Refining the model

The year 2012 is going to be a great time indeed. It will be the year of the dragon, a sign revered for its good fortune and intense power in the lunar calendar; there is the London Olympics and, after a two-year delay, Solvency II is expected to finally kick in.

Solvency II is a proposed directive for insurers covering the capital requirements and regulatory supervision. It relates to the amount of capital an insurance company is obliged to hold against unforeseen circumstances, measured against the risks the company faces. This will ensure that insurers are financially sound and can withstand adverse events, and that policyholders will be protected.

The previous EU solvency rules are over 30 years old and no longer accurately reflect the insurance industry and its regulation today. Many of the 27 member states have introduced their own rules at a national level, leading to a range of regulatory requirements across the EU, undermining the single market.

Solvency II will replace this patchwork of different rules, ensuring a level playing field and a uniform level of consumer protection.

Those involved are the European Commission, the Committee of European Insurance and Occupations Pension Scheme Supervisors and the FSA. Some 500 insurance companies around the UK will be affected.

Three pillars

There are three pillars which cover the issues of internal risk and capital assessment, qualitative review and external disclosure, which are based on the banking industry’s Basel II.

Pillar 1 defines the financial resources a company needs to hold to be solvent. This is determined by the solvency capital requirement (SCR) and the minimum capital requirement (MCR).

Pillar 2 details the framework of supervisory control, focusing attention on internal risk management processes and aspects of operational risk

Pillar 3 is about disclosing transparent information for stakeholders and customers.

The most obvious difference for UK insurers is Pillar 3 which requires public disclosure around capital holding.

Rick Lester, insurance partner at Deloitte, says: “Some insurers who particularly operate at a more advanced level may take advantage to differentiate themselves and gain first mover advantage.”

Insurance companies will be able to choose whether they want to determine the SCR by means of a standard formula or on the basis of an internal model.

Supervisory action will be triggered (based on rules to be defined under Pillar II) if a company’s resources fall below the SCR level.

Generally speaking, an internal model provides a much more accurate reflection of the risk situation and of the effects that risk transfer measures may have. The more accurately a model represents the actual risk position, the easier it will be to ensure optimal use of capital and effective management of a company.

The lowest threshold, the minimum capital requirement will define the level at which the supervisory authority can invoke severe measures, including closure of the company to new business.

Insurers will be required to focus on identifying, measuring and managing risks. They will also have to take into account new business plans and possible future catastrophes that might affect their financial standing.

Teddy Nyahasha, head of group solvency at Norwich Union, points out that many players have been implementing internal models over the past five to 10 years.

Citing Aviva as an example, Nyahasha explains: “Aviva began doing so in 2003, and used its existing internal model to cede into the FSA’s individual capacity adequacy standards (ICAS) regime, which had a similar capital requirement.”

Some tweaking

“One of the key defining principles of Solvency II is to take a risk based approach to capital adequacy

Mark Train, PricewaterhouseCoopers

He adds: “From our point of view, the actual concept of the risk-based capital model is something we’ve prepared for ahead of Solvency II. Looking at what we have already and what’s come out of the draft directive [Framework Directive Proposal, 10 July] we know there will be some tweaking although it is still early days.

“It is fair to say that it [Solvency II] is a fairly industrial and solid process and is constantly evolving. We are at the stage where we just had the first directive set out, which consists of high level guiding principles that are very broad,” says Nyahasha.

Yvonne Braun, assistant director of financial regulation at the ABI, cautions that it will be by no means a ‘tweaking’ exercise. “There is no room for complacency. Small insurers will have to engage strongly. ICAS has models but no model approval process. Under Solvency II, insurers will have to put their models to the FSA and detail how it will be used in business.”

Solvency II is expected to be implemented at a cost of £2bn.

Will smaller companies lose out in trying to comply with the new regime?

Big companies and multinationals have the resources to understand what this regime is all about and have followed it closely. On the other hand smaller companies haven’t had the resources to follow the proceedings and must now try to invest and climb up the learning curve.

Mark Train, partner at PricewaterhouseCoopers, says: “They [smaller companies] will have the option of applying the standard formula but by doing so may not be optimising their capital position.

“One of the key defining principles of Solvency II is to take a risk-based approach to capital adequacy. A standard formula will never reflect the actual risks as well as a company’s own internal model.”

Braun alludes that the standard and internal models are now in the process of being calibrated so that no company will be at a disadvantage.

“Capital is not everything,” says Train. “A niche player that understands its product and its corresponding risks better might override the fact that it is not benefiting from diversification.”

Train cautions that companies that are small and do not have a niche product and therefore lack detailed understanding of the risks, could potentially lose out.

Andreas Grünbichler, Zurich Group’s chief risk officer, says: “Insurers that manage their risks well – because they have rigorous policies, use appropriate risk-mitigation techniques, or diversify their activities – will be rewarded more freedom and permitted to hold less capital.

“On the other hand, poorly managed insurers, or insurers with a higher risk appetite, will be asked to hold more capital in order to ensure that policyholder claims will be met when they fall due.”

Solvency II will not apply to companies with an annual premium income of less than €5m, as stated in Article 4(1) of the draft directive.

Risk concentration

A group supervisor will be responsible for key issues like group solvency, intra-group transactions, risk concentration, risk management and internal control, to be exercised in cooperation and consultation with local supervisors.

As for group entities situated in non-EU member states, Braun explains: “Article 272 in the draft directive applies: a parent undertaking situated outside the EU will only benefit from the directive’s group regime (in particular group support) if the parent undertaking is subject to a supervisory regime which is equivalent to the EU regime.”

Word on the street is there will be a slew of consolidations taking place.

Some insurers have disagreed with this. Rick Lester, insurance partner at Deloitte points out that consolidation has already taken place but there is still plenty more to go.

Lester says: “Consolidation is not solely driven by Solvency II but the latter is a contributing factor. In continental Europe there are 4,500 – 5,000 insurers, some are small organisations which at present are not operating under risk capital sensitive regime. It will not be economically viable for them to hold such high levels of capital. They will either need additional capital or be forced to merge.” IT