Solvency II Directive - A Challenge to the Insurance Industry

EMB, Europe’s largest firm of general insurance actuarial consultants, have broadly welcomed yesterday’s publication of the Solvency II framework directive. They warn, however, that there is still much left to do for insurers and reinsurers to benefit from the new regime; and that there remain a number of important unanswered questions. 

“This announcement gives insurers a series of choices and challenges. How they respond will determine whether or not they are among those who benefit from Solvency 2. Those who grasp the opportunity will gain competitive advantage over those who don’t,” said EMB partner Mike Brockman.

“We are pleased that the Commission has allowed an extra two years, but the delay will only be worthwhile if companies put the time to good use. The deadline has been put back for a good reason; there’s still a tremendous amount of work to do.”

EMB said the framework directive gave companies a clear choice: to adopt the standard formula approach where individual risks are considered on their own and then aggregated; or to opt for internal modelling, which is more challenging in the short run but is widely agreed to provide a much better understanding of the risk inherent in an insurance operation. (The framework directive allows that under some circumstances the regulator might insist upon a modelling exercise, apparently recognising that this is often the preferred way forward.)

“The feedback we are getting from our clients – and these represent both big and small companies – is that the extra effort involved in building and using an internal model is worthwhile. People are really beginning to appreciate the value added once they become familiar with the models and understand what they are showing,” said Brockman.

EMB is concerned that some companies may choose the simpler option of the standard formula, and warn that this may prove more expensive in terms of capital. Because the understanding of risk will be less developed, the regulator will naturally err on the side of caution in any standard approach.

“In a lot of cases the initial costs of developing a proper internal model are really quite low compared with the prudent capital requirements that may come out of the standard formula. Indeed, recent conversations with one client who was at that time in the midst of QIS3 were surprised by how high the answers were, compared to the equivalent produced by their internal model,” said Brockman.

EMB urged the Commission to ensure that the approval process for internal models is practical and streamlined, so that it does not put companies off going down this route. The signs are encouraging: CEIOPS announced in recently a dedicated working party for internal models. EMB are, however, concerned that, under the directive, applications for internal models must be approved or rejected within 6 months of receipt. This looks like a tall order for regulators, particularly in those territories where they may get a lot of applications.

EMB’s analysis contained some good news for smaller companies. Although they may lose out on the diversification credits given to group structures, they will find the “use test” easier to satisfy because they are less complex organisations. This will facilitate the use of internal models and therefore make possible potential savings in terms of capital requirements.

Many larger players have already invested in full internal models and the challenge for them will be to demonstrate that they have embedded them into their processes. EMB say, however, that this is a very positive step and will bring them considerable benefit in terms of improved use of capital, full diversification benefits and greater understanding of their businesses.

This statement was given on 11th July 2007