Address to the 10th Appointed Actuaries Symposium of the Actuarial Society of Hong Kong 3 November 2010 Anthony Neoh1 May you live in interesting times
It is said that there is a Chinese curse, which says “May you live in interesting times”. No one has been able to find the actual Chinese quotation, but extant research traces the origins back to the 1930’s, in fact, to the British Ambassador to China, Sir Hugh Montgomery KnatchbullHugessen, KCMG (26 March 1886 – 21 March 1971), Ambassador Extraordinary and Plenipotentiary to China from 1936 – 1938, who in a letter to a friend used this “curse” as an example of the perilous times. The phrase has been much repeated, famously by Robert F Kennedy in South Africa in a courageous Anti-Apatheid Speech, at the height of apartheid in 1966. But both Sir Hugh and Robert F Kennedy have been unlucky. Sir Hugh’s car was machined gunned by a Japanese fighter plane and he was hit but he survived in fact to the ripe old age of 85. Robert F Kennedy, as history records, was not so lucky. He was assassinated in 1968, when he ran for President of the United States. It may be the use of the “curse” comes with a high price. But I cannot resist doing this, as I believe that this so called “curse” aptly describes the perilous times we all live in. But in all perilous times, there are challenges and there are opportunities. An era of momentous change The Financial Services Industry has not seen such a huge set back as the 2008 Global Financial Crisis, it has been suggested, since the Great Depression of the 1930’s. Whilst that may be an exaggeration (as the destruction of wealth and industrial production was prolonged and had it not been for WWII, the United States might not have recovered its industrial strength), there is no doubt that the landscape of the Financial Services Industry has drastically changed within the short span of 2 years, from November 2008 (with the fall of Lehman Brothers creating an avalanche in the financial markets) to November 2010 (with the fanfare of the G-20 now taking place in Seoul, South Korea). Between these two dates, much has 1
The author would like to acknowledge the kind assistance of Bruce Moore, his fellow director on the
Board of China Life, in discussing some of the ideas in this address. He is also grateful to Margarita Ho of PricewaterhouseCoopers for the generous use of her time in discussing the accounting ideas in this address. All mistakes are of course the author’s and he speaks in a personal capacity only.
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changed which will make fundamental differences to how the Financial Services Industry would operate in the future. Although Hong Kong and China has not been as hard hit as the markets in the West, but because of their international linkages, the changes taking place internationally will be certain to affect us. Challenges posed by changes in financial regulation These changes pose many new challenges to those in the Financial Services Industry, but for the purpose of this morning’s address, I will try to focus on the Insurance Industry. I would suggest that the main challenges lie in the following areas: First, the ascent of financial regulation to the top of the political agenda. Second, the convergence of regulatory concepts in the financial services industry. Third, the convergence of accounting and financial reporting concepts with regulatory concepts in the financial services industry. Fourth, for this region in particular, the geopolitical and environmental challenges which will affect markets and the Financial Services as well as the predictive qualities of financial models however well constructed they may be. Regulation at top of the Political Agenda Prior to 2008, G-20 Leaders and Finance Ministers meetings have been talking about financial liberalization and exchange rates. Since then, large and once proud financial institutions have collapsed and many had come to the brink of collapse. Public monies have had to be poured into them to keep them from collapse. To prevent a recurrence, the G-20 Leaders and Financial Ministers, through international agreement, have created the Financial Stability Board (“FSB”) composed of central bank governors and financial regulators among the G-20 countries to report to them on reform measures to ensure there will not be another disaster in the future. The last letter to the G-20 Leaders from the Chair of the FSB of June 2010 reported that the focus of the FSB’s work has been on the following core areas of reform: 2
• strengthening bank capital and liquidity standards; • reducing the moral hazard posed by systemically important financial institutions; • improving over-the-counter (OTC) derivatives markets; and • enhancing incentive structures and transparency Whilst the FSB are made up of central bank governors and financial regulators, the Agenda is set by the G-20 leaders through their Financial Ministers. The top of the Agenda is dominated by banks, because they have been the overwhelming bulk of the institutions which needed to be bailed out. But other financial institutions, including insurance companies will be affected by the FSB’s Agenda, which from all appearances is being heavily backed by the G-20 leaders. It must be remembered that nearly if not all major financial institutions in the US (AIG in particular) took TARP (Troubled Asset Relief Program) money (including the major investment banks – which asked to be treated as Bank Holding Companies). There is nothing more evident of the political agenda than the Frank-Dodd Act, entitled, the “Wall Street Reform and Consumer Protection Act”. It represents, the most sweeping and far reaching legislative changes since the New Deal legislation, and it was passed within record breaking legislative time of 8 months. This is a mammoth piece of legislation consisting of 16 titles and over 1600 sections, and even then much of the detail will have to await rule making. The stated aim of the Act is: “To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes”. The Frank Dodd Act puts into an American context, many of the financial regulatory concepts under discussion by the G-20 leaders and the FSB. The most important ideas of the Frank Dodd Act tracks the FSB Agenda, such as strengthening regulation of banks and systemically important financial institutions, regulating OTC derivatives and Hedge Fund Advisers. The Act stresses the need to ensure 360 degree supervision of all financial 3
institutions – namely, supervision of all the risks undertaken by an institution, escalating the supervision to the highest level in respect of institutions posing systematic risks, and placing the onus on the directors and management of financial institutions to properly manage risks. One of the aspirations behind the Act is to dispense with the spectre of “too big to fail”. It remains to be seen whether this aspiration will be achieved, since institutions subjected to higher levels of supervision will have to be publicly identified and the market will know that these institutions are considered so important that they may be “too big to fail”. Transparency then creates the conditions for a moral hazard and something has to be done to stop this –resolution authority and living wills may help but it is difficult to understand how the proposed tax to fund future bail-outs can end “too big to fail”, so, the jury has to be out. The Act also introduces important consumer protection provisions, including the strengthening of SEC powers of investor protection by giving it more specific rule making authority to deal with all point of sale disclosures and add fiduciary duties to all broker dealers, when dealing with clients. There is also the establishment of the Office of the Consumer Advocate in the SEC and the Consumer Ombudsman, as well as the Bureau of Consumer Protection, which will operate as an independent unit within the Federal Reserve Board. In terms of insurance, there will be a Federal Insurance Office whose director will sit as an advisory member of the Financial Stability Oversight Council and who will be the person (plus another State Insurance Commissioner who sits with him as an advisory member to the FSOC) who will advise the Federal Reserve Board to use this Act to regulate any insurance company, whether foreign or domestically incorporated, deemed to be systemically important. The pinnacle of the enforcement of all of the provisions of the Frank Dodd Act lies with the FSOC. Inevitably, because of this convergence of regulatory power and if only because all financial institutions use the same markets and all consumers are exposed to the full array of financial product, there will be a high degree of convergence of regulatory concepts. The regulatory ideas in the Frank-Dodd Act are not new. In fact, we find them discussed in Europe and the UK, and in international regulatory bodies. But no country so far has actually enacted them in as complete a package as the Frank Dodd Act in so short a time. We can expect similar legislation from the EU and the United Kingdom, 4
followed in varying degrees by other countries. An important element of these developments is that China is playing an increasingly important role in the G-20 and the FSB. China is of course a major participant in the international markets with its over US $ 2 Trillion in Foreign Currency Reserves and a large domestic financial market which is increasingly connected with the international markets. Therefore the adoption of new regulatory standards internationally, will find ready acceptance in China. Convergence of regulatory concepts The ideas in the political agenda are focused on three basic areas: 1. Well supervised, efficient and transparent markets. 2. Well supervised and governed institutions. 3. Effective consumer protection. Capital and liquidity standards of banks are at the top of the international agenda, as they are the most systematically sensitive grouping of financial institutions. Thus, under the pressure exerted by the G-20 leaders the Basle Committee on Banking Supervision has come up with Basle III, requiring capital standards based on a tougher capital structure (requiring a much higher equity ratio and fewer categories of quasi-captial qualifying for tier1), a capital conservation buffer and a counter-cylical buffer. More importantly, there will be leverage and liquidity requirements, the former requiring a ratio of not less than 3% of common equity over all on and off balance liabilities (the Basle Standard do not allow repos to be netted off but derivatives are allowed to be netted off, according to Basel II standardized approach). A new liquidity ratio will have to be maintained, and redefined in terms of the short and the long term – with the short term ratio requiring marked to market value of high quality liquid assets to be in excess of the amount of net cash flows in the last 30 days, and the long term liquidity ratio requiring Available amount of stable funding to be in excess of Required amount of stable funding. The European Banks will find it most difficult to gear up to meet these capital and liquidity standards and the need to ensure that the fragile economic recovery in Western Europe and North America is not damaged so a long timetable, extending to 2018 is proposed.
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In China, the CBRC has indicated that it wishes either some or all these standards to be applied by 2012. This includes an additional requirement for minimum Non-performing loan (“NPL”) provisioning to NPL of 1.5 times (NPL coverage). Although the above are banking capital standards, the capital reserving and liquidity maintenance concepts proposed in Basle III will inevitably cascade to other institutions, particularly the adoption of quantitative models. Indeed, the European Solvency II uses an approach, universal in all prudential supervision, of requiring an insurance or reinsurance entity to have eligible own funds (equivalent in concept to qualifying Tier I and II capital in the Basle standards) to support Solvency Capital Requirements and technical provisions (similar in concept to liquid capital requirements, to replicate the amount which another institution would require to be paid in order to take over present and future liabilities rising from existing business). But capital represents only one of the cornerstones of good financial supervision. The other is an all round view of risk management well understood by the institution and its financial supervisor. Thus, the concept of the three Pillars adopted by the Basle Committee is being extended to other areas of financial regulation, though in the US, it is not articulated as such, but one can find the same concepts in the Frank-Dodd Act and associated financial supervisory legislation. The three pillars design also finds expression through the European Solvency II Directive, Level I of which has now been issued after the road testing results from the 5th Quantitative Impact Assessment. This three Pillar approach requires from each insurance institution: 1.
The reservation of sufficient capital and liquid assets to meet current and future liabilities and to withstand foreseeable changes in market and operating conditions within defined confidence levels (note the accent on probability based tests and the reliance on models, which one knows is never fool proof and will not fully guard against the unforeseen event – the Rumsfeldian “unknown unknown” or the Black Swan and so, all capital standards, including those for insurance companies, now tries to construct an economic balance sheet, reflective of how the market values assets and liabilities but leaving as much buffer as possible in the valuation of assets to weather the uncertainty economic winds of the future).
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2.
The establishment of a governance structure in each institution to ensure that both the Board and management are fully accountable for the undertaking, are fully understanding of all risks, financial, reputational and operation, and are fully capable of implementing effective systems. From such a governance structure, will, it is hoped, also emerge not only a more realistic and qualitative approach to risk management, which would be more reflective of the actual risks of the entity, than the quantitative models would suggest.
3.
The establishment of adequate reporting of risks to clients, users of financial statements and supervisors. Solvency II envisages an annual published Solvency Financial Condition Report (‘SFCR”) and a private Report to Supervisors (“RTS”).
The challenge to insurance institutions may be the most acute, because liabilities tend to be long term and it is necessary to take regular snap shots of present values of liabilities maturing in the distant future, at least when it is necessary to measure liabilities for accounting and regulatory reporting purposes. Solvency II requires all internal models used for reservation of solvency and minimum capital and calculation of technical provisions to be internally validated by management and approved by the Board of Directors of any insurance company, who will be ultimately responsible for these models, before acceptance by the supervisor. It is seldom easy to match assets to present liabilities, let alone long term liabilities. The trend in all financial regulation is to enable a financial institution to develop an “Economic Balance Sheet”, reflective of the dynamics of the financial market space in which the institution operates. By so doing, the institution will use market data in a dynamic manner (taking consistent periodic measurements), to value its assets and liabilities and make observations as to what amount of excess value it has to weather the uncertain storms of the market. The concepts of capital adequacy are built on this excess value and how readily available is this excess value to weather the risks faced by the institution to the extent that such risks may be identified. Many technical and judgmental elements will come into play and extra prudence will have to attend the business model of suppliers of long term insurance product, particularly those with discretionary bonus or profit participation elements, embedded with derivatives or derivative like features. The fall of Equitable Life, the oldest life insurance company in the 7
World is an object lesson in good governance or the lack thereof. One of the key issues illustrated by the Equitable Life affair (which has been the subject of many reports, including one from the European Union and the Parliamentary Ombudsman) is the lack of an adequate governance structure which enabled the Society’ directors (it was the largest mutual then in existence), the management and the appointed actuary to do an adequate job (who doubled up as the CEO) to do a proper job. These key governance features will figure prominently in the application of the three Pillar supervisory approach. But financial prudential supervision is not all that is at play. There is a strong Agenda internationally for consumer protection, caused by large scale losses in 401 K and pension portfolios and complex financial instruments sold to financially uneducated investors. As can be seen from the Frank Dodd Act, there is a new awakening in the field of consumer protection. Full credit should be given to the UK Tory/Libdem Government for finally moving and passing a Bill for compensating the policyholders of Equitable Life. The MAS in Singapore has strengthened consumer protection requirements in the wake of the Lehmans Minibonds crisis, so has the SFC and the HKMA in the same wake. These steps cannot be seen to be limited to banking and securities business, there is a large range of product with life and investment features, and the same rules of conduct and consumer protection should apply to all consumers who use any financial services provider. We already see this in the aftermath of the Equitable Life debacle in the United Kingdom with the EU and the FSA insisting that financial services providers should comply with the MiFid (Market in Financial Instruments Directive, the IMD (Insurance Mediation Directive and ID3 (Insurance Directive 3). We will see financial regulators catching consumer protection fever as the political agenda pushes the subject to the front pages of the media, as the Frank Dodd Act has done. In Hong Kong and China, before the regulators catch the fever, and they will certainly catch it, perhaps seriously (and I hear from the Secretary for Financial Services that a whole new program of legislation is in the pipeline for the next legislative year), it behoves every financial institution (insurance institutions in particular) to review their consumer protection management measures to ensure that at least the following features are put in place: (1)
Ensuring each customer’s financial resources and needs are fully understood by the client and the intermediary, and a 8
risk tolerance assessment is carefully made according to approved methodology which is constantly reviewed for consistency of application and applicability to circumstances; (2)
Ensuring that any financial product sold to any consumer is within his or her risk tolerance and its risks are fully understood by the consumer;
(3)
Ensuring that the above processes are well documented and available for checking by management and supervisors;
(4)
Ensuring that timely information is given to each client on the performance of their investment and timely advice is given if the risks of the product have substantially change.
(5)
Embark on a continuing financial literacy program for clients.
In China, suitability issues are presently few due to the narrow range of instruments available, but fraud issues are prevalent as can be seen from the reports of the CIRC, thus the management of life companies tends to concentrate on fraud prevention. However, there is no substitute for strict KYC (Know Your Client) regimes to be instituted in all insurance businesses. Convergence of accounting standards with regulatory standards The construction of an “Economic Balance Sheet” as a tool in financial supervision and risk management requires accurate measurement and consistent rules for recognition of assets and liabilities. In this Region, the International Financial Reporting Standards (“IFRS”) will be the dominant applicable accounting standards. The IFRS Exposure Draft on Insurance Contracts (“ED”) represents over 10 years of developmental work. When the ED is applied, it will help supervisors, financial institutions and users of financial statements considerably in making and understanding these measurements. But before we consider the impact of the evolving supervisory and accounting standards, we must be clear as to their respective objectives. Paragraph 12 of the IASB Framework for the Preparation and Presentation of Financial Statements states as follows: 9
“The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions” One might well ask why insurance contracts needed another Accounting Standard. Are insurance contracts not financial instruments and is it not more appropriate (or at least intellectually more elegant) to have a common accounting standard? In fact, the IASB tried to do just this in the first discussion paper published in 2000. But it soon became evident that a very large volume of insurance contracts is long term in nature, and there may be difficulties in measurement using general fair value measures. Insurance contracts also differ from other financial instruments in another respect. Holders of financial instruments generally take pure financial risk. In other words, there is no insurable interest involved, though there may be features of pure financial risk embedded in an insurance contract. Thus, the developmental work then turned to the basis of a specialized accounting standard. This enabled the developmental work to track the developmental work in the area of prudential supervision. The concept of the “Economic Balance Sheet” is common to both the developing accounting and supervision standards. In other words, both will use a market consistent approach in developing measurement models and recognition rules for assets and liabilities. Whereas accounting standards are designed to improve accounting and financial reporting, it must be recognized that Solvency II and for that matter any Code which deals with the supervision of insurance companies, is designed for the protection of holders of insurance policies. Thus this is a comprehensive code, dealing with the whole insurance organization and attempting to capture and manage the risks undertaken by that organization. Thus, the Solvency Financial Condition Report mandated by Solvency II is designed to enable policyholders to tell whether their claims will be met. Furthermore, reporting is only part of the overall design of the Code. But although accounting standards and supervisory standards differ in objective, they play complementary roles, each benefiting from the other’s existence. Here I would only mention a few challenges to insurance institutions arising from the convergence of standards: 1. The first challenge goes data collection and integrity. Whilst the 10
convergence of accounting and regulatory standards in measurements and recognition of assets and liabilities, will relieve insurance companies under Solvency II from unnecessary duplicative work, companies will need to be particularly good at capturing information which encapsulate their risks and ensuring that their measurement models are up to the task. 2. Allied to this first challenge, is the second challenge, which is the institution of internal controls which will ensure that its financial reports and regulatory status is intact. In the PRC, all listed companies will be subject to internal controls audit from the 2010 annual reports and the form of management and audit reports in relation to internal controls will be a challenge to insurance companies. Failure to maintain adequate internal controls may impact an institution’s going concern status. 3. The third challenge lies in explaining the significance and the impact on business of the risk management system. The Annual Report on Solvency required by Solvency II will be technical but it must be accompanied by a Management Discussion which allows both policy holders and investors to understand how changes would affect soundness and profits. 4. The fourth challenge will be the trend to shift towards an increasingly higher capital reservation standards with the need therefore to balance this with assets of lower risk. An increasingly inflexible capital structure is bound to increase the weighted average cost of capital of the company, and thus the Economic Value added by its operations. There will also most probably be a lower ROE as the stricter capital standards and assets and liability management takes root. There are 58 life insurance companies in China. Although it is a vast market, there is fierce competition and profit margins will be one of the important challenges for the future. The geopolitical changes in the Region There is no doubt that China has now emerged as the second largest world economic power. It will seek to use this newfound power to consolidate its status on the world stage. There are long standing geopolitical issues relating to natural resources and climate change, which will need to be resolved. Things such as demographic changes will be relatively easy to factor into life and annuity tables, but the uncertainties arising from the geopolitical and climatic issues will be very difficult to 11
factor into any model. Thus, institutions and regulators will have to use best judgment in their risk management. All of this bodes for the need for more prudent business models and the need to manage expectations for lesser returns than in the recent past (pre 2008 period). Yet the signs are that life expectancies will be longer and the pressures for inflation ever increasing. Investment product catering for these uncertainties will be at a premium. Herein lies perhaps the supreme challenge and the supreme opportunity for financial professionals. The opportunities Actuaries are the first professionals in the financial landscape. They appeared earlier than accountants. It was James Dodson who started the Equitable Life Assurance Society in London and became the first person who called himself an actuary in 1762. Accountants, originally known as Accomptants, did not have a role in audit and financial reporting until the passage of the Joint Stock Companies Acts from 1844. Since the beginning the major insurance companies have employed professionals skilled in mathematics and statistics to measure the probabilities of claims, or their distributions, as a function of time and other variables. 20th century computational power has enabled this activity to be developed. Legislation around the world requires actuaries to be appointed by each insurance company to report on the liabilities of the company based on assumptions of the future. Like accountants, actuaries play an important part in the prudential process. With the development of modern financial theories, accountants have ventured into cost control, risk management and financial management using tools developed in the last half century. A cursory glance at the curriculum for the actuarial examinations will show that actuaries are now trained in the same mathematical and financial economics tools as accountants and other professionals in the financial markets. There is no reason why actuaries with the depth and breadth of their training should not be engaged in a much wider range of activities in the process of management of risk. I hope that I will see actuaries in senior risk management positions in financial institutions of any nature. In fact, I wish more actuaries had been involved in the investment banks, which have developed the derivatives which have brought so much grief to the markets in recent years. The real vice which has occurred is that vast expanses of the financial markets have been dominated by financial engineering using models which are untested by more than one economic 12
cycle, and therefore the models are themselves heavy with untested assumptions and light on real world experience, and even lighter on prudence, if that existed at all. As a result there has been much skepticism of financial mathematics. But I would venture the thought that it is not the mathematics, which is at fault but the practitioners. As professionals in the field, you now have the opportunity to correct this injustice to your Art. I wish you good fortune, and though you may live in interesting times, you will prove by your learning that the phrase is not a curse but a blessing! 3 November 2010 Hong Kong
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