Part two of a three-part series that looks at the challenges facing insurance companies. This week, Michael Faulkner reports on insurers’ preparations for Solvency II, the tough new EU capital regime.
The burden of regulation on insurers is growing. Whether from the FSA or European regulations, the pressure on insurers to comply with an ever-expanding regulatory regime continues to build.
European insurers are currently facing their biggest regulatory challenge in the past 30 years. Solvency II will dramatically shake up the rules on the amount of capital that insurers must hold.
Colin Rawlings a partner at Deloitte says Solvency II is the key regulatory issue for UK insurers. “Insurers have broken the back of FSA regulation. The issue [now] is Solvency II.”
ABI director general Stephen Haddrill has described the Solvency II regime as “the most significant change to insurance regulation in a generation”.
Although Solvency II is not due to come into effect until 2012, insurers are already grappling with the preparations for implementing the new rules.
Experts have predicted that it will cost the European insurance industry hundreds of millions of pounds to implement. The FSA estimates the implementation costs for UK insurers alone will be over £60m.
Solvency II aims to create a Europe-wide regime that determines the amount of capital an insurer must hold based on the inherent risk that the company faces. It is an attempt to harmonise the insurer solvency requirements across Europe, replacing a patchwork of local regulations.
The fine details are currently being thrashed out in the European Parliament, but many insurers are preparing for the new regime. Companies have been urged to participate in an exercise, called a quantitative impact study – the fourth of such studies – that will assist in their preparatory work.
UK insurers have a distinct advantage over their European peers owing to the fact that the FSA capital adequacy regime already incorporates many of the principles of Solvency II.
The proposals – a high level framework was published last year – have been broadly welcomed by the insurance industry, the FSA and politicians.
Last year, Aviva group finance director Philip Scott said Solvency II was a “unique opportunity to create a modern, future-proof insurance supervision framework”, while Munich Re described the proposed regime as a huge step forward for insurers. And earlier this year the House of Lords said Solvency II would give fresh impetus to the European insurance industry.
But despite the broad support for the proposals there are still some concerns, not least that the proposals could see the capital burden on insurers increase and stifle growth. Some experts have warned that increased capital requirements will discourage investment in new insurance companies and could also depress the price of existing insurers.
And there look to be some sticky technical and political issues that need to be overcome as the negotiations over the fine detail take place over the next 18 months.
Insurance Times spoke to four experts on Solvency II – two consultants and two insurers – about the challenges of the new regime.
Consultant. Omar Ripon, senior manager, Deloitte Ripon
Ripon says UK insurers are ahead of their European counterparts because of the the FSA solvency regime. “The UK is ahead as it has the ICAS [individual capital assessment] risk-based regime which contains much of Solvency II. The ICAS regime has most of [Solvency II’s] Pillar 1 and some of Pillar 2,” he says.
Pillar 1 is the quantitative assessment of asset management that sets out a valuation standard for liabilities to policyholders and the capital requirements firms will be required to meet for insurance, credit, market and operational risk. Pillar 2 is the supervisory review process that focuses on evaluating the adequacy of capital and risk management systems and processes.
However, Ripon says that because of the work insurers have done towards ICAS, there is some apathy towards preparing for the new regime. This has been seen by the lower than expected response rate to the latest quantitative impact study.
He highlights two main boiling points for insurers as the fine details are developed. The first relates to the disclosure of information relating to risk and capital levels (known as the Pillar 3 requirements). “There are concerns about disclosing potentially sensitive information, ” Ripon says.
He adds that good companies will want to disclose more information and that increased transparency is good for the insurance industry. “Some companies will use it to show strategy; they will use it as a platform,” he says.
Another area of controversy relates to the treatment of insurance groups and the relationship between the local regulators of subsidiary companies and the regulator of the group company.
Ripon says that Solvency II could encourage acquisition activity. “Companies that are weaker in terms of capital may become targets. Those with strong capital will be rewarded. There will be an advantage for UK companies going into Europe.”
Consultant. Annette Olesen, director PricewaterhouseCoopers
Insurers can choose to develop an internal model for Solvency II. Olesen says that despite the fact that many UK insurers will have developed models to meet the FSA’s capital assessment regime, Solvency II imposes substantial additional requirements.
“Solvency II will make the industry more transparent and may accelerate the pace of consolidation.
Teddy Nyahasha, Aviva
“Under Solvency II, if an insurer wants to use a model, there are tough requirements on terms to validate the model before it will be approved by the supervisor. They need to show that the model is correct, appropriate and used for decision making. Senior managers need to understand the numbers that are coming out of the models, in order to challenge, trust and ultimately rely on them for a strategic risk decision,” Olesen says.
Insurers can choose between using a standard formula or an internal model. There might be capital advantages to using an internal model
In relation to Solvency II’s disclosure requirements, which have yet to be finalised, Olesen says insurers could be struggle with the new regime. “The devil will be in the detail, but the volume of information will most likely be extensive. It could stretch data and processes. At the moment the high level requirements appear reasonable.”
She adds that companies will need to disclose if they fall below the regulatory capital, which is not the case at present.
On the question of the treatment of insurance groups, which is being hotly debated, Olesen says: “The proposals could see groups benefit from lower capital requirements because of their diversification. The debate at the moment is focused on how the group support regime will allow individual group entities to benefit from the overall lower capital requirements. The powers of the local regulator of a group subsidiary are also being debated.”
Olesen argues that insurers need to take a step back and look at their approach to Solvency II. “Are they interested in just compliance or are they looking to take the opportunity to introduce an effective enterprise risk management, managing the risks that could affect the balance sheet?”
Are UK insurers on top of preparing for Solvency II? “They are split; some are engaged and aware, others are waiting for the directive to be finalised this year.”
Olesen says that Solvency II could lead to some consolidation among insurers, and increasingly some companies are reconsidering their group structiures.
Overall, she says that big insurance groups are likely to benefit the most from the regime if they enjoy lower capital requirement due to their size and diversity.
The smaller insurers could fall outside the scope of the rules or receive a lighter-touch approach on the ground of proportionality. The medium size insurers are likely to be the most challenged by Solvency II, she argues.
Insurer. Teddy Nyahasha, head of group solvency, Aviva
“We are still on a journey in terms of the final rules, but we are cautiously optimistic. There is a tendency on the part of companies to focus on the quantitative elements of Solvency II, but we are looking at all aspects of our risk management. We have experience from ICAS and are already investing more widely in our own internal management model and enterprise risk management processes.”
Nyahasha says the main challenges to date have been in relation to the discussions around the rules themselves. “It is difficult to plan for our future investment until we know what the final rules are.”
Solvency II will not necessarily lead to more acquisition activity, he says.
“Consolidation is happening already, driven by economic factors. Solvency II will make the industry more transparent and therefore may accelerate the pace of consolidation that is inevitable over time.”
He says that ultimately the new regime will bring fairer pricing for insurance customers.”Solvency II should enable us to align our product pricing more closely with individual risk profiles of our customers.”
Insurer. Ian Holloway, head of compliance, AXA
“It is a welcome move. On the whole Solvency II is good for insurers. It is still relatively subjective, but less so than the historic position. It gives us more flexibility in the market,” he says.
“There has been a volume of change on the prudential side recently, such as Sarbanes-Oxley and the FSA reforms around systems and controls. It would be good to have had a more co-ordinated approach, but that is wishing for too much.
“I don’t see much change in the UK market [following Solvency II] as insurers have been reasonably well capitalised.
Holloway does have some concerns cost of implementation. “If you look at the changes, I would like to see more careful cost benefit analysis. I see costs going up.”
He highlights the new disclosure requirements. “I don’t see protection for anyone increased by greater disclosure.”
Holloway concludes: “I see Solvency II a journey rather than a landing point. It is not the last thing in this area that we will see.”