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Limiting Factors: how will investments flourish when insurers are blocking them?

Limiting Factors: how will investments flourish when insurers are blocking them?

George Belcher of Dewey & LeBoeuf's Abu Dhabi office analyses the impact of the UAE Insurance Authority’s proposals to impose limits on investments by insurers.

June 28, 2011 8:13 by

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The two major issues arising from the above are:

–          The cap on overseas investment. As a result of this an insurer will of course be required to hold the vast majority of its investments in the UAE;

–          The asset class caps. As a result of this, an insurer’s investment options within the UAE would of course be limited. This would owe not just to the asset caps themselves. It would also owe to what is commercially available. It is not certain, given the current economic climate, whether these UAE asset classes would in themselves (as restricted) offer the “sufficiency, liquidity, security, quality, and profitability” that would comply with the requirements of the draft regulations themselves, or that international regulatory best practice[1] would recommend.

On this basis, the combined effect of the two caps would suggest that an insurer would effectively be forced to hold a high proportion of its assets in the form of UAE fixed deposits, the sole asset class where there is no restriction.

Whilst high deposit levels would of course be good news both for the handful of UAE banks in question as well as the UAE more generally, it must be questioned whether this represents a good result for the insurer concerned. High levels of deposit with banks of course establish credit risk in themselves. We have seen in recent years that banks are not infallible, and this is ironically on account of their exposures to the very assets to which the draft regulations restrict exposure. They also would both deny an insurer other investment opportunities elsewhere in the world as well as tie it into a low-yielding and illiquid asset. This would likely increase the cost for insurers of doing business in the UAE and particularly overseas insurers who may potentially be deterred from entering, or continuing in, the UAE market. Finally, this result would appear to run counter to the spirit of risk-based regulation that the Insurance Authority appears to wish to introduce.

Here, the theory is that an insurer may do as it pleases and make its investments in a manner appropriate to its business profile, provided that it holds the capital necessary to support any risks that result. The aim is to create a virtuous circle whereby an insurer is incentivised to reduce its risk profiles and so reduce its capital charges. By introducing what would be effectively be a compulsory investment in a “safe” harbour, the draft regulations would risk dis-incentivising insurers from taking any measures to improve their investment risk profile.

It is acknowledged that a rules-based approach to investments has certain advantages when compared to a principles-based (“prudent person”) approach. From the insurer’s perspective, it is easier to comply with and from the supervisor’s perspective it is easier to administer and enforce. However, it is important that these advantages are not obtained at the expense of other regulatory goals – in particular diversification and an insurer taking responsibility for its own risk management. The particular risk with a hybrid system (as here) that combines both rules and principles, is that compliance with a rule tends to establish compliance with a principle.

It is suggested therefore that the draft regulations should place a greater emphasis on compliance with the principles that are (rightly) set out therein. At present there is very little detail or guidance here, particularly in the area of systems and controls that will give effect to these principles. The Insurance Authority should work to provide this. Once this additional detail is in place, it is clear that this will require significant investment of an insurer’s time, not just in terms of drafting and design but also in terms of education (from the board, to management to line-managers to other personnel) as to how such policies and procedures should be employed and used in practice. The intention under other risk-based regulatory regimes, for instance Solvency II, is to place risk management at the heart of an insurer’s operations and decision-making processes, and this should be the goal in the UAE. As an incentive to comply with the principles, the potential for higher capital requirements in the event of risky investments should be made explicit.

In addition, it is suggested that the level of the caps should be increased to allow greater holdings of overseas investments[2], corporate debt, government debt and “other assets”. However, these increased caps should be expressed to be subject to compliance with the principles. In this way, an investment holding at the maximum percentage level permitted would not be justified if it carried particular risks that breached the relevant principle.

Finally, the adoption of a more balanced calibration may make it possible to reduce the length of the transitional periods that are set out in the draft regulations, and to introduce the benefits of the new rules at an earlier stage.

This article was originally published in Policy, May-June 2011.

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