Assessing Solvency II: key pillars and timelines
Solvency II is a comprehensive risk-based approach to capital adequacy and risk management for insurance providers, which aims to provide better protection to policyholders and minimize firm failures. It replaces the outdated Solvency I norms, which became obligatory in Europe in 2004 (introduced in the early 1970s) along with its 13 existing insurance directives. The program is to be implemented in all 27 EU member states and three countries from the European Economic Area (EEA).
Solvency II should help to protect policyholders’ interests more effectively by making firms more receptive and responsible towards market volatility and risks inherent in the financial system. The Solvency II regime will be applicable to every insurance company with gross premium income of more than EUR 5 million or gross technical reserves in excess of EUR 25 million. Its directives are supposed to be finalized for national supervisors and the European Insurance and Occupational Pensions Authority (EIOPA) by 30th June 2013 and the regime is expected to be in force from 1st January 2014.
There are three main pillars to the Solvency II program:
Pillar I: Capital Adequacy
Pillar I of Solvency II specifies the minimum capital requirements and valuation methodologies for assets and liabilities that firms will be required to meet. Pillar I has two distinct capital requirements: the Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (MCR).
Pillar II: Supervision
This pillar sets higher standards of risk management and corporate governance within a firm’s business structure. It also provides greater powers to regulators, to challenge insurers on risk management issues.
Pillar III: Disclosure
The third pillar of Solvency II deals with public and supervisory disclosures. Insurers also need to provide quantitative reporting templates (QRTs) for quantitative analysis that will form part of the Report to Supervisors and the public Solvency Financial Condition Report. Some of these templates are required to be submitted on an annual basis and some on a quarterly basis. The QRTs capture information on balance sheet, assets, the Solvency Capital Requirement (SCR), the Minimum Capital Requirement (MCR), technical provisions, variation analysis and reinsurance.
Business and Operational Implications
Where the previous regime, Solvency I, failed to distinguish appropriately between different kinds of risk, Solvency II will require adequate capital backing depending on the type of investment and particular product. This is likely to make insurers more prudent towards their investment strategies and therefore align firms towards a risk profile which is more suited to their capital structure.
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This will require insurers to change their investment strategy and will result in a significant impact on the key market segments i.e. life insurance, non-life or general insurance and reinsurance. In particular, the change in capital requirements across different product types will impact on the relative profitability and economic attractiveness of products.
In general, higher capital charges are likely to induce life and non-life insurers to opt to increase their exposure to high grade sovereign bonds and other less risky assets. These efforts will ensure long term gains to the industry and innovation in financial products. However, some firms will find it difficult to accommodate pressure on their capital reserves and profitability in the short-term.
The reinsurance market will be profoundly impacted by the Solvency II regime, both in terms of business operations and in terms of product pricing and risk diversification. However, the impact on business operations is expected to be largely positive. The demand for proportional reinsurance is expected to be higher, as this will reduce the capital requirements for insurers.
A number of challenges will emerge as companies shift towards meeting the Solvency II requirements. The nature of the challenge will vary according to the different Pillars of Solvency II.
Starting with Pillar I (capital adequacy), an immediate challenge is calculating capital requirements. Solvency II requires all the firms to calculate their solvency capital requirement (SCR) in a way that reflects all risks inherent in products for subsidiaries as well as captives at every level. This is applicable to insurers, irrespective of which calculation method is adopted (internal model or the standard formula). A second challenge is that capital charges may put downside pressure on investment income. Although Solvency II doesn’t bar firms from investing in any class of assets, the risk based capital approach will make some business practices unprofitable for insurance companies. Altogether, the process will require active balance sheet management.
Pillar II requires firms to set up an "Own Risk Solvency Assessment (ORSA)" i.e. a detailed structure identifying all material risks, assessing them and developing a proper strategy to tackle them. It also requires firms to develop an efficient internal control and compliance system and to manage key functions of actuaries and audit. The set up of an effective system of governance will be a challenge, given data constraints and the existence of a limited pool of experts on the subject. Furthermore, Solvency II compliance not only asks insurers to establish and implement a compliant company process, it also demands insurers to show how the process was reached and that the execution is legitimate and consistent.
The third Pillar requires increased disclosure. Achieving the accurate, timely and appropriate data disclosure for public and regulatory bodies required is a demanding process. Many firms are developing plans for improved data management, but implementation is difficult due to the complex nature of the project. Furthermore, achieving greater transparency will require firms to generate a large number of reports with increased frequency, putting a squeeze on resources.
The demands of the new Solvency II regulations have left many insurance firms gasping for air as they struggle to adopt new practices and reevaluate their business strategies. The overhaul of insurance regulations requires insurers not only to evolve organizationally, but to evolve intellectually as well. As Thomas Steffan, former chairman of CEIOPS (now EIOPA) remarks: "Solvency II is not just about capital. It is a change in behavior." This change in behavior is likely to result in substantial costs for insurers and regulators in the short-term, but offers new opportunities and scope for increasing overall industry stability and profit in the long run.
In particular, the new regulations will drive product innovation in the medium term. Given that the new regime requires adequate capital backing for all the risks associated with a product, some existing products, such as guaranteed life products, may become unviable. This will call for innovation in new products that are better suited to a company’s risk profile.
Capital requirements for investment risk are expected to be one of the biggest impacts of Solvency II regulations on the insurance industry. The new capital charges depending on the type of investment may push insurers to take less investment risks than under Solvency I, helping to stabilize balance sheets. Solvency II has redefined the scope of diversification in comparison to Solvency I. Apart from the diversification of financial assets, companies will try to reap diversification opportunities by varying their scale of operation, venturing into new markets and indulging in multi-line operations. Large, well-capitalized and fairly diversified organizations will look at M&A as an opportunity to consolidate their business further.
Solvency II requires insurers need to embrace change. Based on the opportunities highlighted above, there are several areas they can focus on.
Firstly, insurance firms should promote research and innovation of new products which suit the changing regulatory environment and their business models. Meanwhile, existing products should be re-priced according to their new risk profile. A focus on creating product loyalty to retain customers, by improving customer services and offering attractive options, is also vital, but insurers should also seek to expand into new markets to tap new customer bases.
Firms should redesign their investment portfolio to minimize the solvency capital requirement by increasing the share of sovereign debt and short-term higher rated corporate bonds. The integration of risk management in business strategies should be encouraged, and incentives offered for asset managers to identify and include financial instruments which hedge against risk in their portfolios. However, it is not recommendable to completely ignore high return assets, such as equities, as portfolio managers can reap benefits by including them in a well-diversified portfolio.
Moreover, companies should actively engage in internal and external reinsurance to reduce overall risk burden and volatility in operations.
Insurance firms are recommended to improve their overall work culture and plug any holes in the organizational structure. To ensure critical processes are being followed according to prescribed standards, firms should prepare step by step process manuals in an easy and relevant format. They should also monitor waste in resources in order to cut costs. Training and educating employees and management will be important, and firms are advised to select their management carefully and incentivize efforts to explore new avenues for lowering capital requirement through M&A and other viable business strategies.
Finally, it is crucial to develop an adept system of data management and IT support. Reliable and timely data will allow the organization to assess and quantify risks more precisely, and will help it to build a more transparent and reliable business model.
Solvency II Readiness and Global response
According to the level 1 directive adopted in November 2009, the Solvency II regime was to come into force in Europe from 1 November 2012. However, this was revised to 1 January 2014. That remains the date at which the regulations are expected to come into force, but there is speculation that this will be pushed back again, possibly to 1 January 2015.
This can be explained by the different degrees of readiness for the implementation of the new regulations. Although most European insurers are ready to meet the requirements of Pillar I, readiness for Pillar II varies: insurers in the UK, Germany and the Netherlands are confident that most requirements under Pillar II can be met, while countries in southern and Eastern Europe such as Greece, Poland and Czech Republic are relatively under prepared. Meanwhile, with regards to Pillar III, a majority of the companies across Europe have acknowledged that they are lagging significantly.
Meanwhile, there has been a broad international reaction to the Solvency II requirements in Europe. For instance, Latin American countries are actively responding to Solvency II while focusing on enterprise risk management (ERM). Most Latin American countries, such as Brazil and Chile, are making some adjustments to the regulations and companies are starting to understand and adopt ERM.
The North American insurance industry is carefully watching the European capital assessment move, with Canada and Mexico planning to adopt an approach similar to that of Solvency II with an analogous timeline. In the US, the National Association of Insurance Commissioners (NAIC) formed the Solvency Modernization Initiative (SMI) task force in 2008. The SMI was established with the main objective of enhancing the insurance regulatory environment. As the NAIC works through the SMI process, it is mainly focusing on Solvency II Pillar II. It has already begun developing a US Own Risk and Solvency Assessment (ORSA) to address the core principles of the International Association of Insurance Supervisors and to explore companies’ and/or groups’ risk management processes.
Many insurers and regulators in Asia are closely following the development with an intention to either seeking regulatory equivalence or implementing various elements of Solvency II in their risk management initiatives. For example, the Financial Services Agency of Japan set up a task force to look into the possibility and feasibility of introducing a new and modernized solvency framework in 2006. Japan and Australia are formally seeking Solvency II equivalence especially for reinsurance business due to their wide-ranging operations in Europe.
Some of the Asian markets already have elements familiar from Solvency II which include the Stress Testing requirements in Singapore, the Internal Capital Adequacy Ratio (CAR) requirements in Malaysia, the Dynamic Solvency Test (DST) requirements in Hong Kong, and emerging regulatory requirements, such as the new Risk-based Capital (RBC) framework in Thailand.
In November 2010, the China Insurance Regulatory Commission (CIRC) issued a regulation (similar to pillar II type of Solvency II) on implementing comprehensive enterprise risk management in order to embed enterprise risk management (ERM) into the governance structure, daily operation environment and corporate culture of insurance companies. This regulation is aimed to enable risk profiling, risk qualification and assessment, risk warning, and risk supervision and disclosure. According to CIRC, this needs to be initiated in January 2014.
In the light of evolving global regulations especially Solvency II, the Monetary Authority of Singapore (MAS) is reviewing its risk-based capital (RBC) framework for insurers. It aims to improve the risk coverage and risk sensitivity of the current framework and to specify the MAS’ supervisory intervention threshold. In order to arrange a smooth transition from the current to the new framework, MAS has set a timeline for the implementation of reworked RBC requirements running through the end of 2013. In addition, MAS has proposed the introduction of an ERM framework in the style of the Solvency II Own Risk Solvency Assessment (ORSA) requirements. Finally, MAS is planning both to increase the scope of the risks to be included in the total risk requirements (TRR) calculation and to recalibrate the required risk charges for existing risks.