Solvency II: How can EU Insurers Balance Risks and Returns?

After more than 10 years of wrangling among European Union (EU) nations, Solvency II came into effect from January 1, 2016. The legislation was implemented to improve customer protection, modernize supervision, facilitate the development of an integrated EU market for insurance services and expand insurers’ competitiveness.

Following are key changes compared to the previous standard:

• Introduction of economic risk-based solvency requirements

• Quantitative requirements - Over and above the technical provisions

• Own Risk and Solvency Assessment (ORSA) - Likely future developments to be considered

• Supervisory Review Process (SRP) - Better and earlier identification of insurers, which might be heading for difficulties

• Establish functions, or specific areas of responsibility and expertise, to deal with risk management, risk modeling (for internal model users), compliance, internal audit and actuarial issues

The predictable areas where Solvency II will have an impact for insurers are risk management, actuarial and finance departments, and the asset management function. Among core operations, the maximum impact will be on asset management divisions as market risks and counter-party credit risks originate from investments.  

For insurance companies, the following are the focus areas in investment management in the light of Solvency II:

• Reduction in asset liability duration mismatch

• Increased investments in fixed income vs. equity

• Use of analytics to evaluate the unique risk profile and dynamically adjust the asset mix

• Robust risk management and control systems in case activities are outsourced

As Solvency II has impacted the entire insurance value chain (particularly investment management and support functions) and the risk profiles of insurers, industry players have made relevant adjustments such as reducing duration, adopting risk-appropriate pricing, streamlining systems and changing the product mix to reduce risks. However, this strategy may not yield the desired returns and insurers need to optimize risks prudently. This requires a basic comprehension of insurers’ capabilities, competition and market potential in order to generate higher shareholder returns, particularly for life insurers where cash flow underwriting is significantly prevalent.

Outsourcing levels, which were low before the implementation of Solvency II, are likely to pick up post implementation. Some of the plausible causes for outsourcing support functions could be the requirements around performing complex capital calculations, risk assessments and reporting in shorter periods of time, higher data quality and new data management processes. Increase in outsourcing of support functions seems to be more applicable for smaller players as most of them still do not have the required resources for actuarial and risk assessment related work.

Solvency II was mired in controversy from the start. The need to curb systemic risks versus constraining the market in a faltering economy had put the legislation in a gridlock for over a decade. But now the question on everyone’s mind is, ‘How to optimize risks prudently post Solvency II to create higher shareholder returns?’

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