Considering The Business Impacts Of Solvency II - Insurers Take A Leap Into The Unknown

"This is the biggest change in prudential

regulation in my lifetime, maybe ever. There is bound to be

business impact."

Jim Webber, AVIVA

Introduction

A once-in-a-lifetime challenge

April 22 2009 will prove to be a decisive day in the development

of the European insurance industry. Following protracted

negotiations between policymakers, member states and industry

representatives, the European Parliament voted to adopt the

Solvency II framework directive. This will comprise a wide-ranging

overhaul of capital requirements, company structures and product

lines for the industry, and will mandate insurers to set their

capital requirements more in line with their risks. Attention is

now turning to the challenges of implementation that lie ahead, and

the potential competitive advantage that could be gained from the

swift and thorough adoption of the rules.

Solvency II has ambitious objectives. First and foremost, it is

being implemented to strengthen risk management in the industry.

The proposals are similar to the Basel II framework on capital

adequacy for banks in that they are based around three pillars: the

first pillar relates to the calculation of solvency capital

requirements and minimum capital requirements using standard or

internal models; the second pillar refers to general regulatory

principles governing risk and controls; and Pillar 3 describes

required disclosure on the institution's solvency and financial

situation.

The new legislation, which replaces a patchwork of local

regulations, will reward insurers that act in the interests of

investors and customers across the economic bloc. Thus, it

potentially frees up capital from less risky companies, such as

those with diversified operations, and forces companies that

present the most risk to hold more capital. It should also mean

that, if insurers can back less risky products with less capital,

they may be able to reduce prices.

But, more generally, there is a long-held desire among

policy-makers to create a single market for insurance services

across Europe, and Solvency II is seen as a key tool in furthering

this objective. By creating a level playing field for capital

requirements and prudential oversight, it is hoped that there will

be benefits for customers in terms of greater competitiveness and

improved capital allocation.

The challenges of implementation are likely to be considerable.

It is clear that Solvency II is a requirement that spans the entire

business, and will require input across a range of functions,

including risk management, internal controls, financial reporting

and information technology. New expertise may be required, and it

is likely that investments in data and infrastructure will be

needed. In addition, careful co-ordination and management will need

to be in place to ensure a smooth implementation.

For those insurance companies that are able to move towards full

compliance in short order, there are also business benefits to be

gained in terms of improved risk management, reduced capital

requirements and greater visibility across the business.

Peter Skinner, MEP, Rapporteur for the bill and a member of the

European Union's Economics and Monetary Affairs Committee, is

in no doubt that Solvency II will have significant consequences and

insists that it is not another box-ticking directive. "It is

about insurers looking at the underlying risk behind their

businesses instead of just asking whether they have got enough

capital," he says.

Many insurance executives, however, have been taken aback by the

scale of reform imposed on them. Jim Webber, Chief Risk Officer at

Aviva, says: "This is the biggest change in prudential

regulation in my lifetime, maybe ever. There is bound to be

business impact."

In fact, the changes are so significant that the US

Administration asked the EU to brief it on Solvency II

developments, with a view to possible implementation at a later

stage. Skinner, who travelled to Washington in June 2009 to address

the Congressional Sub-committee on Capital Markets, says that

President Obama's Treasury team is now looking closely at

Solvency II to see if it can be adapted as a possible regulatory

initiative in the US insurance industry.

Building a better model

Regulatory efforts to mitigate systemic risk are likely to come

at a price for the industry. Insurers must invest to create or

develop sophisticated models that value assets and liabilities

using a market consistent view. Each insurer and reinsurer has a

choice of approaches for this calculation. The most straightforward

to implement is the Solvency II standard formula, which will treat

risks consistently across insurance companies. This is currently

being calibrated through a series of quantitative impact studies

involving thousands of insurers. For smaller companies or those

that are less exposed to complex risks, the standard model may well

be adequate.

At the other end of the spectrum is a full internal model, which

takes into account company-specific risks and requires more

comprehensive data management and expertise. Larger insurance

companies are likely to adopt this approach, and may already be

some way along the journey with the adoption of economic capital

models. Between these two alternatives lies the third option of a

partial internal model, which combines elements of the standard and

internal models. The closer insurers can get to developing a full

internal model, the easier their relationship with the regulator

will be and the less capital they are likely to have to hold.

If they intend to use an internal model, insurance companies

must seek approval from the regulator first. This will require them

to demonstrate that the model is fully embedded in their business

and based on robust actuarial and statistical techniques

– a costly and complex undertaking.

Yet while the standard model may be less expensive to implement

in the short term, it may place insurance companies at a

disadvantage over the longer term because they may face higher

costs of capital and will have less sophisticated risk management

capabilities. "The big risk for insurers with Solvency II is

not getting pre-approved," says Baldeep Johal, Chief Actuary

at Brit Insurance.

The proposed internal model system, which involves insurers

proving to regulators they are well-run rather than regulators

imposing top-down views, is unusual but is broadly supported by the

industry. "The original Basel requirements put the cart before

the horse," says Paul Barrett, Assistant Director at the

Association of British Insurers. "Solvency II frames the

argument the other way round. It says you must do the right thing

and if the regulator is satisfied, then your model of regulatory

capital can go ahead."

One quirk of the current situation, however, is that the term

"internal model" does not yet have a formal definition

and there is no precise framework around the approval process. So

the pressure is really on companies to work closely with regulators

and industry bodies to make sure they are aware of regulators'

latest thinking and of how other participants are developing their

models. "Before, the regulatory regime across Europe was not

robust enough to make internal models work because regulators and

companies were on different sides of the room," says Barrett.

Now, they are side by side.

Insurance companies must weigh up the pros and cons of the

standard and internal models. While the standard model will be

cheaper and quicker to implement, it is likely that it will require

greater levels of capital to be held against it. For larger

insurance companies that have sufficient resources, an internal

model approach is likely to hold more appeal, as it will require

less capital to be held than the standard model. But the real

benefits of the internal model come from embedding it fully within

the business. This is likely to be a complex undertaking, however,

insurance companies will benefit over the longer term from the more

granular, accurate and timely risk information that they can draw

from their internal models.

"Before, the regulatory regime across Europe was

not robust enough to make internal models work because regulators

and companies were on different sides of the room. Now, they are

side by side."

Paul Barrett, ABI

Daunting timescales

Many insurance companies – privately and publicly

– admit...