As the framework for Solvency II progresses, Keith Lyon takes a step back to assess its potential impact
With the Committee of European Insurance and Occupational Pensions Supervisors having delivered their draft answers to the third wave of calls for advice on the framework of the Solvency II project at the end of last year, inviting comment and consultation from interested parties by mid-January before the advice is formally submitted to the European Commission in February, now seems an appropriate moment to take stock of the progress of the project and its possible impact, both now and in the future.
Solvency II is the proposed new approach to the assessment of the overall solvency position of life insurers, non-life insurers and reinsurers doing business within Europe and is set to be the most radical shake up of prudential regulation for European insurers for a generation.
The proposed new risk-based approach, with its incentives for proper risk management, is one that contrasts starkly with a straightforward fixed minimum solvency limit approach adopted by other regulators around the world, including, for instance, the Bermuda Monetary Authority (a jurisdiction that has proved particularly adept at attracting new capital and business).
So will it work to encourage stronger, more stable and robust entities, and so prove a boon in the flight to quality carriers or will it further blunt the competitive edge of carriers from the Old World?
The proposed new regime is based on the same sort of three pillar structure previously seen with Basel II: Pillar I addresses the quantitative aspect of minimum capital requirements; Pillar II covers qualitative issues such as supervisory activities and risk management processes; and Pillar III deals with supervisory reporting and public disclosure requirements.
In covering these bases, Solvency II is supposed to support the harmonisation of quantitative and qualitative supervisory methods in the European insurance and reinsurance sector, while also bringing about at least a greater measure of regulatory consistency between different financial sectors.
IF IT AIN'T BROKE
The fundamental principle of the proposed new approach is to align an insurance undertaking's regulatory capital requirement more closely with the perception of its risk. In doing so, there is an expectation that insurance undertakings will increasingly use internal models to assess their own risk profile, thereby allowing informed and appropriate decisions to be made about the management of that profile and the capital required to support it.
Furthermore, that risk profile will no longer be focused solely on the undertaking's underwriting exposures (as has been the case in the past) but will adopt a more holistic approach, also assessing its market risk, liquidity risk, credit risk and operational risk.
In brief, the quantitative provisions of Pillar I will introduce a structure for the calculation of an undertaking's minimum capital requirement (MCR) - the minimum level of capital required before regulatory intervention and a capital floor designed to protect policyholders in the event that the insurance undertaking should cease to trade as an ongoing business - and for the risk-based calculation of the solvency capital requirement (SCR) - the capital required by an ongoing business to meet all its obligations over a prescribed period of time to a prescribed level of probability.
Pillar II meanwhile envisages the supervisor of any insurance undertaking being able to exercise discretion to require that undertaking to hold additional capital above the SCR if its risk profile is felt to warrant it.
Of course, if an informed assessment is to be made of these aspects, then in the absence of much in the way of prescriptive rules and regulations, systems and processes will need to be put in place to collect the data required and those data collection systems and processes will need to be transparent so that they can themselves be assessed. This will require the integration of transactional, financial and operational systems, a process that will require the investment of time and money and the commitment of resources away from business generation of premium.
The ramifications for the industry in Europe as a result of the introduction of the new Solvency II regime are likely to be profound and wide-ranging.
The approach being adopted follows the Lamfalussy process, providing for the introduction of a Framework Directive setting out the main principles of the regime, with a target date for adoption of July 2007. This will be followed by a second level comprising EU regulations containing more detailed implementing measures and a final level comprising the detailed rules, guidelines and standards to be applied by the various national supervisors with a target implementation date of 2010 at the earliest.
This "timetable" reflects the fact that the process is running late.
The adoption of the Framework Directive is already delayed and there is a possibility that this could slip even more if there is further protracted debate, lobbying and horse-trading (for instance in the defence of perceived interests on behalf of markets where there is a preponderance of smaller, less well capitalised - especially mutual - insurers).
For all that, there does seem to be support for the introduction of the new regime from many in the European insurance industry, and even an impatience that it could take five years to see it arrive. Those UK insurers who have already experienced the introduction of the FSA's new risk-based approach to capital requirements (including the "enhanced capital requirement") would no doubt support the view that time and resources committed to the early planning and preparation for the shift would be well spent.
In the meantime, only uncertainty can arise from the delay in implementation while a two paced climate develops with debate continuing on a number of key aspects, such as the level of credit to be given to reflect class and geographical spread, investment diversity etc. At the same time others (such as insurance undertakings in the UK where the FSA has already sought to implement its vision as to how Solvency II will look in 2010), for whom tiered capital is already a practical reality, are already looking to utilise innovative risk mitigation techniques by accessing the capital market financial instruments by the use of life insurance securitisations (where Swiss Re is blazing a trail) and catastrophe bond issues.
OPPORTUNITY OR THREAT?
Solvency II is undoubtedly an ambitious project which (provided its edge is not dulled by compromise) should have a deep-seated impact on the future conduct of insurance business. In practical terms, it seems reasonable to assume that the practice of using less capital-intensive classes of business to subsidise their more capital intensive brethren should cease, with each class of business written standing or falling on its own merits, requiring calculation of the right price for any given risk and the commitment of high levels of capital to high risk or long tail lines. This may cause capital to migrate away from certain higher risk classes of business (such a credit and surety, casualty and catastrophe lines) as it is committed elsewhere.
All this should at least in theory enhance results and increase the returns on insurance business and thereby arrest the pattern whereby, over the last 15 years, European insurers are said to have systematically delivered lower returns on equity than the banking sector.
The idea that an insurance undertaking should strive to calculate and charge the right price for a risk (thereby producing profit target yardsticks against which performance can be measured and so allowing for the effective and efficient deployment and management of capital in the light of such performance) seems so blindingly obvious that it might come as a surprise that this is not the universal norm already. However, if this is indeed what Solvency II actually achieves, then all the upheaval that it will entail may yet yield the elusive competitive advantage to European insurers that comes with being seen as more stable and secure than undertakings that enjoy a different prudential regime.
- Keith Lyon is a partner in the regulatory and transactional insurance group of Mayer, Brown, Rowe & Maw.
STANDARD & POOR'S EUROPEAN INDUSTRY REPORT CARD
In a report into the European insurance market published by Standard & Poor's in January, the agency highlighted the increasing public recognition of Solvency II, which is driven by the market's acceptance of the fact that the implementation of the new regime should not be "a 'big bang' in faraway 2010", but rather requires the industry to set the process in motion now.
"In our view, Solvency II will be a major driver for companies to review their business models," said credit analyst Hans Wright. "Ultimately, the competitiveness and performance of companies' divisions will become more transparent for all stakeholders." Standard & Poor's added that the increased transparency which the directive will instill should enhance the overall efficiency of the European insurance market, "accompanied by significant polarisation and consolidation processes, especially in the still more fragmented markets such as Germany and Spain." While a number of groups, according to the rating agency, have already begun implementing the necessary structures and processes to facilitate the adoption of Solvency II, it added that they have done so "based on the potential competitive advantage rather than regulatory incentives".
Looking specifically at efforts in the UK to prepare for the directive, the report stated, "preparedness is high, since the UK Financial Services Authority has already implemented its vision of Solvency II, which is unlikely to be fully implemented in Europe before 2010. In less well-prepared countries, companies will need to respond proactively and quickly before Solvency II becomes a threat to their business."