Insurers in Europe will see the advent of a new regime, come 2012 ─ Solvency II.
Its predecessor and European Union's regulation, Solvency I, which came into effect
in the late 1970s, laid out a simple, but robust framework for assessing capital
requirements of insurance companies to pay potential claims in the future. Since
then, insurance portfolios have undergone changes, and markets have evolved.
This document aims to understand the nuances of the regime
and the challenges in the path ahead.
The mandate for Solvency I was to revise and update the EU
solvency regime, and had little scope for managing the kinds
of risk that the market is exposed to today. Most European
countries, thus introduced regulations to prop up Solvency I,
so that risks could be covered adequately by the insurers.
The result: New sets of rules across Europe that were not
necessarily synchronized with each other. This gave rise to
an imminent need for a more risk-based solvency regime.
2007 saw the introduction of Solvency II. The European
Commission stated that the new regime was meant to improve
consumer protection, modernize supervision, deepen market
integration and increase the international competitiveness of
European insurers. By October 2012, Solvency II will firmly
be in place. Companies involved in life and non-life insurance
and reinsurance in the EU are preparing themselves for this
new regime, which will cover all those insurers with gross
premium income exceeding Euro 5 million.
A Comparison Between The Two Regimes
Solvency I lays out how an insurance company should
calculate its insurance liabilities, and then apply a solvency
margin, which is an industry standard, to arrive at the amount
the company should hold so that all the liabilities are covered.
With Solvency II, national regulators will work with each
insurance company to arrive at their money requirements
based on various risks. Solvency II works on the premise that
one-size-does-not-fit-all. The EU solvency requirements today
concentrate mainly on the liabilities side (i.e. insurance
risks), however, Solvency II will also take into account the
asset-side of risks. The new regime will be a 'total balance
sheet' type approach wherein all the risks and their
interactions will be considered. Solvency I restricts itself to
insurance risk, while the new regime would consider market
risk (fall in the value of insurers' investments), credit risk
(failure on the part of third parties to repay debts) and
operational risk (risk of systems breaking down or
malpractice). These risks are currently not covered by the EU
regime, and experience has shown that they can pose a
material threat to insurers' solvency. The new regime will
usher in an ecosystem of better risk management, overall.
Understanding Solvency II
Solvency II encourages insurers to engage in a lot more
introspection than ever before, and also encourages
transparency with the findings. This lays the foundation for
Own Risk and Solvency Assessment (ORSA), which requires
insurers to assess their overall solvency needs keeping in view
their specific risk profile. The ORSA results are to be shared
with the supervisory authorities.
Solvency II also introduces the Supervisory Review Process
(SRP). The role of SRP is to evaluate the risk profiles of the
insurance companies, and the quality of their risk
management and governance systems.
To arrive at the capital needed, Solvency II requires insurers
to have two capital requirements - Solvency Capital
Requirement (SCR) and Minimum Capital Requirement
(MCR), with SCR being the main solvency control tool.
There are two ways to arrive at SCR. Companies can follow
their own internal models for risk evaluation, provided they
are acceptable to the regulatory authorities. In case insurers
do not have a model of their own, they can opt for the
standard model prescribed under the regime - the European
Standard Formula. MCR is a lower capital requirement, the
non-adherence to which could lead to withdrawal of
authorization of insurers.
Solvency II also prescribes qualitative requirements on
undertakings such as risk management as well as supervisory
activities, and covers supervisory reporting and disclosure.
In general, insurers need to make certain information public
and report more information to their supervisors. Solvency II
also brings in group supervisors who will be able to
streamline the way insurance groups with diversified
presence across the EU operate.
Challenges For Insurers
Clarity on the regulations: A new framework is bound to come
with its own set of challenges, with new requirements to be
met and news ways of conducting day-to-today business.
While insurance companies are unanimous in their
perception that the new regime will bring in the 'Single
Market' in insurance services in Europe, implementing it
would be a challenge at various levels - especially with the
new directives, guidance notes and consultation papers
issued by the European Commission from time-to-time.
The path ahead is not clear, and most insurers are uncertain
about how they should prepare themselves for the new
regime. The pre-application process for internal models is
now on, but most insurers are unsure if the work done for
this process will hold merit.
Moving beyond compliance: Many insurance companies and
their employees consider Solvency II as a new compliance
mechanism. Solvency II goes well beyond that, and tries to
bring in change in the way business is conducted. It requires
a change in thinking, not just at the management level,
but all the way to operations. Insurers need to understand
that the new regime is not a mere technical requirement,
which can be managed by engaging IT resources or by
deploying new applications. It is about modeling for risk in
day-to-day business, which is a continuous process, and not
a one-off project.
Educating employees: Insurers have begun their efforts by
training their employees about the new norms under Solvency II.
However, adherence to Solvency II requires a different
approach from the employees, who might not be too willing to
adapt to the impending change. Insurers have to prepare for
this change management and figure out ways to get the buy-in
from their employees. Solvency II would require various teams
in the company to work a lot more in tandem, and the
company will have to create a conducive environment to
Documentation: Though the exact documentation changes are
yet to be made clear, the fact that a lot more assessment and
information disclosure would be involved implies that
documentation needs could go up significantly. Internal
assessments imply that all internal data will have to be strictly
monitored and controlled, which would bring in new processes
and the documentation thereof. New systems and IT
applications would come into play as well.
New resources: Resources well-versed in Solvency II
stipulations are now being sought out by insurers. Also, with
risk modeling being involved, the demand for actuaries is on
the rise. The spiraling demand for a specialized talent pool is
leading to inflated pay packets, and insurance companies will
have to factor the increase into their plans for Solvency II
implementation. They could explore outsourcing or offshoring
some of these processes to reign-in costs.
While the charter is to mitigate risk, Solvency II can never be
hailed as a 'zero-failure' regime. There is no cast-iron
guarantee that an insurer will not fail. As its requirements and
directives get clearer over the coming months, insurers have to
deal with the uncertainties and the challenges up ahead.
Rather than viewing the new regime as an obstacle to
conducting business, insurers have to convince their teams to
consider this as a mechanism that will bring in business
flexibility and mitigate risk in a methodical manner.
The 3 Pillars Of Solvency II
Pillar 1 consists of the quantitative requirements (for example,
the amount of capital an insurer should hold).
Pillar 2 sets out requirements for governance and risk
management and effective supervision of insurers.
Pillar 3 focuses on disclosure and transparency requirements.
What's New about Solvency II?
Solvency II rules will replace old requirements and establish
more harmonized requirements across the EU, thus promoting
competitive equality as well as high and more uniform levels
of consumer protection.