Opinion - George M Mangion | Wednesday, 26 September 2007

Insurance industry welcomes Solvency 11

It has only been a few weeks since the Draft Solvency II Framework Directive was published by the European Commission on 10th July. It lays out a new framework of capital requirements and promotes transparency and tougher risk management among insurers across European Union member states. The new solvency provisions are principles based and follow the 4 level structure of the Lamfalussy financial services architecture. The new Lamfalussy architecture will enable the new solvency regime to keep pace with future market and technological developments as well as international developments in accounting and (re)insurance regulation. Yet there is more work to be done and it is expected that the implementation date for Solvency II be delayed to 1 November 2012 with the expectation that implementing measures will be agreed in 2010.
This directive has arrived amid a lot of speculation and trepidation particularly among the smaller insurance companies. With over 5,000 insurance firms operating across the EU, there is an enormous diversity in terms of size and nature of operations across different insurers. Solvency II must be calculated to ensure that this diversity is recognised and those small firms providing specialised products or serving particular local market needs are accommodated within the new framework. It comes as a relief that the current exemptions under Solvency I for the smallest insurers are expected to be carried over to Solvency II, meaning that the existing, local arrangements for the supervision of the smallest entities can continue under
Solvency II. The adoption of a ‘standard approach’ for the calculation of the ‘Solvency Capital Requirement ‘ will also facilitate matters for small companies without their own models to undertake the required solvency calculations using more elementary data which they will already have available. It goes without saying that niche players and those with a higher risk profile seem likely to lose out due to its strict rules. The draft directive poses an enigma as can be better explained by views of the Association of British Insurers( ABI ) . At a joint conference with representatives from the UK government, the Financial Services Authority (FSA) and the industry ABI said the project should be radical but proportionate. Opening the conference Stephen Haddrill, director general of the ABI, said the project is currently “pulled in two directions” between those that say the existing regime needs little change and are wary of the costs of a major overhaul and between those that argue current solvency laws are outdated and need complete transformation to keep up to speed with the industry. Let us see the reaction from the accountancy sector amid the necessary interaction between IFRS and Solvency II directive.
Deloitte the accountancy firm has been cautious on its cost of implementation. Rick Lester, insurance partner at Deloitte, warned : “Solvency II will be a significant step-change for many jurisdictions and the cost of compliance for insurers is likely to be high with the costs in the UK running into hundreds of millions of pounds.”
Munich Re’s chief financial officer Jörg Schneider said that greater account of the balancing effects of different types of risk and to structure group supervision even more effectively were needed. He added that the consequences for reinsurance of the new regulation would be far-reaching.
It is wide in scope. Suffice to say that it involves regulators from all EU countries plus Switzerland, Norway, Liechtenstein and Iceland. Furthermore, a growing number of regulators outside the EU, such as Australia, South Africa and some Asian countries, have already moved or are moving in the same direction. This may affect any company with international interests outside Europe. It is opportune to quote Mr Charlie McCreevy, Internal Market and Services Commissioner. He recently remarked that : “This is an ambitious proposal that will completely overhaul the way we ensure the financial soundness of our insurers. We are setting a world leading standard that requires insurers to focus on managing all the risks they face and enables them to operate much more efficiently. It is good news for consumers, for the insurance industry and for the EU economy as a whole.” Most accountancy firms have welcomed the publication of a draft directive by the European Commission outlining the future of insurance regulation in Europe.
Starting with Annette Olesen, a director at PricewaterhouseCoopers she said Solvency II’s drive towards a European Single Market for insurance was a welcome move from the “patchwork” of insurance regulation across EU countries.
She exclaims that “While it presents a significant implementation challenge, the move to Solvency II provides an opportunity for a more informed and forward-looking basis for decision making and could lead to significant changes in the shape of the market in the EU,” she said. KPMG welcomed the announcement but warned the transfer to the new regime would bring winners and losers. Ernst & Young welcomes the publication of the draft directives for Solvency II, which should ultimately lead to a more efficient European insurance market that would better serve the needs of both policyholders and shareholders .
There was a positive reaction from the actuarial sector. Here we mention the favourable remarks by Steve Taylor-Gooby, managing director of actuarial firm Tillinghast.
He exclaimed that : “If successfully implemented, the new regime will lead to more efficient capital allocation across the industry, giving consumers better protection against insurance company failures. It will also create a common standard across Europe, encouraging more competition and ultimately lower prices.”
Let us consider its implementation is greater detail. Here we note that Solvency II will result in much greater emphasis being placed on sound risk management and robust internal controls. The responsibility for an insurers’ financial soundness will be pushed back firmly to its management, where it belongs. Insurers will be given more freedom i.e. they will be required to meet sound principles rather than arbitrary rules. Regulatory requirements and industry practice will be aligned and insurers will be rewarded for introducing risk and capital management systems that best fit their needs and overall risk profile.
In return, they will be subject to strengthened supervisory review. The new regime will also enhance transparency and public disclosure. Supervision shall be based on a prospective and risk-oriented approach. The new regime relies on sound economic principles and make optimal use of the information provided by financial markets.
Importance is therefore attached to the principle of proportionality, which applies to all requirements of this Directive but which is particularly relevant for the application of the quantitative and qualitative requirements of the solvency regime and the rules on supervision.
But the most feared element is the rule that expects insurers to conduct own financial modeling tests.
The paradigm way to produce financial models for insurance and reinsurance companies is through what is known as ‘stochastic’ analysis. This type of model enables you to test the financial robustness of your organization in any number of imaginary but possible situations, taking into account such factors as exceptional loss experience across a wide range of lines, stock market failure and reinsurance default. As can be expected in practice a lot of senior insurance executives find stochastic modelling such a daunting prospect that they put off taking action. Yet it is to be encouraged as the benefits far outweigh the costs. Companies are advised to start in a small way by creating a few simple models and then becoming more ambitious as you grow in confidence and knowledge.
Although it can eventually become highly technical, it is fundamentally a part of an organisation’s risk management process. Solvency II is a big investment and it is advisable to use it to improve the business, as well as meeting regulatory requirements.
Having a small core team will avoid over-committing too early and give flexibility as the programme progresses. It seems that there will be more winners than losers but the industry has to start preparing itself well in advance to meet the challenges ahead.

George M. Mangion
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