Latin Ambition: Solvency 2

Latin American economic powerhouses Brazil and Mexico are introducing new solvency regulations in their fast-growing insurance markets. But while
Mexico has gone straight for a Solvency II -type approach, Brazil is emphasising gradualism and will not make the jump to risk-based regulation in the near future. John Rumsey reports

The Mexico and Brazil insurance sectors are ostensibly similar: both are under-developed markets with great potential for growth and conservative regulatory regimes.

However, their differences are more marked. While foreign insurers are dominant in Mexico, Brazil has a more domestic, bancassurance-dominated market. Mexico is using European models and a fast rollout for its risk-based solvency regime, while slower-moving Brazil is opting for an approach in line with the International Association of Insurance Supervisors (IAIS).

Lack of complexity
By both global and Latin American standards, the Mexican insurance market is small with low penetration, says Norma Alicia Rosas, vice-president of analysis and sectoral studies at the Insurance and Surety National Commission (CNSF) in Mexico City.

The industry accounts for just 2% of gross domestic product (GDP), compared with about 4% in Chile and 12% in the UK, according to data from the US Commercial Service.

Pent-up demand is only just starting to be met and the lack of complexity helped protect Mexico’s fledgling market during a deep recession. In 2009,GDP retreated by 6.8%. Things look brighter now with a recovery of 4.5% forecast for this year, according to a Central Bank poll of economists.

The recession had a limited impact on the
Mexican insurance market and overall the
past decade has been dynamic, Rosas says.
Recovery of the economy will drive insurance
growth, according to José Oliveres, managing
director in risk management at
PricewaterhouseCoopers (PwC) in Mexico
City, who predicts growth of more than 10% per year in the long term.

Foreign companies see Mexico as a growth
opportunity, Rosas says. With its proximity
to the US, Mexico has long been a launch
pad for overseas companies looking for a toehold in Latin America. Some six companies
are working to get a Mexican insurance
licence underscoring the resilience of the
industry, according to the vice-president.

There are 98 insurers in Mexico and 57 of
them are subsidiaries of foreign insurers,
says Oliveres. Products tend to be simple.
Life insurance with savings continue to
dominate at 38% of premiums. Other areas
are growing fast. For example, pensions, which account for 6% of premiums, jumped 82% in the first half. Funding issues in the public healt system are likely to cause a large increase in demand for health and accident coverage, which account for 16.8% of the market.

Solvency in Mexico
This relatively simple market is about to get a
shake-up as Mexico is pursuing a fast-track,
Solvency II -style solution to improving legislation.

The country opted for a European model more than 10 years ago when it introduced a Solvency I-type scheme, says Rosas.

The law drew inspiration from Spain and
France, which were considered to have high
standards, and whose insurance markets had
similarities to Mexico.

There are advantages to the European
model, says Jesús Alfonso Zúñiga San Martín,
risk specialist at Grupo Nacional Provincial (GNP), an insurer based in Mexico City.

Europe has a broader variety of insurance
companies and viewpoints and Solvency II is
more advanced in enterprise risk management
(ERM) than US standards. The CNSF has drafted an Insurance Law, slated to be presented to Congress in September. The new law introduces many of the measures present in Europe’s Solvency II but tailored for a smaller, less complex market. “Although the rationale was the same, we calculated our own parameters as the distribution of claims is not similar to Europe,” says Rosas.

The main difference between the two markets is in the sophistication and range of products, particularly in the life and retirement segments
where Mexico uses simpler, more traditional
products, says Zúñiga. That said, the strong
presence of European companies in Mexico
means many innovations and products are
imported, ensuring the Mexican market is
not too far behind, he notes.

The new solvency laws will take into account
the peculiarities and risk profiles of each capital reserve requirements on those with
riskier appetites and portfolios, Zúñiga says.

It allows greater discretion for insurers to
evaluate adequate reserves themselves and
should also reduce the cost of reinsurance as
current Mexican regulations favour proportional
reinsurance, he notes.

Finessing the qualitative aspects of Solvency
ii is more complex. Many insurers will need
to devise new reporting lines and hire technical
professionals to evaluate the totality of
risks and incorporate new risk models into
decision-making, says Oliveres.

Before, there were no specific requirements
for management to have a clear idea of all the
risks they were exposed to, adds Zúñiga. The
new law means boards will have a more active
role and greater responsibilities and audit
committee and risk management functions
will have greater power. “The controller will
be a more active player in the management of
day-to-day functions,” he says.

Rosas predicts passage of the new law either
later this year or during the first quarter of
2011. “Mexico has the advantage of a purely
federally regulated industry and does not have
to reconcile the voices of many countries or
states to get the law passed,” Rosas says.

Oliveres and Zúñiga agree the law is likely to be approved although Oliveres cautions that a minority in the industry do not welcome it: “Some are saying: ‘why change the laws and regulations when the Mexican insurance market has been solid and never had any major problems?’”.

Differences between the Mexican and European texts are minor, says Zúñiga. registration of products before sale, currently obligatory in Mexico, will be dropped; some conceptual limitations on reinsurance will be introduced; and there will be changes to capital reserve retention.

Although the new law lays down the framework
for Solvency regulations, it has left the detail for later, including the specifics of how the models will be calculated, says Oliveres.

There are only very preliminary results from a quantitative impact study (QIS) in Mexico, points out Zúñiga. The Mexican Association of Insurance Services (amis) has tested a
European version of the QIS, but as a voluntary
scheme, only 25 companies took part and
results have not yet been made public, says
Oliveres.

Rosas says a further QiS will be conducted in January, which will be used as the basis for the standard formula. That makes the timetable for Mexico tight as implementation is slated for January 1, 2012.

Rosas argues that Mexican solvency standards
are advanced already and existing laws go
well beyond the standards of Solvency I,
making the transition to Solvency II easier.
“We do not have Solvency i, but Solvency
one-and-a-half,” she says.

Some insurers, particularly foreign ones, will
begin to use an internal model next year and
will be eligible to adopt it in 2013 as the draft
law requires insurers to run models for two years prior to full implementation, says Rosas.

The uncertainties surrounding models have allowed concerns that some insurers will need to raise capital to flourish. The sector financials are solid and overall the industry has 1.9 times the capital necessary, according to data from Amis.

Rosas believes significant capital raising is unlikely as requirements are already prudent, but concedes: “insurance companies are worried
about higher capital needs.” Oliveres agrees that large and diversified companies may not need more capital, but thinks monoline and small insurers may.

Rosas argues that the proportionality concept
should mitigate the effect on such nsurers. Moreover, the regulator is likely to include a transition period for companies to raise capital, she says. Even so, the new insurance law is likely to encourage an increase in consolidation with the smallest firms absorbed or seeking joint ventures, market watchers agree.

Authorities have been clear they want to implement the law in 2012 and insurers are
moving in the right direction, albeit slowly,
according to Oliveres. To mitigate the effects of
the new law on smaller insurers, the association
and regulators have been stepping up training
and courses to prepare insurance companies,
says Rosas.

Oliveres says: “even with the increase in
assistance, you feel there is a need for more
education, training and dialogue.”

Pent-up demand
Brazil had a much more short-lived recession than Mexico with a 0.2% dip in GDP last year. That has been replaced by roaring growth, which
reached more than 9% in the first quarter of this year, with the most recent Central Bank poll of economists pointing to a full-year growth
of 6.99%.

There is plenty of scope for fast growth in insurance because, as in Mexico, the Brazilian industry is negligible representing just over 3%
of GDP, according to José Tadeu Mota, head of investor relations at independent insurer Porto Seguros in São Paulo. Total revenues for
the industry came in at 107.5 billion real (£38.5 billion) last year, according to the regulator, the Brasília-based Superintendency of Private Insurers (Susep).

“The market has high growth potential with significant pent-up demand,” says Eduardo Fraga, general coordinator of solvency monitoring
at the regulator. Indeed, growth of the insurance market hit 19.8% in the first five months of 2010 year-on-year, according to the Federation of National Private Insurance and Capitalization Firms, an industry association.

A vast government-sponsored infrastructure programme, the hosting of the World Cup in 2014 and Olympics in 2016 will ensure plenty of big-ticket insurance work, says Carlos da Matta, a partner at PwC in São Paulo. Much of that new business will fall into the laps of the large, bank-based players. The Brazilian market is a quintessential bancassurance market and strongly dominated by the big domestic
players. And the continental size of Brazil means bank distribution channels are very important, according to da Matta.

The industry is also concentrated. Bradesco Seguros, Latin America’s largest insurer and part of the bank of the same name, has one-quarter
of the market by premia, says Samuel Monteiro dos Santos Júnior, managing director of administration and finance at the insurer in Rio
de Janeiro. In 2009, the company posted profits of 1.4 billion real or 36.9% of the total profitability of the entire market.

Home insurance and life policies, retirement funds and health coverage are key growth areas and corporate Brazil is extending benefits,
says Monteiro. Lower-income consumers are increasingly turning to insurance for the first time ever, with funeral and dental policies two
of the most popular class C products. “This is a class that cares for its appearance,” quips Monteiro.

Da Matta adds that banks tend to sell their own insurance products leaving space for foreign investors to break into niche segments, such
as guarantees for international transport.

It is not only the bancassurance shape of the industry that looks oldfashioned; the industry was long considered over-regulated and
conservative with limits of 30% in equities, for example. The recession changed that perception. “Brazil has a system that was created in the 1950s, which has been seen by the whole world as inflexible, but it is much more secure,” says Monteiro. “Insurance companies in Brazil are solid and they passed the recent crisis without wavering,” adds Fraga.

Insurers tend to be conservative about investments too. Hyperinflation in the 1980s and ‘90s made bank deposits and fixed income the investments of choice. Not much has changed since then. The base rate was still high at 10.25% in August this year. Bradesco invests just
4% of its portfolio in equities, a figure that has actually been reduced from 5.5% in the last couple of years thanks to equity volatility and a
higher rate cycle, notes Monteiro.

Even though it is conservatively regulated, the industry is not standing still. Last year, a state monopoly in reinsurance was withdrawn. More competition will allow insurers more flexibility in tranching and passing on risk through that market and could bring down prices.
It will also bring know-how and new products, reckons da Matta. Brazil is also implementing international financial reporting standards
(IFRS) this year.

Solvency model
Brazil’s approach to solvency regulation reflects the caution of the industry. Brazil is taking a gradual approach and looking more at international standards than europe’s Solvency II.

According to Fraga, the country has
decided to adopt a flexible approach to modernising its solvency rules and has not
outlined a fixed timetable to avoid setting the process in stone. Susep has implemented
incremental improvements since 2005, constantly
monitoring impacts, he notes. While they are being introduced, Brazil is sticking with existing solvency margins that are analogous to Solvency I, he says.

Each risk related to capital requirements is
to be regulated separately. Subscription risk
was regulated in January 2008 and 95% of
Brazilian insurers are compliant with requirements
today, says Fraga. Capital requirements
on credit risk will be introduced in January
next year and advanced studies on market and
operational risk have already been carried out,
he says. Susep is encouraging take-up of the
standard model initially and internal models
only over the long-term, he notes. Even so,
the big banks are planning ahead: Bradesco
plans to move to an internal model soon,
according to Monteiro.

“in Brazil, we are very far from European
markets in our interpretation of solvency regulations,” says da Matta. The authorities are
still working on the implementation of IFRS
this year and da Matta reckons Brazil will
need another four to five years to implement
solvency regulations completely. Until last year, Susep did not have qualified people to plan for new solvency regulations and hired hundreds of new staff, including many technicians, last year to build the team to apply the new standards, he says.

Brazil’s model for solvency regulation has
been devised on the basis of the IAIS of which
Brazil is a member, says Fraga. There is much
work to be done on quantitative areas, such as
risk-based capital and internal models, and
qualitative areas including governance, controls,
internal risk evaluation and ERM.

Lastly, the supervisor needs to work on systemic
monitoring and stress tests, he notes. The new capital requirement models will better reflect the risks of individual portfolios in areas such as insufficient contributions and premia.

Calculations for these will incorporate risk-free interest rates, reflect longer life spans and embedded options in contracts. For investments, there will be strict limits on derivatives and hedge investments, including the requirement that derivatives be exchange-traded, he says.

The Brazilian industry is heterogenous – while some insurers are worried by capital requirements, others are focused more on developing provisioning methodology, says Fraga.

Additional capital requirements could represent
a serious obstacle for the industry. Brazilian insurers may be relatively well capitalised, but markets have proven an unreliable source of funds, says da Matta. There are just four Brazilian insurers: Sulamérica; Porto Seguro; Bradesco Seguros; and the state-owned Caixa Seguros, and issuing subordinated debt remains virtually untested thanks to high interest rates.

As in Mexico, adapting to new solvency standards will mostly bedevil smaller insurers.
They do not have enough knowledge, staff or internal controls to prepare the information for solvency standards, nor the know-how for capital markets, says da Matta. They are galvanising political pressure to slow the solvency process down, he notes.

If extra capital is finally needed, mergers are likely in the sector, da Matta predicts. Monteiro agrees that that may happen, but adds smaller insurers may opt instead to parcel out risk in the market to keep capital requirements low.

The Mexican and Brazilian insurance markets are enjoying a spectacular spurt of growth as the emerging middle classes gain access to
basic insurance and banking products, while wealthier consumers opt to upgrade their health and retirement plans. Regulators are aware of the need to update regulations, but are marching to different beats and working to different models. Brazil is staggering implementation and testing every stage, while Mexico is planning a big-bang approach. Both may find management distracted by all those market opportunities.

Some Brazilian insurers are set against updated solvency regulations which they see as an additional burden to their work and requiring more capital, says Matta. We are trying to show how the new rules will overhaul concepts of managing risk, contribute to reducing loss ratios and cut administrative expenses, he says. The rub is that: “trying to change the mindset is an uphill battle”.

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