Solvency II’s main objective is to better reflect not only on the regulation and supervision of the industry, but also putting the risk profile of an insurer more directly within the context of economic reality in today’s business. Volatile capital markets, falling interest rates, a rising number of losses and accelerating deregulation of insurance markets have had a significant impact on the equity capital base of many insurance companies. What is required is a financial services sector which can increase the flexibility and dynamism of the wider economy.
Solvency II can contribute to this by creating a level playing field in prudential requirements for insurers, fostering a deeper single market in insurance services with benefits for users as well as providers, and allowing for more efficient allocation of capital. Solvency II is, therefore, a directive which includes investment as well as underwriting in measuring a company’s risks.
A high degree of regulatory alignment is, therefore, not only sensible, but supportive of the European insurance industry’s credibility within financial markets. Clearly, credibility equates to transparency.
The EU’s current regulatory directive, Solvency I, provides a capital buffer which contributes to policyholder protection but has proven to be less effective in meeting other objectives. In particular, early warning for the regulator requires a trigger level of capital which is aligned with the risk that a firm may fail. Solvency I also falls short in several other areas:
• Solvency I hinders efficient economic outcomes by imposing excessive burdens on firms.
• Solvency I imposes capital requirements that for many firms are too low to ensure adequate solvency.
• Solvency I does not provide supervisors with the tools to foster higher quality risk management and control which is arguably as important for policyholder protection as the level of solvency itself.
In 2003, the Committee of European Insurance and Occupational Pensions Supervisory (CEIOPS) was formed as an advisory body to the European Commission (EC). Since then, one of CEIOPS’ main objectives has been shaping the Solvency II capital regime.
The new framework should promote higher quality risk management, challenge key developments within the insurance industry, and ensure that the assessment of regulatory capital is integrated within firms’ wider capital management processes. Solvency II aims to implement solvency requirements that better reflect the risks that companies face and deliver a supervisory system that is consistently implemented across all member states.
Solvency margins under Solvency II
Similar to Basel II, which governs the banking institutions of continental Europe, the Commission has proposed that a three-pillar structure should be adapted for regulating insurance firms. Each of these pillars governs a different aspect of the Solvency II requirements and approach (see figure 1).
Whilst providing insurance companies with the freedom to choose their own risk profile, as long as they hold commensurate risk capital, the regime’s concept of SCR and MCR allows ‘safety triggers’ which can provide early warning of deterioration in solvency levels.
Pillar 1 contains two capital requirements, the Minimum Capital Requirement (MCR) and the Solvency Capital Requirement (SCR)
• MCR reflects an absolute minimum level of required capital below which supervisory action will automatically be triggered.
• SCR represents additional capital to absorb significant unforeseen losses.
Pillar 2 refers to the supervisory review process that complements capital requirements (Pillar 1) and disclosures (Pillar 3). The Pillar 2 supervisory review process has two aims:
• to help ensure that a firm is well run and meets adequate risk management standards; and
• to help ensure that the firm is adequately capitalised.
Pillar 3 requires disclosure of additional information that supervisors feel they need in order to perform their regulatory functions. This means:
• company focused - Transparency
• industry focused - Transparency
Undergoing a number of Qualitative Impact Studies (QIS), CEIOPS aims to address and diminish shortfalls within previous solvency requirements whilst assuring a smooth transaction into the new framework. In October 2006, results from QIS2 were presented to EU Commission to inform the Impact Assessment for the Solvency II Directive. Its main focus was the design and structure, as well as testing the viability of certain methodologies. A further study, QIS3, and the relevant spreadsheet have just been published early this month, addressing further development and calibration of Solvency Capital Requirements (SCR), Minimum Capital Requirements (MCR) and the issue of group prerequisites.
The complexity of Solvency II will continue to cause debate in the year ahead; and whilst it is very likely that at least one or even more QIS may follow, namely QIS’s 4 and 5, these should not be relied upon as opportunities to bring about fundamental change other than rather occasions for fine tuning. Therefore, it is now that the insurance industry should be embracing adequate measurements to prepare itself for the Solvency II regime - participants are still able to shape the resulting legislation up to the 30th of June 2007.
Regardless of what the final outline of the Solvency II regime may be, many regulatory authorities have started modernising their supervisory methodology towards a risk-based approach. The Insurance Day recently published a study carried out by CEIOPS, indicating that 38% of supervisory authorities acknowledge that Solvency II will mean material change not only to their supervisory tools, but also systems and resources.
Solvency II should, therefore, not be seen as an EU directive only. Similar regulatory developments can also be observed within the Asian insurance market, for example. Non-EU reinsurers will need to be aware that in order to compete with reinsurers domiciled in the EU, an adoption of at least Solvency II standards will be crucial to remain vital and compatible in the overall steering process.
Companies that have traditionally enjoyed operating in a relatively undemanding regulatory environment will now see more restrictions being placed on the way they (used to) conduct their business. Implementing Solvency II may entail enormous effort, but it will enable companies to identify their biggest risk drivers and to significantly optimise capital allocation.
Reinsurance offers a great level
of flexibility and corporate independence
Meeting the solvency requirements will mean increased linkage between capital requirements and the overall risk of an insurer - rating agencies, such as Moody’s and Fitch, seem to endorse this concept in particular. Hence, for those insurers wanting to maintain business opportunities or if capitalisation is still too low after the portfolio has been adjusted, there will be three options available:
• reinsurance
• capital increase and
• transfer of risks to the capital markets
It is clear that many national regulators see themselves working in partnership with the local insurance sector to represent collective interests. Likewise, there are trade bodies who again are striving to ensure their national market place remains healthy, competitive and transparent. One thing all these representatives have in common - the need to obtain practical evidence.
It is practical evidence that will now carry weight, not theoretical argument. Increased cooperation and participation are now what the regulators are looking for in their final stage of getting the directory ready for ‘take-off’.
Whilst QIS 1 and QIS 2 were rather steering towards defining the formula and its parameters, QIS 3 looked at the approaches of calculating the quantitative impact. As this stage has now more or less been finalised, regulators expect an increase of insurers actually participating in completing the study.
Current outcomes show that less than half of participating insurance companies employ the integrated risk management structure as outlined by the new Solvency framework. So far, risk management was often regarded as something “nice-to-have”, whereas essentially it can enhance a company’s own business stand in an increasingly competitive and transparent insurance market. Solvency II addresses specific risk dimensions, such as the probability of economic factors, value at risk and others, as illustrated by the chart (figure 2). Throughout analysis, it becomes clear that a risk management-based approach seems to be a “must-have” in order to implement the directive’s higher standards successfully.
Solvency II will significantly change the importance of and demand for reinsurance cover. In addition to standard products, there will be increased demand in the future for solutions more closely geared to individual risk parameters and providing a high degree of flexibility.
Willis offers extensive knowledge on the Solvency II Project and has been in a constant dialogue with various national regulators. Our research has also shown that although about 60 per cent of European insurers believe that Solvency II will improve their organizations’ allocation of capital, less than half, however, have already enacted formal programmes to anticipate the solvency implications.
Determining the structure of insurers’ reinsurance programmes plays an important part in optimising the solvency capital requirements. However, there are also alternative solutions available in the market which often seem to become forgotten: business mix, aggregate cover, run off and hybrid capital, in particular, have proven a steady track record over the recent years. Providing a “gap” analysis with both regulatory and rating agency demands, Willis offers sophisticated and established modelling instruments to develop individual reinsurance programmes - these can be tailored to individual risk structures and solvency objectives, improving working practices, business diversification or access to capital.
