Davao City Mayor Rodrigo Duterte will formally take oath as the 16th President of the Republic of the Philippines on June 30, 2016. Consistent with his promise during the campaign period, majority of Filipinos are likewise proclaiming, with raised, clenched fists, that change is coming for the Philippines. Our people have, indeed, challenged the status quo and voted for Duterte hoping the country would be in a much better position for the next six years. A ray of light from the promised change and a new beginning for 100 million Filipinos.
The insurance industry in the Philippines will likewise begin anew as it prepares for the coming change in the Valuation of Insurance Policy Reserve (Reserve) and Risk Based Capital (RBC) mandated by the Philippine Insurance Commission (IC), which will also take effect beginning June 30, 2016.
The new Reserve and RBC framework
For the insurance industry, a Reserve provides for the minimum amount of obligation that should be recognized by an insurance company for insurance benefit claims that are expected to be settled in the future to its policyholders. The RBC, on the other hand, provides for the minimum amount of capital that should be made available by an insurance company based on the risk it undertakes and serves as its protection from insolvency.
In October 2014 and June 2015, the IC issued Circular Letters 2014-42-A and 2015-32 covering a new set of valuation standards for life and non-life insurance policy reserves, respectively. Moreover, in June 2015, through its Circular Letter 2015-30, the IC conducted a review of the current RBC framework. Consequently, all life and non-life insurance companies were required by the Commission to participate in parallel runs for the Quantitative Impact Study (QIS) with the objective of assessing the collective impact of the implementation of the new Reserve and RBC framework to the insurance industry.
For life insurance companies, the new reserving framework transitioned from the previous Net Premium Valuation (NPV) to Gross Premium Valuation (GPV) in determining the reserve requirement. The shift to GPV supports a market-based approach and reflects the best estimate of reserve for insurance policy obligation. The new reserving framework further provides for the use of the current market rate in discounting to present value the future cash flows in the settlement of insurance benefit obligation, which was capped at the rate of 6 percent under the old framework. Also, the new reserving framework requires consideration of additional assumptions, such as lapse and/or persistency, morbidity and Margin for Adverse Deviation (MfAD) of 10 percent, in determining the reserve requirement.
For non-life insurance companies, the new reserving framework determines the premium obligation based on the higher of Unearned Premium Reserve (or UPR, the premium received from policyholders for the unexpired portion of insurance benefit coverage) and Unexpired Risk Reserve (or URR, the obligation and related expense that are expected to be settled in the future for the unexpired portion of insurance benefit coverage). Previously, premium obligation is determined on the basis of UPR alone. The new reserving framework further requires, in the determination of losses and claims payable, consideration of Loss Adjustment Expense (or LAE, expenses already incurred but not yet paid in connection with settlement of losses and claims). Also, the new reserving framework requires the consideration of MfAD of 10 percent in the determination of premium obligation and losses and claims payable, which make up for the minimum reserve requirement.
For life and non-life insurance companies, the new RBC framework redefines the composition of Total Available (Qualifying) Capital. Risk components have been redefined into Credit, Liability, Market, Operational, Catastrophe and Surrender risks. The assigned risk charges for these risk components have been increased from the old framework. Higher risks undertaken correspond to higher risk charges, which in turn, translate to higher amounts of required capital.
A number of insurance industry CEOs, CFOs and other stakeholders, expressed support to the new framework, particularly with the Reserve valuation applying market-based assumptions and the RBC being more risk-sensitive. The new Reserve and RBC framework is likewise seen providing increased financial stability to the insurance industry as a result of better risk management and aligns our practices closer to international standards.
Challenges and opportunities
The financial and strategic impact, including implementation efforts, underlying the above regulatory change are expected to be significant for insurance industry players. It requires a mechanism capable of looking beyond basic operational compliance and incorporates appropriate financial and strategic impact evaluation to develop an effective company-wide response.
Volatile results of operations
Insurance industry players will now deal with increased reserve cost and obligation for financial reporting purposes. This translates further to more volatile results of operations (fluctuation in profit or loss) given the market-driven reserve assumptions that are susceptible to changes in market conditions. The amount could be considered significant, for both life and non-life insurance industry, but more particularly with life insurance industry players that carry significant traditional, long-term, life insurance products. Significant volatility in the results of operations (profit or loss) could further impact investor confidence and therefore, a well laid out communication plan with investors may need to be incorporated in the implementation strategies.
As of press time, the IC, in consultation with the FRSC and SEC, is yet to clarify its guidance on whether the impact of the increased reserve cost will be taken up in the profit-or-loss or as part of equity, and whether the impact will be recognized as one-time or deferred over a period of time, for financial reporting purposes. Moreover, the IC, working with the BIR, is yet to clarify the guidelines on whether the increased reserve cost will be considered as deductible or non-deductible item for income tax purposes. Currently, the impact of the increased reserve cost is seen being taken up in the profit-or-loss for financial reporting purposes and as a non-deductible item (with no tax benefit) for income tax purposes. While the evaluations are underway, it continues to be crucial for insurance industry players to run impact assessments on each of these potential scenarios to develop responsive implementation strategies.
Product portfolio and pricing strategies
Given the risk charge and capital requirement, insurance product portfolio and pricing strategies will have to be carefully planned to ensure that these continue to deliver expected returns to various stakeholders. Higher risk charge and capital requirement for certain insurance products could drive up costs and erode returns, especially against a backdrop of lower interest rates. This entails strategic business decisions on which insurance products to retain, withdrawn or modified.
Capital and asset liability management
The more stringent risk charge and capital requirement, as well as increased reserve requirement, could significantly bring down the RBC ratio and require a capital build-up plan or capital call (additional capital infusion) from shareholders to comply, not only with the new RBC framework, but also with the existing net worth requirement by the IC.
Investment strategies will have to be revisited to maximize asset returns while staying within reasonable risk limits. The right balance between the capital requirement and asset yield will enable insurance industry players to capitalize on market opportunities while keeping capital cost at a minimum.
Also, the more stringent capital requirement is seen forging potential mergers and consolidations among the insurance industry players (smaller players merging and consolidating with bigger players) and therefore these scenarios should be factored in pursuing growth opportunities and sustaining the entity’s competitive advantage in the market.
Data management and resource requirement
The new framework will require data to be captured at a more granular level not only at the transition period but also on an ongoing basis. Existing systems should be capable of capturing historical data, formulating forecasts and running the required calculations. Investment in appropriate technology will be increasingly critical in reducing the cost of compliance.
People resource that are trained and well versed with the new regulatory framework and its financial and strategic implications will be crucial particularly in the finance, risk and compliance, actuarial valuation and IT teams. Employee KPIs should be revisited to align with the overall implementation plans and objectives.
Ready for the change?
As of press time, the IC has not issued any deferral plans on the implementation of the new regulatory framework and is likely to take effect on June 30, 2016, as originally planned.
An outlook on the varying financial and strategic impact and synchronized action plans to effectively respond to such regulatory development should already be reflected on the CEO and CFO dashboard at this point. Otherwise, the entity will be left out by the bandwagon of change and miss out to turn around these challenges into opportunities and gear up to its competitive advantage.
The regulatory development is seen providing better protection for and strengthened confidence from the insuring public in light of increased financial stability in the insurance industry. Certainly, a welcome development, for over 30 million insured Filipinos.
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Imelda D. Mangundaya is a Partner from Assurance and Assurance Risk Management of Isla Lipana & Co./PwC Philippines. Email your comments and questions to email@example.com. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.