All accord?

Time is running out for the insurance and reinsurance market to shape the key principles that will underpin the Solvency II regime. Although it is not expected to become law for EU member states until 2010, there is a first draft of the Solvency II directive due out this summer.

Solvency II is part of the plan to create an integrated EU financial services market. Its key objectives are to create a more level playing field for (re)insurers and for there to be a minimum level of harmonisation.

The main thrust of Solvency II is to better match the capital regulatory requirements of a (re)insurer to its risk. Put simply, the more risk (market, credit, underwriting, operational etc) that a (re)insurer has in respect of its business, the more capital it will need to support its underwriting obligations and, as a result, better protect its policyholders.

Solvency II is focused on the overall financial position of a (re)insurer and is much wider in scope than Solvency I, which was introduced in 2004. This regime is focused on the solvency margin only (ie in general terms, the difference between a (re)insurer’s assets and liabilities).

Solvency II coverage
There are three main areas covered by Solvency II. These areas are known as pillars.

Pillar 1 deals with the basis of calculation of assets and liabilities (on a market to market basis) and, in very broad terms, provides for there to be a solvency capital requirement (calculated by reference to a standard formula or an internal model) that is designed to act as a buffer against unforeseen losses and which is subject to a minimum capital requirement floor. This floor is calculated by determining the relevant (re)insurer’s best estimate of its exposure to potential claims and losses (its ‘technical provisions’) and then adding a risk margin (for unhedgeable risks) by way of an additional cushion.

Pillar 2 deals with individual risk and capital assessment. This in turn is subject to supervisory review and possible regulatory action. Should a regulator take the view that a (re)insurer requires additional capital over and above its solvency capital requirement, then it may impose, for example, a capital add-on upon that (re)insurer. Incidentally, what is not clear is whether a regulator will be able to impose such an add-on in limited circumstances only, or if this will be another tool in the regulator’s toolkit to be used when it sees fit.

Finally, Pillar 3 deals with the requirement to report to the relevant supervisor on a regular and consistent basis in order to assist the supervisor in making an assessment of a (re)insurer’s capital needs. In this respect a close eye will need to be kept on the content of the International Financial Reporting Standards to ensure that there is not too much divergence between these standards and Solvency II’s reporting requirements.

Potential areas of conflict
With an initiative as wide-ranging as Solvency II, there will inevitably be many issues (some of principle, some of detail) on which there is no broad consensus. It is worth highlighting three such issues.

First, in the case of an EU group of insurance companies, different EU regulators could have responsibility for supervising the companies in that group. This will inevitably require coordination and it remains to be seen how this will be achieved. One concern is that there could be an unlevel playing field if the regulators were to interpret the rules in different ways or if the rules were implemented in different ways at a national level.

One way forward may be to have a lead supervisor based in the jurisdiction in which the group has its head office, with the other relevant regulators being local supervisors. A related issue concerns how much capital must be held in each group company and, where there are for example any diversification benefits, working out how any resultant reduction in capital is to be held.

Second, a great deal of focus to date has been on Pillar I. However, arguably greater focus should be placed on Pillar 2, which is designed to encourage stronger risk management. After all, the key thrust of Solvency II is to better align capital with risk. In order to manage risk effectively it will be critical for a (re)insurer to determine its risk appetite. This will better enable a (re)insurer to determine which risks it will be prepared to swallow and which it will not be prepared to swallow, and which it will try to mitigate or extinguish altogether.

Clear management information will need to be generated in respect of these risks and this will need to be disseminated to the key decision-makers so that it can be taken into account by them – in this way, decisions can be made on an informed risk/reward basis. Finally, checks and balances will need to be built in to the process, such as a regular review by an independent oversight function (for example by internal audit or a risk committee).

Third, it is likely that Solvency II will impact the most on the smallest (re)insurers. This could result in real financial strain for the very smallest undertakings. Thought will need to be given as to whether these (re)insurers should be exempt from some of the rules.

Solvency II in practice
There will be roadblocks along the way to Solvency II, but what will the final destination look like? It is anyone’s guess, but we can look at the possibilities.

Some (re)insurers will be required to increase their capital. This is more likely to be among the smallest (re)insurers.

Solvency II may also prompt (re)insurers to take a closer look at their business models, and some may decide, for example, that certain lines of business increase their risk profile too much and are not worth pursuing anymore. Others may retain their product lines but may review and amend the pricing and/or design of some of these products.

It is unlikely that there will be a wave of consolidation following the introduction of Solvency II. However, the impact and implications of Solvency II will be another factor to be taken into account when framing a consolidation strategy.

Finally, the biggest impact is likely to be the cultural change that many (re)insurers will have to undergo. In order to ensure the most efficient use of capital, (re)insurers will need to embed deeply a risk management culture and put risk management at the heart of what they do on a daily basis. Risk management can no longer be a mere box-ticking exercise.

In very broad terms, Solvency II is welcome. There is widespread agreement that the current EU solvency regime is outdated and in need of overhauling, but precisely how this is to be achieved is still a matter for debate. It is still not too late for the market to have its voice heard – but the time to speak up is now.

Martin Mankabady is a partner at Lawrence Graham