As simple as possible but as complex "as necessary" is the industry's message to those putting the final touches to the ambitious Solvency II project, says Gerard de La Martiniere

Solvency II is the ongoing EU project to create a new, dynamic, more risk-related solvency system for European insurers and reinsurers.

The project's ambitiousness lies in the fact that it considers the full range of risks faced by companies to determine their solvency requirements.

It will also significantly impact insurance supervision by linking supervisors' intervention to the companies' solvency status at different stages. It is therefore a prime strategic project for European insurers and reinsurers.

From Solvency I to Solvency II

The current solvency requirements for insurance companies stem from a set of minimum-harmonisation EU directives complemented, in some countries, by additional national provisions. As well as establishing some supervisory rules, Solvency I basically raised the capital required by an insurance undertaking to ensure it could fulfil its commitments to policyholders and meet claims at any time. These rules are based on a "flat-rate" calculation that is not actually sensitive to the risk of the company.

The new Solvency II project's focus is much wider than pure insurance risks (mainly the commitments registered on the liabilities side) and looks at the overall management of risks. To do so, it has adopted the three-pillar approach known from the Basel II project for the banking sector: capital requirements (Pillar I), supervisory review (Pillar II) and market discipline (Pillar III).

The project should lead to a more efficient and secure single market for insurance and reinsurance by harmonising solvency requirements and supervisory practices, allowing companies from different European countries to operate under the same conditions. By doing so, its key objective is to foster policyholder protection, while ensuring an efficient functioning of capital markets to enable insurers to carry out their core business - ie to take risks on behalf of policyholders. The insurance and reinsurance sectors have since the very beginning called for this fundamental review and are actively involved in the shaping of a new solvency system adapted to their business.

It is acknowledged that Solvency II is a long-term, progressive work, which requires the industry to provide constant input to decision-makers, by presenting precise views on the project's general shape and elaborating its position on specific technical matters. CEA, the European Insurance Federation, has therefore reinforced its structures in order to enhance input and dialogue with the project's key decision-makers and promote ongoing communication with other industry stakeholders.

CEA's main decision-making structure is the Solvency II Steering Group chaired by Olav Jones, head of insurance risk at Fortis. It is composed of experts from national insurance associations and leading European insurance companies. It relies on the work of a wide pool of industry and national insurance association experts, while CEA's secretariat is supported by a permanent team of consultants.

CEA is contributing to the project both with responses to specific questions by the European Commission and the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) as well as with specific documents, which are to serve as a basis for its further work.

What the industry really thinks

In order to build a common understanding of the issues at stake, CEA and Mercer Oliver Wyman conducted a study titled "Solvency assessment models compared", which focuses on Pillar I. It offers a factual overview and qualitative comparison of a number of prevailing solvency assessment models. Its purpose was to build a better understanding of existing regimes and to identify emerging issues and principles amongst existing models in order to develop the best possible one for Europe.

In that context, CEA has also drawn the attention of the EU's decision-makers to the necessity of considering several key structural issues that should be addressed during the build-up to Solvency II. More specifically, in a paper titled "Solvency II structural issues", the industry first stressed the need to perform impact studies to ensure appropriate calibration of Pillar I (quantitative) requirements. This is indeed essential in striking the right balance between the objective of securing policyholders' protection and avoiding the possible negative consequences of unnecessarily conservative capital requirements.

In addition, unintended consequences on the investment decisions or product offerings due to unexpected behaviour by either insurance companies' internal management or policyholders' and consumers' behaviour should be avoided.

This could for instance be the case if Solvency II was to make the holding of certain categories of assets over-onerous in terms of capital charges.

Furthermore, as the aim is to create an EU-wide system living up to the ambition of a truly single market for insurance and reinsurance, harmonisation is essential while ensuring that a certain degree of flexibility is safeguarded to cater for the wide diversity of the business.

Finally, the treatment of insurance groups on a consolidated basis should be a central point in the development of the Solvency II rules, not only for Pillar I, but also for Pillars II and III. For this reason it should be considered at the earliest stage in the process and not after the initial development is completed. CEA considers that the total capital requirements should be driven by the group level solvency capital requirement (SCR), which should incorporate the effects of any diversification benefits or concentration effects.

Solvency II & Basel II

The Basel II project was carried out with similar goals to those now concerning the insurance sector. Thus, the process of developing the supervisory regime for insurance can benefit greatly from the experience and lessons learned from Basel II. However, as the CEA paper "Why care should be taken when using Basel II as a starting point for Solvency II" explains, there are fundamental differences between the banking and insurance sectors which must be kept in mind when considering the possible use of the Basel II approach in the context of Solvency II.

On 18 May, CEA issued a paper - "Building blocks for the Solvency II project" - which marks a milestone in the development of the industry's views on the general framework of Pillar I (capital requirements). This is an essential starting point in developing CEA's feedback to CEIOPS on its "Draft answers to the 'second wave' of calls for advice" (consultation paper no 7). The positions expressed in this paper concerning the total balance sheet approach, the approach to internal models as well as to diversification and risk mitigation are at the core of the industry's views on Pillar I.

A modular approach

The industry positions itself clearly in favour of a total balance sheet approach based on an economic valuation of all assets and liabilities.

This means that the determination of an insurer's ability to cover its obligations with the required level of certainty should be based upon its total financial position (ie all means available to cover its obligations).

For solvency purposes, the level of prudence should have no impact on the total capital requirement. Indeed, under a total balance sheet/economic value based approach, the prudence margin will count towards the total capital requirement. This total capital requirement is assessed above the economic valuation of liabilities. The prudence margin should then be deducted to give the SCR and this will prevent the double counting of risks, as illustrated on the right.

In order to be used across different insurers, in different markets, with varying internal capabilities, the standard approach and internal models should be based on the same guiding principles to create incentives for companies to improve their risk measurement and management through the use of internal models. This would allow a smooth transition from the standard approach to internal models (potentially through the use of partial models). This could imply a modular approach to the SCR. This would allow for separate modules by risk type and product segment where the approach to the SCR can be different for each module. A standard approach, full internal models, and potentially partial internal models in between these should therefore be allowed.

CEA stresses the need that capital requirement recognises the effects of diversification and concentration, noting that the method of capturing the effects of diversification could be different under the standard SCR approach and the internal model approach.

Risk mitigation techniques are also at the core of insurance business and include (but are not limited to) reinsurance, the use of derivatives and securitisation, and management intervention (under certain conditions).

In principle, all types of risk mitigation techniques should be recognised in the standard and internal approaches to calculate the SCR. Nevertheless, practical limitations to the full recognition of risk mitigation techniques would be higher under the standard SCR approach than under the internal model approach.

Solvency II represents a significant challenge and the European insurance and reinsurance industries are clearly committed to play an active role in providing useful input to the EU's decision-makers.

- Gerard de La Martiniere is president of the CEA.

Source: Author's own.