Moving towards risk-based approach

Risk is the exposure to loss or injury. Insurance deals with financial risks that ultimately reduce the ability to pay claims. These risks are dynamic, diverse, and stem from multiple sources. Compliance-based or rule-based approaches emphasise adherence to rules, regulations and directives, rather than material risk. They primarily act upon past behavioural records. However, a compliant company may still be financially weak. Failing to identify risk properly can destabilise an insurer's financial soundness and harm policyholders' interests. It is the regulator's duty to maintain efficient, fair, safe and stable insurance markets for the greater benefit of policyholders. To achieve this, the Risk-Based Supervision (RBS) approach has become central in various jurisdictions.

The Bangladesh insurance market is prone to various risks, including investment risk, solvency risk and high management expense risk. A compliance-based approach is unlikely to protect policyholder interests sufficiently. Therefore, RBS is crucial for maintaining a stable insurance market.

The RBS approach aims to prevent financial difficulties for insurers by acting as an early warning system. To achieve this, a proactive approach is required. The methodology focuses on identifying major risks faced by each insurer and working to bring those risks to acceptable levels. It deals with both inherent risk and residual risk.

Significant inherent risks include insurance, market, credit, operational, compliance, and reputational risks. The RBS approach is judgment-based and forward-looking. It follows the principle of proportionality, prioritising what matters most. It also focuses on key risk areas and allocates resources accordingly.

RBS is based on several key pillars, including quantitative requirements (technical provisions and solvency capital requirements), reporting requirements and governance. Technical provisions involve the proper valuation of actuarial liabilities for both life and non-life insurance, including Incurred But Not Reported (IBNR) reserves and unearned premiums. Solvency capital requirements ensure adequate capital is held above actuarial and technical reserves. Reporting requirements involve submitting various reports to the regulator regularly. Governance refers to an insurer's self-control mechanism, alongside supervisory review by the regulator.

Risk profiling is the cornerstone of the RBS process, providing a true picture of an insurer's financial health. The process begins with profiling insurers based on CARAMEL ratings, their Own Risk Solvency Assessments (ORSAs), dynamic capital stress testing and achievable action plans. Regulatory supervision involves greater off-site surveillance, targeted on-site inspections and meetings with insurers. Through this process, supervisors collect data and categorise companies into high, moderate and low-risk profiles, allocating resources accordingly.

The board plays a crucial role in the overall RBS process, acting as the eyes and ears of the company and the first line of defence. The board also defines the company's compliance and risk management culture. Internal audit is another pivotal line of defence in the RBS framework. The internal control department must be independent and knowledge-based, or risks could go undetected. Other areas of oversight include actuarial, compliance and senior-level management.

The RBS cycle typically lasts 12 to 18 months, depending on the company's risk profile. The cycle starts with a fit and proper test and ends with reducing risks to the desired level. Ensuring adequate resources and timely, and appropriate responses to identified risks are key challenges to successful RBS implementation.

Bangladesh's insurance industry is fundamentally weak and unstable. While a large population offers potential, access to these customers is gradually being denied due to poor customer experiences. Currently, the industry should prioritise stability and sustainability over acquiring more business.

In this context, a risk-based approach is critically important for the industry's sustainable future. Many jurisdictions have successfully implemented RBS for years. Embracing RBS is now essential to make the Bangladeshi insurance industry more resilient and a safer investment avenue for all.

Md Abu Mahmud is the Assistant Director of Actuarial Department at the Insurance Development & Regulatory Authority (IDRA). [email protected]

[This is the writer's personal opinion, not necessarily representing his organisation's views.]