By Graham Buck
Rather like some rail journeys, the introduction of Europe’s Solvency II regime involves a hefty bill and a less-than-reliable timetable. Following a succession of delays, political squabbles and five industry-wide studies of its expected impact, the new capital adequacy rules for Europe’s insurers were eventually scheduled to take effect from the start of 1 January 2013. Reports suggested that any appeals for the deadline to be further delayed would fall on deaf ears, as the project’s credibility would suffer if it were put back any further.
Yet, despite the determination of the European Commission and the insurance industry’s Frankfurt-based new regulatory body the European Insurance and Occupational Pensions Authority (Eiopa) to push ahead, there is evidence that pressure to get the starting date put back by a year to the start of 2014 is gaining momentum. The prospect of a further delay to implementation also irritates many companies that have made great efforts to meet the 2013 deadline.
“We are hearing from a number of our clients that they don’t want Solvency II to be delayed,” says Andrew Cox, insurance partner at Lane Clarke & Peacock. “They have geared themselves up to meet the deadline and they believe that delays will only lead to more time being spent and higher costs without improving the outcome.”
Swiss Re’s spokesman Tom Armitage confirms that the reinsurance giant “remains committed to ensuring that we and our clients are ready for implementation at the beginning of 2013”. He adds that the group is working on its internal preparations and “we remain engaged in the debate around outstanding issues through relevant industry forums”.
The potential delay has as much to do with regulators not being ready in time as much some insurers. Aon Benfield, the global reinsurance intermediary and capital advisory arm of Aon Corporation recently reported that 60 per cent of European insurers attending its conference on Solvency II believed that 2014 would be a better starting date. Slightly more (61 per cent) believed that their national regulator is “not up to speed” with the internal models that insurers must work with under the new regime while 54 per cent thought regulators weren’t fully conversant with their underwriting risks, in particular catastrophe risk.
A consistent approach
How big a change will the new regime and its risk-based rules bring about? According to Michel Barnier, the EU commissioner for internal markets and services, Solvency II constitutes “the most significant regulatory changes in the insurance sector in 30 years”. It will impose on Europe’s insurers a market consistent approach to the valuation of their assets and liabilities.
It also presents them with a hefty bill for instigating measures to ensure that they are compliant. In January, the venerable London insurance market Lloyd’s estimated that getting ready for Solvency II would cost the corporation and its managing agents at least £250 million in all, based on an annual expenditure figure of £70 million since 2009. Lloyd’s general counsel Sean McGovern says that even this figure will be pushed higher if implementation is put back until 2014.
The aim of Solvency II is to improve protection for Europe’s insurance policyholders and to enhance the single market and create a more harmonised regulatory regime. The intention is also to provide European insurers with a competitive advantage, by giving them a regulatory framework around risk-based assessment. So, companies can take risks but must have the capital to support these activities or alternatively seek sufficient reinsurance.
“In essence, Solvency II is an insurance policy for insurers,” says John Mason, chief operating officer of data management group Netik. “Insurers typically have an equities or asset management division, so the concept of ensuring these insurers have sufficient capital adequacy in order to meet claims is a sound one. Of course, the actual execution may, in retrospect, be seen as open to improvement but that will only become apparent in a few years’ time.”
The new regime’s predecessor Solvency I, developed back in the
Eighties, followed a relatively simple approach but has steadily become less
fit for purpose says Naren Persad, a senior consultant at Towers Watson. “Since then we’ve witnessed a whole range of developments from massive advances in technology to the advent of risk management.”
Impetus for the Solvency II project was emerging at least a decade ahead of the financial crisis that erupted in 2007, but attempting to coordinate a growing number of EU member states proved a formidable task for the European Commission, says Persad. Hence the formation of the Committee of European Insurance and Occupational Pensions Supervisors (Ceiops) – since replaced by Eiopa – and a series of five successive Quantitative Impact Studies (QIS).
As many in the industry noted, a particularly tough issue was to devise an approach to be applied uniformly across the EU’s many countries and regions that face widely differing risks from natural catastrophes such as floods, windstorms and earthquakes.
The challenges that the new regime poses to the insurance industry are numerous. “One of the primary areas that insurers will now have to address is the validity and accuracy of the asset side of the balance sheet,” says Mason. “To date, insurance has primarily been about managing the liabilities side.”
So insurers are presented with the options either of bringing their assets in-house and extending their expertise to include portfolio management, or, integrating the asset side of risk management – doing so directly or through a service provider. According to Peter Bonisch, managing director of Paradigm Risk, analysts and markets expect the larger and more complex firms, as well as those pricing more complex risks, to develop their own internal models to ensure sound and sustainable pricing and to optimise their asset and liability positions.
“Actuaries have long contemplated the risk on this side, but Solvency II brings a lens to the assets of the insurer as well,” adds Mason. “In some cases insurers may have to take on a number of the data management and reporting capabilities that asset managers do today and the main question is whether they are equipped to do that? They are now faced with the challenge of aggregating those assets, which potentially reside across multiple asset managers.”
All organisations embedding Solvency II are also required to create a reliable data directory, says Adam Sztuka, managing director at Clarity Resourcing. “This is a cornerstone – although I’m not aware of any organisation that’s actually achieved it yet,” he notes. “And some are taking a very narrow view of the data which needs to be considered, so may well yet find themselves falling foul of the regulator.”
Cox adds that his own experience, based on general insurers and Lloyd’s syndicates in particular, suggests that their data stored in respect of liabilities is “not up to scratch”. He cites various reasons, such as companies having data on a multitude of legacy systems that have resulted from corporate transactions and data that is in the hands of brokers rather than insurers.
“The liability side is also much more material in terms of risk than the assets for general insurers, as the investments are usually high-quality short term debt,” he adds. “This may be more relevant to life insurers, who take a lot more interest in investment risk.”
Netik’s white paper outlined the governance, investment and data implementation issues resulting from Solvency II. Its message is that firms need to create an ‘analytic core’ that clearly links its data, modelling and capital requirements.
“Regulation will require insurance firms to enforce minimum capital standards, governance and risk management routines, but firms also face the commercial imperative of linking the business decision-making to the economic capital position of the firm,” it states. “This places data coverage and quality front and centre in the firm’s Solvency II initiatives and at the heart of its ongoing governance.”
Solvent impacts The impact of the new regime is already in evidence reports Clive Thompson, risk solutions project director for broking group Willis. It is starting to introduce “more rigour” to the pricing models and this should – theoretically at least – identify cases where insurers attempt to sell below cost.
Solvency II looks set to be introduced in an environment in which reinsurers, driven by heavy natural catastrophe losses, attempt to drive up rates. They have already endured 10 years of softening market conditions, which must eventually lead to losses particularly as there is little sign of current poor investment returns improving in the short term.
“You would expect these pressures would feed through to a hardening of price, but this will be tempered by the effect of competition and quite how
that plays out is yet to be seen,” adds Thompson.
It will depend on whether there is a flurry of merger activity among the larger players, resulting in less capacity. Thompson regards this as unlikely but they could swallow up smaller rivals and consolidate the market, thus reducing capacity in niche areas.
Currently there is abundant and increasing capital in the market. Total global reinsurer capital ended 2010 at an all-time high of $470 billion (£292.7 billion), up 17 per cent from 2009.
“How that reacts in Europe under the Solvency II regime will be interesting,” comments Thompson. “Logic suggests that merging balance sheets which
support different risk categories diversifies risk and reduces solvency requirements.
“When capital-hungry catastrophe-exposed business finds itself under strain, and in need of greater capital support than the old regime, you would think the logical option was a merger.” He expects one probable outcome to be that insurers restructure corporately, with their outlying operations becoming branches of parent entities; QIS5 published in March (the fifth and final Quantitative Impact Study) noted that this would produce greater surpluses.
Operations that do not have a larger parent can easily seek similar benefits through merger.
On a positive note, it appears that most of Europe’s insurers and reinsurers are “robust”, meaning that if put to the test they could meet the minimum capital requirements imposed by Solvency II.
Eiopa recently applied an adverse macroeconomic ‘stress test’, involving various scenarios covering market, credit and insurance-related risks to a total of 221 companies. The group collectively had an aggregate solvency surplus of €425 billion (£377.3 billion) at the start of the exercise, which declined to €275bn after the stress test scenarios were applied. Nine in 10 of the group withstood the test, but the remaining 10 per cent were left with a figure that fell below Solvency II’s minimum capital requirement.
Solvency II should also benefit risk managers, thanks to its expanded remit of the risk function claims Sztuka in a paper co-authored with Allan Christian, principal of Governance Matters. Instead of reporting to the chief executive or the chief financial officer, they will move towards more of a leadership role and have unfettered reporting lines to the board and to the audit and risk committees.
Phil Whittingham, European chief enterprise risk officer for XL Insurance, outlines the skill set that risk managers will need in dealing successfully with the requirements of Solvency II.
“They will need to be able to wield influence at board level; understand all risk types; have the ability to engage with actuaries, the various businesses and the regulators; drill down into specific areas of risk and undertake specialist reviews; understand capital planning; know fully the business and its risk strategy and understand actuarial and other modelling techniques,” he states.
Indeed, recent reports on salary levels suggest that individuals able to demonstrate such skills have been heavily in demand for the past couple of years, and can command remuneration that reflects it.
Pitfalls and benefits
So the intentions of the new regime are laudable, but will European companies notice any unintended consequences once it takes effect? Despite the industry’s complaints, some of its major players could reap benefits. “Insurers need to take strategic decisions and be prepared to change their business model in order to be ready in time,” says Gareth Haslip, head of Aon Benfield’s risk and capital strategy team for the EMEA region.