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21 September 2015News

The long road to innovation

Gaining Solvency II equivalence, which is now in sight for Bermuda, represents a critical step for the jurisdiction if it is to remain competitive in the dynamic, ever-changing insurance marketplace, says David Thompson, risk consultant at KPMG in Bermuda.

While he admits that the road to Solvency II equivalence has been extremely long and winding, because of the growing diversity of the investors and risk transfer vehicles operating through Bermuda, its importance to Bermuda is even greater today than it was when the Bermuda Monetary Authority (BMA) embarked on the journey back in 2008.

“Bermuda continues to be the domicile of choice for new capital, whether in the form of hedge fund reinsurers, pension and sovereign wealth funds, insurance-linked securities or collateralised vehicles,” Thompson says.

“Some of this capital is linked with individuals and companies very familiar with the Bermuda market. However, much of it is coming from jurisdictions with significantly less understanding of Bermuda as a domicile. This new breed of capital providers has choices of domicile and needs, among other things, the comfort of a robust and recognised regulatory regime.”

He argues that it is extremely difficult to see this being possible outside of Solvency II. Even if the short-term impacts of not gaining equivalence may be limited, the gradual erosion of confidence in Bermuda as a jurisdiction would have significant negative consequences.

“The extent of tax reform measures being proposed and debated by, among others, the US and the UK (historically Bermuda’s major trading partners) continues to be a discussion topic across the Island. In the face of this, it is vital that Bermuda does everything it can to remain competitive, especially in what remains its life-blood industry,” he argues.

“This is truer today than it has ever been, especially with the potentially unprecedented period of change that the reinsurance sector is starting to experience.

“Regulation may be only one aspect of this need for competitiveness, but there is no doubt that companies and investors continue to value a regulator that understands the business models being placed in front of it and can offer a streamlined, although still robust, licensing process.”

Regulation supporting innovation

Solvency II equivalence also represents an important step forward in Bermuda’s ability to continually innovate, Thompson argues, an attribute that has been central to the jurisdiction’s past success and ability to build market share in so many sectors.

"Companies and investors continue to value a regulator that understands the business models being placed in front of it and can offer a streamlined, although still robust, licensing process.” David Thompson 

Innovation is an increasingly important issue in every sense. A KPMG global survey of insurance executives conducted over the first half of 2015 found that 83 percent believe their organisation’s future is tied to their ability to innovate, while 65 percent did not see the regulatory environment as supporting product and channel innovation.

Thompson believes that good regulation should go hand in hand with innovation. “Bermuda has historically been a driver of innovation in reinsurance,” he points out. “Although this has principally been the result of the resident intellectual capacity, regulation has provided an environment where this can happen.”

In contrast, he says, Solvency II and reforms by the National Association of Insurance Commissioners (NAIC) have done very little to persuade insurance leaders that the major markets are supporting the revolution, or even the evolution, that they believe is essential.

“For Bermuda, therefore, remaining competitive in today’s marketplace clearly means being a jurisdiction where innovation can thrive,” he says. “While the BMA can’t lose sight of this, there is also no doubt that this needs to be accomplished while being in step with global regulation.”

He also notes that the fact that some classes of insurers will be exempt from Solvency II requirements, including most captives, is equally important when it comes to the market’s ongoing ability to innovate.

But going hand in hand with this logic around innovation, Thompson stresses that good governance will remain central to the way companies on Bermuda operate—innovation should not prevail at the expense of good governance.

While this ethos has been embraced by the Island’s established companies, he believes that new and recent entrants have also placed risk management at the forefront of their organisations.

“KPMG has assisted a number of these to build out their risk framework, assess their risks and their appetites at a granular level, and develop the processes and controls that will help them manage and mitigate these risks,” he explains. “This is an excellent indicator that not only is the legislation appropriate, but that entities are living by the spirit and not just the letter of the law.

“A regime that allows innovation while adhering to a robust framework for good governance essentially requires entities to hold risk management at the forefront. This is a key feature of any smart organisation that is looking to encourage experimentation, while still mitigating financial risks.”

Modelling as a differentiator

Agam Jain, a manager in the actuarial & financial risk management team at KPMG in Bermuda, says that the result of this logic will be an increased focus on the risk models used by companies and on their skills when it comes to managing capital and risk.

Jain notes that there has been widespread debate within the industry as to what may happen to alternative capital structures in the wake of significant catastrophe losses. “In particular, will the realisation of what an actual risk-return profile looks like drive investors away from the sector, or simply reinforce the view that reinsurance has genuine value as a non-correlated part of a portfolio?” he asks.

He believes that in order to maintain their relevance, reinsurers need to be able to use their modelling skills to predict and agilely respond to these market dynamics. Those that get these decisions right will be best-placed to benefit from the eventual up-tick in rates that will follow.

“In reality, the use of economic models and dynamic financial analysis to drive business decisions, including pricing, retro purchasing, portfolio management and investment strategy, becomes one of the few game-changing differentiators that reinsurers can employ.

“What a good regulatory regime requires is that the theoretical and practical concepts being used in these models exist in a validated environment. Utilising a second set of eyes over risk management practices and the use of these highly developed tools for efficient decision-making at management and board level provides comfort to all stakeholders,” Jain says.

“It not only allows for a platform to make these apparent ‘black boxes’ more transparent, it gives insight into how risk-based decisions allow for better use of capital and hence the potentially higher return on capital. In addition, it enables good practices to permeate the industry, as regulators and third parties provide regular suggestions for enhancement.”

The final lap

Thompson stresses that the BMA has been working hard to remove the final few caveats that will allow an assessment of equivalence to be made ahead of the January 1, 2016 implementation date in Europe. But he believes that the process itself has benefited, and still is benefiting, companies on Bermuda in ways that are usually unseen.

“What has at times been lost during the journey is that companies in Bermuda have benefited from the lessons learned in the UK and Europe over the last few years,” he says.

“One of the key areas where this is visible is in the approval of internal capital models. The BMA has already been recognised by European regulators for their approach and expertise, so reinsurers should now have confidence that the process is one that they can benefit from.”

Summing up, Thompson says that innovation always has been and remains Bermuda’s lifeline to new business and new markets. This ability to innovate is now protected, rather than being hindered, thanks to Solvency II equivalence because it will give confidence to investors and companies operating in the market or thinking about which jurisdictions to use.

Second, he believes many companies will reap value from using the BMA model approval process that will become available to them—this potentially allowing them to learn, share expertise and gain a cutting edge in some aspects of their business.

“The BMA put itself in a great position to learn from European regulators and we are hearing some very positive stories of how the modelling of risk can be a differentiator for companies. This is why KPMG believes that the equivalency status is a necessary and ever more valuable step towards driving the engines of good governance in a market still thriving with innovation.”

David Thompson is a risk consultant at KPMG in Bermuda. He can be contacted at: davidthompson@kpmg.bm

Agam Jain is a manager in the actuarial & financial risk management team at KPMG in Bermuda. He can be contacted at: agamjain@kpmg.bm