Will Solvency II be Bad for your Business?

Plans to water down the risk-based approach to Solvency 2 and introduce a flawed compromise threaten to undermine all the good work done by the FSA, warns Mike Brockman of EMB.

There is a lot more to protecting policyholders than having sufficient capital. Yes it helps, but good management and business processes are just as important, if not more so. Insurance is complicated, and capital can disappear as fast as it was created.

We have learnt this lesson the hard way as an industry. We forget it at our peril, which is one reason why recent developments in the Solvency 2 process are cause for concern. They threaten the impressive gains we have made in the UK.

The Financial Services and Markets Act 2000, which introduced risk-based, principles-based regulation, was a leap forward in the way the insurance industry is regulated.

The FSA’s new regime, including the dreaded Arrow visits, has seen the greatest improvement in management standards and professionalism in any period over the last 25 years. As a consultant for more than 20 of these, I have witnessed the dramatic improvements. Risk management, technical competence and business processes have all advanced significantly.

Above all, accountability has been the biggest driver. The FSA has created an environment where not just board directors, but senior, and in some cases, relatively junior management are made accountable for their actions. The Arrow visits keep everyone on their toes, and for the first time, each manager knows and understands their role in the organisation.

The ICAS regime, with its internal models, has played a fundamental part in all of this. The promotion of the internal model, where the onus is on the insurer to “suggest” the capital amount that it needs to run its business, given the risks it is taking on, was bold, effective and forward-thinking. The FSA always has the last word, of course, and the difference between the Capital Guidance and your Internal Capital Assessment tells you something about how good you are.

Yes, there was Solvency 2 on the horizon. Yes, other countries had tried the internal model approach, but in reality they had failed. But the FSA did not wait for Solvency II as it knew the industry needed to be changed. So it pushed the ICAS regime forward.

It is quite amazing how so many companies and Lloyd’s syndicates have managed to build these models. This is a real credit to management, and If I can say, actuaries as well.

These models have become quite sophisticated, and the FSA has encouraged the development of them, making sure the assumptions and outputs are consistent with the business plans. The move from one-year to multi-year models was also a big step forward as lessons were learned from the early starters. “Rome wasn’t built in a day”, and this strategy seemed to be sensible and progressive.

Now, though, the Solvency 2 roadshow is finally taking some shape. Regrettably, after many years of wrangling, the bankers and life assurers seem to have got their way in the name of so-called market transparency. The silo approach, where capital is determined by looking at each risk element separately, (with a separate formula for liquidity, credit, market, insurance, group and operational risk) seems to have won the day.

There are still a few technical arguments floating around, and these are currently being tested under the QIS3 process, but fundamentally the approach is flawed. However complex the formula, risk cannot be partitioned and calculated in this way. Risk to a company is an enterprise-wide phenomenon with intertwined relationships. Financial and market transparency will simply be a delusion.

In response to Solvency 2, the FSA has already begun to water down its requirements and one-year models seem to have gained favour again. This is disappointing. I hope that insurers will still have to justify their business plans and the capital that backs it. This does seem to be the sentiment implied by the FSA’s latest circulars, but the real test will be how they pursue their Arrow visits. I hope they maintain their vigour, otherwise it will be a big opportunity lost.

Let’s not forget that the internal models demanded by the FSA are good for competitiveness. They provide such powerful business information and, if the model inputs are “embedded” and key assumptions are demonstrably derived from within the business, they can be used as a living and breathing management tool. The knowledge and technology is there and the FSA were the catalyst to make it happen. There is a real danger Solvency 2 will destroy all the good work.

I know of several insurers who use these models for all sorts of business applications. Uses include: optimising reinsurance; deciding on which lines of business to write and with how much volume; quantifying the financial impact of diversification; deciding on when to grow and when to contract; and understanding the main drivers of the P&L (not just at the extreme loss levels but also the more day to day 1-in-4 year loss scenarios.)

A detailed read of the Solvency 2 proposals, does reveal that “internal models” may be the ultimate goal, and if approved, will be an acceptable alternative to the “silo” approach. However, the main thrust seems to be towards the “silo” approach in the name of simplicity and practicality.

I hope that the FSA sticks to the principles it has pursued to such good effect over the last few years. Then, at least, the UK will be the shining light in the minefield of European regulation. 

This article appeared in Post Magazine in May 2007