Paul Barrett says time is running out to approve the European directive on capital requirements. The industry has to take action

The proposed European directive, Solvency II, is designed to substantially modernise the regulatory regime and capital requirements for insurers on a consistent basis across the European Union. It also introduces big changes to the use of internal models; risk management, systems and controls; reporting to supervisors and public disclosure; supervision of groups; treatment of risk-transfer and reinsurance; and recognition/equivalence for third-country regimes.

So it’s quite a substantial package. The current plan is for implementation from 31 October 2012, although insurers and supervisors still have a huge amount of preparation to do. For those planning to use internal models, the FSA has set initial target dates in the first half of this year. However, we have not yet reached final agreement on the directive text itself, although there is a good chance that this may happen in the next couple of months. Once the directive has been agreed (this is “level 1”) the implementation measures (“level 2”) can be developed.

The European commission published its first text in July 2007 and, by October 2008, the European parliament had voted broadly in support of the commission’s proposals. This text is strongly supported by the ABI and the European insurance industry. However, discussions in the European council – which represents the governments of each of the 27 member states, who must also approve the directive – have been more difficult.

A minority led by Spain and Poland have opposed proposals for a radical overhaul of group supervision, which would allow group capital structures and diversification effects to be properly recognised using “group support” as a capital instrument.

Instead, such countries prefer to look back towards solo supervision and solo capital requirements. This runs contrary to the intention of the single market and undermines one of the key proposals of Solvency II. This group has been effective in marking out its position as a blocking minority under EU rules, however.

Recent events in the financial markets have made governments and supervisors more cautious. This means we are likely to get a compromise. Although the details will be crucial, as Solvency II offers many advantages, it is not a deal to be done at any price.

There is also an issue over the treatment of equity risk and asset risks more generally. While the specifics tend to affect life insurers more than non-life companies, this has been a major roadblock in the negotiations.

The French have been pressing for a liberal approach to equity risk but they have failed to produce any detailed proposals, nor have they been able to satisfactorily answer the genuine concerns raised by supervisors across Europe. This intransigence had serious consequences for the negotiations on Solvency II in the second half of last year, since France held the EU presidency and controlled the drafting and amendment process for the council.

The Czech Republic assumed the presidency on 1 January, however, and we are hopeful that it will adopt a more conventional negotiating style, enabling a sensible compromise to be reached.

If Solvency II is to remain on track, a deal must be reached that the council and the European parliament can accept before May 2009, when the parliament will be dissolved for elections.

If a deal is not reached by then, Solvency II is likely to be delayed by at least a year.

The FSA has run qualitative impact studies to calculate possible changes in a firm’s capital reserve under Solvency II, and the latest (known as QIS4) shows Solvency II will be a significant step forward for insurers’ solvency. The study covered 88% of the non-life companies represented by market share. Eleven small, 29 medium-sized and 20 large firms took part.

We remain hopeful that a deal will be reached before May, with consultation on the detailed implementation measures expected to follow almost immediately if the directive is approved. Provided key elements such as group supervision and group support are not undermined, and the robustness of the capital calculations are adhered to, Solvency II will allow insurers to remain resilient even in difficult times.

If you would like to learn more, please take a look at our website at abi.org.uk/solvency

Paul Barrett is assistant director of financial regulation at the ABI