Background
The Insurance Regulatory and Development Authority of India (“IRDAI”) has notified the introduction of first phase of pilots for implementing ‘Risk Based Supervision’ (“RBS”) framework for the insurance sector in India[1], commencing from July 2023. The IRDAI has collaborated with M/s Toronto Centre[2] for the aforesaid project. According to the IRDAI press release, RBS is a shift towards adopting global best practices for supervision which focuses on proportionality, materiality and relies on holistic analysis of the activities of regulated entity from risk perspective. The IRDAI’s intention to shift to the RBS framework for the insurance sector was first divulged vide a notification in October 2018[3], which listed the following benefits for insurance supervision[4]:
- structured approach to assess internal and external risks;
- forward-looking and outcome-based with responsibility thrust upon Board and senior management; and
- facilitates early identification of various risks relating to market conduct and prudential aspects for timely regulatory intervention.
Although nearly five years have elapsed since the initial proposal of the IRDAI to implement RBS framework, commencement of the same, even on pilot basis, heralds a new supervisory regime. This development is indicative of a matured insurance industry in India. It also ties in with the overall regulatory intent of the IRDAI to transition from a prescription-based regulatory framework to principle-based regulatory framework.
Considerations for implementation of RBS in the insurance industry[5]
The way in which an entity is evaluated and supervised may largely depend on its risk profile and business activities undertaken by the entity. However, some basic steps that can be considered in order to carry out this process are:
The risk-based supervisory framework would necessitate the development and utilisation of intervention tools by the IRDAI. This may involve setting thresholds for risk indicators, defining triggers for intervention actions, and specifying appropriate supervisory responses to mitigate risks or address non-compliance. Given this backdrop, the insurers are also expected to proactively emphasize/ monitor the risks associated with each of their activities. It is essential they build a framework that enables internal risk assessment and implement corresponding control mechanism. Overall, implementing a risk-based supervisory framework by the IRDAI would significantly change the regulatory landscape for the Indian insurance industry. It would enhance the focus on risk assessment, promote stronger risk management practices, and contribute to the overall stability and soundness of the insurance sector.
Adoption of RBS approach by other countries and regulators
Several countries around the world, including the United States of America[6], United Kingdom[7], Australia[8], Canada[9] and Singapore[10] have implemented risk-based supervisory frameworks in their financial services sectors. In fact, even in India, the Reserve Bank of India (“RBI”) has implemented the RBS model to supervise banks, NBFCs and all other financial institutions under its supervisory purview. The RBI Governor has repeatedly emphasised on the need of an efficient risk management culture in banks and NBFCs. In RBI’s August 2020 annual report, the apex bank Governor reiterated the need for an effective and sophisticated risk management system that can identify risks and vulnerabilities well in advance, thereby capturing them in sync with the changes in the external environment and best practices.[11]
The RBI highlighted the need of building a resilient financial system by stating that such a system should be able to deal with an entire range of shocks.[12] The RBI reviews the RBS model under the CAMELS approach (Capital Adequacy, Asset Quality, Management, Earnings, Liquidity, and Systems & Control), which, it believes, will enable the apex bank to capture risk remove inconsistencies, if any. The RBI puts this process into practise to supervise and evaluate supervised entities with the aim of evaluating their financial health, liquidity, solvency, asset quality and governance framework.
Impact of implementation of RBS by RBI
The RBI has developed a system for early identification of vulnerabilities. After adopting the RBS model, it has been deploying data analytics to the quarterly offsite returns to provide an effective and more comprehensive inputs to onsite supervisory teams. An early warning framework – which tracks macroeconomic variables, and market and banking indicators – complements the analysis. The model allows bank-wise as well as system-wide supervisory stress testing, which adds a forward-looking identification dimension to vulnerable areas. The regulator identified stressed sectors by conducting micro-prudential and macro-prudential analytical studies that served as an input to the RBS model. Further, market surveillance and misconduct analysis are also undertaken on an ongoing basis.[13] Implementing this mechanism assisted the RBI in revising and creating prompt corrective actions for banks to enable supervisory intervention at appropriate time. It also compelled the banks to initiate and implement remedial measures in a timely manner to restore their financial health.
To substantiate and further the impact of carrying the process of supervision, the profitability of banks was assessed. To judge its effect, the net profit / loss as a percentage of total assets of banks was analysed. The increase in operating profits can be attributed to efficient operations of banks along with good RBI supervision. Additionally, an improvement in the capital-to-risk asset ratio data of all the banks (private, public, and foreign) provided in the reports analysing trend and progress of the sector in India[14] in the last few years show enhancement of capital adequacy of the banks. The improvement was, however, more pronounced due to the risks highlighted and the resultant actions taken.
These examples highlight that risk-based supervisory frameworks are broadly implemented across various jurisdictions, albeit with some variations in approach and specific practices. The common thread is the focus on assessing and managing risks, tailoring supervision based on risk profiles, and ensuring the overall stability and soundness of the financial system.
Conclusion
RBS is a risk-management tool to help regulators mitigate systemic risks which helps achieve the goals of regulation, policyholder protection and financial stability. It is believed that the implementation of this model of regulatory supervision would help reduce vulnerabilities and allow insurers to carry out business with all the risks highlighted along with methods to pre-emptively deal with those risks. Most supervisors that have adopted a risk-based approach have introduced it gradually and in tandem with their existing compliance approaches. Only after they have become confident in the ability of their supervisors to make sound risk judgments and the reliability of their measurement tools do they become entirely risk based.[15] It is hoped that the implementation of risk-based supervision for the insurance sector, coupled with the IRDAI’s objective of transitioning into a principle-based regulatory regime will address the needs of a maturing insurance industry.
[1] See: https://irdai.gov.in/web/guest/document-detail?documentId=3552628
[2] M/s Toronto Centre is a not-for profit organisation, working with mission of promoting strong supervision in order to enhance financial stability, crisis preparedness, and consumer protection. See supra note 1
[3] See: https://policyholder.gov.in/web/guest/document-detail?documentId=389510
[4] Paragraph 5 of the IRDAI notification titled: Moving towards ‘Risk Based Supervision’ of the Insurance Sector, dated October 4, 2018. See supra note 3
[5] See supra note 5.
[6] The U.S. Federal Reserve implements risk-based supervision through its supervisory framework known as the Comprehensive Capital Analysis and Review (CCAR). Under CCAR, large financial institutions are subject to an annual capital adequacy assessment, stress testing, and evaluation of their risk management practices.
[7] The Financial Conduct Authority (FCA) in the UK implements a risk-based approach to supervision. It focuses on conducting risk assessments, setting risk tolerance levels, and tailoring supervision based on the risk profile of regulated entities. The FCA’s Supervisory Approach document outlines its risk-based supervisory strategy.
[8] The Australian Prudential Regulation Authority (APRA) applies a risk-based supervisory framework across the financial services sector. APRA conducts regular risk assessments and employs a range of supervisory tools, including issuing prudential standards, conducting thematic reviews, and setting capital requirements based on the risk profile of regulated entities.
[9] The Office of the Superintendent of Financial Institutions (OSFI) in Canada employs a risk-based supervisory model for overseeing banks, insurers, and other financial institutions. OSFI utilizes a risk assessment methodology called the Supervisory Framework, which involves assessing risks, assigning risk ratings, and determining the level of supervisory intensity based on the risk profile of each institution.
[10] The Monetary Authority of Singapore (MAS) applies a risk-focused supervisory approach to the financial services sector. MAS assesses risks faced by regulated entities through its supervisory framework, and supervisory intensity is determined by the assessed level of risk. MAS also conducts regular risk assessments and engages in dialogue with regulated entities to address emerging risks.
[11] See: https://economictimes.indiatimes.com/industry/banking/finance/banking/risk-aversion-will-be-self-defeating-for-banks-rbi-governor-shaktikanta-das/articleshow/77778982.cms?from=mdr
[12] See: https://www.rbi.org.in/Scripts/BS_ViewBulletin.aspx?Id=20497
[13] See: Annual Report of RBI- 2021-22, 0RBIAR2021226AD1119FF6674A13865C988DF70B4E1A.PDF
[14] See: 0RTP20212225730A6FC708454BB270AC1705CCF178.PDF (rbi.org.in)
[15] Randle, Tony, Risk Based Supervision. See: https://documents.worldbank.org/curated/en/807661468177834997/pdf/625140NWP0Risk00Bo
