premium measured in local currency contracted by 1 percent in real terms compared to 2013, and further declined by 12 percent in 2015 (Figure 2). The insurance market is suffering from the adverse economic conditions and has contracted due to the reduced purchasing power of the population, falling demand for voluntary insurance products, the increasing price competition across all business lines, and the downgrade of Russia’s sovereign rating from BBB- to BB+ with negative outlook (S&P, 2015), which reduced the ability of large Russian insurers to write inward foreign reinsurance business. 13 Figure 2: Macroeconomic impact on insurance development Source: CBR, World Bank (http://data.worldbank.org/) 33. With about RUB 988bn (USD 26bn) in 2014, the Russian insurance industry ranked 27th in the world in terms of gross premiums written3 of which 89 percent came from non- life and 11 percent life insurance. The ratio of insurance assets to GDP amounted to 1.4 percent, which is far below the 8.7 percent average ratio for the OECD countries or countries similar to Russia in terms of GDP per capita such as Poland (10 percent) and Estonia (10.6 percent). Table 3: Insurance market size and structure bn RUB 2011 2012 2013 2014 Gross written premium Non-life 634 759 823 879 Life 35 53 85 109 Total 669 812 908 988 GWP to GDP 1.2% 1.3% 1.4% 1.4% Insurance assets Non-life 883 962 1,078 1,240 Life 83 109 143 200 Total 965 1,070 1,221 1,440 Insurance assets to GDP 1.7% 1.7% 1.8% 2.0% Source: CBR 34. As shown in Table 4 below, in 2015 non-life insurance premiums recorded a slight nominal growth (3%) which was mainly due to the increase of the CMTPL statutory tariffs. 3 http://www.swissre.com/media/news_releases/Stronger_advanced_markets_performance_boosts_insurance_indust ry_growth_in_2014.html 14 Other major insurance business lines such as motor CASCO, property, accident and health insurance contracted for the first time over the last five years. Table 4: Non-life insurance premiums bn RUB # Type of insurance 2010 2011 2012 2013 2014 2015 2015/2014-1 a CMTPL 91.9 103.7 121.7 134.9 151.6 218.7 44% b CASCO Motor 139.3 165.3 196.1 213.3 219.4 187.2 -15% c Property 102.1 169.5 180.4 183.5 202.6 187.5 -7% d Liability 36.8 28.0 39.3 39.2 44.5 46.3 4% e Accident and Health 36.8 49.7 75.7 94.6 95.9 80.9 -16% f Other 26.4 117.4 145.5 157.4 165.5 171.0 3% Total 433.3 633.7 758.7 822.9 879.4 891.6 3% Source: CBR Non-life solvency 35. Insurers are required to calculate the normative solvency ratio as a ratio of regulatory available solvency to the minimum required solvency margin (EU SI – like approach) and ensure that it does not fall below 1. Based on the current market data, the non- life insurance industry as a whole appears to comply with the normative solvency requirements. However, the normative solvency ratio a) has worsened from 2011 to 2014 for the market as a whole and b) has fallen below 1.54 for about 38 percent of non-life insurers in 2014 (Figure 3). The small share (3.3 percent) of insurers with normative solvency ratios below 1.3 (the point of supervisory intervention set by the Finance Directive 90N) is mainly due to the calculation of normative solvency ratios based on a relaxed (less prudent) version of EU Solvency (see paragraph 49). 4 The ICPs note that it is useful to establish solvency control levels above the minimum solvency margin. A point of intervention at 1.5 times the minimum solvency margin level is a good practice adopted by various regulators. Maintaining a 150% solvency level might not only increase the chances of securing the ability to meet obligations but also the capacity to continue operating after an adverse event. 15 Figure 3: Non-life insurance solvency Source: CBR Non-life sector underwriting performance 36. In the last four years the non-life insurance sector recorded marginal profits, which were mainly due to investment returns rather than the core underwriting operations. As non-life insurers are expected to generate value added through insurance coverage rather than through asset management services, in a healthy insurance sector the combined ratio should generally be below 100 percent. However, this was not the case with the non-life insurance market in the Russian Federation where the combined ratios were consistently close to 100% during 2011- 2014 and might be even higher in reality due to the potentially understated rule-based IBNR reserves used to calculate the claims ratios. Table 5: Non-life insurance market profitability In percent 2011 2012 2013 2014 Non-life insurance profitability ratios a Net claims ratio 49.7 56.4 57.9 60.3 b Expense ratio 49.6 41.9 41.2 37.6 c Combined ratio [c] = [a] + [b] 99.3 98.3 99.1 97.8 d Investment ratio 3.5 3.9 3.2 4.2 e Operating ratio [e] = [c] - [d] 95.8 94.3 95.9 93.7 f Net profit ratio [f] = 1- [e] 4.2 5.7 4.1 6.3 Source: CBR and assessors’ calculations CMTPL 37. The overall profitability of the non-life insurance sector has been reduced by the increases in the cost of insurance claims for all personal lines and particularly the compulsory CMTPL insurance. The CMTPL insurers are witnessing a significant increase in claims following a double digit inflation caused by the depreciation of national currency and the 16 resulting increases in the costs of imported vehicle spare parts. Based on the industry’s feedback, the deteriorating technical results forced a number of insurers to reduce their CMTPL business in regions where claims ratios exceed 100 percent. Agricultural insurance 38. Although agriculture is one of the four main contributors to the country’s GDP, the agricultural insurance accounts only for less 2 percent of the non-life insurance premiums. Despite a major support from the government, which subsidizes about 50 percent of insurance premiums for a wide range of insurance coverages, only 15 percent of cultivated areas are currently insured. The demand for agricultural insurance will remain low for as long as in the aftermath of disasters causing loss of crops uninsured farmers are compensated by the federal budget at levels similar to those for uninsured. Table 6: Agricultural insurance bn RUB 2013 2014 Agricultural insurance Agricultural insurance GWP 14.3 16.7 Share to non-life GWP 1.74% 1.90% Source: ARIA Developer’s liability insurance 39. Based on legal requirements (2012), all developers should conclude insurance against the liability to buyers for unfinished but prepaid construction projects. Rejected by professional insurers, this insurance coverage is provided by a specialized mutual insurer which was established in 2013 by the largest real estate developers in the country. Although the developers’ insurance portfolio accounts for a very large and highly concentrated aggregate risk exposure (RUB 175bn /USD 2.8 bn), with less than USD 10 million in surplus capital, the mutual has no capacity to pay insured claims in case of any serious developers’ defaults. Life insurance 40. Life sector is under-developed and offers traditional insurance comprising mainly credit life insurance and, as of recently, individual endowment products (including with- profit participation contracts) which are rather short-term (3-7 years). Life insurers operate based on bank-assurance models (mostly within the same financial groups), which help them with making use of the branch networks, expertise and client bases developed by commercial banks. The recent macroeconomic conditions are reducing consumers’ saving capacity with an adverse impact on life insurance growth (Table 7). Credit life insurance is directly affected by the declining trend in loan originations countrywide due to the increase in inflation and interest rates. 17 Table 7: Life insurance premiums bn RUB # Type of insurance 2010 2011 2012 2013 2014 2015 Life insurance a Credit life and endowment 18.4 29.4 44.4 64.7 75.3 87.1 b Annuity and pensions 4.3 5.6 8.5 20.2 33.6 42.6 Total 22.7 35.0 52.9 84.9 108.9 129.7 Annual growth rate N/A 54% 51% 61% 28% 19% Underwriting commission rate N/A N/A 42% 50% 38% N/A Source: CBR 41. The life insurance premiums and benefits are tax deductible for individual consumers. However, the current tax regime does not encourage the development of employees’ group life schemes, due to the taxation of employers’ premium contributions. Life insurance companies pay out 40 to 50 percent of their annual premiums in commissions, which is considerable for a rather short term life insurance business. Reinsurance 42. Western sanctions posed difficulties for domestic insurers with reinsuring risks of the state and Russian companies (over 1500 in total) which are facing Western sanctions with well rated US and EU reinsurers, which in the past assumed about 80 percent of such risks. A new draft law has been recently prepared for establishing a national reinsurance company (NRC) to be capitalized by the CBR. Based on the draft law, the national reinsurer will reinsure risks of companies which are facing sanctions, the Russian military and the state. To improve the overall risk profile of the NCR, the Russian insurers will be required to mandatorily place 10 percent of all reinsurance programs with the NRC. In addition, the NRC intends to provide reinsurance capacity to those insurers who provide third party liability coverage to residential developers that finance construction projects with advance deposits from future buyers of apartments. 43. The downgrade of Russia’s sovereign rating to a BB+ (2015) has reduced the ability of large Russian reinsurers to write inward foreign reinsurance business. To address the problem, the reinsurers are seeking to further expand their operations in Asian countries and are considering to establish subsidiaries in the EU countries. Industry consolidation 44. The number of insurance companies has been declining continuously. At the time of the FSAP in March 2015, there were 315 insurers operating in the market. Since 2013, when the CBR took over supervision of the sector, insurers have been under increasing pressure to increase its capital and liquidity of assets, improve the quality of regulatory compliance and financial management. Poor results in the CMTPL and the tightened regulatory requirements are driving the process of market consolidation further. As a result, in 2015 alone 70 insurers lost their 18 licenses. With the first 20 largest insurers already accounting for about 77 percent of the written gross insurance premium, further consolidation will have no negative effect on market competition. Table 8: Number of insurance companies 2010 2011 2012 2013 2014 Non-life Domestic capital 482 416 313 290 278 Foreign capital 29 25 21 21 21 Total non-life 511 441 334 311 299 Life Domestic capital 41 35 28 28 29 Foreign capital 7 8 8 7 6 Total life 48 43 36 35 35 Pure reinsurers 23 18 15 13 13 Mutuals 7 7 11 12 12 Total 589 509 396 371 359 Source: CBR Industry concentration 45. The market concentration is ongoing with top insurers continuing to increase their market shares. In 2014, about 48 percent of the non-life insurance premiums were underwritten by five companies and 65 percent by ten companies out of 299 non-life insurers. About 57 percent of life insurance assets were owned by the top five companies out of 35 life insurers which operated in 2014. The concentration at the group level cannot be measured due to the lack of consolidated accounts, which will start to be reported by 2017 with the introduction of the IFRS accounting system. Table 9: Insurance sector concentration In percent 2011 2012 2013 2014 Non-Life GWP Top five (aggregate) 42 43 43 47 Top Ten (aggregate) 59 61 62 65 Life insurance assets Top five (aggregate) 52 44 49 57 Source: CBR Role of associations 46. The All Russian Insurance Association (ARIA) is the biggest insurance association representing 160 out of the current 315 life and non-life insurers. The ARIA played an 19 instrumental role in addressing the issues relating to the increase in insurance fraud in the CMTPL during 2012-2014. By 2017, ARIA aims to bring together all other professional unions (including Motor Insurance Association and Agricultural Union) into a single organization with a view to effectively a) representing and protecting the industry’s interests; b) actively contributing to sound market development; and c) introducing and safeguarding sound industry standards. The new legislation was recently approved with regards to the activities of actuarial self-regulated associations. However, due to the short term of its existence, it was not feasible to assess its impact on the development of actuarial standards for the industry. IV. MAIN FINDINGS AND CHALLENGES C. Regulatory and Supervisory Key Findings Effectiveness of insurance supervision 47. While the dispersion of insurance supervisory functions among numerous CBR departments with various reporting lines carries certain advantages (such as a reduced potential for the conflict of interest), it also has a potential for major drawbacks. These include the (a) potential for insufficient coordination among different departments, (b) shortage of necessary insurance expertise within departments universally dealing with a wide range of financial services, and (c) impaired ability of the regulator as a whole to systematically detect problems with compliance in such a technically complex industry as insurance at an early stage. The ongoing consolidation of the industry (from 1,056 in 2005 to about 315 in 2016) accompanied by the growing professionalization of insurance companies, along with a strategic course taken by CBR toward risk-based supervision, dictate a new operational approach to the insurance supervision, which would require the CBR to (a) integrate its core supervision functions into a well-structured supervision process supported by a modern management information system and (b) strengthen technical capabilities and insurance qualifications of the insurance supervision staff working outside the IMD with a view to ensuring timely and effective reviews, input and decision- making from respective stakeholders involved in the insurance supervision process. 48. The CBR applies a rule-based supervisory approach which (a) does not adequately account for the proper identification and assessment of insurance risks and (b) does not allow to determine supervisory plans and priorities which take into account the nature, scale and complexity of insurers. The current monitoring system is not efficient in supporting the CBR efforts to timely detect, prevent and correct problems with the minimal impact on policyholders and shareholders. 49. Although the CBR has an electronic supervisory filing system in place to collect relevant financial and statistical information from insurers on a quarterly basis, until now the IMD staff has processed the information manually which is fraught with errors and significant delays and makes it difficult to validate insurers’ assessments made by the supervisor. An IT project has been undertaken by the CBR to develop automated processing of 20 submitted information for the purpose of compiling timely and reliable supervisory reports on insurance companies. 50. The supervisory monitoring process consists of checking the compliance of insurers’ financial parameters with the rules set by the Insurance Law and regulations on a) formulaic calculation of technical reserves, b) structure and quality of assets, c) surplus capital, and d) the minimum required solvency margin. The results of such an analysis based on manual data processing bear a high risk of errors. A system of financial ratios was introduced in January 2016. However, due to the absence of well-defined performance thresholds, it is not clear how it can be used for monitoring, and early warnings for internal risk rating purposes. Solvency 51. The normative solvency ratio calculated as a quotient of available solvency to the minimum solvency margin falls short of measuring insurer’s real solvency position against the EU Solvency I standard due to the potential understatement of the components underlying the ratio: a) While a rather relaxed version of the EU Solvency I is used to calculate insurers’ minimum required solvency margins, this approach leads to results which are at least 12.5 percent lower than those calculated under the standard EU Solvency I approach for most non-life insurers (Figure 4a). Such a deviation from the EU Solvency standard is due to (i) the normative adjustment of standard EU coefficients used in premium and claims based methods from 0.18 and 0.26 to 0.16 and 0.23, respectively; and (ii) non-consideration of the EU Solvency I requirement specific to liability insurances (other than motor), which requires insurers to inflate respective premiums and claims by 50 percent for the purpose of minimum solvency margin calculations. As a result, if insurers were to measure their minimum solvency margins against the EU Solvency I standard, the market would look less solvent, with the group of weaker companies (with solvency ratios below 1.5) growing from 38 percent to 50 percent of the total number of non-life insurers. (Figure 4.b). The impact would be especially pronounced for the group of insurers with solvency ratios below 1.3 (current intervention threshold). As shown in Figure 4b, the share of such insurers would grow from 3.3 percent to 34.3 percent of the total number of non-life insurers when switching from the current normative approach to the standard EU Solvency I. b) Non-life insurers’ available solvency calculated as a difference between their regulatory assets and liabilities, may be further materially underestimated due to the universal approach to the calculation of the IBNR claims reserves for all lines of insurance business (Paragraphs 50 - 54). 21 Figure 4: Impact of normative coefficients to solvency ratios a. b. Source: CBR and assessors’ calculations Claims reserving 52. Even though the CBR requires insurers to submit actuarial assessments of reserves as part of their regular reporting, such estimates play no role in determining companies’ legal compliance with the insurance solvency requirement, which instead relies on a normative approach universally applied to all lines of insurance business regardless of insurers’ size and claims performance record. Although the Bornhuetter–Ferguson (BF) method is widely used world-wide as a normalizing claims reserving approach, it does not fit well to all business lines, claims patterns and business sizes. The BF method would be more suitable for small and medium size insurers in the cases when a) the data is thin and volatile; b) lines of business have a long tail and c) areas where credible data is not available. 53. The outcomes of calculations under the BF method heavily depend on the assumptions relating to the a) claims development factor (CDF) and b) the a-priori ultimate loss ratio (ULR) for a given accident year. While the normative act defines the assumptions, their material deviation from the real claims patterns may lead to a major underestimation of the IBNR claims reserves and the overall ultimate claims amounts. As shown in Figure 5 below, 22 different assumptions used for claims development factors and ultimate loss ratios can lead to major deviations in the IBNR estimates. Figure 5: BF method results’ reliance upon static assumptions 54. To summarize, the BF method may not be suitable for all business lines, claims patterns and companies. When the BF method is chosen to calculate the reserves, the actuaries of insurance companies should ascertain that the underlying assumptions (CDF and ULR) are selected by them in a conservative way on the basis of a thorough actuarial analysis. 55. Based on the normative act, insurers should calculate their future claims adjustment costs as three percent of their indemnity claims reserve. However, such a provision for costs is very small (especially for the CMTPL) when compared to the currently high claims adjustment expenses which include inflated lawyers’ costs related to court cases. 56. While the impacts of under-reserving to insurers’ solvency should be analyzed at the company level, Figure 6 below demonstrates an indicative correlation between the level of claims reserve underestimation and respective solvency ratios for 2014. Based on such a correlation, the real solvency ratio of the insurance market calculated based on the EU Solvency I approach would fall below 1.53 if reserves (including adjustment costs) were underestimated by more than 20 percent. 23 Figure 6: Impact of potentially understated reserves to solvency Source: CBR and assessors calculations 57. As of 2017, with the introduction of IFRS reporting standards companies will be required to present actuarial assessments of their reserves on their solvency reporting forms. However, it needs to be ascertained that these risk-based assessments of insurance liabilities will be fully reflected in the calculation of insurers’ solvency ratio. Risk retention and reinsurance 58. The current regulation does not require insurers to have an annual reinsurance program that would define the objectives of reinsurance arrangements in line with the company’s risk appetite, risk concentrations and its net capacity for risk retention. 59. There are no regulatory requirements with regard to insurers’ per-risk or aggregate net risk retentions relative to their net capacity. Although major losses arising from catastrophic events may lead to numerous simultaneous insolvencies, there are no regulatory requirements to limit the insurers’ own risk exposure to such catastrophic scenarios through a catastrophe reinsurance arrangement. 60. The regulation on the investment of assets covering technical reserves sets indirect restrictions on the credit quality of reinsurance counterparties. However, these are well below those required by best international supervision practices. Insurance intermediaries 61. There are no requirements to intermediaries’ professional qualifications, minimum professional training and competence or minimum third party liability insurance. 24 62. Insurance agents, who account for most of intermediaries operating in the insurance market, are not subject to the licensing requirements. Their suitability, professional training and market conduct are the responsibility of insurers. 63. Although insurance premium in Russia is not subject to either a VAT or sales tax, insurance brokerage commission is. The 18 percent VAT on the brokerage commission translates into the additional 1.5-2 percent markup on insurance premium, which seems to be inconsistent with the general spirit of the current insurance tax regime. Prevention and enforcement 64. Due to the absence of a risk-based early warning system, the CBR does not have adequate capabilities to timely detect and prevent insurers’ failures with the view to minimizing the impact on policyholders, creditors and shareholders. 65. The existing regulations on enforcement are incompatible with the IAIS ICP requirements for supervisory transparency and proportionality of supervisor’s actions due to the lack of minimum statutory periods within which insurers should (a) restore their solvency; (b) comply with the supervisory data requests that fall beyond the scope of regulatory reporting. To ensure an equitable and fair treatment of insurers, the CBR should consider defining in statutory by-laws and regulations the minimum reasonable time allowed for insurers to implement corrective measures prescribed by the supervisor. Corporate governance and risk management 66. One of the most notable gaps in the CBR’s compliance with the IAIS ICPs is the lack of sufficient requirements on corporate governance. The current legislation sets only very general suitability criteria for shareholders and Board memberswithout further specifying essential requirements such as reputation, level of knowledge, skills and expertise at the Board level, which should be commensurate with the governance structure and the nature, scale and complexity of the insurer’s business competence and capability of Board members. . 67. Due to the lack of specific legal requirements on corporate governance, the CBR does not have sufficient powers to require an insurer to demonstrate the adequacy and effectiveness of its corporate governance framework. As a result, currently insurers are not required to define the role of Board in the oversight of risk management policies including the responsibility for (a) the appointment, remuneration, authority, performance, assessment, and dismissal of the insurer’s senior staff positions whose actions may have a material impact on the risk exposure and (b) implementation of clear policies, procedures and levels of authority for sound insurance operations. 68. Although the legislation defines general objectives of the internal control systems, there are no specific requirements to guide (a) the insurers in developing their internal control systems and (b) the CBR in assessing the adequacy of systems implemented by 25 insurers. Specifically, the insurers are not required to define control activities for the main activities, including (a) the underwriting policy in line with internal risk tolerance policies; (b) distribution channels; (c) claims management; (d) control of the reinsurance program; and (e) the adequacy of the IT systems. The law defines the roles and responsibilities of the internal audit. However such a key control function is yet to be driven by clear strategic plans and internal risk management criteria and procedures approved by the Board, with a view to ensuring a reasonably prudent approach to business with adequate control of all risks. Although the recent legislation has introduced the role of actuaries in insurance companies, the requirements limit their responsibility to calculating technical reserves and assessing the adequacy of assets covering them. 69. There are no oversight and accountability requirements for outsourced activities and the regulation does not require insurers to notify the CBR of any material outsourcing. 70. Due to the current rule-based supervisory regime, there are no requirements for enterprise risk management. The legislation does not define ERM requirements for quantification of risk under a sufficiently wide range of risk scenarios that require the use of complex simulation and modeling techniques to reflect the nature, scale and complexity of the risks that the insurer bears. The current rule-based regulation also does not provide for the use of (ORSA) own risk and solvency assessment to assess the adequacy of insurers’ risk management, and the current and likely future of their solvency position. Group supervision With its establishment as a mega-regulator of the overall financial sector, the CBR has adopted a good practice of coordinated on-site inspections over individual companies of same financial groups, including insurers and banks. There are no legal restrictions for the CBR to coordinate its on-site inspections of the members of a financial group and take supervisory decisions for the inspected entities based on such inspections. During 2015 - 16, the Chief Inspection arranged coordinated inspections over 117 financial entities, including 14 insurers. However, the CBR is yet to introduce specific requirements for insurance supervision at the group level. With the introduction of the IFRS accounting standards in 2017, insurance groups will be required to report consolidated financial statements. D. Market Key Findings Financial strength 71. To determine the financial strength of the insurance sector in the Russian Federation we have analyzed three key ratios comprising the solvency margin ratio, leverage ratio and receivables ratio. The results are shown in Table 10 below. Table 10: Key performance indicators Key performance indicators In percent 26 Non-life 2011 2012 2013 2014 1 Premium retention ratio (NPW/GPW) 84.5 85.0 85.8 84.5 2 Net claims ratio 49.7 56.4 57.9 60.3 3 Combined ratio 99.3 98.3 99.1 97.8 4 Receivables ratio (receivables/total assets) 20.0 17.8 18.4 18.5 5 Normative solvency ratio 243.5 188.7 194.3 208.5 5.1 Largest five companies 186.3 178.4 198.0 208.4 5.2 Smallest five companies 468.6 133.2 140.0 172.6 6 Premium leverage ratio (NPW/surplus capital) 209.7 216.8 224.0 218.6 Non-life technical reserves ratio (Technical 7 81.9 72.8 73.8 77.3 reserves/NPW) 8 Number of insolvent companies 6 57 16 9 9 Market share of insolvent companies 1.7 5.4 3.3 3.5 Life 2011 2012 2013 2014 1 Premium retention ratio (NPW/GPW) 97.7 97.6 97.6 98.4 2 Receivables ratio (receivables/total assets) 5.9 6.6 6.3 6.4 3 Normative solvency ratio 380.7 219.9 220.6 201.4 3.1 Largest five companies 337.0 275.8 274.6 190.7 3.2 Smallest five companies 292.1 121.0 122.2 148.2 4 Number of insolvent companies 2 10 4 2 5 Market share of insolvent companies 0.1 2.0 0.1 5.8 Source: CBR and assessors calculations 72. The normative solvency margin ratio (SMR) is defined as the quotient of total available surplus capital and the minimum solvency margin defined by the law. From 2011 to 2014, the normative solvency ratios declined from 243 percent to 209 percent for non-life insurance sector and from 381 percent to 201 percent for life insurance. The weakening of solvency can be explained by the negative or marginal profits realized by most of insurers (especially small and medium sized) over the last few years due to the formidable challenges discussed in the insurance market overview section. 73. The premium leverage ratio is the quotient of net premium written and available solvency. The PLR approximates the amount of non-life’s insurer’s available solvency to back every unit of retained premium (NWP is a measure of insurer’s risk exposure). The higher is the premium leverage ratio, the less financially stable is the insurance industry. For non-life insurance portfolios consisting predominantly of non-volatile business lines, a PLR of 200 percent to 250 percent are generally viewed as robust. In 2014, the PLR ratio for the non-life insurance market was within the normal range also due to the inability of the market to materially grow the premium base. 74. The receivables ratio (RR), defined as a percentage of receivables to total assets, indicates the ability of insurers to collect insurance premiums on time. The higher is the RR, 27 the worse is the quality of the insurers’ balance sheet. The receivable ratio has been consistently high for non-life insurance (from 20 percent in 2011 to 18.5 percent in 2014). Another test defined as a ratio of receivables to equity (available solvency), confirms a high level of the non-life sector receivables (above 60 percent of equity). The overdue receivables do not account for solvency calculations or assets covering the reserves, however the assessors did not receive the breakdown of receivables to carry out a more detailed analysis in this regard. Life insurance 75. Due to the current unfavorable tax treatment of employers’ contribution to corporate life insurance plans, group life remains nascent. Yet, in most countries group life accounts for the largest share of life insurance market and its growth. 76. Currently, due to the lack of appropriate legislation life insurers are unable to offer unit-linked endowment products, which restricts potential investment choices of insurance clients and consequently limits the growth prospects of the industry. CMTPL 77. The current CMTPL insurance statutory tariffs are not actuarially set to reflect underlying risks and the real cost of claims. While insurers are only allowed to raise premiums within a narrow corridor, the tariffs were raised in early 2015 to reflect the legal changes in minimum statutory limits from RUB 160 thousand (USD 2,626) to RUB 500 thousand (USD 8,205). Although the change looks material in relative terms, the CMTPL statutory limits ‘per se’ remain a) very low when compared to other countries or EU minimum standards and as such, insufficient to properly compensate damages of rather expensive cars or major bodily injury claims. 78. In the absence of standard claims settlement guidelines, courts in several regions awarded arbitrarily high compensation to claimants represented by lawyers who retained considerable amounts out of the awarded compensation. In 2012-14, the CMTPL insurance market witnessed a major increase in insurance fraud in the MTPL. However the situation considerably improved in 2015 due to some amendments to the Insurance Law and the proactive stance taken by the ARIA on that issue. Developers’ insurance 79. The risk of developers’ default on its third party obligations represents a systemic (non-diversifiable and uninsurable) form of credit risk, which adversely affects the whole construction industry in times of economic downturns. Despite the existing legislative requirements to insure developers’ liabilities to third parties and the creation of a specialized mutual insurer established by the largest property developers in the country, the risk of developers’ liability to third parties for unfinished but prepaid construction projects in case of their default is still carried mainly by investors (buyers of apartments) and ultimately the state. 28 National Reinsurance Company 80. The experience shows that the establishment of national reinsurers, whether directly or in some way backed by the state, is a rather outdated business model. Such companies were initially introduced in the first half of 20th century to address the needs for capacity and development in the rather young and immature insurance markets. However, the growth of local insurance markets alongside the globalization of reinsurance industry challenged the very business rationale behind the existence of state-backed national reinsurers. In the past, state owned reinsurers were typically set up as highly inefficient government monopolies with the potential to create enormous liabilities for the state (outside the normal fiscal process). Brazil Re was one of such state-owned reinsurers. a) Since its establishment (1939) and until 2007, the state-owned IRB-Brazil Re operated as the monopoly reinsurer in the local reinsurance market in Brazil with the 100% market share. In 2007, however, the domestic reinsurance market was opened for competition from other local and international players. Since its partial privatization in 2013, Brazil Re has been organized as a public private partnership between the state (represented by the federal government and the Bank of Brazil holding together 48 percent5) and private stakeholders. Figure 7: Development of reinsurance premiums in Brazil Source: SUSEP b) With the opening of the reinsurance market in Brazil, the IRB market share declined sharply from 85 percent (in 2008) to about 25 percent (in 2011), with international reinsurers writing about 50 percent of the reinsurance business. However, as shown in Figure 7 above, after 2011 Brazil Re managed to regain a large market share only due to changes in the regulations, which restricted direct reinsurance cessions to the international reinsurance markets. While such changes were criticized by the international markets, several top international reinsurers 5 http://www.bnamericas.com/en/news/insurance/tcu-approves-irb-brasil-resseguros-privatization1 29 addressed the issue through establishing their reinsurance subsidiaries in Brazil. The impact can be clearly seen at the end of 2013, when local private reinsurers altogether wrote the same share as the IRB (Figure 7). c) With the growth and professionalization of the insurance market, Brazil Re’s performance has been mainly a function of political decisions rather than the result of its business operations. While frequent changes in the regulation have helped Brasil Re to keep its leading position, these adversely impacted the performance of primary insurers by limiting their choice of reinsurance carriers based on price competitiveness and quality of reinsurance coverage. d) Although Brazil Re demonstrates some better underwriting results compared to the other locally established reinsurers (mainly subsidiaries of top international reinsurers), these differences in underwriting results might be due to (i) higher standards used by private reinsurers to evaluate their insurance liabilities as well as (ii) a bigger and more diversified portfolio written by Brazil Re, which has been supported by the law. e) In contrast with the proposed NCR, Brazil Re has full access to the international markets, which enables it to retrocede a major part of its portfolio risk to the global players thus reducing its peak risk accumulations. f) Finally, referring to SUSEP6 (insurance regulator in Brazil), with the recent approval of new regulations and operational guidelines, the market expects to see a greater portion of the risks in Brazil being reinsured by global programs. The consequences will include increased reinsurance capacity, more specialization in the reinsurance market, new products and competitive prices due to the market’s newfound efficiency. 81. Given the current stage of market development in the Russian Federation with a large number of professional and well capitalized (re) insurers, the creation of the NCR may not be the most effective solution to the problems created by the sanctions regime for the insurance industry due to a) the rather negative international experience with national reinsurance companies, most of which have been eventually privatized at a considerable cost to the state and b) the adverse potential impact on the development of a competitive reinsurance market in the Russian Federation. a) With only USD 1 billion in capital, it is unlikely that the NCR will succeed in addressing the very challenges which will have ‘triggered’ its creation. Due to its inherent inability to transfer a part of risk aggregates arising from reinsurance of risks of the state or private companies under the Western sanctions to credible international reinsurance players, the NCR is likely to retain a very large risk exposure which may exceed by far its net retention capacity and further pose a major fiscal risk to the state in its role of the guarantor of last resort. As shown in Figure 8, the NCR’s capital is comparable to the equity of the top five biggest non-life (re) insurers 6 http://www.susep.gov.br/english-susep/insurancemarket 30 which altogether had about USD 2bn in equity in (2014), and whose capacity is likely to be underutilized in 2016 due to the adverse economic environment and the Western sanctions. Figure 8: NCR’s capacity vs. commercial reinsurers Source: CBR b) The creation of NCR will also have adverse effects on the market competition and long-term stability of the insurance market as the company is likely to emerge as the largest (not the safest though) reinsurance player in the Russian insurance/reinsurance market a) with mandatory cessions coming from insurers’ ordinary business and b) without being subject to the market competition. E. Insurance Sector Key Challenges Table 11 below summarizes the key institutional, regulatory and market development challenges to be addressed by the insurance sector in the Russian Federation: Table 11: Key challenges of insurance sector in the Russian Federation # Key challenges of insurance sector to be addressed Term* Introducing actuarial reserves for solvency assessment purposes and enhancing the role of 1 S supervision actuaries Bringing the calculation of the minimum solvency margin at least in line with the EU Solvency I 2 standard requirements and introducing a buffer for the solvency ratio, which shall be used as a S threshold to trigger early interventions. Introducing minimum requirements regarding the insurers' net retentions on per risk and 3 S aggregate level. 31 Developing an effective insurance supervision approach with automated data storing and 4 processing capabilities which ensures the optimization of contribution from all involved CBR M departments; Developing an effective Early Warning System (EWS) with clearly set benchmarks to determine 5 M the areas and companies which require close attention. 6 Introducing sound corporate governance criteria and risk management function M Considering to make employers’ contributions to employees’ life insurance/endowment plans tax 7 S deductible the government 8 Developing sound CMTPL claims reserving standards as a prerequisite for the tariff liberalization M 9 Introducing agricultural insurance requirements for farmers receiving agricultural subsidies M Developing claims settlement standards relating to both material and non-material damages that 10 S can be equally applied by insurance companies and courts Considering an alternative market-based approach to secure additional reinsurance capacity 11 S instead of creating a national reinsurer Addressing the claims-paying-capacity issues relating to developers’ liability insurance against 12 S the third parties for unfinished but prepaid construction Term*: S-Short Term; M-Medium Term 32 V. RECOMMENDATIONS The recommendations are based on the review of the current regulatory and institutional framework and the performance of the insurance market. Effectiveness of insurance supervisory process 82. The international experience shows that there is no single best approach to the institutional organization of the integrated financial supervision. Various countries have developed various organizational structures, which take into account the (a) objectives of the integrated supervision, (b) financial market developments and their trends within countries (e.g. development of financial conglomerates), as well as the (c) optimization of the resources and costs dedicated to the financial supervision. The supervisors should identify and address the risks around their organizational models.  In this context, the supervisors organized along the lines of a sectoral model (where a dedicated supervision department carries out the supervision of a specific segment of the financial sector) should effectively address the risks relating to the interrelations among sub- sectors, which becomes increasingly important with the growing presence of financial conglomerates and complexity of financial products.  Likewise, the financial supervisors with a horizontal model of organization (where functional departments assume all the supervisory functions relating to a given sub-sector), should dedicate appropriate level of attention and establish sufficient sector-related expertise and experience for each of the supervised segments of the financial sector.  Finally, to address the drawbacks relating to both models and their combinations, the supervisors should build effective coordination and harmonization of supervisory units (whether sectoral or functional) with a view to achieving the overall objectives of the integrated supervision. The case of the Russian Federation appears to be more reminiscent of the horizontal approach of integrated supervision where core supervision functions (e.g. onsite, licensing) are carried out by integrated multi-sectoral functional departments. However there is also an element of specialization as the off-site monitoring of the insurance sector is conducted exclusively for the insurance sector by the dedicated Insurance Market Department. 83. A switch to the risk-based supervision should be supported by the internal insurance supervision reorganization aiming at the professionalization of all core functions of insurance supervision (from off-site to onsite and licensing) with the view to achieving more transparency and accountability for every member of supervisory staff involved in the supervision process. To increase the effectiveness of the integrated insurance supervision, the CBR may consider forming multi-disciplinary teams with each team member providing his professional input to the insurer’s supervision file (e.g. an actuary - providing a validating of 33 insurer’s reserves and solvency margin, an onsite inspector - an input on the quality of data used for statutory and financial reporting purposes; a reinsurance expert – on the adequacy of the insurer’s reinsurance program; a finance expert – on the adequacy of insurer’s assets (jointly with onsite inspector); a curator – on the adequacy of management, business plan, and risk management, etc.). The company’s annual file should be annotated by the IMD senior manager, who would add his comments to the report, which by then would already have all expert inputs from the members of the supervision team for his review. The initiative of creating insurers’ automated dossiers could serve as a good platform in this regard. 84. The CBR should consolidate an effective review and monitoring approach with IT capabilities to a) automatically process and store the information submitted by each insurance company and b) keep track of automated analysis and additional input provided by various departments through the overall cycle of insurance supervision. Such a recommendation follows the EU guidelines 7 on the supervisory process, which requires the regulator to ensure that the information supporting the conclusions from the supervisory review process is documented and easily accessible within the regulatory body. To this effect, it is recommended that the CBR creates electronic dossiers for individual insurers with useful information on their a) business profile; b) corporate governance and risk management; c) statistical and technical information per lines of insurance business; and c) financial information comprising solvency, reserves adequacy, and assets. The electronic folders (databases) should be standard for all insurers in terms of information, with a view to enabling generation of timely automated reports at the company and market level for the purpose of supervision and public disclosure. A clear protocol should be developed with regard to the level and type of access for specific CBR departments to the electronic folders, which should consistently track all supervisory steps, including a) rationale for the close supervision; b) on-site inspection findings; c) assessment and analysis; d) supervisory decision; and e) enforcement. Figure 9: Insurer’s electronic dossier 7 EIOPA-BoS-14/179 EN, Guidelines in supervisory review process 34 85. An effective Early Warning System (EWS) should be developed to help the IMD determine the areas and companies which require close attention and further coordinate activities with other CBR departments involved in insurance supervision. Early identification of problematic companies is essential to a) determine if the companies can regain their financial strength or otherwise b) minimize the impact resulting from insolvencies. Based on other countries’ experiences, the early warning system may consist of two phases combined with a follow-up component. Figure 10: Early warning system phases Early warning system phases Financial Financial ratios Expert review to information generated and identify insurers / Follow up reported analyzed areas requiring electronically automatically increased attention 86. In many countries, a set of ratios with respective benchmarks constitutes the early warning system. As such, when a ratio or a series of ratios moves in an adverse direction or crosses some determined thresholds then escalation of concern follows. In many cases, each of the ratios is examined separately and then a qualitative judgment is made about the conclusions that should be drawn from the results. In other cases, a more quantitative decision rule is applied based on the assessment of a combination of specific ratios. An even more advanced approach involves taking a set of ratios and determining a formula for their conversion into a combined one single risk index. However the results of these more advanced approaches have generally not been sufficiently conclusive compared to the assessment of individual ratios and the amount of work required to develop such systems is substantial. 87. The adoption of a fully risk-based supervision regime requires the insurers to provide supervisors with relevant information as soon as they become aware of any issues that can materially impact their solvency. When internal models are used, these should be able to generate results based on the ongoing operations of the insurer. However, it is noted that the ratio analysis can also form an important element of off-site supervision which can assist the supervisors with making informed decisions with regard to the allocation of regulatory efforts toward those companies that display the weakest ratios in the market. 88. As shown in Figure 10, the IT system should automatically process the submitted information and integrate analysis into key ratios which will be analyzed within well-defined risk bands established by the supervisor. The ratios shall evaluate various aspects of the insurer’s financial condition and stability based on ‘accepted’ ranges defined for each ratio as benchmarks for performance. At a later stage, the ratios can be aggregated into one internal risk index that can be used (in conjunction with individual ratings) to rate companies for the purposes of allocating supervisory resources. 89. The ratios should be easily traceable to the data provided by the companies and verified in the course of onsite inspections by onsite supervisors. Key risk indicators should 35 be made available to the companies to enable them take timely preventive actions and avoid unwarranted CBR interventions. Based on the experiences of other supervisors,8 the CBR may decide to make the results publicly available by clearly highlighting areas falling outside the normal ranges. The development of the CBR automated capabilities is also expected to reduce the growing costs of insurers’ regulatory compliance. 90. Finally, together the set of ratios and the risk index can provide a good indication of which companies may require closer supervision. However, on their own, such an indicator based assessment cannot provide a full and conclusive characterization of the situation. While the early warning system is essential for identifying problems at an early state, its results, especially those falling outside the usual ranges, should be subject to the additional analysis and inspections of concerned insurers by respective CBR departments. Figure 11 below provides a set of key ratios which can be considered and further amended based on the other international experiences9 and specific guidance provided in this regard by the World Bank and the IAIS.10 Figure 11: A sample of key tests and ratios for non-life insurance 8 http://www.naic.org/documents/RRI-ZU-15-03.pdf (IRIS Ratio Results for 2014) 9 http://www.naic.org/documents/prod_serv_fin_receivership_uir_zb.pdf 10 http://www.iaisweb.org/modules/cciais/assets/files/pdf/061002_ICP_12B__A_Primer_on_Non- Life_Insurance_Ratios.pdf 36 Claims reserving standards 91. The CBR should introduce requirements on risk-based actuarial assessment of insurers’ claims reserves and related adjustment costs and ascertain their use in the calculation of insurers’ available solvency. The requirements should provide guidance on a comprehensive set of claims reserving methods that can be used by non-life insurers to calculate their IBNR claims reserves based on claims patterns for each line of business. The set of actuarial methods should be determined by the CBR in close cooperation with the self-regulated actuarial organizations based on the best international experience and the Russian insurance market specifics. The self-regulated actuarial organizations should play a key role in ensuring the practical implementation of the actuarial methods by insurers. To this effect, self-regulated actuarial organizations should be involved in a) preparing detailed claims reserving manuals and b) observing the implementation of the actuarial claims reserving practices by the insurance industry. 92. To resolve material disagreements, which may arise among companies’ and supervision actuaries with regards to the calculation of reserves, it is further suggested to mandate the Actuarial Council11 consisting of the CBR actuaries and representatives from the self-regulated actuarial organizations with the task of handling the technical disputes in a professional manner. The new supervisory approach to insurance reserves requires (i) a major strengthening and consolidation of the actuarial function within the CBR and (ii) an increased role of the self-regulated actuarial organizations. It is further recommended that the supervisory actuarial function is taken over by the IMD as the core insurance supervision department. Capital adequacy 93. The IAIS has established a number of requirements to insurers’ solvency regime. The minimum solvency margin is used to measure the level of risk that the company is carrying. While it is not possible to have a perfect measure, reliable measurements require considerable data collection and information, something usually practical only at the level of individual insurer. Both methods (Solvency I and Solvency II) account for business volumes respectively through the use of indexes and exposures (which are to some extent correlated with volumes). However, in line with the ICPs and the Principles on Capital Adequacy and Solvency, the minimum solvency margins calculated based on the index (EU Solvency I) or even the risk-based measure of capital needs (EU solvency II) are deemed to be insufficient for insurers with small volumes and thus are further reinforced by fixed minimum levels of capital requirements independent. The reason is that, regardless of the size of the insurer, some risks exist, and new or small insurance companies face particular risks and challenges which include the following: 11 The Actuarial Council was established by the CBR in 2014 in accordance with article 9 of 222-FZ “On the Credit Rating Agencies Activity in the Russian Federation, following the amendments to the Federal Law №86-FZ “On the Central Bank of the Russian Federation” and Other Legislative Acts”. 37 a) Difficulties in managing start-up operation that do not exist in an ongoing business. (e.g. due to insufficient data to estimate the amount of claims that may arise from insurance policies. An established company of a considerable size usually has sufficiently good data for its claims projections. b) To quickly build their book of business up to a viable size, new or small insurers are more eager to accept riskier or less profitable business (poorly priced) compared to a well- established insurer. c) Another reason for the absolute minimum capital requirement relates to the unique nature of insurance, which requires an insurer to meet long-term obligations arising from the insurance contracts. To this effect, absolute minimum capital requirements aim to ensure that only operations with sufficient capital resources are permitted to enter the insurance market. 94. To achieve a more reliable calculation of the insurers’ solvency margin (which is yet index based in the case of Russian Federation), the solvency requirements should address in a consistent manner the valuation of liabilities (mainly technical reserves), which is not the case today. To this effect, the CBR should ascertain that the risk-based actuarial assessments of insurance liabilities will be considered in the calculation of insurers’ available solvency. 95. While both the regulator and insurers are not yet prepared for a risk-based solvency regime, the CBR should bring the calculation of the minimum solvency margin at least in line with the EU Solvency I standard requirements and further develop a prudent risk management and corporate governance framework as a pre-requisite for the introduction of EU Solvency II in the future. The CBR should further introduce a buffer for the solvency ratio, which shall be used as a threshold to trigger early interventions. Such a buffer can be set at 150 percent of the minimum solvency margin calculated through the standard EU Solvency I approach similar to the good regulatory practices in some other countries12. Reinsurance 96. To address the current gap with the risk management requirements, the CBR should require insurers to develop annual reinsurance programs with details on reinsurances they plan to arrange for main lines of business, including types of reinsurance, maximum net limits per line of business, as well as criteria used for selecting their reinsurers. 97. With the introduction of more prudent risk management requirements, the CBR should require insurance companies (at least initially those which are systematically important) to determine maximum amounts that they will have to pay out in the case of a 12 Canada: OSFI suggests that the ratio of actual capital to required capital should be at least 150%. A ladder of intervention exists if an insurer falls below this level. http://www.naic.org/documents/committees_smi_int_solvency_canada.pdf In India, insurers are required to maintain a minimum solvency ratio of 1.50. Insurance players whose solvency ratios are dangerously close to this minimum level are closely watched by the insurance regulator, the IRDA. http://www.morningstar.in/posts/27829/why-solvency-ratio-matters-in-insurance-1.aspx . 38 single big risk event (the Net Maximum Event Retention or ‘NMER’), or the maximum total claims arising from the event of a probable but very unlikely event (referred to as the Probable Maximum Loss-PML). The minimum requirements for such events can be described by the CBR based on their low probability or return period where an event with a probability of say ‘0.5 percent’ would have a ‘return period’ of ‘200’ years or be described as a ‘one-in-‘200’ year’ PML event. The CBR should require insurers calculate and report the NMER or PML as part of supervisory financial reporting on an annual basis. Insurers and reinsurers may set “per risk” and “per event” risk retention limits as well as consider blocks of business in aggregate. For example, Stenhouse (2002) gives the long-standing position of the Australian supervisor in this regard: a) Per risk retention. Not more than 5 percent of net tangible assets, with a maximum of 3 percent considered more prudent, especially as the size of the insurer grows. b) Per event retention. Not to exceed the amount of net tangible assets over the insurer’s statutory mi nimum solvency. This seeks to ensure that the insurer can withstand extreme claims without breaching statutory solvency. Source: IAIS 98. Appropriate and documented criteria are needed to assess the financial condition and credit risk of reinsurers (OECD 1998). These criteria can include credit-risk requirements based on the financial condition or the credit standing of the reinsurer. The criteria for the locally registered reinsurers may be determined based on their size and capacity (capital base) by also using applicable reliable ratings. The below recommendation provided by Swiss Re for non-life insurers may need to be further amended with additional criteria on the local reinsurers’ solvency ratios calculated based on the a prudent actuarial valuation of the technical reserves. Swiss Re (2003) Whereas in life insurance (with the exception of the United States) reinsurance is not a big credit risk, in non-life insurance it is significantly higher. As the primary insurers have generally diversified their reinsurance cessions, even the share of a big reinsurer ought not to come to more than 4 percent of the non-life insurance balance sheet (total assets). So that the possible bankruptcy of an individual reinsurer does not hold any systemic risk. Source: IAIS 99. For reinsurers supervised based on the EU Solvency II or equivalent regimes (as recognized by the EC), the CBR may introduce a credit risk charge for reinsurers based on (i) their credit rating assigned by the agencies accepted by the EU or (ii) solvency ratios for unrated reinsurers subject to fulfillment of the criteria set by the EU regulations 13 . It is 13 Commission Delegated Regulation (EU) 2015/35 of 10 October 2014 supplementing Directive 2009/138/EC (http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32015R0035&from=EN) 39 recommended that the unlimited layers of reinsurance programs are covered only by strong reinsurers (rated A- by Standard and Poors’ or equivalent). Until the EU Solvency II risk-based solvency calculations are introduced, the reinsurers’ credit risk charge shall be deducted from the reinsurance assets for the purpose of calculating the insurers’ solvency. Besides these general recommendations, the CBR should undertake a thorough assessment of current and proposed reinsurance requirements in consultation with market stakeholders with a view to determining a most workable approach for the country. Table 12: Mapping credit quality steps with ECAI ratings Credit quality step 0 1 2 3 4 5 6 Probability of default 0.00% 0.01% 0.05% 0.24% 1.20% 4.20% 4.20% Solvency ratio of unrated reinsurer based in EU 196% 175% 125% 95% 75% equivalent regimes 1 S&P´s AAA AA A BBB BB B