The implementation of Europe-wide capital adequacy regulation, Solvency II, will be a huge landmark for the insurance industry. Set to be implemented by 2012, it will have a significant impact on the capital structures of insurance companies and how risk is managed.

As organisations endeavour to become Solvency II-compliant, many will see the regulation as a demanding challenge. It is certainly true that the scale of the task should not be underestimated. It is important however to recognise that the effort will be worth it; compliance will provide a range of tangible business benefits which will make all the hard work worthwhile.

The potential headache
Implementing Solvency II will involve three main challenges: People, systems and timing.The regulation will require companies to upgrade their levels of skill and expertise in risk management. Employees with extensive understanding of the field will be in great demand – all insurers will be looking to hire these personnel, and so competition over hiring them will be fierce, which will drive their salaries up. As well as securing new employees, there will also be a need to invest in training to improve the appropriate skills of existing staff.

The need for significant investment in systems will become evident. Solvency II will prompt insurers to implement a range of systems and controls in order to comply, including governance structures and risk policies that need to be embedded into the business at every level. A significant proportion of insurance companies, particularly the larger organisations, will undoutedly want to build tailored internal models and risk reporting systems. These demands will result in significant investments of time, effort and money in the right technology and enterprise solutions.

Timing is also a challenge. The exact details and requirements of Solvency II are continually evolving, so insurers can be forgiven for wanting to wait until the details are more concrete before creating internal systems and processes in response. However, ensuring that such systems can be created, and that they are embedded into the workings of the business – passing the “use test” – will take several years. To this end insurance companies will have to begin preparing while the details of the regulation are still in flux.

Multiple benefits
For insurers facing these significant challenges, Solvency II can look like a compliance nightmare. However, they will also enjoy considerable business benefits, and it’s these benefits that make all the hard work worthwhile. The challenges of Solvency II will result in a better understanding of risk, which will in turn help insurers to upgrade their financial management and become stronger companies. These benefits can be divided into six broad categories.

Better decision making
By defining and implementing risk policies to comply with Solvency II, organisations will gain a much improved visibility of risk within their business and greater consistency of risk policies throughout the organisation. Tillinghast expects that risk policies will not just address limits on the amount of risk that an organisation will take on, but will also consider the risk/return tradeoff, ie how much reward makes a particular risk worth taking.

“Solvency II will prompt insurers to implement a range of systems and controls in order to comply, including governance structures and risk policies that need to be embedded into the business at every level.

This improved level of information will help personnel make better decisions when looking at key questions such as whether to accept a risk, whether to reinsure part of it or how to decide on investment strategies. This improved level of decision making should permeate all levels of decision makers. In the UK, where the Financial Services Authority (FSA) already requires companies to document their risk policies, insurers are seeing the benefits of having a greater understanding of risk throughout the management team.

A lower cost of capital
Analysts and investors often express the opinion that insurance companies are relatively opaque organisations, and because they struggle to understand insurers, investors tend to be more wary of the risks of investing in the industry. This lack of trust and understanding affects the price of capital. Compliance with Solvency II will improve this situation.

As insurers gather more information about their risks, they will be able to disclose more information to investors, providing greater levels of transparency. This enhanced transparency means that investors will better understand what they are investing in, and so insurers should find it easier to raise capital. Also the demonstration of good risk management practices will lead to rating agencies granting insurers more favourable credit ratings.

Lower prices for consumers
The current framework for capital requirements, Solvency I, results in some inconsistent levels of capital across the industry. Some low risk products have unnecessarily high levels of capital required while for other higher risks, the requirement is not high enough.

Solvency II will match the capital requirement to the level of risk more evenly, resulting in a more efficient use of capital by the industry. As capital comes with a cost, more efficient levels of capital will lead to lower prices for some products. Also, organisations with better risk management standards will have to hold less capital and hence will be able to offer lower prices than others. To the extent that Solvency II will ensure a high level of risk management across the whole insurance industry, the overall price of insurance will fall.

Reduced risk of corporate failure
At present, the risk of a company failing varies, depending on the country that it operates in and the type of insurance that it writes. For example, up until recently, options and guarantees did not attract a capital requirement commensurate with their risk, and Equitable Life took on a large quantity of products with options and guarantees as they were cheaper to write. The resultant lack of capital caused the company to collapse, a catastrophe for both the organisation and savers. The stricter capital demands of Solvency II (which demands sufficient provision to allow only a one-in-200 chance of failure every year) will ensure a more even standard of solvency across the industry, reducing the chance of corporate failure.

More accurate pricing
To price a product accurately and profitably, an insurer needs to base the pricing of a risk on the amount of capital they will have to hold and the level of risk they will take on. Historically insurers have based their pricing on the regulatory capital requirement – this means they are basing prices on regulatory demands, not the actual amount of capital needed to absorb risks. This is inherently inaccurate; higher risks will require more capital than the regulatory amount, and lower risks won’t need as much. In other words lower risk products are sometimes being priced too expensively, and higher risks products can be too cheap.

“To the extent that Solvency II will ensure a high level of risk management across the whole insurance industry, the overall price of insurance will fall

As compliance with Solvency II provides more accurate analysis of the capital required for risks, companies will be able to base prices on the economic capital – the actual amount of capital required – and therefore be able to price much more accurately.

A component of a wider financial management framework

Accurate capital management is not an end in itself. It forms an important part of a wider financial management framework for insurers, allowing them to focus on creating business value. This can be seen as a three-stage process:

1) Develop a risk strategy based on those risks the company specialises in, and where it has a competitive advantage;
2) Calculate the capital needed to support that risk strategy; and
3) Use analytical tools to estimate the returns from that strategy

In other words companies can ensure they are delivering value by ensuring that the returns generated by a strategy exceed the market price of the risks they are taking (the price to lay off those risks through reinsurance or hedging). The same tools that will be needed under Solvency II for assessing capital needs can also be used to assess the potential returns on strategies, thus capital management supports the management and creation of value.

A step forward
All agree that insurers face significant challenges to comply successfully with Solvency II. Getting the systems, personnel, and timing right will not be an easy task. However, it will be easier if they focus on the light at the end of the tunnel; Solvency II will drive a number of very positive changes within the insurance industry, and create considerable benefits for organisations who take well-planned, carefully considered steps to comply.

Insurers need to stop seeing Solvency II as a difficult set of boxes to tick, but as an opportunity to revolutionise the way they manage their capital and their business, and a chance to create real value by changing the way they work.

Steve Taylor-Gooby is managing director for the Tillinghast business of Towers Perrin