Whether the European Union is trying to be fashionable, or is simply struggling in the face of a bureaucratic mountain, its Solvency II directive is running late. However, as Ed Murray reports, the UK is still leading the way.
The fact that the European Union's Solvency II directive is running late is unlikely to surprise many and it is now generally held that the draft framework for the risk-based capital regime will be available by the autumn of next year. Thereafter, the finalised draft is expected to be ready by summer 2007 with implementation taking place around the turn of the decade.
This timetable, like so many others, is subject to change and whether it is met will depend on the amount of wrangling that takes place once the draft has been released. The UK is unlikely to put much in the way of the new legislation, although whether some of the European insurers are so compliant is a moot point.
The UK insurance market has had Solvency II on its radar for quite some time and has already done much of the preliminary work that will be required, thanks to the Financial Services Authority's independent capital adequacy standards. These came into play alongside the insurance mediation regulation earlier in the year and - despite the industry's usual harrumphing - they look certain to stand the UK market in good stead internationally.
ICAS standards
In putting together its thinking on ICAS, the FSA has certainly had its eyes and ears open to what is happening across the water in continental Europe and it seems reasonable to believe that the standards already in place will sit comfortably with the new legislation currently being thrashed out.
Simone Peakin, associate director of insurance at ratings agency Fitch, says: "The current proposals indicate many similarities to the FSA's regime. For example, attempting to align regulatory capital more closely to economic capital and encouraging improved risk management. However, differences do exist - the ICAS regime requires every insurer to do at least some basic internal modelling - stress and scenario testing. Under the standardised approach in Solvency II, however, insurers will simply be able to apply a formula rather than be required to do internal modelling."
Whether the more hands-on requirement for modelling and testing is a surer bet to plug any holes in insurers' capital assessments, than the formulaic approach favoured by Europe, remains to be seen. The important point for the UK market is that in preparing, meeting and implementing the FSA's regime it has gone a long way to being ready for Solvency II. As Paul Bennett, senior manager at advisory and accountancy firm Mazars, says: "The FSA is engaged in the Solvency II process which had started when the FSA was devising its capital adequacy regime. The regulator has tried to anticipate where Solvency II would go and so Solvency II and its own capital adequacy regime should be a reasonably good fit." He adds: "Obviously there is some potential for conflict but FSA rules will have to change if there is a conflict. However, this should only mean fine tuning."
Inter-group reinsurance
In the more complex insurance transactions there will be close inspection of how Solvency II will affect what is already in place in the UK market, and arrangements such as inter-group reinsurance contracts have been mentioned as the type of area where real scrutiny will take place to determine what the two regulatory regimes require and whether they are complementary. That said, until there is a definitive draft it is going to be very difficult for anyone to second-guess the specifics that may cause problems.
Nonetheless, insurers are keenly watching the differing levels of capital requirements that are to be introduced by Solvency II for various lines of business. The problem for insurers writing high risk or long tail lines of insurance is that large amounts of capital will have to be set against them to meet the new requirements. Solvency II will also represent a move away from the traditional practice of subsidising capital intensive lines with other classes of business and could create problems for some providers. In making each line of business 'pay for itself', many believe it is reasonable to expect a reduction in capital allocation - and hence capacity - for particular lines of business such as catastrophe, credit and surety, casualty and industrial risks.
However, not all subscribe to this point of view and Mr Peakin says: "Within the UK many of the capital intensive lines tend to be written by the more sophisticated insurers who often require an investment grade (BBB range and above) rating in order to win business. This would tend to imply that these insurers are already adequately capitalised and thus Solvency II would not necessarily result in an increase in their capital requirements."
The smaller, more specialised insurers will not necessarily suffer either as Mr Bennett comments: "Mono-line and niche insurers may have to provide more capital than diversified insurers and this may put them at a competitive disadvantage. However, this does not mean that they will cease to exist. There are advantages from specialising that may outweigh the higher costs of capital: better systems, better knowledge of the market and the influence that comes from being a market leader."
The effect of diversification
For the bigger insurers with wide-ranging portfolios, there are advantages to be gained from their inherent diversification. A definitive figure is yet to be placed on this but a recent report produced by the Association of British Insurers in association with Deloitte claims that capital requirements could be reduced by as much as 50% for certain providers. The report states: "The diversification effect may reduce the ICA by between 25% and 50% over what might prevail. At its simplest, the effect of diversification is to reduce the total amount of capital an insurer will need because, using an agreed mark of probability, we can demonstrate that not all risk events that could occur will in fact occur at the same time.
"This means that for an insurer managing a diverse range of risks, with appropriate risk management policies in place, the amount of capital needed to support the entire business is less than the figure suggested by the simple summation of the capital amounts required to support each of the risks individually." Put in simple terms, the report is highlighting the benefits of insurers not carrying all of their eggs in one basket.
Larger firms' level of appetite for the more capital intensive lines of business will only be determined when the finalised benefits of diversification are eventually set out and this will have a large part to play in determining whether or not capacity is lost in certain markets. Catherine Burton, partner at Deloitte, adds: "I think the viability of the long-term classes of business in multi-line insurers really does rest on the higher capital requirements that are needed, due to the inherent uncertainty in reserving and underwriting those classes versus the diversification benefits that can be allocated to those lines of business. Those benefits are notoriously difficult to calculate and even harder to allocate to different lines of business."
Capital benefits
Even for the smaller insurers there will be more to look at than simply the capital they have to put behind the lines they are writing. Deciding to diversify their operation simply to achieve regulatory capital benefits is a risky business and the decision should be based on business criteria. To successfully diversify, providers will have to have a clear understanding of the new markets they wish to enter, be able to absorb the costs that this will bring and be sure of being able to compete on a long-term basis. Whether such a move would prove worthwhile will be for each firm to decide.
There are, however, positives in all this for the smaller firms and what the regulations take away with one hand, they give back with the other. Raj Ahuja, partner at EMB Consultancy LLP, points out: "It is not only about size and diversification - Pillar One of Solvency II is framed around quantification of capital and Pillar Two around risk management of processes and procedures. So it is not inconceivable that you could have a smaller to medium sized firm that does not benefit from Pillar One because they do not get a lot of capital relief stemming from diversification. But conceivably, because they are a smaller sized business, it is easier for them to bed in risk management and governance so they do get a lot of relief on that element." Again, how this will manifest itself in practice remains to be seen but it is important that firms are aware of the possibilities when looking at the way forward under the forthcoming legislation.
In facing up to Solvency II and implementing it on arrival, the UK market is well placed. There are also many oversees insurers operating in the UK market who will be similarly ahead of the game in light of the FSA's requirements for doing business here. However, this is not the case for all insurers in the EU and when the draft is released next year there is likely to be a good deal of horse trading as they seek to influence a regime that will not overly inhibit the way they currently do business. Mr Ahuja comments: "I think the lobbying power of those in continental Europe is quite influential and so it is still up for grabs the way the final directive from the EU is framed. I do not think they will be able to ignore the vast number of people that have put forward some reasonable points about the way businesses are run and there is still some lobbying to go."
Internal processes
However, while the debates rage on the continent, UK firms have the opportunity to drive their businesses forward knowing that they have already taken care of the major chunk of legislation that is to come. This does not mean for one minute that they can in any way relax, but it does mean that they should not have to lose focus by later concentrating on internal processes. The UK market has been through a real transition in recent years as it prepared and then took on FSA regulation and it seems that its hard work will pay dividends.
Ms Burton is confident that this is the case and comments: "When firms take their eye off the ball in terms of what their real commercial objectives are, they do not tend to do as well. To the extent that the Solvency II procedures and processes have not been put in place in other countries - and this needs to be done - their eyes will come off the ball and the UK should be able to take advantage of this."
There is no doubt that Solvency II will bring with it a marked change in the way that insurers across Europe do business and there are both opportunities and threats to be assessed. However, there is also no doubt that the risk-based capital regime, which the directive is seeking to introduce across the continent, is the way firms will have to operate in the future. By being up to date and indeed at the forefront of those changes, the UK market has much to praise itself for and it must now endeavor to ensure it does not lose this advantage by sitting back on its laurels in the coming years.
This article appeared in Post Magazine in October 2005
