Solvency II is on its way and, despite its challenges, the effort should be worth it
The deadline for Solvency II is less than three years away, and represents a major overhaul of the existing supervisory system. There are concerns that in the current climate insurers could do without another layer of regulation – particularly considering that Basel II, a similar set of rules for the banks, failed to prevent financial catastrophe. Nevertheless, Solvency II is going ahead, so the best companies will get on board early and design programmes that deliver business benefits, not just compliance.
One of the main challenges is that insurers are required to develop their plans while the details of the new framework are still being ironed out. The high-level principles have been agreed, but there are over a thousand pages of consultation that need to be factored into planning.
Solvency II seeks to embed risk management into the culture of the organisation by including measures to ensure that companies are using risk information in the day-to-day management of their business. Solvency II delivery teams will probably have to overcome significant resistance to change internally. Do not underestimate the cultural challenge.
Designing Solvency II internal models is a huge undertaking. After the models are built, they need to be consistently re-evaluated as the business and markets evolve. To do so, the modelling team may have to grow. With a limited pool of talent out there, some companies will face problems locking in the required risk management and actuarial resources, as well as training management on the implications of the new regime.
Risk-based solvency requirements are at the heart of Solvency II. Insurers are required to hold capital commensurate with a range of risks. If a company’s risk management controls are good enough, they may be able to convince the regulator that they don't need to hold onto as much capital as their competitors. Companies are expected to report on the efficacy of their internal systems and controls. Insurers can win the confidence of the authorities if they convince them that they understand the strengths and limitations of their own risk systems.
Companies should update business processes and make sure data is complete, accurate and appropriate. They have to demonstrate good documentation and a clear understanding of their own internal models. With accurate data, insurers will be able to calculate capital requirements and price their products more competitively. Compared with their European counterparts, UK insurers are generally a step further down the Solvency II road as most of them already use internal capital assessment models. UK companies may be able to steal a march on their continental competitors, who will have more work to do to overhaul their internal models.
The opportunity to improve professionalism, make business processes cleaner, faster and manage risks better should be warmly welcomed. Further, demonstrating risk management robustness will become increasingly important for insurers as credit ratings become more tightly linked to the sophistication and effectiveness of their risk management capabilities.
So will it be worth the effort? One of the main problems with Basel II was that banks went into it with the wrong attitude. Instead of asking how it could help improve their business, many of them simply looked for ways to reduce their capital requirements. Solvency II is about better risk management and, while the transition will be painful, ultimately it should help raise standards across the industry.
- Do not underestimate the time and resources it takes to overhaul internal models and embed a culture of risk management
- Companies that have good risk management controls and the confidence of the regulator, will have less stringent capital requirements
- Most UK insurers, which already use internal capital assessment models, may have the advantage over their European counterparts
- We should welcome the opportunity to improve professionalism and make business processes cleaner and faster