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...
To continue reading
Request your trial