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September 14, 2009updated 13 Apr 2017 8:55am

The compliance modelling challenge

Work on the Solvency II compliance modelling needed to ensure stages are ready for implementation by 31 October 2012 is proceeding at a frenetic pace. Jeremy Woolfe looks behind the scenes of what is, for insurers, an extremely costly and complex implementation process.

By Jeremy Woolfe

Work on the Solvency II compliance modelling needed to ensure stages are ready for implementation by 31 October 2012 is proceeding at a frenetic pace. Jeremy Woolfe looks behind the scenes of what is, for insurers, an extremely costly and complex implementation process.

Solvency II Framework Directive, which cleared through the European Parliament in April this year with an 87 percent majority, addresses risk management, as well as market transparency and guidelines for disclosure to regulatory authorities.

Under it, insurers are having to boost up their quantitative and qualitative risk management systems, or possibly face having their licenses revoked by regulators, explained Jürgen Weiss, principal research analyst at technology consultancy Gartner.

Weiss is obviously aware of the sentiment expressed by Member of the European Parliament Peter Skinner, who was responsible for nursing the directive through to conclusion. In Skinner’s words the Solvency II legislation “shifts the focus of supervisory authorities from merely checking compliance with a tick-the-box approach based on a set of rules to more pro-actively supervising the risk management of individual companies based on a set of principles”.

Weiss observes that the directive impacts most heavily on the life insurance sector, because its principles-based rules are designed to mitigate risks involved in investments. Capital reserves aspects dominate in the industry’s “long tail” sectors, and play only a small role in such sectors as motor insurance.

Notably, total investment by life insurance member companies of the industry federation, the Comité Européen des Assurances, totals some €6.8 trillion ($9.8 trillion).

No room for error

Weiss stressed that the legislation coincides with the present slack markets at a time when companies are thinking about innovations, such as variable annuity products. He adds that, incidentally, here the fund management aspect is important.

“If you don’t get this right then you are going to run into serious problems,” Weiss told LII.

He noted that the introduction of Solvency II will also impact the information technology (IT) departments of insurance companies, both for compliance reasons, and also for strategy planning to cope with changing developing business strategies that fit the expected changes as a result of Solvency II.

Companies should analyse their competitive positions, he stressed. For example, if a company is a comfortable leader in a saturated home market, it should be aware that this is no guarantee that there will not be new competitors entering the market.

Other companies could form regional clusters (for example, for Eastern Europe) to establish shared-service centres for certain business processes, such as policy administration, or claims management.

As for the compliance needs, the timing for setting up new IT management modelling software to meet requirements of the new rules has to follow a set programme. For instance, in the UK, the Financial Services Authority (FSA) required that as early as March this year companies should have stated whether they plan to apply for internal model approval, according to risk management consultancy Watson Wyatt.

The start of the first Solvency II model dry-run period runs from June to November 2010, and by October 2011 the FSA should be in receipt of the first batch of dry-run submissions, that consultancy continues. Second dry runs should take place in 2011 and 2012 with the FSA review/approval process running in 2012 and onwards.

Main contenders for the compliance modelling software could include technology industry majors IBM and SAS and a fragmented array of smaller specialist application providers.

Companies in this field are conscious that their work could be combined with developments in the fields of XBRL (eXtensible Business Reporting Language), an open data standard for financial reporting.

IBM has noted that it also strongly advocates the use of other industry standards. These include ACORD, the emerging international standard for information exchange between insurers, and services orientated architecture (SOA) for data exchange.

John Smith, IBM’s associate partner, insurance strategic business solutions, refers warmly to Phase 2 of the International Accounting Standard Board’s (IASB) forthcoming international financial reporting standards (IFRS) on insurance contracts (IFRS 4). An exposure draft was expected from the IASB’s Insurance Working Group late this year, but the project has been subject to delay.

Phase 2 is set to replace the current, “interim standard”, which, according to the IASB, “will provide a basis for consistent accounting for insurance contracts in the longer term”. The Board describes the current IFRS 4 as accepting “practices that differ from those used in other sectors and make if difficult to understand insurers’ financial statements.

Software vendors line up

Various business management software vendors are currently lining up to supply their share of Solvency II’s considerable compliance software cost budgets. Here the background is stated in a summary impact assessment from the European Commission.

It states: “Solvency II will spur significant up-front costs, both for the industry and supervisors, if they have not already introduced modern risk management systems or moved to a system of risk-based supervision.”

An early impact assessment, dated during July 2007, “anticipates that the initial net cost of implementing Solvency II for the whole EU insurance industry will be between €2 billion and €3 billion.”

It adds: “However, these costs will be outweighed in the long run by the expected benefits.”

However, the European Commission is planning a further, “level 2” impact assessment exercise, which is expected to provide another estimate next year. Various draft versions are expected up to mid-2010. The work is to apply the European Standard Cost Model. It will take in advice from the Frankfurt-based Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS).

The European Standard Cost Model dates back to October 2005 when the European Commission proposed a common EU methodology for measuring administrative costs imposed by legislation – both existing and planned. The methodology is based on the different variants of standard cost models applied in a large number of EU member states.

Another cost-guide is the expenditure on implementing Solvency II’s elder brother, Basel II, covering capital adequacy for banking. A banking industry estimate puts this as €10 billion, that is, a figure that is “far from trivial”. The total for Solvency II will be incurred from three sectors: the software itself, hardware, and also services, such as training.

For Solvency II, IBM’s Smith said that large insurance firms (tier 1 companies, such as Aviva, Munich Re and Allianz) could be facing bills for around €100 million each.

However, many have partially completed work on data and processes leaving only “heavy lift work in intellectual modelling and embedding their enterprise risk models” to be done, noted Smith.

He assumes that second-tier players will need to invest between €30 million and €40 million each over three years. The smaller, companies could expect to pay out between €1 million and €1.5 million apiece, depending, said Smith “on what else is thrown in the Solvency II pot”.

According to the CEA, the total number of insurance companies operating in the European Union is 5,200. This figure could be increased if one takes in associated economic zones, such as the European Economic Community.

IBM reports that at present it is in discussion with potential clients with the aim of arriving at clear specification of exactly what will be required. Brian Jewsbury, an IBM specialist in insurance IT systems, says that most large insurers are currently in the process of designing their programmes. He noted “a scarcity of suitable resources” within the supply industry.

Jewsbury added that Solvency II compliance can also be used to provide other benefits. These include help to minimise the cost of raising capital by making risks more transparent. Another benefit could be to improve capital allocation by identifying those risks that can earn appropriate risk-adjusted returns.

Meanwhile, CEIOPS has been releasing a series of consultation papers giving advice on the implementation of Solvency II. Titles include Report on National Measures regarding Disclosure Requirements and Professional Requirements for Unit-linked Life Insurance Products; The IMD [Insurance Mediation Directive] and other intermediaries’ related issues – practical solutions and examples; Input to the EC work on Insurance Guarantee Schemes; and Securitisation, which explores insurance-linked securities as one part of the wider spectrum of alternative risk transfers.

US interest

As to interest in the EU’s regulatory reform from the US, where legislation is state-based, a US-EU conference held in Washington in April this year heard from Skinner, who referred to the meeting as a “first step towards achieving regulatory convergence between the US and EU”.

Other speakers included Karel Van Hulle, head of the European Commission’s insurance and pensions unit and Thomas Steffen, chair of CEIOPS. The panel was moderated by Michaela Koller, director general of the CEA.

Separately, Rolf-Peter Höner, of the GVD German insurance association, has written to Congress suggesting that the US set up a voluntary version of Solvency II, presumably to save international insurance companies from having to do duplicate book-keeping.

Weiss adds that countries such as Bermuda, Chile and Mexico have already adopted Solvency II, or are in the process of doing so. As insurance becomes more international, stakeholders, such as rating agencies, could well apply pressure for increased transparency from the US.

Perhaps just a sideshow, but UK insurer Legal & General’s CEO Tim Breedon has recently protested that, unless modified, the new Solvency II rules would be “a betrayal of savers”. Breedon and other industry players fear that stricter investment reserve rules will cost their UK savers 10 percent to 20 percent of their pension capital (see page 3).

A continental European bystander, well aware of the years that the Solvency II directive took to get EU clearance, commented: “This protest is a bit late! The train has already left the station!”

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