Complex risk management systems have been developed by the insurance industry and have advanced a considerable amount, which has led to a better understanding on how to manage risk, or so we believe. Insurance companies use these sophisticated systems to price effectively and competitively so that premiums are adequate enough to reflect the risk they are taking while being able to cover expenses and most importantly make a profit. The pricing of the premiums is entirely up to the company and there are currently no restrictions in place. However,there are solvency capital requirements that have been put in place through legislations by the European Union(EU) directives, most recently through Solvency II, which will be implemented in 2012.
Solvency refers to a company's current assetsand it's ability to meet expenses. The solvency margin as suggested by regulators is the amount of capital an insurance company is obliged to hold and is intended for use in unforeseen events. The solvency framework that is currently in place was introduced in the early 1970's, which defined the capital requirements for insurers and specified the requirements for solvency margins. Solvency I was introduced in 2002 after developments in the 1990's led to a review by the European Insurance Industry and the outcome involved a set of rules to focus on the minimum capital requirements, which were implemented in 2004. There still remained plenty of scrutiny from the industry and regulators on the importance of the best risk management practice and this led to the proposal in 2007, following the Basel Capital II Accord in the European Banking Industry. It was a proposal for a more fundamental review to establish a standard across the entire European market for which everyone can follow.
The aim was to establish the much-needed stability for the insurance industry and to assist regulators with managing individual company's performance based on an industry standard. Creating a more stable market will benefit not only the insurance companies but also the whole population. Looking at it from a policyholder's point of view, almost every single person needs insurance of some sort and a stable market means that premiums are not so volatile as there is a more competitive market. The premiums paid will also be priced appropriately as well as competitively so that adequate reserves are made and claims will be met with no problem should there be a need for one to be made. From an insurer's point of view this will lead to efficient capital utilisation and create an efficient market, which means that you can ensure the best return possible and there can be no concerns about the company's ability to meet liabilities.
The aim of this project is to focus on the Insurance market and how Solvency II will affect it.Solvency II is the second round in a sparring match between the need for a European Industry standard to be set and the individual needs of each company in the complex and diverse market. I will be discussing the changes that will be made and thentrying to discuss the benefits and advantages of the legislations and the possible drawbacks associated.
Chapter 2
Introduction to Solvency I and II
In 1973 the first Solvency frameworks were introduced for non-life insurers and in 1979 for life insurers and since then the art of risk management has evolved considerably. The European Commission agreed that updating was needed on some of their requirements following the review of the solvency requirements for the European Insurance Industry in the 1990's.
Since then insurance markets such as Lloyd's of London have developed unique sophisticated risk management systems, used for defining capital adequacy and identifying and measuring risk so that it may be managed. The long term success of the topinsurance companies such as Zurich and Allianz can be used as evidence that pricing and reserving methods already in practice are effective and accurate and so there is no need for restrictions and regulations. Also, the fact that General Insurance companies seem to be less affected by the economic downturn further suggests that regulations may be needed but not in every sector.
One of the reasons why General Insurance companies have been less affected is the fact that they tend to invest in short-dated government bonds. These are not only risk freebut being short-dated means the company doesn't stay insolvent and without capital for too long and they can pay off claims adequately.However, the failure and the demise of other companies will argue that while themodelscurrently in useare working work well at the moment, there is still a need for regulations to be put in place now rather than waiting for another dramatic event like the latest economic downturn before making the necessary changes. This is to avoid large companies allowing themselves to be exposed to too much risk and being able to cause a large disruption in the market should they experience a period of high claims and large losses.
National regulators are keen to regulate the way costs are calculated by setting standards not only to minimise the differences from one company to another but also the differences between each country in the European Union. In the UK, the FSA derived its conceptual framework directly from the Basel Capital Accord (Basel II). The name of this project was Solvency I and it was the first stage in finding a common platform for financial services regulation but was not intended to be a full implementation of the revised solvency regime (2).
There are many different types of companies in the EU that provide a wide range of insurance types and this causes a problem when trying to regulate the whole industry. One way to do this is individually by assessing each company's position separately and independently from another. While this may suit some of the larger companies who have put in a lot of research and money into developing their system, it would be too time consuming and complex to handle. It can also create issues when similar companies are assessed and the regulator's assessment differs from one to the other, which could simply be because the way each company values it's assets is different.
So the only practical solution is to work on finding a standard for everyone to follow and be regulated by. In April 2003 Consultation Paper 181 was published by the FSA for the implementation of the Solvency I Directives and included rule changes. These rule changes implement the European Union Solvency I Directives for life and non-life insurers(1). This came into effect in the financial year beginning 1 January 2004 and it aimed to work along the principles of the Basel framework, providing an analysis of the costs. The simplest reason for the Basel II requirements is consumer protection.
Basel II is the second of the Basel Accords and it was initially published in June 2004. According to the FSA(2), "Solvency II is a fundamental review of the capital adequacy regime for the European Insurance Industry. It aims to establish a revised set of EU-wide capital requirements and risk management standards that will replace the current Solvency requirements". It will replace 14 existing insurance directives and is going to set out new, strengthened EU-wide requirements on capital adequacy and risk management for insurers with the aim of increasing policyholder protection and the strengthened regime should reduce the possibility of consumer loss or market disruption in insurance. The companies affected are insurance and reinsurance companies with gross premium income exceeding €5 million or gross technical provisions in excess of €25 million.
The aims also included setting International Accounting Standards for the whole of the EU and to do this the FSA released a separate Consultation Paper in the previous year in July 2003 (CP190), the Paper was addressed "enhanced capital requirements and individual capital assessments for non-life insurers"(3). This was released only in the United Kingdom but it was aimed to coincide with developments of a new solvency standard across the entire EU. It was released before the rest of the EU with the hopes of getting an advantage by beingable to set the standard and trying to have some influence on the final product so that it's more suited to the UK while showing the rest of the EU that the UK were on board with any new regulations in the hopes that member states follow suit.
Currently, most major economies are using Risk Based Capital (RBC) standards as solvency regulations in favour of fixed capital standards. Examples of those are the USA and Japan who use a rules based regime and make insurers hold capital reserves that amount to at least the value of the RBC requirement. The Solvency II regime uses a principle-based regime and the framework is designed to help the EU derive risk-based methods that suit associate countries. Itwill put into operation the new capital requirements that will be directly based on the risk acquired by the insurance companies, allowing for internal modelling subject to meeting certain criteria.
The European Insurance and Reinsurance Federation (CEA) explains that Solvency II is expected to introduce a common European approach based on economic principles for the measurement of assets and liabilities (4). The objectives take into consideration the fact that the system will need to be risk-based to ensure that risk is based on consistent principles already in place and that capital requirements are measured appropriately to reflect the risk taken. This is probably the most challenging but important idea that must be kept in mind by regulators. Although the regulations might suit some companies that have approaches similar to the new standards that are being set, other companies will find it extremely difficult if they have to change their entire system to suit these new requirements that will come into effect very soon. It could be disruptive and costly if their methods need a lot of change or improvement and this provides an unfair advantage to companies who can continue with their business without too much disruption or costs to affect their business.
Chapter 3
Individual Capital Assessment (ICA) & Quantitative Impact Studies (QIS)
3.1 ICA
The need to hold a capital reserve has been highlighted a lot more in recent times than ever before. Natural disasters such as Hurricane Katrina, the New Zealand earthquake and most recently the Japan earthquake have caused so much damage to commercial and domestic properties and of course this means large claims on insurance policies. When these risks were taken on the insurer would have taken into account the potential size of claims and the likelihood of such disasters happening. The reason why they still chose to take on this risk is because no matter what the nature or size of the risk and size of the expected claim amount, there is always a price that will get the cover provided.
At the time when cover was provided the insurer would have expected the probability of a claim being made as small, as that is an ideal characteristic. The large expected claim amounts associated with the mentioned types of risks makes the importance of having a high reserve in liquid assets very clear. It is no good having money tied up in assets that are used in the everyday running of the business because using those assets to pay off claims would not only be difficult as property takes time to sell but also impractical as it would mean there would no longer be a place of work for employees and effectively close the business down.
Before looking at the changes the new regime will bring into effect it is helpful to understand the requirements that are going to be replaced.
In 2001, against a backdrop of sharply falling equity markets and some specific problems in individual firms, the FSA outlined their agenda for change in the regulation of the insurance sector. They have been reforming their domestic insurance capital adequacy framework with the aim of delivering soundly managed firms with adequate financial resources. An important part of these prudential reforms is the Individual Capital Adequacy Standards (ICAS) framework. The ICAS framework required firms to undertake regular assessments of the amount and quality of capital, which is adequate for the size and nature of its business - it's Individual Capital Assessment (ICA) (20).
The ICA allows an internal model to be used by the insurer but is subject to stress testing, scenario testing and sensitivity testing to determine the amount of reserves needed to be held to cover the event of 0.5% ruin. There is no standard formula for these calculations and the use of realistic reserving assumptions is used to calculate the minimum capital requirement. The modelling used is internal and when the SCR is calculated it would then be subject to review by the FSA.
The ICAS framework was designed to reduce market disruption and the chances of consumer loss due to prudential failure. This process is risk-based and included two key elements. One of which is the Internal Capital Assessment to address business and systems and controls risks not adequately captured in the minimum capital requirements set out before. The second element, a supervisory tool, known as a Supplementary Capital Assessment (SCA), by which means the FSA are able to advise or require firms to hold additional capital in response to specific systems and controls related concerns, or to business risks not adequately captured by its Internal Capital Assessment(99).
3.2 Quantitative Impact Studies
There is obviously a need to test the effects of the new regulations set out in Solvency II and there is a method developed by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS). To test the impact on an insurer's risk capital reserving the testing method used is Quantitative Impact Studies (QIS). They are also designed to help insurers in their preparations for Solvency II and all studies are performed voluntarily.
So far there have been 5 QIS each with different objectives.
QIS1 was designed to test the level of prudence in technical provisions.
QIS2 dealt with the calculation of the Solvency Capital Requirement (SCR) and focused on the methods use for that.
QIS3 objectives were to collect information and data to assist the further development and calibration of both the SCR and MCR.
QIS4 aimed at assessing the qualitative and quantitative impacts of the proposals and checking that the standards set out in the framework directive are met.
QIS5 was requested by the European Commission and was run between August and November 2010 by CEIOPS and the results of the report will be published in April 2011. This will provide quantitative input to the finalisation of the Commission's proposal on level 2 implementing measures for the Solvency II Framework Directive (9).
The focus of the four studies QIS 1 to 4 have been on Pillar 1 just like the majority of the discussions regarding Solvency II. The following chapter will discuss and try to show some of the differences in calculations under Solvency I and Solvency II.
3.3The Use Test
To gain regulatory approval the Internal Model must pass the Use Test. The standard formulas aim to reflect the risk taken on by insurers. If an organisation feels that this formula does not adequately reflect the key risks then they will be able to use an Internal Model. This can be a model they already have in place or one that they would need to develop but either way it will be an integral part of the overall Business Operating Model of the insurer. It will provide an assessment of the risks involved and translate them into quantifiably capital requirements. The Use Test will enable the insurer to demonstrate that there has been sufficient discipline in the development of its Internal Model as well as ensuring that there is robust governance around the ongoing management of any changes.
Chapter 4
Comparison Between Solvency I and Solvency II
There are many differences to mention and we will be highlighting some of those as mentioned in the 2006 paper by CEA, "Assessing the Impact of Solvency II on the Average Level of Capital"(5). The Quantitative Impact Study 2 (QIS2) was the study that would help to determine the most effective approach to calculate the SCR and MCR and allows us to discuss the differences theoretically so we can see the impacts it would have on insurers and assess their advantages.
Solvency Capital Requirements (SCR) refers to the level of capital an insurer must hold specifically for the risks taken on by the insurer. Minimum Capital Requirement (MCR) refers to the minimum amount of capital an insurer must hold to cover the risk it has taken on. Any drop in the level of the SCR or MCR then the insurer would be subject to regulatory intervention and this includes being prohibited from writing any further policies.
The first difference between Solvency I and II is how assets and liabilities are valued. Under Solvency I,the capital requirements and the prudence in the technical provisions are mixed together and the valuations vary. This is because they are subject to meeting admissibility criteria and many other factors. Under Solvency II,the available capital is defined as the difference between the assets and liabilities and market consistent values for both of those would be taken. The reasons for the changes here are quite clear as under the old framework it can be difficult to know an insurer's actual position and the valuations from one company to another can vary considerably even if they are essential similar. So to better understand the overall position of an insurer and to make regulation easier these changes will be introduce.
The second difference is the capital requirements. Only a partial recognition is given under Solvency I and an arbitrary approach is used. The new regime will use Value-at-Risk techniques to calculate the requirements and this will be in accordance with the standard formula or an internal model. The company would need to limit the probability of ruin to 0.5% and all potential losses over 12 months would be assessed and will reflect the true risk profile undertaken. It is to be calculated at least once a year and will take account of all quantifiable risks and the net impact of risk mitigating techniques.These techniques along with diversification are fully recognised under Solvency II, an improvement from partial or no recognition at all. In order for a company to use an internal model should they wish to they must seek approval from the supervisory authority and will need to demonstrate that they meet certain standards as well as passing the use test.
The third difference is eligible element of capital.Risk absorption refers mainly to how adequately an insurer's assets or reserves can cover losses or claims. Solvency I only used an arbitrary approach but Solvency II uses a total balance sheet approach where eligible elements of capital are based on economic ability to absorb risk. Two companies may have similar experience in a year in relation to claims but this does not mean they have the same risk absorbing abilities. One company may be larger than the other and therefore hold a larger reserve meaning they can pay of the same amount of claims while still maintaining a sufficient reserve should any more claims arise. The smaller company however may find the same amount of claims put a lot of strain on the business. The difference in types of insurance also affect the insurer's risk absorption ability, an example would help to understand this. A general motor insurance company will insure someone driving a car worth £20000. If the policy is fully comprehensive and we look at just the claims made for collisions, which eventually lead to the cars being written off then some of the risk can be absorbed by the car. This is because the whole amount is not lost asselling the wrecked car in an auction or for parts can recover some of the costs. This gives the car risk absorbing ability and this means a company would not need to have reserves to cover the full cost of the vehicle insured. When comparing this to a life insurer, if a claim is made there is nothing that the insurer will have in terms of assets for the policyholder to help with the costs.
The fourth difference is the form of the control level. Solvency II will support a two-tier approach and uses the SCR as a target and the MCR as a hard limit. The industry has also stated that the SCR should be an important target and breach of the SCR would not trigger the severe supervisory actions that would result from breach of the Solvency I control level (5).
Chapter 5
Implementation and Introduction to the 3 Pillars
5.1 Implementation & the Lamfalussy Process
Solvency II will be implemented using the "Lamfalussy Process", which is a standard framework that will be used by the EU as an approach to develop the regulations. This is composed of four levels and each focuses on a specific stage of implementation of legislation.
Level 1 - Defining a proposal's broad principles. For Solvency II this is the "Solvency II Framework Directive", which is formally entitled the "Directive on the taking up and pursuit of the business of insurance and reinsurance". It involves the European Parliament and Council of the European Union reviewing the Framework Directive proposed by the European Commission and approving it before it can take effect. Once in force, EU member states will have until 1 January 2013 to amend their national legislation to reflect the Directive (6).
Level 2 - Technical Implementing Measures. Specific committees and regulators will handle this and advise the European Commission, namely the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), which is made up of representatives of national supervisory authorities. These Solvency II implementing measures will be brought to vote in front of member-state representatives and will then form the detailed requirements that insurers must meet. CEIOPS had been asked by the European Commission to run quantitative impact studies (QIS) to investigate the possible impacts of the new regulations and the most recent one is QIS4, which is the fourth study that had been run from April to July 2008. A QIS is conducted and CEIOPS uses it to get detailed technical specifications which insurers are asked to use and report the implications for their financial positions when complying with these specifications.
Level 3 - Cooperation between national supervisors to ensure harmonised outcomes.
Level 4 - Post-implementation enforcement. This is the responsibility of the European Commission to make sure than member states are complying with the legislation and to take appropriate action if they are not.
(These levels are from the Lloyd's of London Website) (6).
5.2 The 3 Pillars
The regulatory framework has been divided into three main categories. They are the three pillars and I will be discussing them briefly in this chapter:
Figure 1 - Solvency II based on a three-pillar approach(7)
Pillar 1 - This sets out the minimum quantitative requirements required to stay solvent. It requires companies to demonstrate adequate financial resources. The standards are set out for the calculation of the requirements for Solvency Capital Requirements (SCR), Minimum Capital Requirements (MCR), technical provisions and so on. This aims to bring about a standard for the valuation of a company's assets and liabilities.
Pillar 2 - Here the qualitative aspects are dealt with. This involves the insurer's requirements for having certain internal controls and management in the everyday running of the business to ensure they have appropriate management that can adhere to the risk strategy of the firm at every level in the business. Also, the monitoring of management is important and it's made clear in pillar 2 of the importance of corporate governance setting out clearly the responsibilities of managers.
Pillar 3 - The responsibility of the disclosures that the insurer makes to present an insight to the risk that is actually taken and their return profile. This responsibility belongs to the company and they must develop a system to produce reports, which will be disclosed publicly and to supervisors so that it is available for shareholders, regulators, analysts and rating agencies. (8)
5.3 Key Differences
The requirements for Pillar 1 are based on an economic total balance sheet approach. This approach relies on an appraisal of the whole balance sheet of insurance and reinsurance undertakings, on an integrated basis, where assets and liabilities are valued consistently (10).
The CEA have explained that some of the variability includes economic risk factors such as share prices, property movements and interest rate movement. Others include variability in underwriting results and even assumptions of relationships between different risk types.
There has been strong backing by the industry for a framework like the one adopted by Solvency II. Data would be analysed to derive parameters so an economic calibration could be set. This is to reflect the variability in a company's available capital during the year of business so that there is always the right amount of capital available and to make sure they know how much capital is available if any. It helps companies become more efficient by encouraging good risk management practises with the help of this approach adequately recognising risk mitigation and diversification.
In one of the papers by the CEA there is a summary to the key differences between the current framework and the risk based capital framework supported by the industry (5). Here the differences are shown in the table below.
Solvency II - Risk Based Capital Framework
Solvency I - Current Framework
Valuation of Assets
Market consistent value for assets
Market/Book value of assets subject to them satisfying certain admissibility criteria
Valuation of Liabilities
Market consistent value for liabilities
Varied but in most cases, prudential margins are included within the technical provisions
Available Capital
Adopts a Total Balance Sheet approach based on the economic ability to absorb risk
Partial recognition based on designation or certain items
Diversification
Fully Recognised
Not recognised
Risk Mitigation
Fully Recognised
Partially recognised
Solvency Control Levels
SCR as an important target, MCR as a hard limit
Only a single control level supplemented by various national rules of thumb, stress testing, etc.
Group Issues
Fully recognised on an economic basis
Partially recognised in the Group directive but not on an economic basis
Calibration
Factors are calibrated on an economic basis using market/historic data and actual experience - more objective
Subjective and not specific to the company's circumstances
Figure 2 - Difference in Frameworks
Using the different approaches we can use a diagrammatical example to show some of the differences in calculations:
Market Consistent Value of Assets
Excess Capital
SCR
Market Consistent Value of Policyholder & Other Liabilities
Book Value of Assets
Excess Capital
Solvency I
Current Technical Provisions & Other Liabilities
Solvency I Balance Sheet Economic Balance Sheet
Figure 3 - Difference of both approaches (5).
Chapter 6
Analysis and Implications of the 3 Pillars
To better understand the difference in solvency calculations we need to look at how they differ between the two regimes. This next chapter will try to show these changes and discuss the implications involved for insures.
6.1 Pillar 1
As mentioned above, Pillar 1 has received the most attention and has been the main focus of the first four Quantitative Impact Studies. It focuses on quantitative requirements and the way assets and liabilities are calculated to ensure an adequate level of capital is maintained to consider the company solvent.
6.1.1
6.2 Pillar 2
Pillar 2 in my opinion is the most important of the three while some will argue it's Pillar 1. Of course all 3 Pillars are important and must have the same objectives and targets to achieve the required outcome in the best way possible.
Chapter 7
Conclusion
Solvency II is more than just minimum capital requirements. It is about changing the attitude and behaviour of those involved in the industry. Most people are under so much pressure at work to make sure the company is making the best use of their capital and making as much profit as possible. While this attitude means strong competition and incentives for people to work hard it also leads to a decrease in underwriting, pricing and reserving standards and this filters through to infect the entire business with damaging effects. That is why setting an industry standard for the whole of the EU will work to create the stability required to ensure the long term success of the insurance industry.
Allowing companies to use their own internal models means they still have freedom and are able to gain an advantage over competitors should their models pass certain criteria, while monitoring and regulations ensure they remain well within the minimum requirements. Some companies may not feel so positive about the new regime and feel like they are being controlled too much but the response from the majority has been positive and with good reason.
The new regime will actually offer more business to firms in all member countries as supervisory requirements will be much more consistent. Also, for new companies there will be more opportunities to learn from well-establishedfirms, as they would be well prepared and resourced satisfactorily.
