A golden rule in management indicates that changes should ideally take place before problems emerge, anticipating them and ensuring a timely response, thus enhancing effectiveness. In order to do so, changes need to be thought and discussed when the existing environment is still functioning correctly. This is exactly how Solvency II was designed.
It is now over a decade since the European Commission triggered a fully comprehensive project that would bring risk-based regulation and supervision to the field of insurance. It was not only ambitious, but also revolutionary, and it has taken some time for all stakeholders, from supervisors to insurers, to acknowledge that Solvency II was on its way and that the change would be significant – and lasting.
Lots of relevant strategic decisions have been taken, shaping Solvency II in the way we see it now. Such decisions have implied risks, and have addressed them, but also have allowed building upon opportunities that the project brings to insurance.
It is worth focusing on some of these strategic areas, and look at the decisions made and their implications.
Timing of the project
Solvency II will come into force on 1 January, 2013. However, its design started in 2000 and will not conclude with the implementation date. On the contrary, after 2013 further refinements and improvements will be made to the system. This is one of the opportunities streaming from a principle-based first-level directive, which is complemented and developed with detailed second level implementing measures. It is our task and obligation to make the best out of it.
The project has been designed with sufficient time to create a framework aimed to be a regulatory reference for the next few decades. It has certainly benefited from continuous testing of the different alternatives considered, improving its technical quality and ensuring all options were tested before implementation. A series of quantitative impact exercises have ensured the appropriateness of the system, with more than 95 percent of technical provisions or 85 percent in terms of premiums of the EU insurance sector participating in the last study.
As important as it is to look back, it is now vital to look forward to 2013 – and beyond. The scope of Solvency II is such that there needs to be a smooth shift from the current regime to the new risk based regulation, and it cannot imply artificial or unjustified disruptions. There are two ways to do so: either by deviating from the principles of Solvency II (i.e. watering down the project), or by setting up appropriate transitional measures.
The choice seems clear but there is a risk to be addressed: phased steps make sense provided they assist a smooth transition, but it is paramount that they are not prolonged unduly, or they will lose their positive effect. In other words, it is not about bringing old problems to the new framework, but about avoiding creating new problems.
Design of the project
Solvency II brings risk-based supervision to European insurers. By doing so, insurers will need to hold regulatory capital according to the risks that they are facing and the way they are managing them, and to do so in a fully transparent manner. It is a risk-based, principle-based, economic-based system, and has the right elements and incentives to become a regulatory reference throughout and beyond the field of insurance.
Following the approach set up in the banking regulatory environment, it includes three pillars, covering quantitative requirements, qualitative requirements, and transparency and disclosure rules. Two main risks emerged from day one: the risk of simply transplanting banking regulation onto the insurance sector without recognising their differences; and the risk of giving more weight to one of the pillars, particularly to quantitative issues, than the others.
If we look at the insurance business, it relies strongly on the liability side of the balance sheet, demands sound Application Lifestyle Management practices, and presents long-term commitments. None of these elements are present in the banking sector, where risks such as credit and liquidity are the primary focus. A simple copy-and-paste of the banking framework therefore would make no sense. The insurance sector must be differentiated from the banking sector – and this best way of doing this is by starting from areas of similarity, such as ensuring quality of capital requirements. By doing so, insurers will be in a position to explain and justify that banking measures regarding, for example, liquidity risk, simply do not make any sense when it comes to insurance.
Risk-based supervision is built on a very basic premise, by which the regulatory framework has to introduce sufficient incentives to foster good risk management within companies. If we look at Solvency II, the recognition of internal models, both partial and full, indicate that the regulator had this premise in mind and has been ambitious enough to give an extra step compared to banking, so as to allow for both full modelling and recognition – in terms of effective capital requirements – of diversification effects.
Just as important as the capital and risk management requirements is the commitment that Solvency II makes in terms of market valuation of assets and liabilities, and enhanced transparency of the system. Market consistent valuation is one of the cornerstones of Solvency II. Insurance can only benefit from a better understanding by all its stakeholders of how it operates and the solvency situation of the different undertakings. This will become particularly important in the upcoming years, where both countries and other areas of the financial sector, and in particular banking, will have to refinance significant amounts of money.
Last but not least, Solvency II will not only enhance transparency and disclosure, but will also address one of the main concerns with the current regulatory regime: the lack of comparability among insurance companies operating and doing business in different countries, particularly due to the fact that technical provisions are calculated with completely different discount rates within Europe. EIOPA calculates that at present, for every 100 basis points added to (or subtracted from) the discount rate, it affects the total amount of technical provisions by 10 percent – a colossal impact.
Implications of the project
Solvency II will affect the insurance world in different ways, and will demand changes both from supervisors and supervised companies. The question that remains in the air is whether it will also bring changes with regards to consumers, in particular regarding access to products, cost of products or amount of offer.
The main change to consumers will be a positive and fundamental one: Solvency II will improve the management of risks within insurers. Recent years have demonstrated how weak risk management, soft internal controls and excessive risk appetite can lie dormat for years before building to an almighty crisis. From that perspective, Solvency II emerges as the right regulation at the right time. Everything that has a positive effect on the way risks are managed will be of benefit to consumers.
When it comes to supervisors, they will have to undertake radical operational change. Areas such as validation of internal models will certainly change the way supervision is undertaken, and the enhanced focus on qualitative issues that the second pillar of the system demands should also mean a new way to supervise.
All these changes come at a time when there is a complex debate regarding how supervision should be undertaken and how intrusive it should be; and also when supervisory authorities are facing a big risk of losing some of their experts to industry, with the risks that it implies. Therefore we can conclude that Solvency II will not be less challenging to supervisors than to supervised entities.
What about insurers? Will they be able to meet the new requirements and, more importantly, will they be able to adapt their risk management to what is expected out of Solvency II? We have to be positive.
Of course it will be challenging. The system will demand changes: in terms of how to manage the business, and in terms of practices that made sense in the past but do not necessarily fit with Solvency II in terms of reporting. Yet the insurance sector is doing excellent work to be ready for the implementation date. The solvency situation of insurers under the new Solvency II rules is also a sound one, as demonstrated by the recent quantitative impact exercise that showed an excess of capital over regulatory requirements of €400bn.
Perhaps we should address openly another question that many may have: will Solvency II lead to concentration in insurance? The answer is that the system provides good incentives for all companies, big or small, that appropriately manage their risks. Therefore, small companies with sound management and a good business model that aims to provide added value to their customers will certainly reinforce their position after the implementation of the framework. How could it be different if, ultimately, Solvency II is about understanding risk, managing risk, and making the best out of the underlying opportunities that come with those risks?
I started by saying that Solvency II is here to stay. After reading this, I hope you agree that it is also here for good.