It's finally here. After numerous delays the draft directive for Solvency II has arrived. Will Roberts discovers that hopes of harmonisation are undermined by fears the directive will create imbalances

Solvency II will herald a new era for reinsurance regulation in Europe. The draft directive was finally launched in July after numerous delays. It clears the way for a single European reinsurance market and promises fundamental revisions in transparency and risk management when it is finally implemented in 2012. The impact of Solvency II will vary widely, and concerns have been raised over its implementation.

The central aim of Solvency II, introduced by the European Commission, is to reform capital requirements by emphasising a higher standard of risk management and disclosure. It places the responsibility for this on the company itself by providing principles to guide reinsurers, rather than enforcing a prescriptive set of rules. It encourages the use of internal risk models to monitor firms' risk exposures. Ultimately it is hoped this will ensure companies have the necessary capital to withstand adverse events.

Does it go far enough? Bob Haken, associate at Norton Rose, believes its scope is too narrow. "Companies face lots of risks in today's world, only one of which is claims," he explains. "There are a host of other risks, such as blackouts and computer hacking. None of these were taken into consideration with the current formula. But with Solvency II, the capital model takes account of all risks. The idea is to break down the risks, weigh them up, and decide how much capital you need so that if a one-in-two-hundred year event happens, a company is still solvent. The capital model is a massive actuarial exercise. It is a fundamentally different way of thinking."

Thinking ahead

Solvency II will adopt a forward-thinking and progressive focus. Whereas at present solvency requirements are based largely on historical data, the new capital models will require insurers to think about any future developments - such as new business, expansion plans or the possibility of adverse events which could affect their financial standing.

Solvency II is based on the Basel II-type three-pillar approach used in banking. Pillar 1 sets out the rules for financial resources, Pillar 2 defines the principles of the supervisory process and risk management, and Pillar 3 is designed to increase transparency. The current system, Solvency I, was introduced 30 years ago and there is no doubt that today's financial markets require a regulatory upgrade.

A big issue with the current system is that member states have adopted their own national rules, creating an uneven playing field and protectionist tendencies. "The idea of Solvency II is to stop the protectionist element," says Haken. "You could find, for example, a country only allowing companies of the home nationality to issue insurance. All of this works to the detriment of consumers because there would be no competition. Solvency II is the notion of opening up the markets to everyone, with no state restrictions. Then, market forces and economics will dictate."

This view is echoed by Steve Taylor-Gooby, managing director at Tillinghast. "It is a major achievement to produce a framework based on modern economic principles. If successfully implemented, the new regime will lead to more efficient capital allocation across the industry."

The implementation is essentially a cut and paste directive known as intelligent copy out. This is a two-stage process whereby the European directive, or minimum standard, is implemented into national rules to achieve consistency with other states. Effort has been made to distance the intelligent copy out process from "gold plating", which is the practice of over-implementing at a national level a directive passed by the EU. This has been criticised for over-complicating minimum standards.

“London is the pre-eminent financial market, and it is hard to see this position being displaced by Solvency II

Uncertain impact

But does Solvency II provide the solution for the current outdated, patchwork system and what does it mean for reinsurers? "Clearly the answer will vary from group to group, depending upon the type of business," says David Whear, partner at the Association of British Insurers. "It will depend largely upon the degree of diversification."

Rick Lester, insurance partner at Deloitte, agrees: "One group of winners from a capital perspective will be those insurers with a diversified portfolio. Monoline businesses will not benefit from these capital requirements and this may lead to imbalances across the industry."

A further concern aired by industry experts is that Solvency II will benefit larger reinsurers to the detriment of smaller ones - ironically creating exactly the same type of imbalance that the directive was put in place to remove. Under the new solvency requirements, smaller companies might be deemed to have insufficient amounts of capital. If this happens it may encourage further industry consolidation.

European member states also have widely varying insurance regimes. The UK system is the most developed in terms of risk-based capital. "London is an enormous centre of underwriting and support services, with a well-developed legal framework. London will always be a key market," insists Whear. This is unlikely to change says John Ahern, partner at DLA Piper. "London is the pre-eminent financial market, and it is hard to see this position being displaced by Solvency II. A level playing field will not affect that dynamic. Lloyd's is not going to just up and move."

In the UK risk-based approach, in place since 2005, firms do their own individual capital assessments. These are then sent to the Financial Services Authority which reviews them under a system known as individual capital guidance. This is essentially the same process as Solvency II, just under a different guise. For those larger insurance and reinsurance groups under the capital assessment rules, therefore, Solvency II will be an extension of existing practices.

One step behind

Member states without these procedures, such as France and Germany, which have instead a myriad of smaller insurance groups, will find the transition much tougher. They will also battle to find these necessary resources. In the UK, there has been an increase in the resources required to deliver sensible assessments of capital needs to regulators. With Solvency II expanding this requirement across Europe, industry experts predict a fight for resources between countries.

There are also very different sales practices in member states and this could create barriers. "Europe doesn't have a consistent regulatory regime - when conducting insurance in the UK it is activities-based, whereas in France regulation is based towards on-site risk. These are clearly key inhibitors to a truly level playing field across Europe," continues Whear.

“The UK's individual capital assessment is essentially the same process as Solvency II, just under a different guise

A question mark remains over the process by which the directive is to be implemented. The majority of the rules will be put in place by secondary legislation, not actually in the directive. "A key aspect of Solvency II is to let firms develop their own internal capital models. The details of what goes into that will not be found in the directive - but national regulations under the directive," said Whear.

The fear is that each member state will implement the rules differently. Mark Nicholson, a director in Fitch Ratings' insurance group, does not think that individual countries will deliberately set out to change these regulations. "However, there may be differences in the way that national regulations are interpreted by countries," he submits. Cultural and political differences between member states will fuel these interpretative variations.

It is perhaps these cultural and political differences that remain the greatest obstacle to a single European insurance regime. The development and ultimate success of Solvency II is intrinsically bound with European political harmonisation and the move towards a federal Europe. "The more Europe is integrated across borders, the more political integration there is, the greater the harmonisation of member state laws and labour markets... the closer to a single European insurance market we will be," says Ahern.

Rodney Bonnard, actuarial partner at Ernst & Young, believes insurers have a vital part to play in ensuring the directive is right for the industry. "The insurance industry will continue to lobby hard over detailed implementing measures and seek clarity on how national regulations across Europe will put Solvency II into practice," he says. Areas Bonnard says need further consideration include governance issues and risk management. The committees will decide upon the detail in the regulations and will follow the guidance of the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) - which has representatives from all the regulators around Europe. CEIOPS clearly has a huge role to play in Solvency II.

The scope of Solvency II is far-reaching and ambitious - it harmonises 14 different directives, such as the life directive, solvency margin directive and group directive, into a complete whole. While there is general agreement in principle to the draft directive, it is the details that need fine-tuning.

If these issues are ironed out and it is successfully implemented, the new directive should be a groundbreaking piece of legislation. Indeed, with expectations that US and Asian regulators might consider adopting something similar, it could it provide a model for a global reinsurance regime.

"Yes, it could be a global model," says Haken. "Solvency II is actually inspired by Australia - it follows a similar philosophy. It represents the most modern approach. The question is whether there is the political will to move to a single standard."

Whear believes we are already heading towards a global regime. "Going hand in hand with Solvency II are international accounting standards," he says. "The International Association of Insurance Supervisors is looking at the way in which national regulations interact. So, there's already a body looking towards harmonisation and getting consistency in international accounting standards - and this is the first step towards a global reinsurance regime."

Will Roberts is a reporter on Global Reinsurance.