October 12th, 2009

Turn Solvency II Compliance into a Competitive Advantage

Posted at 1:00 AM ET

keeling_henry_141x141Henry Keeling, President and CEO of Guy Carpenter’s International Operations

The emerging consensus seems to be that Solvency II will cost a lot and make the (re)insurance business more complicated. If conventional approaches to regulatory compliance are applied, this is likely to be true. After all, compliance tends to be seen as just another expense. This does not have to be the case for Solvency II, however. Choosing the right approach could free capital for investment elsewhere, ultimately resulting in a competitive advantage. “Competitive compliance,” consequently, can create an upside where most would perceive only a cost to be managed.

The purpose of Solvency II is straightforward: to ensure that European (re)insurers have enough capital on hand to support the risks they have assumed. Carriers need to demonstrate a 99.5 percent likelihood of their solvency in the coming 12 months. To demonstrate this, the Solvency Capital Requirement (SCR) must be calculated. The SCR is where carriers can decide to make Solvency II a cost or an investment, based on the calculation method they choose.

There are two ways to determine the SCR — the standard formula and an internal model (or a blend of the two). The standard formula uses portfolio-agnostic factors applied to financial statement values (with some exceptions). Consequently, this approach can lead to missed opportunities, as the standard formula does not consider the specific risks in a (re)insurer’s portfolio. In some cases, the SCR may be higher than is really necessary to maintain a 99.5 percent likelihood of solvency.

Fortunately, there is an alternative under Solvency II. (Re)insurers can use partial or full internal models — approved by the relevant supervisory authorities — to calculate their SCRs. Instead of accepting a one-size-fits-all approach to compliance and capital management, (re)insurers can model the risks in their portfolios against specific risk profiles and reinsurance structures to ascertain the outcomes that will affect their balance sheets. In addition to attaining compliance with Solvency II, they will benefit from actionable information that can be used to improve decision-making and capital productivity.

Through the use of internal capital models, (re)insurers may find that their SCRs are higher or lower than those determined using the standard formula. If the models require more capital, carriers learn that additional protection — either through increased capital or risk transfer — is necessary to support their risks. A lower level may be fine for compliance, but more may be necessary to protect shareholder value in the event of a shock loss. On the other hand, a lower model-determined SCR suggests that the standard formula results are unnecessarily high given the risks covered, freeing capital for investment in new business opportunities.

This is where the competitive advantage can be secured.

Focusing strictly on compliance — i.e., the “expense” perspective — will put some (re)insurers at a disadvantage, as they will have the added cost of Solvency II compliance without an attendant growth opportunity. Meanwhile, carriers using internal models can gain returns on their compliance investments by optimizing their capital through the course of addressing the regulation. Resources not needed to support the SCR can be deployed to write new policies or for strategic initiatives, such as market entry, new lines of business or acquisitions. The effects of this newly available capital may be evident all the way to market capitalization: comply prudently, and create shareholder value.

Although regulators do not plan to approve specific software platforms, just entire systems including implementation and use, Guy Carpenter’s MetaRisk®, our proprietary economic capital model, can form the basis for an internal model. MetaRisk is among the fastest, most robust and easiest solutions to use in the (re)insurance industry, making it possible to model countless combinations of risk and capital. With MetaRisk, a carrier can evaluate the extremes and everything in between to find the best uses for its capital - for compliance and to achieve its financial objectives.

Approved internal models can turn Solvency II compliance into a competitive advantage. With tools such as MetaRisk, (re)insurers can take the opportunity to improve the productivity of their capital while calculating the SCR, leading to shareholder value-accretive decisions. Rather than spend on a regulatory effort, it is better to invest in capital flexibility while addressing Solvency II in the process. Though many see Solvency II as an obligation, it really offers the opportunity for competitive compliance.

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This article is intended for general information only. The information is not intended to be taken as advice with respect to any individual situation and cannot be relied upon as such. Statements concerning accounting, legal, regulatory or tax matters should be understood to be general observations based solely on the author’s experience in the reinsurance industry, and may not be relied upon as accounting, legal, regulatory or tax advice which he is not authorized to provide. All such matters should be reviewed with your own qualified advisors in these areas.

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