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How Will Solvency 2 Change Things, and What Must UK Firms Do Today?
London & Bermuda Newsletter
On 22 April 2009 the European Parliament adopted the Framework Directive, which sets out essential principles for the revised, harmonised approach to supervision of insurers in Europe. The Framework Directive was endorsed by the European Council of Ministers on 5 May 2009.
The Framework Directive is a key step on the road to “Solvency 2”. Solvency 2 is a fundamental review of the capital adequacy regime for the European insurance industry. It will apply to all insurance and reinsurance firms with gross premium income exceeding 5 million euros or gross technical provisions in excess of 25 million euros.
The Framework Directive confirms the basic principles that Solvency 2 will apply. Three further steps remain before the process is complete: the development and adoption of “implementation measures” stipulating how the principles of the Framework Directive are to be put into practice (consultation is due to start in October 2009); the preparation of guidance to ensure uniform domestic implementation of the principles and implementation measures; and enhanced cooperation among member states of the European Union, their regulators and the industry itself.
The programme currently envisages that member states will individually implement Solvency 2 into domestic legislation by October 2012.
What does the Framework Directive tell us about Solvency 2, what practical effects will Solvency 2 have on how firms manage themselves in the future, and how will it affect the shape of the market?
What is Solvency 2?
There are three fundamental components to Solvency 2: a “risk-based” approach to the quantitative measuring capital adequacy (Pillar 1); an adequate system of governance by reference to “qualitative requirements”, focusing on clear allocation of duties and giving central importance to the understanding of a wide range of risks facing the firm (Pillar 2); and public disclosure and regulatory reporting (Pillar 3). What follows focuses on Pillars 1 and 2.
Quantitative requirements
Current prevailing European (although see below as to the UK) supervisory rules just require firms to allocate capital to their insurance liabilities (case reserves and incurred but not reported (IBNR) claims). Pillar 1 will revolutionise this by requiring firms to take into account not just insurance risk but a broad range of risks, including market, credit, operational, etc.
The quantitative requirements will oblige firms to assess expected claims, and value assets (technical provisions) necessary to pay them, and to add a loading sufficient to allow the firm to cope with one-in-200-year events.
Assets and liabilities are valued on the basis of the amount an independent insurer, purchasing a portfolio in an arm’s length transaction, would require to assume the liabilities. The process therefore has regard to what risk premium a third party purchaser would require.
This risk adjustment will have significant impacts on how much capital firms must allocate to lines of business. It may encourage firms to discontinue some lines and to allocate more capital to others producing a better risk-adjusted rate of return.
Impact on UK firms?
Risk-based assessment is nothing new in the UK. The general approach was introduced in 2004 in the form of “Individual Capital Assessments” (ICAS). ICAS involves solvency assessment based on a one-in-200-year event. UK firms are therefore not expected to be as affected by Solvency 2 as many of their continental counterparts. Indeed, a vast number of UK industry participants have already completed internal assessments to identify the quantitative impact of Solvency 2.
Nevertheless, under Solvency 2, firms will need to obtain approval from the Financial Services Authority (FSA) if they wish to use their own “internal formula” for assessing risk.
Qualitative requirements
The qualitative requirements concern the clear division of responsibilities within the firm, and the identification and monitoring of risk. Division of responsibilities within the firm will not be new to the UK, as the FSA Handbook already provides for a similar regime. However, even UK firms will need to revamp their approach to risk.
Enhance and entrench risk management procedures
Pillar 2 will require firms to enhance and entrench many of their risk management procedures, ensuring strong top-down overview of systems and controls and monitoring of risk assumption.
Some firms recently have been asked by the FSA in an Advanced Risk Review Operational Framework (ARROW) visit why their risk manager is not a member of the board and whether they consider it to be necessary to amend this. Firms may feel that the meteoric promotion of individuals within the firm may be an excessively expeditious response to the need for effective risk management. There is no doubt that effective risk management should be achieved through more ingrained, systemic or grassroots level changes. Intimate involvement of senior management is vital to effective risk management. But sudden promotion can look more like filling “quotas”.
Enhanced internal reporting
Pillar 2 will oblige firms to monitor and understand all the risks to which they are exposed, and ensure risk management systems are fully integrated and a fundamental part of their operation.
Senior management will therefore need reports on the varieties of risk they must take into account. Those reports will need to be accurate and comprehensible. These individuals cannot be expert in every form of risk. Firms will therefore need to develop reporting methods and strategies for rendering technical data understandable without omitting key features.
Supervisors will be on the lookout for poor reporting and/or failure to demonstrate a sound system of governance as “early warning” signs of financial distress.
ORSA compulsory internal audit
The FSA Handbook currently provides for an optional internal audit. Solvency 2 will render this compulsory, and while the function may be outsourced, senior management will need to exercise meaningful oversight of the function and “challenge” where necessary. That will require appropriately qualified internal personnel.
The Own Risk and Solvency Assessment (ORSA) will involve a wide-ranging stock-taking of all risks facing the firm and the solvency necessary to mitigate them. The ORSA is an internal process, intended to verify that senior management understand the range of risks and have conducted the necessary review of solvency requirement. The outcome of the ORSA determines calculation of capital adequacy, exemplifying the interrelationship of quantitative and qualitative requirements.
Compulsory actuarial function
At present, the actuarial function is an optional add-on for firms other than life insurers and Lloyd’s syndicates. Solvency 2 will make it compulsory. Many firms will need to enhance their systems. An actuarial qualification will not be necessary but “sufficient knowledge of actuarial and financial mathematics” will.
Effect of what is missing from Solvency 2: group support
A major disappointment (particularly for large European groups) was the failure to agree on a “group support” proposals in the Framework Directive. Group support would have allowed pan-European groups to base their capital adequacy on the group’s consolidated position. That would have removed the need for groups to allocate capital for each subsidiary.
While a “review clause” in the Framework Directives leaves open the possibility for a return to issues of group support in the future, the industry may see a number of corporate consolidations or restructurings, unifying the businesses of multiple subsidiaries into one.
Action now
By now many firms will have been asked by the FSA, whether in writing or during ARROW visits, to confirm they have an accountable individual on the board charged with the task of overseeing the implementation of Solvency 2 at the firm. They will also have been asked whether they intend to seek permission for use of its own capital model. Firms are being pressed to act now.
One key concern of Solvency 2 is to ensure meaningful day-to-day involvement of senior management with the skills, qualification and experience to understand risks as reported by operational divisions, and to question and challenge those reports.
This is part of a wider initiative. In a recent statement (May 2009), the CEO of the FSA considered the key lesson from the financial crisis was the need for a “culture of challenge” to improve management decisions about the running of a firm. This applies to executive and non-executive board members, as well as shareholders. It is by changing the culture, the FSA considers, that the industry can best protect itself (and the consumer) against financial disaster.
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