Solvency II sees the implementation of risked-based capital requirements for re/insurers, but it will only be effective if companies can identify their risks and assign a value to them, says Maria Kielmas
In the eighties it happened to the banks, in the nineties to the energy industries and in the "naughties" to the re/insurers. New crisis, new regulations, new versions of risk management. Since the late 1990s, re/insurers worldwide saw their capital slashed as a result of their exposure to catastrophic losses, litigation-based claims, financial market slumps and corporate scandals. Like the banks two decades ago which were hit by their overblown ambitions in infrastructure financing, Latin American sovereign loans and property investment, or the energy industries in the 1990s with their misplaced faith in making trading operations a principal profit centre, re/insurers have been forced to re-examine, redefine and re-determine their risks.
The EU's Solvency II proposals (see box), which follow on from similar regulatory requirements in Australia, Canada, the US and the UK, define an international trend towards risk-based supervision of financial institutions.
Re/insurers have to demonstrate a full grasp of their risk profile, even if such a culture is not already present in any given company, or a company's management may not be interested in it.
"The new system should create capital requirements and prudential rules closer to the risk," says Alberto Corinti, secretary-general of Frankfurt-based Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS). And this system is going to be more far-reaching than the new rules of Basel II which have been developed for the banking sector, thinks Thomas Schubert, head of the Business Administration Institute of the Association of German Insurers (GDV). "Basel II does not take a view of the whole company," he says, adding that in contrast to Basel II, which only considers the effects of isolated risks on the asset side, Solvency II looks at the risks which affect the overall solvency of the company.
For reinsurers improved risk management will lead to a more diversified risk profile and more efficient capital usage. According to John Drzik, President of New York-based risk management consultancy Mercer Oliver Wyman1, the efficiency with which reinsurers are able to price and manage risk is their principle source of competitive differentiation. Mr Drzik adds that less sophisticated reinsurers will suffer from a flight to quality as their rating declines and primary insurers seek a better-rated company.
For the ceding companies a stronger risk management framework will allow them to assess the cost-benefit of potential reinsurance strategies and optimise their overall portfolio of reinsurance contracts. In the current hard reinsurance market, such an application can be of significant benefit and can have a short-term positive earnings impact, Mr Drzik notes.
But first companies have to identify their risks and assign a value to them. This is where the problems begin. A late-2004 survey by management consultants KPMG found that the insurance industry as a whole has not fully embraced the need to calculate economic capital, although this is changing with reinsurers and bancassureurs leading the way. The study noted that insurers are beginning to acknowledge that risks are not independent of each other but are struggling to understand the links between risks, a relationship which in turn will impact on risk aggregation. There is little precise understanding of the risks inherent in business processes - operational risk - while the single greatest concern is over market risk. The study also found that insurers are finding risks difficult to quantify. "If an underwriting decision doesn't turn out as expected, is that an operational failure?" asks Melanie McLaren, a partner at the financial services regulatory division at Pricewaterhousecoopers (PwC) in London.
The new regulatory regime will oblige re/insurers to recognise changes in their liabilities in line with market movements, known as a fair-value model for accounting, thus introducing more market volatility. So any given company's level of 'acceptable-table risk' or the degree of uncertainty it can tolerate, is a dynamic process the consequences of which may be largely unforeseen and the assessment, management and mitigation of which remains at a conceptual stage. While some financial analysts observe that a risk-based approach in banking has meant that the banking sector emerged from the most recent capital markets slump relatively unscathed, compared with its experiences in the 1980s, other analysts note that this result was helped by the fact that banks had hived off most of their credit risk exposure - to re/insurers and hedge funds.
So how well are re/insurers able to model their risk exposure? Kevin Dowd, professor of financial risk management at Nottingham University Business School says he is a great believer in the stochastic modelling process but adds that it is necessary to recognise that any estimates from them are extremely prone to 'model risk' and the assumptions about them made by key personnel. One example would be a question about a stock market's expected return. "If someone says 'here is an estimate' it is worthless," says Mr Dowd.
Such uncertainties will affect any future rules on admissible levels of investment and diversification. CEIOPS's Alberto Corinti gives as an example limits on the share of a company's technical provisions which could be placed in financial instruments held by just one counterparty.
But a more fundamental uncertainty is the measure of risk itself. Regulatory models developed to date use Value-at-Risk (VaR) as a standard measure, largely because of the absence of other alternatives. VaR is defined as the amount of capital required to ensure that the company is not technically insolvent over a certain time period with a chosen degree of certainty. This is usually 99.5%.
Kevin Dowd thinks that the shortcomings of the VaR methodology are not well enough understood. It is not a coherent risk measure and it does not address catastrophic outcomes. Although a measure called tail value at risk (TVaR) has been developed for such extreme events, Mr Dowd thinks that there is a deeper issue. "If the use of a VaR tool for capital requirements forces all companies to engage in the same risk management process, this is very destabilising," he says.
Mr Dowd's conclusion is a challenge to all of the thinking behind Solvency II and Basel II. "The principal of risk-based capital regulatory requirements is fundamentally unsound," he says. The only reason for it is to offset the moral hazard to a lender of last resort. "It's like trying to solve a problem that doesn't have a solution. The markets will always be ahead of the regulators," Mr Dowd adds. One example is the European Commission's aim to harmonise risks held by banks and for re/insurers (see box). "Even if you use the same models you can't avoid regulatory arbitrage," Mr Dowd says. He thinks that the new regulations are just "ossifying best practice" for the next 20 years. Mr Dowd believes that the real answer to all regulatory problems would be a return to first principles as existed in the 19th century: unlimited liability for company directors and officers, and a stricter legal system to ensure their imprisonment in the event of misdemeanour.
Mr Dowd claims that in private conversations with officials from the British Treasury and the US Federal Reserve these have admitted that his free market approach is the correct one while the development of ever more complex and expensive risk-based solutions serve vested interests and governments covering their own backs.
Hitesh Patel, a partner at KPMG in London, does not subscribe to the free market approach but acknowledges that there is no perfect solution to risk modelling. For him the main pitfalls in the future will be the quality of data available to re/insurers and the complexity of the modelling.
But risk-based capital remains the future.
1 John Drzik, "At the Crossroads of Change: Risk and Capital Management in the Insurance Industry", The Geneva Papers, 2005, 30 (72 - 87).
2 The so-called "Lamfalussy process" aims to improve the quality and effectiveness of EU financial services legislation. It was named after Baron Alexandre Lamfalussy, who chaired a Committee of Wise Men established in July 2000 by the EU Council of Economics and Finance Ministers (ECOFIN).
This committee recommended a four-level approach to the adoption and implementation of EU legislation affecting securities markets and published its report, "The Regulation of European Securities Markets", in February 2001.
The bulk of the technical input for the Solvency II project will be managed by the newly-created, Frankfurt-based Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS). CEIOPS receives 'calls for advice' from the European Commission. These are requests to draft specific proposals for technical input into the new regulations in consultation with the re/insurance industry. CEIOPS then provides its recommendations to the EC. According to CEIOPS secretary-general Alberto Corinti, the EC's June 2004 call for advice should be answered by July this year. A draft paper for public (ie, industry) consultation was due to be published by end-February.
WHAT IS SOLVENCY II?
The Solvency II project aims to produce a new set of EU-wide capital adequacy standards for the re/insurance industry. The European Commission began a fundamental review of the industry in early 2000. This resulted in Solvency I, a directive published in October 2000 and which entered into force in March 2002. It has been applied to accounts for the financial year beginning January 2004. The Solvency II draft directive is not expected to be ready until end-2006, according to European Commission sources, almost one year behind the original schedule. The need to examine various aspects of Solvency II, and an unresolved issue of how to value insurance contracts under the new International Financial Reporting Standards (IFRS), has caused much of the delay.
Nevertheless, Solvency I has not resulted in a fundamental change as it is based on rules adapted from the 1970s. So Solvency II aims to overhaul the current system by introducing what the European Commission describes as a "risk-oriented approach which encourages insurance undertakings to measure and manage their risks". The system should ensure consistency between financial sectors, in particular between banking and insurance.
A new solvency system should furthermore aim at a more efficient supervision of insurance groups and financial conglomerates.
The Commission believes that the future system should lead to increased harmonisation of quantitative and qualitative supervisory methods. Lamfalussy 2 or comitology techniques should be used to make the system as efficient and flexible as possible from a legislative perspective. A future system should furthermore take international developments into account with the aim of promoting further convergence in prudential standard setting. Solvency II should develop in parallel with ongoing work in organisations like the International Association of Insurance Supervisors (IAIS), the International Actuarial Association (IAA) and the International Accounting Standards Board (IASB). In particular, the Commission says, the intention should be to implement accounting rules which are compatible with the estimated outcome of the IASB work.
Solvency II adopts a three-pillar approach to capital requirement similar to the Basel II accord for banks: (1) minimum capital requirement, (2) supervisory review of capital adequacy and (3) public disclosure.
Pillar 1. The principal issue here is how to obtain a true and fair measure of the required risk-bearing capital in order to avoid financial distress or corporate default. Capital requirements would be determined by taking into account underwriting risk, credit risk, market risk, operational risk, premium risk etc. The Commission foresees this as a two-tier capital structure with a 'target capital level' and a 'safety net'. The first should reflect the economic capital a company would need to operate with a low possibility of failure, while the latter should be established in order to constitute a basic trigger level for ultimate supervisory action.
Pillar 2. This comprises the key principles of supervisory review, and of risk and financial management. It focuses in particular on internal controls and procedures. Internal models of risk should be used as a daily tool for company decision-making and management and not just for regulatory compliance. There should be minimum criteria for on-site inspections by the supervisory authorities. Such intervention powers and responsibilities should be more closely defined.
Pillar 3. The aim here is to enhance public disclosure of risk taken on by re/insurers on the reasoning that this will provide an increased market discipline. This will allow companies to assess better the risks inherent to their operations, reward those which manage risks effectively and penalise those which do not. Companies may also be required to provide their policyholders with more information.
- Maria Kielmas is a freelance journalist and consultant.