Why supervising risk, rather than rules, matters when developing insurance markets

A series of recent deep-dive studies across Nigeria, Kenya, Ghana and Rwanda have shown that insurance matters for sustainable development and growth in Africa. The studies have also identified the imperatives necessary to help ensure that insurance development happens in Africa. The studies, and some consequent research motivated by the findings, have confirmed that one key imperative for growth in the insurance market in sub-Saharan Africa is a risk-based approach to regulation and supervision. This is because risk-based approaches provide an environment that not only helps to achieve financial stability and compliance with international standards and codes; the approaches also often motivate reforms. These approaches can directly foster development in the insurance sector.

There are several benefits to adopting a risk-based approach to regulation and of insurance markets, ranging from more developed technical skills for stakeholders, room for new products and services that better meet customer needs, better incentives for investment, and less fragmentation in markets. All in all, risk-based approaches create the financial space needed to innovate and grow.

Risk-based approaches encourage professionalism.

The deep-dive studies into the insurance markets of the four sub-Saharan Africa countries highlighted a shortfall in technical capacity within insurers at the supervisory authorities as a key constraint to growth in insurance markets. They also highlighted that this shortfall received attention largely as the financial regulatory requirements became more risk-sensitive and complex. The findings of the studies clearly show that investing in the technical skills needed for risk management and modern financial oversight can no longer be avoided.

Moving to risk-based approaches necessitates an upgrade in technical skills. Without a risk-sensitive framework, there is little incentive to improve risk management, investment, pricing, capital management and any number of other important elements of insurance operations. Without a reduced regulatory burden (whether insurers do things well or badly), in implementing a risk-based insurance regulatory approach, boards and senior managers will struggle to justify investment in the professional staff and associated data and infrastructure needed to implement it. This is highlighted by the fact that, in stakeholder meetings today, even insurer CEOs who understand the theory and benefits of scientific risk management well say that they do not have a cost-benefit incentive to implement it.

Other insurance CEOs have learned the benefits in hindsight. As one insurance CEO noted, “we used to think an actuarial review once every three years was nothing more than a cost burden – now we do it quarterly and get a great deal from our relationship with our actuary”.

Risk-based capital incentivises and facilitates sound risk-taking.

A risk-based approach not only incentivises a better understanding of risk; it also aids in the understanding of risk and facilitates smoother decision-making.

One of the other key findings from the deep-dive studies was the opportunity for risk-based capital rules to play an effective role in investing insurance assets. Institutional investment activity by the insurance sector contributes to deeper, more liquid markets and provides particular opportunities for fixed-interest markets, longer-duration bonds, and infrastructure, given that insurers tend to have lower liquidity needs from their assets driven by the nature of their liabilities than other financial institutions.

Risk-based capital rules can play an important role in supporting investments by the insurance sector. For example, asset and liability management (ALM) capital elements incentivise ALM practice. Consequent effects on asset market development, depth and liquidity appear clearly linked to these incentives. For example, if the risk-based capital regime adjusts for better ALM, particularly for interest rate duration risks, then the incentives to develop systems to measure and monitor mismatching costs, and consequent demand for longer-term fixed interest, help to develop the insurer role as institutional investors and also support longer-term bond markets.

Winning on a larger sporting field usually requires a more talented and fitter team!

This is just one example. Infrastructure finance is also a critical need in most countries, which is not well reflected in capital requirements. In many ways, rules-based systems stand in the way of the flexibility that is needed to find and meet the needs of new markets of underserved clients. But, flexibility requires effective management of risk; winning on a larger sporting field usually requires a more talented and fitter team. With technical skills, systems, policies and procedures, insurers can safely take steps forward. This is in stark contrast to a rules-based approach that prohibits risk-taking on the clear presumption that no insurer can manage risk adequately.

Risk-based capital is more effective in rationalising fragmented markets

Excessively fragmented markets have been shown to hold back the development of insurance markets. In such markets, insurers scramble to grow market share, aggressively targeting one another’s distribution with higher commissions, and irrational price wars and under-pricing, especially in compulsory classes. This zero-sum game tends to reduce profitability, which forces insurers to look to harsh claim-handling in an effort to improve financial performance for shareholders. This creates an environment where customers have a low expectation that insurers pay valid claims. A poor industry reputation leaves clients undervaluing insurance – a totally justifiable decision based on experience if insurance products offer poor value! This can be a never-ending downward spiral that counters the development of insurance markets.

Irrational competition in fragmented markets undermines development goals and pollutes the market and customer perceptions. It is a never-ending downward spiral.

Rationalisation eventually must come to the market, but it is currently happening more slowly than might be useful and will have a negative developmental impact if left to its own course. Instead, it needs to be pushed to avoid extended damage.

As the deep-dive studies suggested, and as has subsequently been validated through broader data, risk-based capital is more effective at incentivising rationalisation when it is actually needed, rather than implementing blunt increases in nominal absolute minimum capital requirements as has been common practice.

More professional, soundly managed, efficient markets can invest in much-needed innovation.

Low profitability has been cited as the main reason that innovation is not advancing in the insurance sector. All stakeholders agree with the obvious premise – that to get a different result in terms of future growth, things have to be done differently. Too many markets have a history of limited progress.

Innovation is needed. Change does not happen by doing the same thing over and over again!

The main reason often given for not investing in “doing things differently” has been the absence of funds for new efforts and the limited capacity of management to change their mindset from one focused on defending market share. Risk-based approaches offer the opportunity to address both of these constraints.

As counter-intuitive as it may seem, a major capital reform can set the scene for a brighter future for insurance markets on all these fronts. Our findings suggest that the argument that capital reform should be delayed is one that sells the long-term benefits for short-term failure and a continuation of the status quo. Markets, policyholders, the broader economy and the population in countries deserve better.

Craig Thorburn is the Lead Insurance Specialist at the World Bank.