Destined to be the blueprint for insurance regulation worldwide, the European Union’s (EU) Solvency II regime is tantalisingly near.
Implementation of sweeping changes across the EU’s 27 member states is set for 1 January 2014, but whether this deadline will be met is fraught with uncertainty.
“I can’t see implementation happening on time,” says Bob Haken, corporate and regulatory insurance partner at law firm Norton Rose.
A growing number of industry players agree that implementation is destined for delay – and not of insurers’ making.
“There is no appetite for delay among large insurers,” says Paul Clark, Solvency II global leader at PricewaterhouseCoopers (PwC).
“They have invested a lot in preparation.” In the UK alone, the Financial Services Authority (FSA) estimates that insurers have already spent £2bn ($3.1bn) on Solvency II.
Meeting the implementation deadline is now in the hands of the politicians. “If there is the political will, January 2014 will work,” says Naren Persad, a senior consultant at Towers Watson.
Whether that will is found in a process that has been beset by delays remains to be seen.
Following the EU Parliament’s adoption of the Solvency II Directive in April 2009, implementation of the regulatory regime was set for 31 October 2012.
“Things were then very much on track to meet that deadline,” says Persad.
Then came two politically driven changes: the Lisbon Treaty in December 2009 and the creation of the European Insurance and Occupational Pensions Authority (EIOPA) in January 2011.
Both required amendments to the directive and led to Solvency II’s implementation being pushed forward to January 2013 and, more recently, to January 2014.
To facilitate the amendments to the Solvency II directive, the European Commission (EC) published the Omnibus II directive in January 2011. Omnibus II is now the subject of a trialogue between the European Parliament, the EU Council of ministers and the EC.
“The trialogue must produce a compromise text on which the EU Parliament can vote on 15 September,” says Clark. “We should know the outcome by the end of June or early July.”
Persad comments: “The trialogue is a political process.” This is where the danger lies. There have been big political changes recently, not least a new government in France.
Gary Wells, a principal and consulting actuary at Milliman, says, “One also has to be sceptical about dates until we get a lot closer to a resolution of the euro crisis.”
“Change of political participation in the trialogue process runs the risk of already agreed-on matters being disputed,” says Clark.
“If Omnibus II is not voted on in September the January 2014 implementation of Solvency II is unlikely to be met.
Another voting slot would have to be found and that may not be easy.”
Even if the deadline is met, Persad believes there could be an amendment to the implementation process.
“We may see implementation phased in,” he says. In a similar vein, Haken says: “There’s a possibility Solvency II will be phased in over three to four years.”
A change of this nature would come as a relief to many insurers yet to fully get to grips with Solvency II. Rating agency Moody’s Investors Service noted in a recent study that phasing in Solvency II would benefit smaller, less prepared players but that larger, more sophisticated insurers already well prepared for the switch would lose a potential competitive advantage.
Change had to come
Delays were perhaps inevitable in what is arguably the most ambitious change in the history of insurance regulation.
Also inevitable was a radical revision of a regulatory regime largely unaltered since the early 1970s.
The existing Solvency I regime is focused primarily on insurance risk with a standard capital requirement applied to all insurers.
Regulators have a very much rule of thumb approach to imposing capital requirements, says Clark.
Another big shortcoming of Solvency I is that it does not include requirements for risk management and governance within insurance companies.
As a regulatory regime, Solvency I is clearly inadequate given the increased complexity of insurance markets and significant differences in the risk profiles of individual insurers.
Following a radically different approach to the current regime, Solvency II makes effective risk management the overriding objective.
Solvency II is based on three pillars: risk-based quantitative requirements; governance and supervision; and disclosure and transparency.
Pillar one has two elements, the first is a minimum capital requirement (MCR) that insurers will have to adhere to. The MCR is a minimum threshold below which insurers will be forced to cease trading.
The second element is the solvency capital requirement (SCR). This measures capital based on a one-year value-at-risk calculation of the market value of assets versus liabilities, at the 99.5% confidence level. If an insurer’s available capital is between the SCR and MCR, this will trigger regulators to take action.
Expressed another way, the SCR is a risk-based calculation aimed at ensuring that there is a less than one in 200 chance of an insurer’s capital being inadequate over a one-year time horizon.
When calculating their SCR, insurers have the option of using either the standard formula or an internal regulator-approved model.
The second pillar of Solvency II focuses on insurers’ risk management systems, supervision
of these systems and controls.
Included under pillar two is an insurer’s own risk and solvency assessment (ORSA) in which an
insurer assesses its capital requirements with reference to its risk profile and strategy.
The third pillar is devoted to ensuring effective disclosure by insurers’ of their financial standing, publicly and to regulators.
This includes governance, risk exposure and the methods used to value assets and liabilities.
The exact number of Europe’s 5,350 insurance companies that have opted either for the standard formula or an internal model is unknown.
But certainly few, if any, large insurers will have opted for the standard formula while all reinsurers will have gone the internal model route.
In the UK between 60 and 70 insurers have opted for internal models, says Wells.
The Association of British Insurers (ABI) has over 300 members. Solvency II’s impact on capital requirements using the standard formula has been subjected to five quantitative impact studies (QIS), the last and most significant, QIS5, run between August and November 2010.
According to EIOPA, almost 70% of insurers and reinsurers under the scope of Solvency II participated. This covered 85% of the industry based on premiums.
EIOPA reported that across participating companies there was a capital surplus of €395bn over the SCR and €676bn over the MCR. Compared to the calculation under Solvency I, insurance companies had a total of €86bn less surplus capital available.
This represented a 44% reduction. And not all insurers made the grade in QIS5 with 15% not meeting their SCRs and 9% falling short of their SCRs by 25% or more.
A number of insurers also used their prototype internal models during QIS5. According to Moody’s, those using an internal model to calculate their SCR showed a 6% increase in surplus capital when moving from Solvency I to Solvency II.
“This confirms our view that large, well-diversified groups with robust and entrenched risk-management and internal models are best placed to transition to Solvency II,” observed Moody’s.
For general insurers specifically the standard formulae can pose problems. “The one size fits all approach of the standard formula is in some areas not ideal for small and medium size general insurers,” says Wells.
“It is supposed to be typical of business written in the EU but errs on the side of prudence.”
For example, Wells says the loading for catastrophic risk can be very heavy depending on the type of business written.
In addition, large general insurers with a wide geographic footprint have the advantage of risk spreading not enjoyed by a smaller, localised insurer.
The benefits of scale and diversification have been assessed by consultancy Oliver Wyman and financial services company Morgan Stanley based on data from QIS5.
According to their analysis, diversification can reduce capital requirements under Solvency II by
25% to 30%. This, they noted, excludes geographic diversification benefits.
Their analysis also showed that composite insurers benefit the most in terms of reduced capital requirements thanks to the low correlation between their life and non-life risks.
The capital benefit of diversification to pure life and general insurers is about one third lower than that enjoyed by composite insurers.
Not surprisingly, Oliver Wyman and Morgan Stanley came to the conclusion that Solvency II will spark a significant increase in merger and acquisition activity in the insurance industry.
“Solvency II will accelerate consolidation,” says Persad. In the UK, he notes, consolidation has already been seen, driven by life insurance consolidation specialists Resolution Life and Phoenix Group.
“There has not been that much on the continent, but it will come,” he adds.
“Consolidation has been widely commented on but there has been only limited evidence of it occurring so far,” says Clark. “I think it will take some years to occur.”
A solution for the myriad of very small insurers in Europe could be a change in their models.
For example, Clark says their brand and distribution structure could remain in place, but the products they sell be underwritten by other insurers.
Paul Walsh, CEO of CUNA Mutual Europe, shares this view. He believes many insurers are likely to find the cost of governance under Solvency II beyond their means.
As a result, many will opt for white label products supplied by strong organisations and become distribution shop windows.
More than just solvency II
Though Solvency II is by far the most onerous regulatory change facing insurers in the EU, it is far from the only one. Also looming is a ruling by the European Court of Justice abolishing the use gender when assessing insurance risk. This takes effect on 21 December 2012.
The ABI warns that the gender ruling poses a major administrative burden on insurers.
Large-scale changes needed include amending all affected policy documents, contacting customers with new information, updating and changing computer systems, ensuring insurance brokers have the right pricing information and updating sales material.
While this impacts all insurers in the EU, for UK insurers it adds another burden at a time when they are in the final stages of preparing for the implementation of the FSA’s Retail Distribution Review (RDR) on 31 December 2012.
Implementation of the RDR will see commission on all investment products paid to advisers cease and be replaced by a fee-based remuneration structure.
Advisers will be obliged to tell consumers upfront how much their services cost and reach agreement on a fee. Consumers can also opt to have the cost deducted from their investment.
The implications of the RDR were well summed up in a recent study by Accenture:
“Once enacted, RDR will, at a stroke, remove commission as a competitive lever by which life insurers can control distribution,” noted the consultancy.
What the impact of the RDR will be on consumer attitudes is a matter of speculation.
But ominously, a survey of financial advisers conducted on behalf of Zurich Financial Services in late 2011 found that almost half fear that customers may not be prepared to pay a fee instead of commission for financial advice.
There is also uncertainty on how financial advisers will react with a number of studies pointing to a potential exodus from the industry.
“There were some dramatic projections,” says Towers Watson consultant Jeremy Forty. “That large numbers of advisers will exit altogether is now less of an issue, we believe.”
“We have not yet seen an exodus of financial advisers,” says Noleen John, a consultant at Norton Rose.
“With sales still commission driven this year many see a last-minute opportunity.” She adds that it is not certain if there will be a mass exodus of financial advisers when the RDR comes into force.
“But if there were I would be surprised,” she stresses.
Forty says that of most concern now is that financial advisers will migrate from smaller to large financial advisory firms.
“This could concentrate power in the hands of large advisory firms and limit life companies’ route to market,” he says. Also looming for insurers across Europe is the International Financial Reporting Standard (IFRS) for financial instruments.
At present, European insurers use International Accounting Standard 39 for financial instruments introduced in 2004.
This is to be replaced by IFRS 9 for financial instruments. In December 2011 the International Accounting Standards Board deferred the mandatory date for the use of IFRS9 from January 2013 to January 2015.
That European insurers are suffering from regulatory overload was highlighted by PwC’s Insurance Banana Skins 2011 survey. From 26 possible risks to select from, insurers in all categories selected regulatory change as their top concern. This was followed by capital requirements.
Among groups participating in the survey there was one exception, regulators, although they still ranked regulatory change as the eighth-biggest risk.
Regulators’ top concerns were retail sales practices, capital and solvency and the quality of the insurance industry’s assessment of risk.
The study’s authors noted that regulators clearly expect some consolidation in the industry since they are also concerned about the management of mergers.
The study said: “The sheer volume and complexity of new regulations now flowing at three levels – international, regional and local – imposes a heavy cost and distraction on insurance companies at a time when capital and management are already tightly stretched.”
The authors added that as a result of increased regulatory burden there has been a diversion of talent to managing regulatory risk, “potentially to the detriment of oversight of the commercial challenges”.