How to take advantage of Solvency II

Many insurers and reinsurers are using Solvency II to increase their competitiveness and profitability. The others risk being left behind, says Raj Ahuja of EMB 

“Leaders in adopting Solvency II principles may benefit from significant competitive advantages, while laggards risk having to give up their independence or even quit the market.”

These are not my words, but those of the ratings agency Standard & Poor’s. There is no doubt that we are seeing the emergence of a two- or even three-tier industry in Europe when it comes to implementing Solvency II, with huge divergences between and within different countries.

In the top tier are those companies that see the disciplines demanded by Solvency II as best practice and are acting accordingly. They would be implementing them regardless of regulatory requirements. In the middle are insurers that understand or are learning what needs to be done, but see implementation as a chore, rather than beneficial in its own right. In the bottom tier are the many firms that have barely got started.

The advice to any insurance or reinsurance company has to be, aim for the top tier regardless of your size. If you embrace the principles of Solvency II with enthusiasm your firm will become more stable and more competitive.

Most analysts agree that Solvency II will encourage further insurer consolidation as players leave the market. This is not because capital requirements will rise overall, but because the process will create winners (enthusiastic adopters) and losers (the laggards). As a rough rule, the bigger the insurer the more likely it is to be getting to grips with the issues raised by Solvency II. This is partly because they are already likely to be comfortable with the practice of financial modelling.

Another advantage for larger companies is that Solvency II will accentuate the benefits of diversification, reducing the capital requirements for (re)insurers that spread their risks. Smaller companies could achieve similar benefits with well-planned reallocation of resources, but in practice most have not yet done so.

The effect of these developments is that we can anticipate a lot of medium-sized companies coming under pressure for failure to grasp the full benefits of Solvency II. But it need not be like this.

Why Solvency II can make you more competitive
To look at this question in more detail, where is the upside?

Solvency II will require insurers and reinsurers to demonstrate that they have identified the risks inherent in their businesses and allocated sufficient resources (including reinsurance) to meet them. This process will not necessarily demand more capital – in some cases there may be a reduction – but better use of capital. And that is where the potential advantages lie.

It goes without saying that an understanding of risk and how best to deploy capital lies at the heart of any successful insurance or reinsurance operation. Even if this were not a requirement of Solvency II, how else can you guide an insurance company? The information you learn will underpin many core strategic decisions, including:
• Reinsurance purchase;
• Capital allocation;
• Product and pricing strategy;
• Business expansion;
• Mergers and acquisitions;
• Investment strategy;
• Ratings agencies;
• Alternative Risk Transfer mechanisms.

Improving return on capital
Let’s now consider Solvency II – and how it will ultimately help you to make better use of capital - with two real-life examples:

1. Reinsurance purchase
An insurance company models ten different reinsurance structures as part of a Solvency II-type exercise. The current return on capital on the portfolio is 18% with a capital required of €200m. However, the diagram illustrated a way to improve the return on capital and reduce the capital required by changing the existing structure. In particular, the company could improve return on capital to 27% and reduce capital required to €190m under the scenario near the top of the graph. 



2. Capital allocation and investment
A personal lines insurer with approximately two million motor and two million household policyholders chose to model its risk profile. The exercise would help management make decisions about capital allocation, product pricing and volumes, investment strategy and reinsurance purchase. Annual premium was €1400 million for Motor and €315 million for Household.

The company decided to concentrate on three types of risk as being the most business-critical:
• Reserve risk (i.e. the danger of under-reserving);
• Asset risk (including stock market volatility, bonds and broker solvency)
• Insurance risk (including property catastrophe claims, attritional and large claims and reinsurer credit risk);

The modelling exercise produced a number of insights into what was driving the business. The equity strategy (approximately 15% equities, 15% cash, 35% gilts, 35% corporate bonds) was found to be unduly conservative. A modest increase in the equity holding would significantly boost long-term returns with only a marginal effect on asset risk.

Reinsurance purchase placed undue emphasis on the relatively stable (albeit larger) Motor book. The main potential for volatility lay with Household. Despite reinsurance protection, the company had underestimated its vulnerability to catastrophes, especially beyond a one-in-hundred-year event.

The Household book, being the more capital-intensive and accounting for 33.5% of net premiums (c.f. motor 12.4%), was found to be overweight. By making a suitable adjustment it would be possible to reduce the capital allocation, whilst at the same time increasing the expected returns and probability of meeting targets.

In response to this information, the company was able to make the following decisions: a 5% increase in equity investments; a 10% increase in Motor premium income and a corresponding reduction in Household; increased Excess of Loss reinsurance purchase for Household, but less Motor reinsurance.

As a result, the insurer was able to increase its expected profit and the probability of meeting its target return, whilst reducing its overall capital requirements and demonstrating it could withstand a one in 200-year event.

Financial modelling demystified
Both the examples described above involve financial modelling, which will become an integral part of Solvency II. Although modelling is commonplace among the largest international companies, many medium-sized insurers and reinsurers still find it an intimidating prospect; people are often surprised to discover that it is relatively straightforward provided you approach it in a logical manner, especially with the most up-to-date software.

The main pitfalls are to be too ambitious at the outset or to employ models that lack the flexibility to match the profile of the company. Many insurers get around these problems by starting with a small, relatively self-contained project and then extending its scope once they feel comfortable with the way it works.

The biggest difficulties often emerge not with the models themselves but with the quality of internal data. Take reinsurance purchase, for example. At the heart of any reinsurance modelling analysis are good quality gross loss profiles for all classes and subclasses of business written. This kind of information is often been hard to acquire because of how claims have traditionally been logged.

Once you have made the necessary changes to the way you store and retrieve data, however, it should not be too laborious to extract what you need. This type of exercise then has many other ongoing advantages for the business.

The prize is an accurate and detailed picture of your company’s financial dynamics, eliminating much of the guesswork from strategic decisions. It does not remove the need for human judgement, but it does ensure that it is based on the best possible information. In today’s increasingly competitive environment, it is what your business deserves. 

This article appeared in Insurance Insider in September 2006