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Worth the weight?
Written by Christopher Andrews
Solvency II: Ball and chain or much needed anchor? Christopher Andrews investigates
It seems a simple idea, right – insurers having sufficient capital and proper governance structures in place while being transparent about the whole process. But simple it is not.
It turns out that providing a high degree of financial certainty to policy holders and regulators is a complex business, particularly if that certainty results in increasing the cost of capital and complexity of reporting, potentially to the point where those policy holders who are meant to be protected end up out of pocket for the pleasure.
Solvency II will, of course, set out new requirements on capital adequacy and risk management for insurers, with the ultimate goal of reducing the possibility of consumer loss or insurance market disruption.
It’s been in the works for some time now, and we are rapidly approaching the launch of the fifth Quantitative Impact Study (QIS 5), which is set to run from August to November this year, field testing the likely effects of Solvency II on the insurance industry. But on the eve of QIS5, debate around the potential ramifications of Solvency II is still going strong.
At the beginning of May, the European Commission held a public hearing on the so-called ‘level 2’ implementation measures, at which the CEA’s director-general, Michaela Koller, said the proposals were still too conservative in many areas, and “much work remains to be done before they truly reflect the economic, risk-based principles that form the basis of the Framework Directive”.
Koller warned, among other things, of the dangers of imposing overly conservative capital requirements as excessive capital requirements, she said, would have “unnecessary and harmful consequences for the insurance industry, for the economy and for society”.
“The economic crisis cannot be used as justification for imposing excessive capital requirements on an industry that not only did not cause the crisis but also that withstood it well,” she added. The director-general shares the view that it is a worrying trend for all financial services to be regulated in the same manner, failing to recognise the differences between the business models of different sub-sectors.
WHERE WE STAND
The CEA is not alone in its concerns over Solvency II, but this is still very much a moveable feast, and ongoing lobbying and consultation mean we are certainly not at the end of the road. This is a good thing, as getting policy right is of obvious importance in the long term, but this also means a short term lack of clarity, which makes implementing business changes difficult at this point in the game.
“If we could deconstruct it as much as possible, the basic premise for Solvency II is obviously sound, and that is protection of policy holders,” says Paul Howard, head of insurance and risk management at Sainsbury’s and chairman of Airmic. “I think if you start that as the building block, to have some form of revised formula for the framework where insurers demonstrate that they have adequate funds for their liabilities, is a good thing.
“Obviously the devil is in the detail and from the initial set up for how organisations will have to show this, and how it will actually come in, that is at the key stage of the process that we’re in at the moment.”
Beyond general insurance, as things stand there are a number of concerns for captives as well, though Howard says based on meetings he’s attended with MEPs and regulators, there is an awareness that the situation for captives is indeed different and might require different treatment, though this has not yet come to the fore.
“The situation as I understand it is that we’ve all commented on the various consultation documents that have been issued. We all think that the definition of captives is crazy because it discounts most of them, we all think that there’s very little in the arguments about proportionality that they’ve proposed, and we’re waiting to see whether there’s any give on all these things,” says Alan Fleming, vice-president of Airmic and chair of the captives special interest group.
“Now a lot of the captives that Airmic have are fronted by insurance companies, and these mainstream insurance companies are developing their own internal models as opposed to using a standard model, so it’s different,” he says. “And the issues there are in relation to recognition of the existing situation, where a lot of these transactions are collateralised. “So the risk to the fronting companies is pretty low because they’ve got letters of credit or other types of back up. And to my mind there should be recognition of that. If there is then there isn’t a great deal that changes.”
Fleming says that while QIS5 has not yet been formally issued, he has received feedback that the new rules which are being tested by the exercise could push up the cost of capital for captives, and beyond this that there could be enormous administration implications in meeting this standard model. This, he says, is totally disproportionate in relation to what captives are all about. If the idea is to try and make the market safer, he says, “well the problems haven’t been with captives. I think we’re just trying to get that message through to somebody.”
While it may be argued that greater proportionality is needed for captives, in terms of capital as well as governance and disclosure (so pillars 2 and 3), there are various concerns around the wider market as well, as the CEA’s Koller has made clear.
“It is very complex,” says Jerome Berset, Solvency II program manager for Zurich Financial Services. “Capitalisation, measurement of risk, what are the best means to guarantee a high level of policy holder protection, what are the best means to produce an efficient regulatory framework on the other side? These are extremely complex issues, and the insurance sector itself is also complex to understand. We deal with uncertainty.”
Berset says that while there are many discussions going on hammering out fine details, from liquidity premium, to discounting to calibration of future capital requirements, there is a danger that the basics are being forgotten in these discussions, and it is important not to lose sight of this. This, he says, means enhancing policy holder protection, but also creating a competitive environment for European insurers. “And we need to strike the right balance between the policy holder protection and the competitive environment,” he says.
As an example, Berset believes that the proposals go too far in terms of the amount of information required to be turned over to the regulator. This includes information at a single investment level, explaining every position within an investment portfolio.
“We don’t have a problem preparing this, but the question is what is the purpose of it?” he says. “What is the regulator going to do with this information? Will they be able to cope with it? Does this fulfil the objective of policy holder protection, or on the other side will it just impose a higher bureaucratic burden, administrative burden in producing all this information for very little value added for the supervisor.
“I remain optimistic that we are going to find a solution which strikes the balance in the end. We do not want to turn Solvency 2 into an irrelevant bureaucratic exercise. That’s not in our interest, the supervisor’s interest or policy holders’ interest.”
Again, this is still a question of devils and details, and it really is too early to know what the final framework is going to look like, and the effects it will have on business (particularly for captives).
But this doesn’t mean that insurers should not be well under way in preparing for implementation, according to the law firm Clifford Chance, which has produced a number of policy papers updating the industry on Solvency II developments.
Clifford Chance says that as the rules evolve, it is clear that a number of insurers still have a significant amount of preparatory work to do. Insurers should by now be well on the way to calibrating their internal models in line with the recent Level 3 guidance while keeping an eye on the relevant technical specifications and embedding the models in their operational and governance structures.
“Insurers are also considering internal reorganisations to eliminate capital inefficiencies in view of the removal of the previous group support proposals. We have already seen a move towards branch structures amongst large pan-European insurers and reinsurers such as XL, SCOR and Swiss Re and we expect that this trend will continue. Other means to maximise capital efficiency could include intra group reinsurance, relocation of parts of the business (realising capital, tax or operational benefits) or focussing on less capital intensive business in certain subsidiaries. These types of arrangements are likely to involve complex legal, tax, accounting and actuarial analysis, and not just from the perspective of Solvency II.”
The law firm also notes that recent developments in Solvency II are pointing towards a less prescriptive approach, which is a good thing, but there remains uncertainty over whether the new regime will impose excessive “potentially damaging” capital requirements. The EC, of course, wants to minimise that uncertainty. Michel Barnier, member of the European Commission responsible for the internal market and services, gave the opening address at that same public hearing where Michaela Koller warned of the amount of work still needed on Solvency II.
In that address he said: “I am not in favour of regulation for the sake of regulation. I am in favour of better regulation.
“I will also refuse changes made in haste, simply in order to be able to say that we have responded to the crisis. In any case, the crisis did not arise in the insurance sector, even if some of its operators may have been affected, particularly outside Europe. “We did not wait for the crisis to propose Solvency II. We have been working on this text for ten years.”
That ten year journey’s end is in sight (theoretically on 31st December 2012) and it is now up to the insurance sector to carry on lobbying to ensure Berset’s balance is achieved. If not, excessive cost of capital and needlessly onerous reporting conditions could mean consumer protection ends up costing those consumers through the nose. And that wouldn’t be good for anyone.