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Friday 20 April 2018

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Better late than never?

Written by Graham Buck
August 2015

Despite a chequered history and criticism from many insurers and reinsurers, the new capital adequacy rules are finally about to become reality, reports Graham Buck

January 1st 2016 is the official implementation date for the Solvency II capital adequacy regime across the European Union. Anyone who hasn’t closely followed the progress of the new rules being applied to the insurance and reinsurance industry might assume the launch had already occurred. Three years ago, Solvency II was making news as teams diligently worked towards meeting a 1st January 2013 deadline. At that time, reinsurance giants including Munich Re insisted that the industry needed a five year transition period for the new rules. Lloyd’s argued that the amount of capital that Solvency II required insurers to carry against potential major disasters was excessive. Alongside these demands for a rethink, reports suggested that such were the complexities of Solvency II even national supervisors might not be ready for implementation by then.

Eventually the target was moved. Despite warnings that delay would undermine the credibility of both the European Commission and the European Parliament, the implementation date was postponed – initially by one year and ultimately by three years.

Given its lengthy gestation period, most industry professionals will be aware that Solvency II shares a number of similarities to the Basel III capital adequacy regime for banks, including the ‘three pillar’ structure. The professed aim is to apply solvency requirements to insurers and reinsurers that more accurately reflect the risks that they face, and also to introduce consistency across the supervisory systems across the European Economic Area (EEA). The result should be a more unified insurance market, better protection for consumers and the prevention of financial contagion.

Laudable aims, but ever since the early days many major figures in the re/insurance sector have been adamant that Solvency II is not even necessary. The fact that the industry emerged from the 2008-09 global financial crisis in much better shape than the banks has regularly been cited as evidence.

“Solvency II is perhaps a technically elegant solution looking for a problem that does not exist - at least for non-life insurers,” says Jean-Michel Briot, associate director at Luxembourg-based Aon Risk Solutions.

Briot, who for the past four years has worked with colleagues in implementing Pillar II solutions in response to Solvency II for various European insurers, adds, “The insurance and reinsurance industry has been proven for centuries in Europe – mainly the UK, Germany and Switzerland – and has not depended on regulation for this sustainability.” He believes that as with the Basel III, the complexity of Solvency II regulation “could introduce opportunities to ‘game the system’, with unintended consequences in the future.”

Briot describes the three pillars of Solvency II as follows:

•Pillar I is purely quantitative and asks each company to assess the solvency capital requirement that must cover with its own capital in order to survive to its calibrated possible loss on a time horizon of one year with a likelihood of 99.5 per cent
•Pillar II is dedicated to implementing a new system of governance; one that invites the market to shift from efficient, but implicit governance to a new one which has at its core an efficient risk management system leveraging on explicit accountabilities across the whole organisation.
•Pillar III focuses on the communication of key information and figures to the market and to the regulatory authorities.

Fatigue sets in

At PwC, the firm’s UK insurance regulatory leader, Jim Bichard, has worked on Solvency II issues since 2007 but says that many accountants, auditors and others have been involved for even longer. He provides a regular commentary on Twitter, offering views on what companies should be doing and what they need to think about regarding their compliance with the new regime.

Bichard reports that there is more than a degree of “Solvency II fatigue”, particularly among those who, following earlier postponements, had expected implementation to finally take place in January 2013. “Significant resources were dedicated to projects at that time and SII’s halting progress has been something of a roller coaster ride,” he comments.

Reports have cited a lack of boardroom engagement at many firms as impeding the progress of Solvency II. Charles Portsmouth, director of insurance at the firm of Moore Stephens, says that it is not only the irritation of having to re-engage with the issue after a three-year hiatus.

Many smaller insurers may have simply decided to wait until the final details of the regime were thrashed out before incurring the substantial compliance costs. Not surprising, given that the likes of Aviva have spent millions on their Solvency II projects.

There were a number of likely unintended consequences resulting from the original first draft of the Directive, among them the impact on captive insurers. Briot says that Solvency II originally took little account of the business rationale for captive insurance

“To this day, the Directive still does not make many concessions in this area,” he suggests. “This could lead to a re-location of captives outside Europe and fewer new start-ups.”

However, by early 2014 it was evident that implementation was finally close to taking place and the past 18 months has seen a steady build-up of preparations, says Bichard.

“We’ve ended up with a version that, in certain areas, represents a degree of dilution of Solvency II’s original requirements,” he adds. “Chief among these is the five year transitional period, which doesn’t require the new arrangements to be in place before 2021.”

Firms still lagging

At a recent seminar hosted by the International Underwriting Association (IUA), Portsmouth and his Moore Stephens colleague Omar Ripon outlined the various issues that many firms still needed to address in the run-up to Solvency II.

Watchdog the Prudential Regulation Authority (PRA) reported in mid-June that the Own Risk and Solvency Assessment (ORSA) - described by PwC as a “key regulatory mechanism under the new regime”- had found two major weaknesses; firstly a lack of adequate stress and scenario testing by many firms and secondly inadequate forward-looking assessments of their future capital and solvency needs.

Jo Fox, who chairs the IUA’s Solvency II working group, commented: “Those who haven’t already done so really need to pay attention to this forward-looking aspect.”
With 2016 fast approaching, reports indicate that most major re/insurers are prepared for Solvency II’s introduction – as evidenced by “the boom in demand for actuaries”, says Briot. However, his experience suggests that smaller re/insurers and captives are somewhat further behind. “The hardest aspect for most is the technical hurdles required for Pillar III’s reporting requirements,” he adds.

Bichard agrees that there are still many companies with much ground to make up between now and the end of the year. However, the European Insurance and Occupational Pensions Authority (EIOPA) and others have offered to help these firms, while the PRA’s own website provides regular updates as the implementation date approaches.

“There has been a lot of guidance offered – our job is to interpret it and add a touch of pragmatism,” he says “An advantage of being a smaller firm is that complying with Solvency II is not overly complicated – it shouldn’t take too long in meeting the requirements on governance, nor should it be too costly to implement.”

What do firms still need to do in the few months left before implementation? Portsmouth cites the Pillar II component, requiring insurers to have their documentation fully up to date and to ensure that it is fit for purpose going forward.

They must install a senior insurance management regime and – as Fox highlighs – develop their ORSA to ensure that it is more forward looking.

“If you state that you review annually, you must be able to demonstrate that one was actually carried out in the past year – and not back in 2011,” he points out.

In addition, to meet Pillar III, he says more firms need to conduct ‘dry runs’ ahead of January 2016. Many are likely to be surprised by the sheer volume and level of data involved in communicating key information.



This article was published in the September 2015 issue of CIR Magazine.

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