The FSA is moving fast to implement solvency regulations for insurance companies, but Marie-Louise Rossi says the system should be fair and workable

Three years ago, at the International Underwriting Association seminar in Stockholm, delegates were urged to prepare for the coming convergence of insurance, reinsurance and banking regulation. The alert - from the vice-president of the International Association of Insurance Supervisors - seemed to many at the time to be a rather remote, theoretical possibility.

Yet here we are in 2002 and the Financial Services Authority's (FSA) new solvency regulations, due to be implemented at the end of 2004, represent a practical manifestation of the new regime.

In effect, the FSA has looked at how solvency is assessed among the banking and insurance industries and decided that it prefers the risk-based approach that bankers have been using in recent years. The implications for insurers are far-reaching. Although they affect companies regulated by the FSA, the European Commission's own review known as Solvency II is likely to move European-wide regulation in very much the same direction.

The details of the FSA's new approach are still being formulated, but much is already known. Insurers will be required to demonstrate that they understand their assets and exposures and how they would react given the full range of scenarios for which they can reasonably be expected to prepare. This will involve the use of financial models to calculate their solvency requirements. Creating these models is a complex exercise, and for some it is quite a challenge to meet the 2004 deadline.

Capital level
It may also force insurers and reinsurers to rethink their assumptions about capital adequacy. A recent consultation paper on individual capital standards sets out the rationale for applying an "internal capital assessment" and a "supplementary capital assessment".

In so doing it establishes a new principle for both insurers and many securities firms in that the regulator can require a level of capital that is significantly higher than would previously have applied. It offers assurances that such an approach will not necessarily increase the "actual" amount of capital in the industry overall, but individual firms may find that the new rules have affected them quite dramatically.

In fact, the FSA proposals are ahead of the commission's Solvency II timetable. A draft paper is expected from the commission at the end of this year, with a view to implementation in 2006 at the earliest. The FSA has admitted that it will have to review its own regulations if they are significantly out of line with the eventual approach of the commission.

Like the FSA, the commission is expected to require risk models for the calculation of solvency levels. For those insurers and reinsurers able to implement models across part of their entire book, there should be capital savings and tighter product pricing. Such a development would tend to favour the more sophisticated companies over time and would help the transfer of risk between insurance, reinsurance, investment management and banking.

Business benefits
While happy to support the aims of the commission and the FSA, the UK insurance industry and the London Market are seeking to ensure that implementation is pragmatic, fair and workable. For many, the issue is how far model parameters can be designed such that supervisors can have confidence in them for prudential purposes; and whether or not firms can generate real business benefits from using them.

If the recent past is any guide, there are many more changes for insurers in the pipeline, indicating a continuing need for vigilance. As the borderland between banking and insurance becomes ever bigger, we can expect still more convergence of regulatory regimes.