Wishing for Basel 2

KPMG’s 16th Annual Insurance Issues Conference

Canadian property and casualty insurers enthusiastically watched banks implement Basel 2 capital solvency requirements on Nov. 1, 2007. But even though they might envy the banking industry’s new capital standards, insurers shouldn’t underestimate the amount of work involved in establishing a form of Basel 2 for the insurance industry, Canada’s Superintendent of Financial Institutions, Julie Dickson, cautions.

“Basel 2 is a journey, it is not like Y2K,” Dickson told insurance industry representatives attending KPMG’s 16th Annual Insurance Issues Conference. “With Y2K, as you know, we all knew a few seconds after midnight whether we had succeeded or not.

“That’s not the case with Basel 2. We are only going to know how successful we’ve been as risk management practices and processes become rigid, as formally expressed testing improves, as more data is generated and as decisions about risk management are being made.”

In fact, the journey may take as long as five years before the P&C industry is ready to initiate the implementation phase, Dickson guessed.

Implemented in 1988, Basel 1 was designed to strengthen the soundness and stability of the international banking system as a result of the higher capital ratios it required. Basel 2 is a revision of the existing capital framework, aiming to make it more risk-sensitive and representative of modern banks’ risk management practices.

Dickson was clearly impressed by the Canadian property and casualty industry’s desire to move towards its own version of a Basel 2-style framework. “I like to tell the banking industry, when they start to complain: ‘Well, the insurance companies seem to think this is a good idea.'”

But the road to Basel 2 “is not an easy road to travel,” she added.

Dickson listed 10 obstacles Canadian banks faced in implementing the Basel 2 framework last November. “You [insurers] will have exactly the same challenges,” she predicted.

OBSTACLES

Perhaps the most glaring difficulty for the banks was their own overconfidence, Dickson said. She said banks worldwide initially said “adopting Basel 2 was not a big deal, not a problem,” and therefore seriously underestimated the amount of time it would take in order to comply with the new risk management requirements incorporated into the Basel 2 framework.

Property and casualty insurers are falling into the same trap, Dickson said. She said she has heard Canadian insurers say in informal discussions that European insurers are “already there” when it comes to implementing Basel 2 forms of capital models. “There is a major overstatement,” Dickson said. “They have really just started doing dynamic stress capital testing.”

In fact, the demand of incorporating risk management analyses into capital testing required major “organizational and cultural shifts” and is “certainly not a slam dunk,” Dickson said. The associated change management required “took a lot of time and a lot of resources, and the scale of implementation was much bigger than anyone had anticipated.”

And banks didn’t just underestimate the impact of the cultural shift, added Dickson. She noted bank executives pinned the costs of implementing Basel 2 in a certain range, but the costs were in fact much higher than originally anticipated, primarily because risk management systems had to be integrated with financial systems.

Data integrity proved to be a challenge in the implementation of Basel 2. Legacy systems are a real issue when trying to do a Basel 2 type of approach, Dickson said, because you need “a sufficient quantity and quality” of data “and that’s in a form that can be easily used and reconciled. You need that in order to run your models and to support your assessments of risk and use of capital, so legacy systems, with potential overlaps and duplications in data sources, can make that extremely difficult.”

In addition, large Canadian banks are international and operate in many different countries, creating a huge challenge for Solvency II-style approaches, Dickson noted. “Adopting advanced capital approaches in countries with far-flung material operations is a huge challenge,” Dickson observed. And the problem of consolidating credible data across jurisdictions is magnified when regulators in different jurisdictions are at different states of readiness when it comes to implementing Basel 2.

Once the data is compiled, there is always the problem of meeting the Basel 2 model’s capital use test. “The use test is extremely difficult to meet,” Dickson said. “What I mean by the use test is that [a company] actually has to use the results of its models in its decision-making. It’s like eating while you cook.”

Once the models are created, there is a challenge in establishing what Basel 2 requires as an “independent review process for the models” in the context of the bank and insurance sectors, Dickson said. For the banks, the issue “boiled down to what constituted an independent group within the bank — what skills would be sufficient, what scope would be necessary,” she noted.

Moreover, the role of the internal audit wasn’t always clear.” For example, who should do the audit? Should it be done internally, or by external auditors? How important is data accuracy in the minds of both internal and external auditors?

COMMUNICATIONS

Dickson gave three additional matters for insurers to consider in their quest to see a form of Basel 2 introduced into the insurance industry; all of them relate to communications. For example, insurers need to be clear about the messages they are relaying to the companies’ executive committees and policyholders.

These messages are likely to be mixed so long as insurers remain confused as to the real purpose of implementing Basel 2. “There is a confusion about goals,” Dickson noted. “Some say the goal of Basel 2 is capital reduction, while others think it is about compliance. Still others think it’s about internal use and controls.”

This needs to be worked out, Dickson noted, because Basel 2 calls on better communications with senior executives — and improved disclosure to the public — about how the company is arriving at its financial risk estimates and figures. “Explaining to senior management and directors what you are doing is not easy,” Dickson noted. “Basel requires that your senior management and board know what the process is all about. If it’s considered to be the domain of rocket scientists safely ensconced in the bowels of the institution, you will not get a passing grade.”

Certainly explanations the board doesn’t understand will not pass muster with the public. One speaker at the KPMG conference noted a European insurer company implementing Basel 2 had an annual report so thick, the company had to make a special arrangement with the postal carriers’ union in order to address the carriers’ workplace safety concerns about having to lug the heavy reports to the mailboxes of shareholders.

And would the policyholder be able to read, much less digest and understand, such a thorough disclosure? “Do not underestimate the challenge of explaining why your assessment of risk for a commoditized product is different from the estimates of your competitors,” Dickson cautioned.