UK: The Same But Different - What Can The Insurance Market Learn From Banks In The Implementation Of Solvency II?

Introduction

Hot on the heels of Basel II, the new riskbased approach for regulatory capital in the banking sector, comes Solvency II. You could be forgiven for thinking of Solvency II as "Basel for Insurers" but the nuances of the risk exposures faced and risk management practices deployed by insurers is driving a Solvency II that can stand out on its own.

Nevertheless, there are undoubtedly similarities between the two, particularly in the structure and requirements of the regulation and the way in which Basel II led banks to enhance the way they managed and quantified risk as well as the substantial investment involved. There are significant opportunities for insurers to take advantage of the lessons learnt through Basel II implementations as they start to prepare for Solvency II, continuing to build on and embed their ICA framework.

Before focusing on the key learning points from Basel II, it important to note that UK insurers are in a unique position within Europe as a result of the introduction of the ICA regime at the end of 2004. Considered by many to be the FSA’s preview of Solvency II, some technical aspects of ICA are likely to be carried over in substantially the same form, thus providing some valuable short cuts. Other aspects of ICA, while requiring change, provide a sound base for the next phase of development.

The experience gained from ICA implementation has already heightened the awareness of boards and senior management to new capital management techniques and highlighted the need to make further progress with operational risk modelling and embedding risk based capital management processes firmly within their businesses areas which the FSA continues to highlight as requiring further attention.

The foundation of Solvency II shares much with Basel II – most notably the adoption of a three pillared approach (Pillar 1 – Minimum Standards, Pillar 2 – Supervisory Review and Pillar 3 – Disclosure) for establishing the regulatory capital requirement with a view to enhancing the financial soundness of the industry sector.

At the heart of Pillar 1 is the requirement for insurers to understand the nature of their risk exposure and hold regulatory capital to a confidence interval of 99.5%. Solvency II identifies two levels of capital requirement: the minimum capital requirement (MCR) and the solvency capital requirement (SCR). These capital requirements will be compared to the actual available capital which effectively corresponds to available economic capital.

Pillar 2 deals with the qualitative elements and focuses on the internal control and risk management processes of the company as well as the supervision process. Pillar 2 requires the insurer to demonstrate that there is an appropriate capital amount for all the risks it faces. The supervisor has the ability to require additional capital to be held if they feel that the level of capital determined is not appropriate for the organisation – this is much the same as Basel II.

Pillar 3 deals with market transparency and discipline in the insurance industry. This will result in improvements in both transparency and discipline and provide a better insight into the actual risk and return profile of an insurance company. Pillar 3 aims to harmonise reporting to supervisors and goes beyond the notion of financial reporting rules, including different types of information a supervisor needs to perform their functions and information normally not in the public domain. It is intended that Pillar 3 of Solvency II will be compatible with the disclosure requirements of the banking sector introduced through Basel II.

Further similarities exist in the nature of the challenge the financial institutions face in implementing the directives. To implement Basel II banks established change programmes against a backdrop of uncertain regulation and hot industry debate. For insurers, Solvency II is much the same, with many leading insurers already establishing their Solvency II change programmes.

The similarities are a good thing – establishing a level playing field across the financial markets helps to ensure consistency and avoid regulatory arbitrage. The similarities also provide an opportunity for insurers to accelerate their Solvency II implementations and avoid some of the pitfalls encountered by the banking industry.

We have already mentioned that in implementing Basel II significant investment was required by the banks and high profile change programmes were established. Whilst precise details of Solvency II are not fully developed at this stage some of the key lessons learned from the implementation of Basel II will be equally applicable in the large scale Solvency II initiatives:

• Gaining executive buy-in to the change programme and obtaining senior executive sponsorship is essential. Failure to do so can lead to the erosion of resources and budget as other "priority" issues arise and take precedence. Further, the changes required are likely to impact a number of functional areas and senior sponsorship is invaluable in navigating the political quagmire.

• Coupled with executive buy-in is clear programme management and governance. The implementation of best practice programme management and strong project disciplines at the outset will set the tone for successful implementation. Equally, establishing at an early stage who has accountability for delivery of each aspect of Solvency II is essential to ensure an effective and efficient change programme.

• Clear programme governance has particular relevance in large Groups where the change impacts a number of business units. Understanding the division of responsibilities for gap analysis and design, build and implementation of solutions across the Group is critical. Clear lines of responsibility in these areas will ensure that an enterprise solution of sufficient consistency can be implemented, whilst maintaining sufficient specificity to drive value for the business.

• The business case for change, both the regulatory drivers and the additional commercial benefits sought, should be articulated at an early stage in order to ensure, crucially, that the change is viewed as a business change programme. Solvency II is likely to impact business processes, governance structures, risk strategies and skills and resources as well as the IT solutions used to deliver risk and other financial management information. These changes need to be viewed holistically in order to realise the potential benefits to the organisation, (such as risk-based business planning, product governance and customer management).

• Strong documentation disciplines must be implemented. A key element of any successful Solvency II implementation will be the ‘story’ of how the organisation has got there, coupled with well documented policies and procedures for ongoing business as usual. This has been a key problem area with Basel II. The earlier in the project lifecycle that documentation structures and hierarchies are identified and populated, the clearer the future target state becomes, increasing the likelihood of successful implementation.

• In articulating the business case it can be easy to wave the compliance flag, ‘we must implement these changes’, but experience has shown that greater commitment and success is gained and greater value delivered to the business if the change programme seeks to deliver business benefit not simply compliance. Further it can help compliance itself since a core requirement of Basel II and potentially Solvency II is the ‘usage’ of many of the requirements in the day to day management of the organisation.

• It is never too early to engage with the regulator. As detailed above, Solvency II programmes are being initiated against a backdrop of uncertain regulation and hot industry debate. This will undoubtedly lead to changes in the requirements going forward. Many banks engaged early with the regulator during Basel II implementation, seeking to influence debate and understand better how the directive would be applied, and have seen the benefits of this as the implementation programme has developed.

• As discussed above, such change programmes are often significant – they will only be achieved if the right resources are deployed. This means ring-fencing full time resources for the project with input from Subject Matter Experts to help shape and advise the programme. The strong project management disciplines which need to be employed, as detailed above, should enable detailed resource plans to be developed which will highlight overall requirements as well as indicate when and to what extent specialist resources are required.

• Lastly, it is important to prioritise the work steps – potential IT issues e.g. disparate systems can take the longest time to fix, so build on work already undertaken for ICA, understand the critical path and interdependencies and prioritise work accordingly.

Along with the lessons learnt from Basel are a myriad of misconceptions. If you find you are thinking along these lines it may be that there’s an aspect you’ve yet to consider:

• ‘Once the IT/data issues are fixed, the rest will just fall into place’ – the Basel experience has shown that it’s not just about IT. Risk frameworks in their entirety are impacted and perhaps the biggest challenge is embedding the new processes into the organisation and having sufficient documentation and business procedures to support this implementation.

• ‘All efforts should be concentrated on getting the Pillar 1 mathematical calculation correct’ – equal importance should be placed on Pillars 2 and 3. Critical to successful implementation is how the practices developed under Pillar 1 are then communicated and justified through Pillar 2, with further disclosure to the market place under Pillar 3. Early effort in the implementation plan will undoubtedly focus on Pillar 1 but the most successful organisations will be those that take a joined up view of all of the requirements.

• ‘The new regulation will lead to a release in capital’ – the new regulation will lead to a more risk sensitive approach to calculating regulatory capital – this may be higher or lower than the current requirement depending on the risk profile of the organisation. Further, even with a lower regulatory capital requirement this does not necessarily mean there will be a capital release, as institutions typically hold capital over and above the regulatory minimum; this is unlikely to change under Solvency II but it may enable organisations to manage more efficiently the level and reasoning for the capital buffer.

We have highlighted above the opportunity that the insurance industry has to take advantage of the lessons learnt by banks in implementing similar risk-based capital requirements, as well as trying to dispel some common myths. Successful institutions will choose to seize this opportunity and gain advantage by implementing Solvency II in a manner which leverages experience from the banking sector’s pain while at the same time complementing the significant progress made from the UK’s early implementation of ICA.

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