"This is the biggest change in prudential regulation in my lifetime, maybe ever. There is bound to be business impact."
Jim Webber, AVIVA
Introduction
A once-in-a-lifetime challenge
April 22 2009 will prove to be a decisive day in the development of the European insurance industry. Following protracted negotiations between policymakers, member states and industry representatives, the European Parliament voted to adopt the Solvency II framework directive. This will comprise a wide-ranging overhaul of capital requirements, company structures and product lines for the industry, and will mandate insurers to set their capital requirements more in line with their risks. Attention is now turning to the challenges of implementation that lie ahead, and the potential competitive advantage that could be gained from the swift and thorough adoption of the rules.
Solvency II has ambitious objectives. First and foremost, it is being implemented to strengthen risk management in the industry. The proposals are similar to the Basel II framework on capital adequacy for banks in that they are based around three pillars: the first pillar relates to the calculation of solvency capital requirements and minimum capital requirements using standard or internal models; the second pillar refers to general regulatory principles governing risk and controls; and Pillar 3 describes required disclosure on the institution's solvency and financial situation.
The new legislation, which replaces a patchwork of local regulations, will reward insurers that act in the interests of investors and customers across the economic bloc. Thus, it potentially frees up capital from less risky companies, such as those with diversified operations, and forces companies that present the most risk to hold more capital. It should also mean that, if insurers can back less risky products with less capital, they may be able to reduce prices.
But, more generally, there is a long-held desire among policy-makers to create a single market for insurance services across Europe, and Solvency II is seen as a key tool in furthering this objective. By creating a level playing field for capital requirements and prudential oversight, it is hoped that there will be benefits for customers in terms of greater competitiveness and improved capital allocation.
The challenges of implementation are likely to be considerable. It is clear that Solvency II is a requirement that spans the entire business, and will require input across a range of functions, including risk management, internal controls, financial reporting and information technology. New expertise may be required, and it is likely that investments in data and infrastructure will be needed. In addition, careful co-ordination and management will need to be in place to ensure a smooth implementation.
For those insurance companies that are able to move towards full compliance in short order, there are also business benefits to be gained in terms of improved risk management, reduced capital requirements and greater visibility across the business.
Peter Skinner, MEP, Rapporteur for the bill and a member of the European Union's Economics and Monetary Affairs Committee, is in no doubt that Solvency II will have significant consequences and insists that it is not another box-ticking directive. "It is about insurers looking at the underlying risk behind their businesses instead of just asking whether they have got enough capital," he says.
Many insurance executives, however, have been taken aback by the scale of reform imposed on them. Jim Webber, Chief Risk Officer at Aviva, says: "This is the biggest change in prudential regulation in my lifetime, maybe ever. There is bound to be business impact."
In fact, the changes are so significant that the US Administration asked the EU to brief it on Solvency II developments, with a view to possible implementation at a later stage. Skinner, who travelled to Washington in June 2009 to address the Congressional Sub-committee on Capital Markets, says that President Obama's Treasury team is now looking closely at Solvency II to see if it can be adapted as a possible regulatory initiative in the US insurance industry.
Building a better model
Regulatory efforts to mitigate systemic risk are likely to come at a price for the industry. Insurers must invest to create or develop sophisticated models that value assets and liabilities using a market consistent view. Each insurer and reinsurer has a choice of approaches for this calculation. The most straightforward to implement is the Solvency II standard formula, which will treat risks consistently across insurance companies. This is currently being calibrated through a series of quantitative impact studies involving thousands of insurers. For smaller companies or those that are less exposed to complex risks, the standard model may well be adequate.
At the other end of the spectrum is a full internal model, which takes into account company-specific risks and requires more comprehensive data management and expertise. Larger insurance companies are likely to adopt this approach, and may already be some way along the journey with the adoption of economic capital models. Between these two alternatives lies the third option of a partial internal model, which combines elements of the standard and internal models. The closer insurers can get to developing a full internal model, the easier their relationship with the regulator will be and the less capital they are likely to have to hold.
If they intend to use an internal model, insurance companies must seek approval from the regulator first. This will require them to demonstrate that the model is fully embedded in their business and based on robust actuarial and statistical techniques – a costly and complex undertaking.
Yet while the standard model may be less expensive to implement in the short term, it may place insurance companies at a disadvantage over the longer term because they may face higher costs of capital and will have less sophisticated risk management capabilities. "The big risk for insurers with Solvency II is not getting pre-approved," says Baldeep Johal, Chief Actuary at Brit Insurance.
The proposed internal model system, which involves insurers proving to regulators they are well-run rather than regulators imposing top-down views, is unusual but is broadly supported by the industry. "The original Basel requirements put the cart before the horse," says Paul Barrett, Assistant Director at the Association of British Insurers. "Solvency II frames the argument the other way round. It says you must do the right thing and if the regulator is satisfied, then your model of regulatory capital can go ahead."
One quirk of the current situation, however, is that the term "internal model" does not yet have a formal definition and there is no precise framework around the approval process. So the pressure is really on companies to work closely with regulators and industry bodies to make sure they are aware of regulators' latest thinking and of how other participants are developing their models. "Before, the regulatory regime across Europe was not robust enough to make internal models work because regulators and companies were on different sides of the room," says Barrett. "Now, they are side by side."
Insurance companies must weigh up the pros and cons of the standard and internal models. While the standard model will be cheaper and quicker to implement, it is likely that it will require greater levels of capital to be held against it. For larger insurance companies that have sufficient resources, an internal model approach is likely to hold more appeal, as it will require less capital to be held than the standard model. But the real benefits of the internal model come from embedding it fully within the business. This is likely to be a complex undertaking, however, insurance companies will benefit over the longer term from the more granular, accurate and timely risk information that they can draw from their internal models.
"Before, the regulatory regime across Europe was not robust enough to make internal models work because regulators and companies were on different sides of the room. Now, they are side by side."
Paul Barrett, ABI
Daunting timescales
Many insurance companies – privately and publicly – admit that the effort involved with Solvency II implementation is daunting. "Firms have to change the way that they have traditionally operated and the timescales are very tight," says Randle Williams, Group Investment Actuary at Legal & General (L&G). "You need to get your internal models approved and for this you need the documentation, the data and certificates of evidence. In addition, firms need to change their culture and some are finding this is more work than they had anticipated."
Some insurers have used a risk-based approach for years but have discovered that the implementation process involved in Solvency II will nevertheless be extensive. James Illingworth, Chief Risk Officer at Amlin, which first built an economic capital model in 2001, says: "For many insurers, it will take a huge amount of time and effort to develop the risk and governance frameworks to meet the requirements."
Others are preparing to increase human resources to meet the challenge. Although RSA has economic capital and modelling teams, a gap analysis showed that it would require additional skills and man hours to meet documentation and auditable reconciliation demands. In other words, it cannot only apply a risk-based approach, but must demonstrate that this has been implemented across the organisation. "It's potentially a large, onerous exercise, probably more so than was intended," says Mike Harris, Director of Corporate Finance at RSA.
Illingworth believes that the correct implementation of risk and governance frameworks and development of sound modelling technology will be key to achieving pre-approval. "You need to have good risk management modelling – if you haven't started there's an awful lot to do," he says. The models required revolve mainly around a central capital model linked to outputs from catastrophe modelling and pricing, and also to investment, credit and even operational risk analysis modelling.
Solvency II intentionally removes much human-based discretion from the process of risk and capital management so models have to be demonstrably more robust. Checks on the reliability of systems, methodologies, data and statistical justifications will need to be carried out in advance, more formally and more frequently than is currently the case in order to demonstrate their use in the business and in day-to-day decision making.
"In the past, insurers could discuss their workings with the FSA after they had done the calculations," says Randle Williams. "If the FSA saw that you were an outlier, they would signal this and discuss it with you, which may or may not lead to changes. The future process is very different and any disagreements with the FSA may lead to more capital add-ons than at present."
In future, projects or products must be tied to risk factors, which is not how most firms are currently run he adds. For instance, Solvency II demands formal justification for mortality assumption rates with supporting data. "With Basel II, banks were caught by a lack of data to support their positions and Solvency II seeks to ensure this is not repeated in insurance," says Williams.
The implementation demands placed on insurers can be partly offset by synergies within large pan-European insurers. AXA, for one, sees the benefit of a shared capital framework for Solvency II that services the whole group. "We can structure our operations in France, the UK and other countries on one measure rather than using a variety of metrics," says Andy Parsons, Financial Director of AXA UK. The company's model was developed centrally in Paris and then rolled out across its European entities. "We started developing a model three or four years ago, so we feel well advanced," says Parsons. "We are already calculating and reporting into the group. So we have the basis of an internal model."
But AXA laments that a current lack of co-operation between regulators means that models have to be ratified in each country of operation, not just in the country of a firm's headquarters. "It's a bit painful, but we are hopeful that European regulators will come to see eye to eye," Parsons adds.
Building robust internal models and getting them approved is no easy task even for the largest insurers. While many of the larger insurers have detailed models today they may need upgrading to satisfy regulatory scrutiny and to became an integral part of managing the business as opposed to a solely technical tool.
Beneficial side-effects of Implementation
Although the Directive is proving onerous, many firms perceive that there are intrinsic benefits of going through the process of implementation. Many see it as an opportunity to revamp their systems worldwide and take advantage of efficiencies. Aviva, for example, argues that firms need to realise that compliance and risk are now intertwined. Combining them can improve both functions and create savings that can be rolled out worldwide, not just in Europe where Solvency II applies. "Compliance used to be a specific function relating to point-of-sale activities," says Jim Webber, Aviva's Chief Risk Officer. "Now the regulator is interested in a far wider view of risk and compliance must adapt accordingly. From an efficiency viewpoint it makes sense to look at integrating these functions and we have started on that journey."
The ABI supports the idea of basing regulation around models because it encourages companies to make wide-reaching reviews of their businesses. "The whole idea is not to try to calculate every risk to the nth degree," says Barrett. "The Directive wants insurers to be able to identify signals and triggers for extreme events."
There is, however, some caution about the model-based approach. "Internal models will be more and more central to how insurance firms are run," says Johal. "But care needs to be taken that we do not as an industry become too reliant on models. It very much depends on how the models are defined, but there is a potential danger that needs to be guarded against."
The recent banking crisis has shown how over-reliance on models, without sufficient understanding of the business risks and impact, can be hugely damaging. Insurers need to embrace new ways of managing the business around the understanding of risks, rather than merely moving to comply with a checklist of Solvency II requirements.
UK insurers ahead of the pack but no room for complacency
"Solvency II goes quite a bit further than ICA. It requires us to demonstrate that the model is not just used for rules, but embedded in the business and used to make business decisions."
Baldeep Johal, Brit Insurance
It could be argued that UK insurers have an advantage in terms of their preparation for Solvency II. On January 1 2005, the Financial Services Authority introduced regulations – the Individual Capital Adequacy regime – under which firms are required to calculate their own capital requirements. There are similarities between this regime and the requirements of Solvency II.
But, despite the headstart on European competitors, the advantage could be lost if UK insurers become complacent. "Solvency II goes quite a bit further than ICA," says Baldeep Johal. "It requires us to demonstrate that the model is not just used for rules, but embedded in the business and used to make business decisions." Firms need to demonstrate that there are clear processes, governance and documentation around the model. "There is considerable effort involved in the embedding process," Johal adds.
As the second-largest insurance market globally, the UK is the most significant European country to have introduced a risk-based approach. But, to some extent, it will be forced to move towards continental European practices as some of the general insurance categorisations in Solvency II do not accord with UK market practices.
Some types of motor insurance, for instance, exist as a discrete category in the UK but not in continental Europe. "We don't know whether these categories are fixed in stone," says Williams. "But if a lot of European countries do things differently from us we will have to change and that will create considerable work."
Some in the industry argue that, for many well-run large insurers, Solvency II represents a duplication of resources that have been in place for a number of years. For example, RSA allocated significant cash and resources to implementing the ICA regime several years ago, and believes the current process adds little to its business model. "There will be big changes in processes without a big change in the result," says Mike Harris. "We have our own models already, and now we are required to calculate liabilities in a different way. It costs a lot of money but does not really tell firms how to manage their business any better. From that point of view it is quite frustrating."
Business strategy under the Microscope
Under the auspices of the European Commission, the industry has undergone four impact assessments so far, involving thousands of companies across Europe. The exercise has been critical as it has revealed a host of issues that could impact insurers when the Directive comes into force. Both benefits and potential encumbrances will need to be factored into business strategy and it may even be that portfolio changes are necessary.
General insurance: business mix to be reviewed?
Solvency II may well bring greater visibility to financial risks in general insurance product lines. "If you have a property portfolio, you need to understand what a one in 200-year event would cost and carry the capital to cover it," says Parsons. The Directive increases transparency within the business and may encourage firms to look, for instance, for better returns on product lines with a heavy capital requirement.
This, in turn, may lead to some withdrawals of business lines and products as insurers become more aware of the true risk and reward profile of their portfolios and begin to uncover unwanted lines of business which distort their risk profile.
Others believe, however, that the profitability of different market segments is more to do with competition than with technical issues such as capital requirements. Jim Webber of Aviva says that Solvency II encourages greater consideration of these issues and believes that insurers will take a more granular approach to pricing. "A lot of companies are looking to enhance economic capital opportunities so there will be far more sophistication in the application of pricing," he says.
For London market insurers that do not achieve model approval, the standard capital formula under Solvency II does not make sufficient distinction between some types of insurance classes. Inherent diversification is therefore ignored. "It basically lumps together classes and territories," says Amlin's James Illingworth. For US-based business, for instance, Florida and California are seen as being equal fire risks under Solvency II, even though fire losses in Florida are small in comparison to California.
Insurers may decide to broaden their range as a consequence. Jim Webber has a warning for them though: "The marginal capital requirements would be small, but it's a dangerous strategy.
There is usually great competition for market share and they may have no experience and skills in that particular market. Writing business based on a theoretical capital advantage is a high-risk strategy." The Lloyd's Market Association and others have asked the FSA to recognise that there is diversification even within product lines and to set appropriate capital requirements. But progress on this could be slow. "The FSA is inclined to be as specific as possible and will try to ensure the requirements are clear," says Illingworth. "But there is a huge amount of documentation from the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) to standardise the way that each EU regulator exercises its powers, to try to ensure a uniform approach."
Premium on diversification
It is possible that some monoline insurers will achieve lower minimum regulatory capital costs if they can demonstrate that they have a deeper understanding than the rest of the market of their particular business line. However, due to the fact that such companies hold capital well in excess of minimum levels and that there is little diversification within their insurance exposures, it is unlikely that advantages will accrue to them in the final analysis. "If the monoline operates in a high risk area, it may be hard for it to avoid an increase in its capital requirement," says Illingworth. "At the same time, if it is in a low-risk area, the benefit may not be that great." Amlin believes that for general insurers with pre-approved models there should not be a substantial increase in the capital required.
Many in the industry believe that competitive advantage will naturally accrue to large, diversified groups. "If you are diversified by business, geography and distribution you will get due credit," says Parsons. "But scale is also important to understand the size of change going on and how to deal with it. Solvency II is a big ask and could pose real difficulties for some insurers."
"Solvency II is a big ask and could pose real difficulties for some insurers."
Andy Parsons, AXA
Life assurance: annuity nuisance
The potential issues relating to annuities in the wake of Solvency II have been exercising minds, particularly in the UK where the annuity business is larger than in most other European countries.
Solvency II will strengthen the basis for technical provisions as risk free rates will be used for discounting, regardless of the assets used to match liabilities. So, annuity providers currently investing in securities such as corporate bonds will attract higher technical provisions under Solvency II.
This also means that firms will face increasing balance sheet volatility, as movements in credit spreads could affect asset values whilst liabilities will remain neutral to these changes. In addition a risk margin, based on the cost of capital locked in the business until it runs off, will be added to technical provisions. This is particularly onerous for long duration products and it thus exacerbates the problem for annuity providers. For those firms with large existing annuity books, the additional funds required as a result of the strengthening of the basis for technical provisions could be very onerous. Andy Parsons from AXA which writes about £1bn of new life business in the UK each year, believes that this could have a major impact on the annuity market, if customers are asked to pay more to buy an annuity.
Aviva sees three main impacts. It believes, like AXA, that Solvency II as it currently stands will affect both the price of annuities and the attractiveness of their returns. It will also mean that larger European companies will find it harder to issue corporate debt because life companies cannot afford to hold it. Finally, Europe could become less attractive as a base for insurers. "We are already seeing a number of insurers moving to a branch structure in Europe to provide extra fungibility of capital," says Webber. "It is possible that some groups may move their headquarters outside Europe. After all, we are already seeing other UK companies moving their tax base outside the UK."
Higher technical provisions for annuities are not the only reason that insurers may consider a change of headquarters. The most controversial part of the legislation, which would have allowed large cross-border insurance groups to be supervised by a single 'home' regulator and to centralise their capital bases, has been dropped.
Although the proposals were heavily supported by companies such as Aviva and AXA, they ran into opposition from smaller European member states, which feared they would play second fiddle to regulators from the UK, France and Germany. The matter will be reconsidered in 2015, three years after the Solvency II rules come into force.
The ABI says it is not surprised that the 'group support' measure was dropped. "It was a very bold feature of the original draft," says Barrett. "The concept was brilliant but the execution would have required a Herculean effort to overcome the problems. The regulators need confidence that the basic tenets work first and then group support can perhaps be reintroduced."
"We are already seeing a number of insurers moving to a branch structure in Europe to provide extra fungibility of capital."
Jim Webber, AVIVA
In a multi-year process involving a range of complex issues, differences of opinion between regulators and industry are bound to arise. Subsidiarity means that domestic regulators have a degree of flexibility when interpreting rules. But insurers should make no positive assumptions about how local regulators may react. "It is up to the UK authorities to do what is prudent," says Webber. "They are likely to be safe rather than sorry."
Paul Barrett of the ABI agrees. "Those who think that the difficult issues will just go away are wrong," he says. "The FSA will look for a sensible and intelligent application on the basis of what is reasonable. Those hoping for no change may well be deluding themselves."
Annuities are not the only issue for the life industry to address; the capital position of issuers of guaranteed products may also be impacted by the new Directive. Insurers will be forced to hold more capital for options and other complex instruments they own to create their guaranteed products. L&G estimates that firms will need to run anything between 10,000 and 40,000 scenarios to calculate the capital they would need to hold. "This is a major issue for small firms with limited infrastructure," says Randle Williams. "They used to be able to round the capital to 5%. They cannot do this any longer and will need to run more and better scenarios in the future." This could have the greatest impact in continental Europe, particularly in France and Germany, where more insurance business is transacted by smaller firms than in the UK.
Reinsurance: higher volumes?
There is little consensus about the impact of the Directive on the demand for reinsurance. Amlin, which has a large reinsurance arm and a reinsurance operation in Bermuda, argues that, even if insurers' models are approved by the regulator, the result of Solvency II may be higher minimum capital costs for most insurers. In the absence of alternative debt or equity solutions, this will force them to offload some of their risk through reinsurance. "In this climate it is not easy to raise equity capital or debt so some companies are likely to seek to reinsure more of their liabilities," says Illingworth.
However, others, such as Brit Insurance, do not agree. "The consequences are far from clear cut," says Johal. "But larger groups will understand their capital better as a result of this process so may buy less reinsurance than before."
Pension buyouts: nascent market faces a challenge
The pension buy-out market has been growing steadily over the past few years as companies have attempted to de-risk their balance sheets. But the market may be negatively impacted by Solvency II because the guarantees implied in Defined Benefit schemes are more difficult to honour in volatile markets. Even in calm markets, erroneous asset allocation decisions can lead to deficits that need to be made good by the sponsor or the buy-out vehicle.
The ABI is unsympathetic to the potential plight of the pensions buy-out industry and to pension plan sponsors. "If you make a guarantee, you have to make good on it," says Paul Barrett. "DB schemes have onerous guarantees and if you take them on it is quite a task to honour them. The price of risk has gone up so if you want to make a profit you will have to meet all promises."
"Those who think that the difficult issues will just go away are wrong. The FSA will look for a sensible and intelligent application on the basis of what is reasonable. Those hoping for no change may well be deluding themselves."
Paul Barrett, ABI
Conclusion
These are early days in the life-cycle of Solvency II and many adjustments may yet be made during the implementation of the Directive before the format is finalised and launched.
But a few issues seem clear. The new rules are likely to increase, in aggregate, the amount of capital the insurance industry must hold, as well as its overall costs. However, some of the larger groups that already have sophisticated risk-based systems may well find themselves in a position of competitive advantage. To capitalise on this they must be absolutely clear how their size and technical sophistication can be translated into management actions. They will need to re-shape their business portfolio proactively, scaling up in areas of advantage and cutting back on areas where they have little advantage or where market profitability might be adversely impacted by their competitors' response to Solvency II.
A period of consolidation leading up to 2012 is likely, as smaller, niche firms realise that they do not possess the economies of scale to install costly infrastructure. But, large or small, insurers face a tough time in adjusting to the new environment. A fundamental review of their business model is required to ensure their governance, processes and capabilities are fit for purpose under Solvency II. For those that make it through, the benefits of a better regulated, more trusted industry should be felt by all.
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