Regulatory changes: The authorities look to tighten rules of the game to boost market oversight

The Treasury’s wide-ranging financial reform over the next three years will affect South Africa’s insurance sector in at least three distinct ways. Four key objectives have defined the reforms of the financial sector: preserving financial stability, ensuring consumer protection and fair market conduct, extending financial inclusion and cracking down on financial crime. Amidst the move towards a “twin-peaks” regulatory structure, where responsibility for prudential regulation will be transferred to the South African Reserve Bank (SARB) and market oversight to the Financial Services Board (FSB), revisions to the insurance sector’s current prudential framework and its market conduct rules are creating a sense of far-reaching changes afoot. While many underwriters have expressed concerns over rising compliance costs, regulators expect the reforms to yield dividends in the form of higher long-term growth in the sector, while emphasising their desire to move gradually. “The various regulatory changes will not be implemented in one big bang of reform, but we do see the costs of compliance rising,” Viviene Pearson, a general manager at the South African Insurance Association (SAIA), told OBG. The devil will be in the detail as bills covering each reform are presented to Parliament in the 2013 legislative session.

Prudential

In a roadmap published in November 2010, the shift to a new prudential regulatory structure – Solvency Assessment and Management (SAM) – is structured along the Solvency II directive now in the process of implementation in the EU. The reform consists of three pillars: the first covering valuation of assets and liabilities, as well as the calculation of capital requirements; the second addressing qualitative requirements including governance, risk management and internal controls; and the third setting clear disclosure and reporting requirements. Rather than appraising solvency as aggregate-free assets to premiums, the move to a risk-based capital framework requires underwriters to establish tested internal risk management systems, hold different levels of capital according to their risk exposure, and provision for risk more counter-cyclically. Underwriters will also have the choice of establishing their own internal risk-weighted capital assessment models, which were approved by the FSB following rules published in April 2011, or use the common FSB model. Implementation of the new SAM rules is expected to take place in January 2016. “South Africa’s financial service regulations are aimed at protecting consumers and are therefore very necessary,” Vinay Padayachee, the managing director of Virgin Money, told OBG.

Costs

Estimates of the full cost of compliance vary, from around R25m ($3.05m) to R50m ($6.1m) by smaller insurers and R200m ($24.38m) to R300m ($36.57m) by larger ones, while Alexander Forbes, a leading independent African retirement fund, expects costs to average R150m ($18.29m) for the industry a year, with much of these costs passed on to policyholders. Meanwhile, the firm expects the total capital requirements for the industry to rise from around R45bn ($5.49bn) in 2012 to R115bn ($14.02bn) once SAM is fully implemented in 2016. A series of interim measures are planned in the meantime.

“We expect interim legislation to be tabled to Parliament in 2013, pending SAM coming into force in 2016: the two key areas of reform will be additional governance and risk management requirements, close to SAM’s pillar 2, and to empower the registrar to undertake formal insurance group supervision,” Jo-Ann Ferreira, a senior manager in the insurance supervision department of the FSB, told OBG.

Fair Conduct

New rules strictly regulating market conduct are also on the table, which under the twin peaks structure will fall under the purview of a bolstered FSB. Named “treating customers fairly” (TCF) and modelled after the UK’s eponymous rules, the rules set out six simple principles covering the entire lifecycle of an insurance product, from design to marketing and after-sale service such as claims processing. Placing the onus squarely on underwriters to prove compliance and ensure fair practice by intermediaries like brokers and agents, the rules require insurers to design products to fit different target groups’ needs and to provide them at transparent and reasonable prices. Although FSB does not certify products individually, it sets clear principles to which underwriters must demonstrate compliance in any new product development.

While the original FSB discussion paper was published in April 2010, underwriters have raised significant uncertainties over the scope of the rules as well as the costs of compliance. In particular, and despite significant equity links held by underwriters in brokers, TCF could expose insurers to liabilities incurred through the interaction of any intermediaries with policyholders. The FSB ran a self-assessment survey for underwriters in 2012, which revealed a broad lack of preparedness and focus on compliance with TCF. Underwriters have argued that the rules are ill-suited to the South African context. The FSB is thus in 2013 reviewing the scope of TCF and proposing exemptions or dilution of the rules for micro-insurance, while studying the applicability of TCF to reinsurers operating in South Africa.

Governance Is King

Strict standards for corporate governance are also high on the reform agenda, with the implementation of the King 3 code on corporate governance in March 2010. Following the two previous codes published in 1994 and 2002, the third set of rules is mandatory for all publicly listed firms, while non-listed insurers must comply or explain the reasons for not meeting the criteria. The rules cover a comprehensive set of topics, from the composition of board of directors to the appointment of non-executive directors, establishing criteria that bolster the independence of company oversight. The FSB is preparing new rules to bolster the powers of registrars, providing them with the authority to oversee affiliated group activities.

In addition, the framework for financial reporting requirements continues to be revised. While the first phase of International Financial Reporting Standards 4 was implemented in 2008, the second phase has been delayed to 2016. This next reform will affect the treatment of liabilities in insurance contracts, setting out uniform accounting and valuation standards. Implementation of phase two is likely to cause more volatility in insurers’ income statements, according to accountancy PwC, while prompting underwriters to invest in more sophisticated data and modelling systems.

Impact Of Reforms

KPMG’s 2012 study of the insurance sector highlights how growth in administrative costs has fast outpaced rises in profitability and premium income, for example. “Given the slew of new legislation and regulations being enacted, the compliance responsibility is increasing and most underwriters are expanding their compliance departments,” Suzette Strydom, a general manager at SAIA, told OBG.

As underwriters raise doubts over the capacity of smaller players to comply with the new rules and their ability to raise new capital to meet prudential requirements, foreign insurers not present on the market have been keeping a close eye on developments. Despite the above-average growth of mid-sized players such as direct insurers in recent years, PwC’s June 2012 sector report argues that underwriters have become more cautious in their risk profile domestically and in their drive towards foreign acquisitions. “There are concerns that rising costs could impact small companies particularly and prompt their absorption by large corporations.

This could stifle entrepreneurship, which is important for developing economies,” Daryl De Vos, managing director at Africa Reinsurance, said. “We must be careful that new regulations do not reduce competition.”

The current regulator has fostered dialogue with sector players through the two industry associations to minimise the costs for smaller players. “We don’t intend to purposefully consolidate the sector with the implementation of SAM and are looking for ways to apply the regulatory framework in a proportional manner for smaller insurers,” Ferreira told OBG.

With the detail of the various new rules still unclear pending passage of legislation, the regulators – both FSB and SARB – will both pay close attention to the challenges faced by their small and mid-sized players.