A picture is slowly emerging of how Solvency II will affect UK-regulated insurers and reinsurers. Their position is different from the rest of Europe as they already have a regime of risk-based regulation. Does this give the UK industry a competitive advantage, or does it just mean another set of hurdles to jump? Mike Wilkinson of EMB discusses the issues that management will have to consider.
There is now much greater clarity around the shape of Solvency II, thanks to a range of official and semi-official publications. These include the draft Directive; the results of QIS 3; various other documents from CEIOPS on a range of questions including risk management, and group supervision; and an FSA briefing on the lessons from the ICAS regime.
Although there are bound to be some further modifications, there is more than enough information for firms to begin planning confident that decisions taken now will still be relevant when Solvency II is implemented in 2012.
It is generally recognised that the UK insurance industry is further advanced on the road to Solvency II than most of its European counterparts as a result of the implementation of the FSA’s ICAS regime. Having recently reached its third birthday, the regime is well-established, although the extent to which a risk management culture has become embedded varies significantly from company to company. However, it has taken this length of time, through year-on-year incremental improvements, for insurers to fully understand the implications of the new regime for the business and how to make the best of it.
In a recent review, the FSA gave its implementation the thumbs-up, and in our experience this is a fair assessment. Risk management, technical competence, business processes and, above all, accountability have all advanced significantly.
This head start does not mean, however, that UK management can sit back and relax; Solvency II will be different. True, both regimes are principles- and risk-based and the similarities will be greater than the differences, but this may make the differences easier to overlook. The temptation to do so will be all the greater when management calculates the cost of implementing Solvency II, in terms of both additional resource and financial burden. Coming on top of the upheaval of the change-over to ICAS, there is a somewhat understandable element of change fatigue.
Significant differences between the two regimes include:
• New ‘standard’ calculations for solvency and minimum capital requirements;
• The option for a full or partial internal model to calculate the solvency capital requirement, but which must be approved formally by the regulator;
• The requirement to satisfy the regulator that any internal model is embedded in the business through the application of a formal ‘use test’;
• The requirement for international Groups to be under the supervision of a ‘lead’ regulator;
• An explicit requirement for firms to have defined actuarial and risk management functions;
• The requirement for public disclosure of key solvency information.
It is important, therefore, for UK insurers in particular to take a rational and economic approach to the requirements of Solvency II. This will involve careful planning and a relatively detailed assessment of the main differences, not only between the ICAS regime and Solvency II but between the ICAS target and their own current implementation of it.
One challenge for management in these circumstances will be to ensure that the benefits of ICAS are retained and enhanced and that any further changes are consistent with the firm’s business objectives, rather than presenting just another regulatory hurdle. We believe that the UK is generally ready to consider the next step of increased sophistication and to really grasp the potential business benefits that the ICAS and forthcoming Solvency II regimes offer.
UK firms can expect a great deal of support and incentives in this respect as the FSA wishes to sustain the advances of the past few years. UK insurers, too, should share this view. If insurers with internal models were to revert to the relatively simple Standard Formula for Solvency II, it would be a retrograde step. It would be less reflective of the actual risk in the business, would probably require a higher level of capital and would reduce their ability to manage the business effectively.
A key issue to be considered is that, despite its support, the FSA is likely to have less flexibility to define and interpret the requirements under Solvency II than under the ICAS regime. This would put firms with robust risk management frameworks, processes and internal models at a real advantage over their less advanced competitors.
When should we start?
Let’s now move from general observations and consider some of the specific strategic steps that management should be considering as part of the transition to Solvency II. This article assumes that firms wish to retain the benefits of the ICAS regime, which have given them the head start referred to earlier. It is almost inconceivable that a UK insurance executive today would deny that their business is better managed now.
This scenario includes the use of internal models as strategic tools and the embedding of an Enterprise Risk Management culture within the business. In the last few years, this latter aspect has been developed systematically by the rating agencies and is now a core element of their assessment of insurers globally. We expect this to become even more significant as more regulators across the world move towards risk based regulatory regimes.
We are sometimes asked, when should we start to implement Solvency II? Such a question suggests that Solvency II and the principles of Enterprise Risk Management that it promotes are seen as merely a regulatory chore. We would argue differently: that both ICAS and Solvency II define principles to assist insurers to manage their businesses better; that the business and competitive benefits of ERM are well established, regardless of any regulatory imperative; and that the question should, therefore, be based on the business case for realising these benefits. All businesses have many competing priorities and limited resource. Therefore, the benefits of improved ERM should be weighed up against the opportunity cost of other initiatives, with the proviso that there is also a regulatory deadline.
The advantages of ERM have been spelt out many times but, for the record, they include: a greater understanding of the risk inherent in the business and therefore an ability to manage it efficiently; improved use of capital; more cost-effective use of reinsurance/retrocession; better informed decisions across all aspects of the business, including pricing and capital allocation; improved relations with ratings agencies; a greater understanding of the advantages and pitfalls of proposed merger and acquisition activity; and better use of Alternative Risk Transfer.
We also have it on good authority from the FSA that there is no time to lose. Their recent briefing suggests that the development, implementation and embedding in the business of an economic capital model is a five-year project – so those yet to embark on the process should make it a New Year priority.
For those insurers that are already some way down the road and have an internal model, much will depend on where they are in the development cycle. Whatever the answer, they should consider what remains to be put in place to meet the expected requirements – including how long this is likely to take and at what cost. And, on the basis that any change is likely to take some time to bed in and will still be subject to incremental improvements, the earlier the new requirements are taken on board, the better. In addition, as supervisors will be required to opine on internal models within a six-month period, being fully ready in advance could be of significant benefit.
Where do we start?
Many firms are now considering how to embed their internal models into the business, not only from a regulatory aspect but because of the economic benefits. The single most important step for any UK re/insurer planning to adapt its ERM infrastructure to Solvency II, including internal model, is the so-called ‘use test’.
The principle is very simple: the regulators will want firm evidence that the model is integral to the way the company works and that senior management is so confident in its output and value that they use it to help make strategic decisions.
The practice of the ‘use test’ is still to be defined and will vary from state to state. The FSA have, however, set out the general principles, which are similar in approach to Basel II:
• Directors must understand the structure and principles of the model, its underlying assumptions and key parameters.
• The model must be ‘embedded’ in the business.
• And it must be demonstrably used for taking strategic and major decisions. For instance, the Board must be informed on a regular basis about the performance of the internal model, weaknesses and material risks through reporting of Key Risk Indicators and available capital compared to required.
It is worth noting that embedding a fully-developed, highly sophisticated capital model into existing management and decision-making processes can be like hammering a square peg into a round hole. Therefore, the earlier the embedding requirements are considered the better as it will give greater flexibility and help shape the model development.
Ideally, consideration of how a model will be used within the business and identification of the key business benefits will take place before it is developed. The first discussions should not be confined to the actuarial department, but include the business users. Equally, once a model is up and running, it becomes a key component of Business As Usual and as such, should perhaps be owned and run by an ‘operational’ department. In this way, internal models will have greater visibility within the business and therefore be better understood and, over time, used more widely.
So what should UK re/insurers be doing now?It is worth spelling out that no two insurers are the same. The actions they should be taking now will depend on a variety of factors, including their progress to date with ERM, corporate objectives, appetite for risk, the types of business they write and their ambition as far as Solvency II is concerned. There are, nonetheless, a number of necessary steps common to all companies.
1. Understand the differences between the ICAS regime and Solvency II, including a realistic assessment of the shortcomings in their current ICAS implementation and plans
2. Educate the Board about their own internal model.
• What it is, what it does and why, what it does not do, current enhancement plans and how the model compares with competitors.
• The potential for enhanced value from the internal model – what it must be used for under Solvency II and other ‘added value’ uses, together with the likely resource, cost and organisational implications.
• What ‘embedding in the business’ actually means to them: for instance how they best achieve consistency of approach and process for both decision-making and solvency.
3. Assess what changes are required to ‘embed’ the internal model in the business and to conform to the ‘use test’, together with how the organisation can get greater value from the model.
4. Consider the expected capital benefits from maintaining an internal model for solvency purposes compared to the Standard Formula on the basis of current information.
5. Look at the implications of the treatment of international groups both from their own perspective (if relevant) and their competitors, including the potential for differing interpretations of the regulation in different territories.
6. Map out a high level programme of activity between now and 2012 to maximise the value achieved from what is, in effect, a mandatory change programme.
Reasons to be cheerful
Provided these steps are approached in a systematic way, and communicated throughout the organisation, they should not be unduly onerous. More than that, they could be seen as a natural and beneficial extension of the direction already started under the FSA’s ICAS regime. It generally takes several years for organisations to experience the full benefits of ERM, and the steps outlined above will help realise them.
This article first appeared in Insurance Regulation and Accounting
