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

“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

Following the EU
Parliament’s adoption of the Solvency II Directive in April 2009,
implementation of the regulatory regime was set for 31 October

“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

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

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

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,

of these systems and

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

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


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

According to EIOPA,
almost 70% of insurers and reinsurers under the scope of Solvency
II participated. This covered 85% of the industry based on

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

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

“It is supposed to be
typical of business written in the EU but errs on the side of

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


The benefits of scale
and diversification have been assessed by consultancy Oliver Wyman
and financial services company Morgan Stanley based on data from

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

“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

A solution for the
myriad of very small insurers in Europe could be a change in their

For example, Clark says
their brand and distribution structure could remain in place, but
the products they sell be underwritten by other

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

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

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.

RDR impact

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

What the impact of the
RDR will be on consumer attitudes is a matter of

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

“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

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

Among groups
participating in the survey there was one exception, regulators,
although they still ranked regulatory change as the eighth-biggest

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

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