The waiting game

With a big push in its preparations for Solvency II last year, the London market is now ready to implement. The question now is ‘when’? Helen Yates reports on the uncertainty surrounding Solvency II implementation

With the European Parliament firmly focused on sorting out the eurozone sovereign debt crisis, it has been somewhat inevitable that the hearing on whether to adopt Omnibus II has been beset by delays. The original vote on the directive’s proposed amendments to Solvency II was supposed to have taken place at the end of 2011. It was pushed back to January and is now expected to take place in March. But there are rumblings in the market that the final vote may not actually happen until September.

The transitional measures proposed under Omnibus II should be generally welcomed by the market. “It does give some breathing space – the thing about Solvency II is companies are trying to move from an older regulatory system to a newer system, so they do need some time to adapt,” says Niamh Hensey, senior consultant, risk and financial services at Towers Watson. “There do need to be transitional measures – they are a good thing and are likely to give some comfort to insurers and reinsurers, although we don’t know exactly what they are going to look like yet.”

But for many UK insurers and reinsurers – particularly those about to go through the internal model approval process (IMAP) – the lack of clarity on Omnibus II is introducing uncertainty. There is concern there could be additional costs associated with Solvency II, after an already massive investment on behalf of the market, and frustration over the information coming from the regulators.

Extra overheads

“Having uncertainty over the deadlines is not hurting us or causing us to have a cost overrun,” says Justin Skinner, enterprise risk management director at QBE European Operations. “But it means we need to continually provide updates on our progress on Solvency II, so there is a small amount of admin overhead to the delays. It would be good to have a firm deadline, if only to focus the minds of people who haven’t been taking Solvency II seriously.”

Compared to the rest of Europe, the UK and London market in particular, has been taking Solvency II very seriously – investing significant sums in ramping up for the new principles-based regulatory framework at a time when capital has been under intense pressure. In 2007, the CEA (European Insurance and Reinsurance Federation) estimated the industry would spend around €3bn in initial one-off Solvency II costs. It is now clear this was a gross underestimate.

For the UK alone, the FSA estimates the one-off cost of preparing for Solvency II is £1.9bn. The Lloyd’s market – which made headlines with its gruelling timetable for syndicates last year – estimates its preparation costs will be in the region of £300mn. And that is before the ongoing administrative costs are taken into account.

So has the investment been worth it? “Internally I think about 80% of Solvency II is useful and adds genuine business value,” says Skinner. “There’s 20% that’s overhead: compliance, reporting and regulatory submissions... all the additional stuff you have to do to satisfy the regulator that doesn’t help you understand your business any better.”

There is also concern that further delays to Solvency II could increase costs for UK firms if they are forced to renew their ICAS models for another year. But Hensey thinks dual running of the two regimes would have occurred anyway. “The IMAP process is starting from the end of March this year so some companies will be at an earlier stage than others,” she explains. “The FSA has effectively said that those firms can use the models for the ICAS provided they meet the ICAS requirements.

“What we’ve seen is that most firms in the UK are using their ICAS as a starting point for their internal model,” she continues. “Many firms are already running an ICAS process because they are aiming to reconcile their internal model results back to their ICA.”

Given all this preparation, and an IMAP process that is underway, the FSA is adamant it will continue to work to the current proposed implementation deadline of 2014 for Solvency II. And it is unlikely the European regulator will want to see the FSA lose momentum, regardless of what happens with the rest of Europe.

If the deadline is put back further there is some debate as to whether London’s big push will put the market at a competitive disadvantage, given that other parts of Europe will have longer to get up-to-speed. But Skinner sees the market’s readiness as an advantage.

“The accelerated timelines during 2011, particularly for Lloyd’s (they had a very aggressive solvency II timetable) means the managing agents are in very good shape for Solvency II readiness and model approval. Because of that they can close large parts of the Solvency II programme and not have the cost creep associated with continual running of projects. And the London market is now realising the advantages of properly understanding their risk profiles.”

Whatever happens with the European Parliament vote or instructions coming from the FSA, QBE is progressing to business-as-usual with Solvency II this year. “Any project will work to a timetable and if you extend your deadlines your project goes on for another year and therefore you incur another year’s worth of project costs,” he explains. “Yes you can improve things but it’s better to move it into business-as-usual because then you get the benefits of Solvency II.”

n many ways it was always inevitable that the London market would be further ahead in the Solvency II process than the rest of Europe. The market, with its international focus, meant significantly more firms would opt to go the internal model route than in other European markets. As demonstrated by the quantitative impact studies, the standard formula does not provide enough diversification credit, particularly for companies writing international catastrophe business.

“The standard formula just doesn’t work for our business,” says Skinner. “We write specialist lines of business and tend to operate more in the commercial market than most European insurers do. So the internal model was always going to be a big issue for London by the specialised nature of what we do.”

But it was also the head start afforded by the ICAS regime that meant UK firms would be further ahead with Solvency II than their counterparts in Europe. “The FSA introduced the ICAS regime back in 2004 and it doesn’t get firms all the way to Solvency II requirements, but at least in terms of technical modelling they should be a few steps further ahead than the firms that haven’t done any stochastic modelling previously,” explains Wendy Hawes, principal in the insurance consulting practice at Lane Clark & Peacock, who recently moved from the FSA.

Embedding the model

Some argue the additional breathing space that could be afforded if there are further delays will be welcomed by the market. With all the focus to date on the technical aspects of Solvency II, in particular the IMAP process, another year would allow firms to actually embed the models into their business.

“If they do delay implementation I’m hoping firms won’t lose the impetus they’ve got,” says Hawes. “Most of them should be getting to the stage of completing, validating and documenting their model. I would hope that any extra time they have between now and having to submit their approval will allow them to gather more evidence of it actually being used within the business. While we’ve focused a lot on the modelling recently what I think we should be focused on now is the risk management requirements of Solvency II,” she continues. “Because everyone has focused on the Pillar One aspects, in terms of technical modelling we’ve kind of stepped away from that.”

Even firms that are opting to use the standard formula under Solvency II will need to complete an ORSA [Own Risk and Solvency Assessment] under the new regime. As part of this they need to demonstrate the embedding of wider risk management practices throughout their business.

All firms will need to demonstrate they are using the output of the models to inform strategic decision-making at all levels of the business. For many firms, there is now a push to train the board of directors how to better understand and use model output. “In most boards currently you wouldn’t get comprehensive understanding of why the model is being used and its limitations,” says Hawes.

Under Solvency II, boards will need to demonstrate they understand the impact of capital requirements on pricing and product design, for instance, as well as more strategic business decisions such as mergers and acquisitions. For many firms it falls to the chief actuary or chief risk officer to communicate model output in layman’s terms so the board can make better decisions based on their risk appetite.

Ultimately, the focus on implementation is missing the point a bit with Solvency II. Hawes thinks it will be a process of continual improvement and evolution over time, whether the regime becomes business-as-usual for firms next year or the year after. “Solvency II has been on the cards for over a decade now,” she says. “It’s a huge overhaul in the regime – the biggest change anyone has seen – and anyone who thinks it will be a switch on date and then that’s it, is being naive.”

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