Moving the ICS Forward to a Successful Conclusion

Imagine you are an executive of a global insurer and you are required to share financial results with your insurance regulators from many of your most important markets, but the framework you used was flawed and incomplete, and the results unclear and unreliable.

Obviously no leader of an insurance company would ever want to be in this position, particularly because this would cause confusion and possibly lead to a lack of trust among its regulators. Yet, this is essentially the position that many global insurers will find themselves in once the 2.0 version of the Insurance Capital Standard (ICS) is launched later this year and the monitoring period begins. This is clearly not the intent of the many policymakers, industry participants, regulators and others who have worked hard over the years to develop a workable ICS construct.

At this critical juncture in the ICS process, we need to collectively acknowledge the challenges that remain, and explore ways to enable the ICS to be a valuable and credible tool as we move forward.

Last October, I shared some of my public policy concerns about the overall direction of the work by the International Association of Insurance Supervisors (IAIS) to develop a globally-applicable ICS. Over these past several years of its development, I’ve had the opportunity to view the ICS from a number of perspectives, including as a policymaker and regulator (both as a member of the IAIS Executive Committee and as Insurance Commissioner of Connecticut), as a third-party market participant evaluating the potential implications to the sector as a whole, and now as part of the executive management team at AIG.

My earlier comments focused on over-arching issues related to both the substance and process around the ICS. “Balance” was a central theme. Substantively, I emphasized the need for the IAIS to strike the right balance between supporting prudential safety and soundness, while at the same time preserving the important role that insurers play in society as whole - most notably in serving and protecting our policyholders and as a critical and reliable source of long-term funding. In terms of process, I highlighted how we need to balance the role of capital standards within the broader array of complementary tools that undergrid group-wide supervision. 

An over-reliance on capital standards as a panacea can lead to misleading conclusions and can misallocate supervisory resources by drawing attention away from other meaningful signals and mechanisms. 

Within the totality of IAIS post-crisis regulatory reform efforts, the focus on ICS has been all-consuming, disproportionate, and even distracting.

As I reflect on where we are today – half a year later – I’m struck not only by how much more we need to do to right these fundamental imbalances, but also by the significant practical and technical challenges as we move towards a critical juncture in the ICS process. In roughly six months, the IAIS is planning to approve ICS version 2.0, followed by a so-called “Monitoring Period” during which internationally-active insurance groups (IAIGs) are expected to report ICS ratios for use in Supervisory Colleges alongside existing standards such as the Risk Based Capital methodology and Solvency II (which thus far have proved to be successful in adequately assessing the financial viability of IAIGs while ensuring policyholder protection and financial stability).

Notwithstanding the confidential treatment of the ICS results, this next phase is highly problematic given that the ICS will likely remain unfinished, unreliable, uneven, unwieldy, and untested by that point. 

Let me explain each of these descriptions in turn.

First, the ICS will remain unfinished. The current version is hampered by numerous technical design flaws, including several highly complex modeling issues that are currently being “field tested” as well as a host of other issues that have been the subject of intensive political wrangling within the IAIS for several years. Even if we optimistically assume that each of these fifteen or twenty technical issues are resolved in short order, it would be an impossibility to piece these components back together into a coherent capital framework that aligns with the IAIS design, calibration, and policy objectives. In other words, in the unlikely event that we can fix all of the underlying parts, we still will not be able to reassemble them into a smoothly running engine.

Second, any ICS results reported during the Monitoring Period will continue to be unreliable, since the calculations are unaudited, based on “best effort” company assumptions and extrapolations, and subject to a range of operational errors. 

Put simply, among the significant priorities of insurer Finance and Risk departments, the generation of ad hoc ICS results does not merit the same priority and attention as public financial reporting and the application of corporate controls. 

Any potential end-user must understand that, for the same book of business, different insurers could generate materially different ICS results. Given that the ICS is an unfinished construct and that there could be material differences in the level of preparation of each company’s ICS, it is concerning that regulators or analysts (if the results are requested) may compare one insurers favorable ICS against another’s poor ICS ratio. This imbalance will lead to further confusion among stakeholders who rely on this data.

Third, the application of the ICS will be uneven (and, arguably, competitively unfair), since it ostensibly applies only to IAIGs. The notion of an “IAIG” is a synthetic regulatory construct, which in practice crudely captures aspects of firm size and foreign underwriting. In practice, this approach introduces a cliff effect, where the ICS applies to some companies, but not others, based on a threshold devised by regulators. It is a construct which has no apparent analog within the insurance marketplace and is prone to create an un-level playing field.

Fourth, the ICS is unwieldy, in that the complexity of the calculations mean that the results will not be readily intuitive or comprehensible to third parties. Even technical experts will have to finely dissect the assumptions and formulae underlying the market-adjusted liability valuation, margin over current estimate, interest rate risk, non-default spread charges, and hierarchy of correlation matrices (to name just a few examples), in order to derive any meaning from the reported ICS ratios. In fact, ICS data will be meaningless as a peer to peer benchmarking tool, or as a way to assess the level of capitalization of the sector.

Fifth, the ICS remains untested. I do not mean in the narrow sense of “field testing” the iterative versions of the ICS proposals, a resource-intensive exercise which, at least to this point, has not gotten us to a workable and coherent capital framework. Rather, I refer here to broader impact testing, namely the potential for negative externalities and unintended consequences of the ICS on the provision of affordable long-duration insurance coverage, the role of insurers as a source of capital for long-term investing, and the undesirable pro-cyclicality that might result from a volatile ICS that over-reacts to short-term market fluctuations. 

So how do we move forward from here?

The top priority, in my view, should be for the IAIS to reset its current course and forge a more viable pathway forward by:

1. Communicating publicly to market participants and jurisdictional supervisors that ICS 2.0 is a milestone along the journey, and not a final destination. More specifically, it is important that the IAIS candidly convey that the ICS remains unfinished, unreliable, and therefore inappropriate for any meaningful usage for the foreseeable future. Such “warning labels” are crucial to signaling that the ICS is not suitable for use by third-party market or supervisory actors.
2. Providing more “breathing room” for the various jurisdictional initiatives to develop group regulatory systems appropriate to respective local markets. As an example, US insurance regulators are making significant progress towards an Aggregation approach, alongside other efforts to enhance group-wide supervision. The IAIS should more explicitly reflect this work in its overall ICS work-plan, including an achievable and pragmatic set of criteria for international acceptance of Aggregation alongside any final ICS design.
3. Redefining its objectives for the Monitoring Period to more expressly acknowledge the considerable work that needs to be done on ICS technical refinement, the pathway to acceptance of alternative methods (such as, but not limited to, Aggregation), and market impact testing and assessment. One idea recently discussed is to introduce an ICS 3.0 as a next milestone, given the significant technical and assessment work that lies ahead.

At heart, for the ICS to succeed as an endeavor – meaning, to my mind, that it produces sufficient public benefit to justify its attendant uncertainties, constraints, and costs – we need to view progress not in terms of milestones completed or spreadsheets submitted, but as a journey towards credibility, trust, and understanding across jurisdictions.