As compliance efforts step up a gear, many are questioning whether the impending Solvency II regime is just one more headache for insurance companies
The deadline is looming for the new principles-based regulatory regime in Europe. While the Solvency II directive is not due to be transposed until 31 December 2012, the clock is ticking for insurers to assess their business models and develop internal capital models for approval by the FSA.
“In theory, it sounds like there’s a long way to go – the Olympics will have come and gone by the time all this is in place – but when you sit down and think about what’s got to be done and the regulations that have to be drafted, there’s a lot of ground to cover,” Mayer Brown’s head of corporate insurance in London, Martin Mankabady, says.
Much of the focus so far with Solvency II has been on how it will affect solvency capital requirements (SCR), which fall under ORSA (the own risk and solvency assessment). And with good reason. “We’re coming off the back of 18 months where investment returns have been falling. It’s a bit difficult to make money in this climate,” Mankabady says, “and then you look at Solvency II and know people are probably thinking ‘this is all I need’.”
Fears that the latest impact study for Solvency II would dramatically increase insurers’ capital requirements have been partly assuaged. Final specifications for the fifth quantitative impact study (QIS5) include reduced calibrations since the first draft was published in April, resulting in slightly less onerous capital requirements.
“There are a few amendments to the standard formula,” Mayer Brown senior associate Sarah Russell says, “but it still looks to us as though it’s worth insurers putting in place their own internal model for the SCR calculation.”
There was a violent reaction from the insurance industry around Europe when the initial calibrations were set for QIS5. Actuarial firm EMB estimated that, under the standard formula, capital requirements would go up by an average of 62%, proving a major burden for insurers. Bodies representing the industry lobbied the Committee of European Insurance and Occupational Pension Supervisors (Ceiops) and the European Commission to relax their stance.
The European Insurance Association published a paper in March titled ‘Why excessive capital requirements harm consumers, insurers and the economy’, which warned against a knee-jerk reaction to the financial crisis and pointed out that insurance companies have fundamentally different business models to banks.
“There is that concern that there’s a lot of political pressure to be seen to be doing things,” Mankabady says, “that insurers are getting the rough end of the stick and will end up being subject to regulation that isn’t relevant or appropriate.”
By levying insurers with an unfair capital burden, there is also a risk that available cover could tighten as insurance companies pull back from expensive lines of business. This could prove a detriment to policyholders, particularly if premiums go up as a result.
“If you have to hold that much capital, then you need to think about making sure you’re not writing lines of business that are no longer commercially viable for you,” Russell says. “So there may be some areas of business, especially on the life side, where policyholders are particularly adversely affected.”
Shunning the standard formula route in favour of developing an internal model is guaranteed to better reflect the risk profile of a company. But it is also a labour-intensive process. The FSA sent out a letter to insurers in February outlining the pre-application process for internal models. “The FSA’s resources are limited, so if you only start thinking about your internal model in November 2011 [when formal applications can be made], you’re definitely not going to be able to put it in place at the start of the new Solvency II regime,” Russell says.
Companies also need to be assessing their business models to see whether they have the right spread across different business classes. Under the internal model route, insurers with well-diversified portfolios should benefit from a diversification credit, as they will be required to hold less capital.
“Insurers need to work out if there are any lines of business they want to exit from, because maybe being in that line of business means they’re going to have to hold a disproportionate amount of capital,” Mankabady says. “The large diversified insurers are probably better placed in that sense; perhaps they are more capital efficient.”
Raise your game
The new regime is expected to be particularly tough for small monoline companies, mutual insurers and captives. There is a concern that these entities could see their capital requirements rise significantly under the standard formula, but that they lack the resources to develop their own internal models or even to seek partial model approval. How captives will be treated under the directive also remains subject to uncertainty.
But compliance with the new regime will prove costly for insurers of all shapes and sizes as they bring in resources to get up to speed with the regulation. Lloyd’s has estimated that Solvency II will cost the market around £50m this year and it is thought many firms have hired specialist lobbyists to represent their needs in Brussels.
“My feedback from clients is there’s suddenly been a realisation that this is just around the corner. They don’t like everything that’s been put forward and they need to do something about it now,” Russell says.
UK insurers are also keen to ensure that their requirements under Solvency II are not more burdensome under the FSA’s measures than for other European insurers. The UK has a history of gold-plating legislation, warns Mankabady. “It’s important to raise the game, but you don’t want to raise it to such a high level that the costs outweigh the benefits. That’s the fine line that’s got to be drawn. We tend to moan about EU directives but then we’re the first to implement them.”
The FSA’s uncertain future as its powers are handed over to the Bank of England is also cause for concern at a time when insurers are putting the finishing touches to their practice submissions for internal model approval. “We believe that the new government is unlikely to get rid of any substantial parts of the FSA, but problems still may occur as a result of the disruption,” Russell says.
As QIS5 gets under way, the general expectation is that capital charges will remain higher for many insurers. “To be fair, the various impact studies are just that,” Markel International’s head of capital and investment accounting, Denise Woods, says.
“They’re a means of Ceiops and the Commission testing the standard formula and of firms assessing the impact on their balance sheets and capital requirements. While it has been stated that it’s not the intention to increase the capital for the insurance industry, there is a fair amount of concern in the market as to where the calibrations will ultimately end up.”
Markel International’s director of risk management, Greg Shepherd, thinks the industry could see some consolidation as insurers get to grips with the requirements of Solvency II. “Some of the larger European entities have been used to using models within their business – the embedding and use test is much further on than some of the UK entities.
“But some of the smaller entities will find Solvency II difficult and I think there will be consolidation in Europe as some people struggle to find the resources to make Solvency II happen.”
In theory, the individual capital assessment (ICA) regime, introduced by the FSA as it waited for Europe to refine Solvency II, should give UK insurers something of a head start over their European counterparts. “Although under Solvency II you need to take ICA work a long way forward, it has enabled people to get used to the idea of modelling capital,” Shepherd explains.
Much of the current preparations for Solvency II continue to be focused on capital assessments, but details are emerging on how carriers will need to satisfy the directive’s other requirements, such as corporate governance and reporting. Some of the finer details will not be released until next year, leaving insurers with little time to prepare. As a result, many hope the deadline for Solvency II will be pushed back, although this now looks unlikely.
“I suspect that people will just make it happen and throw the necessary resources at it, but a deferral of any kind will be welcome to make sure that we’re able to meet all the requirements as best we can,” Shepherd says. “Until we have the final regulations released, there are uncertainties and ambiguities to deal with.”
“Having your capital directly linked with the risks you’re bearing is very much consistent with good risk management,” he continues. “But a challenge of Solvency II is that there is so much detail that you can end up getting absorbed in it rather than being able to stand back and think about sound risk management.” IT