Pillar talk on Solvency II

The Solvency II Directive, which came into force this month, is a major overhaul of European insurance regulation and supervision. It aims to offer policyholders better protection, create a level playing field for insurers and reinsurers across Europe and harmonise the region’s insurance regulation.

The directive has been more than 10 years in the making. While the finishing line for all insurers and reinsurers in the European Economic Area (EEA) is supposedly the same, the starting point varied hugely across EEA countries; both in terms of the maturity of the respective domestic insurance markets and in terms of the capability of the respective national regulatory authorities to implement the Solvency II rules.

Some may argue that the “one” finishing line is also subject to debate, since it is very much dependent on how individual European regulators transpose Solvency II into their respective national rules. This particular issue could potentially create discrepancies in Insurance supervision across Europe, contrary to the objective of creating a level playing field.

The insurance industry in the UK finds itself further along on the maturity curve than most other countries, not least because of the introduction of the individual capital adequacy standards (ICAS) regime by the Financial Services Authority (FSA), the regulatory body at the time. The ICAS regime, through its adoption of risk-based regulatory capital requirements, was, in effect, a precursor to Solvency II that already gave the UK Insurance industry a “leg up” in its preparations for the EU directive.

Not having had time to embed ICAS into business as usual (BAU), UK insurers still had considerable preparation work for Solvency II left to do. The UK insurance industry has been criticised at times for spending billions of pounds on Solvency II projects without demonstrating a corresponding ambition to derive equal value from the investment. Value can only be secured by embedding the regulatory change into BAU.

The three pillars

Solvency II is a complex set of rules and, like Basel II, is modelled on three pillars:

· Pillar 1, describing quantitative capital requirements, which can be calculated either by using a largely prescribed standard formula (with allowances for individual-specific parameters) or by using an internal capital model (partially or fully);
· Pillar 2, covering qualitative supervisory review and including mainly governance arrangements, a risk management framework and the internal control environment; and
· Pillar 3, revolving around market discipline or, more specifically, public disclosure and supervisory reporting.

It is fair to say that Pillar I was initially the thrust of Solvency II implementation projects. Insurers spent most of their time and effort on designing and implementing internal models to calculate their solvency capital requirement (SCR). In addition, UK insurers taking the internal model route have also had to meet rigorous internal model approval criteria and tests set by the UK regulator. This generated some debate within the UK insurance industry as to whether the regulator was “gold-plating” the standard with its high expectations from insurers implementing an internal model.

Eventually, several insurers did a U-turn and, from an internal model route, decided to adopt the standard formula for their SCR calculation, with a view to implementing an internal model at a later stage, following their Solvency II implementation. One could argue that this move was triggered by both firm-specific compliance issues and a supervisory steer from the UK regulator, who is keen to ensure that internal models continue to be approval-worthy – not just at a point in time but on a continuous and ongoing basis beyond the Solvency II implementation date.

Arguably, Pillar II is where UK insurers have derived – and stand a chance to derive – most value from their investment in the Solvency II project. The own risk and solvency assessment (ORSA) process has helped insurers overlay a top-down approach over their Solvency II implementation activities.

The ORSA requires an insurance firm’s C-suite and its board, including non-executive directors (NEDs), on one hand, to challenge assumptions and expert judgement underlying the SCR calculation and, on the other hand, to challenge the output capital number from the internal model and intended for use in the firm’s strategic decisions in driving business growth. The ORSA has led to a conscious effort to link risk management practices, processes and day-to-day operations to the firm’s strategic planning process and horizon.

Insurance firms, to some extent, are still grappling with Pillar III implementation. This is hardly surprising, given the practical implications of the data, IT and systems changes entailed. Moreover, under Pillar III, the valuation basis of an insurer’s balance sheet is different from the valuation basis under the international financial reporting standards (IFRS) governing insurance. Consequently, insurers are going to have to reconcile Solvency II and IFRS valuation bases as part of their public disclosure and supervisory reporting requirements.

Conclusion

To put this in a rather clichéd way, Solvency II implementation has been more about the journey than the destination. For insurers, the January 2016 implementation deadline is not the end of Solvency II but the beginning – or continuation – of a business-as-usual, risk-based organisational mindset and strategic appetite to grow their business and derive value for shareholders.

It is precisely insurers’ own agility and ability to harness and embed newly-enhanced risk management practices in their day-to-day operations that will make Solvency II fit for purpose in terms of protecting policy holders and increasing value for shareholders.

– For further recent commentaries on Solvency II, click here

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