New legislation from Brussels will have an impact on the way insurance and risk management will be conducted in the future, not only in Europe but far beyond. However the work behind Solvency II, let alone implementation, has been more than a struggle

A lot has happened in the 11 years since the European Commission announced it was to undertake a process to create a new regulatory landscape for the insurance market.

The Solvency II scheme was set to mirror the banking sector’s Basel II, which would drive secure capital levels to eradicate the risk of insurers going bust to the detriment of their policyholders. However, the global financial crisis – the effects of which are still being felt – has changed much of the thinking behind the new scheme and, with it, the timetable.

The deadline for Solvency II has been pushed back regularly. This year saw yet another delay to the revised date of 1 January 2013 – this time by a further 12 months. “We are hearing from a number of our clients that they don’t want Solvency II to be delayed, says Andrew Cox, insurance partner at LCP. “They have geared themselves up to meet the 2013 deadline. They believe that delays will only lead to more time being spent and higher costs without improving the outcome.”

This is a view shared by reinsurers. “From what we at Flagstone know and see, reinsurers and the companies they do business with in Europe have been busy over the past few years getting themselves ready for the implementation of Solvency II, and should be ready for January 2013, despite what opposing sides say about the process,” says chief operating officer there Frederic Traimond. “Similarly, it was mandatory to be compliant with the Swiss Solvency Test governance starting from back in 2008, and in terms of capital requirements since 2011.”

Solvency II is a complex structure which has three pillars, one looking at solvency levels, another on requirements to disclose risk and capital information, and a third on internal risk management controls.

There are also some core details of the scheme that still have yet to be fully decided which, in tandem with reports of certain national regulators and some underwriters struggling to meet the 2013 deadline, is the reason for the latest delay. In the immediate aftermath of the banking crisis there was a drive from the insurance market to highlight the difference in the performance of the insurance community and their banking peers, but in recent weeks, that desire for distinction has given way to a growing acknowledgement of a need for greater collaboration between those drawing up the Solvency II regime and those responsible for Basel III.
Additionally, the European Union is seeking to create an equivalency system with other major insurance markets across the world, which will make Solvency II a global concern. Bermuda is one of the first to be chosen for the equivalency scheme and it has been working towards compliance, and there is some concern that the US is not too keen on doing the same.

The view from Lime Street

The Lloyd’s Market has said while it does not welcome the delay, it will continue with its efforts to ensure it is compliant with the Solvency II regime by the 2013 deadline. The Market has spent approximately £350m preparing for the regulators.

Under the new scheme, underwriters will be able to submit their own internal capital model for approval by the regulators, with harsh penalties for failure to do so, warns Lloyd’s finance director Luke Savage. Using Lloyd’s as an example, he says the failure to obtain such a capital model and therefore to have the standard model imposed would have far reaching implications.
“Let’s assume that the QIS 5 proposals are reigned in so that the additional capital requirement rises by 66 per cent under the standard formula,” he suggests. The would require Lloyd’s to obtain £10m in extra capital. “Just to maintain the market’s five year average pre-tax return on capital at 21 per cent the market would need to generate an additional £2.1 billion per annum.”

However the benefits to the market are significant. “The way the market is structured with the central fund means that we are only as strong as our weakest syndicate,” says Savage. “Solvency II will enable the market to prove to the rating agencies our weakest syndicate is not as weak as they believe.”

He points out the market is working with managing agencies and syndicates to ensure they are meeting requirements and warns that those syndicates who start to fall behind may well face a range of sanctions in an effort to focus their minds on the task. “Where the market believes that a syndicate will not achieve the relevant status in time we will consider a range of actions for the 2012 year of account,” Savage adds.

These will include restrictions on the business plan. “If firms are not operating with the required level of solvency we certainly do not want to allow them to increase their underwriting and with it the problem.”
There may well be a capital loading although there may be some syndicates which are happy to accept such a loading. Therefore the third sanction would be an increased central fund contribution of up to 1.5 per cent of premium. He stresses the benefits for undertaking the Solvency II process include the need for syndicates to truly understand and measure the risk and exposure they assumed. “It enables the syndicates to examine the business they underwrite and better understand the merits of the respective classes in terms of risk and reward,” he says.

On the proposed delay to implementation Savage believes that in the short-term there will be those who have not put in the work towards Solvency II compliance who will think they have got off lightly “having not made the sizeable financial investments which we have seen are required”.
What is quite clear is that no major player will be able to survive if they are not able to ensure their internal capital model is accepted by the regulators and are forced to work under the standard model. “Therefore in the medium term we will be better off than those who have not progressed their preparations as we will be in effect ahead of the game.”

On a broader basis, the Institute of International Finance (IIF) has issued its own report on the impact of regulation on the industry and it calls for greater co-operation across both geographic and business regulatory bodies.

The IIF’s Insurance Working Party which is made up of senior managers from across the global re/insurance industry warns there needs to be a consistency in the international regulatory approach which also recognises the clear difference between the banking and underwriting sectors.
Swiss Re chairman, Walter Kielholz, who chairs the working party, says the report has come at a pivotal time for the future of financial services.
“We are now at a crucial moment in the formulation of global regulations – many driven by the experience of the recent financial crisis – that will impact both the banking and insurance industries. Our main message today is – we believe it is vital that the new regulatory regimes must be well coordinated on a cross sectoral basis at national and international levels if they are to achieve their objectives of enhancing the stability and soundness of the global financial system.”

“In today’s complex cross-border financial arena the interest and the operations of insurance companies and banks overlap and intersect in a wide variety of ways, even though they do fundamentally different things. A great deal is at stake if policymakers fail to understand how the insurance and banking sectors differ and how they will interact under the new regulatory regimes,” he says.

Zurich CEO and member of the IIF board, Martin Senn, explained that while there were clear differences between banking and insurance the actions of regulators in each sector had an effect on the other.

“Banks and insurers have different business models and regulation needs to reflect that,” he adds. “But banking regulation affects the activities of insurers and vice versa and both will be less effective if these spill over effects are insufficiently recognised. Regulation does not need to be harmonised across sectors but it definitely needs to be coordinated.
“We emphatically support the need for improvements in the regulation of the financial sector but the authorities need to pay more attention to cross-sectoral coordination. We would see value in the creation of a standing committee of the Financial Stability Board (FSB) charged with examining the consistency of regulation from both a geographical and cross-sectoral perspective.”

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