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The Insurance Regulatory and Development Authority of India (IRDAI) announced in a circular dated 10 August 2023 that it has been taking many steps to bring the Indian insurance industry in line with international standards to facilitate business and ultimately reach the last mile of "Insurance for All by 2047." The circular was related to Technical Guidance regarding the Indian Risk-Based Capital Framework -Quantitative Impact Study-1. One of the key initiatives pertains to developing and implementing a Risk-Based Capital (RBC) Framework for the Indian insurance industry.
Major international insurance markets have already transitioned to the risk-based capital framework. The IND-RBC framework will impact the amount of capital insurance companies must set aside to meet solvency margins.
In this industry, the move to a risk-based capital structure is seen as a more effective use of resources. Under the RBC approach, capital requirements are determined based on the risks an insurance company faces, encompassing factors such as investments, underwriting, operations, market risk, etc. In contrast, the prevailing factor-based method employs a fixed ratio to calculate capital requirements. This article will explain key terms/concepts involved in risk-based capital and its impact on insurance companies.
The risk-weighted method of capital allocation is expected to release capital in specific instances, potentially benefiting larger insurers with diversified underwriting portfolios while requiring an infusion of greater capital for insurers dealing with riskier business. Consequently, this movement might elevate the significance of reinsurance to handle fluctuations in earnings and balance sheet volatility effectively.
Volatility of the market and size of companies
The Indian insurance sector is dominated by public insurers, and the business structures of public and private insurers are different. The introduction of RBC significantly impacts the insurance sector and can potentially alter the competitive environment. The RBC will split financially strong players with the weaker ones. To maintain their business strategy, smaller players needed more funding. Instead of trying to be everywhere, players can choose a target market based on how much risk they are willing to take and how stable they are.
Interest rate risks
Due to interest rate risk, businesses that offer traditional long-term goods with guarantees must pay a substantial capital charge. The long-term bond market is underdeveloped enough to match long-term assets and liabilities. Companies must manage their assets and liabilities, close the duration gap between them, and hedge their derivative risks to control this risk.
Risk management
Capital is based on risk in an RBC regime. There is a direct relationship between better risk management and capital management. Hence, there is a need to ensure a robust risk management framework. The role of CRO becomes very important in balancing the act of helping to identify and assess risks promptly to meet business objectives.
Operational impact
Companies must invest considerably in systems and process upgrades. Potential impacts include higher regulatory compliance costs, automation of reporting processes (example, modeling), allowance for additional resources, time and cost of implementation, continuous maintenance, and focus on data quality.
Impact on business strategy
Possible effects on business strategy could include adjustments to internal capital triggers and risk appetite, modifications to the level playing field for a few companies, a review of the investment plan, a thorough ERM framework, and improved decision-making, or more effective use of capital.
Need for product innovation
By providing flexibility to innovate, RBC will allow insurance companies and support regulators’ visions to reach every nook and corner of India. This will give a path to dedicated standalone microinsurance institutions thereby making insurance affordable and available to low-income families, thereby providing a measure of risk mitigation and security.
RBC requirements aim to identify under capitalised firms, necessitating regulatory intervention to assure policyholders receive committed benefits without relying on wider capital infusion or public funds. RBC requirements aren't intended as a sole determinant of financial solvency; instead, they serve as one tool that empowers regulators to assume control of an insurance company. These risk-based capital requirements serve as a safeguard, shielding companies from insolvency. Essentially, the RBC limits shall be critical thresholds that raise triggers for timely regulatory intervention.