January 25th, 2010

Solvency II – Gearing up for tougher Capital Requirements

Posted at 10:00 AM ET

The development of Solvency II continues to be one of the most significant regulatory developments for the insurance industry applicable to both primary carriers and reinsurers. European insurers are starting to focus now on the risk-sensitive regime they will face in 2012, especially on the impact of the risk-based quantitative requirements for measuring financial positions and capital adequacy.

Following completion of Level I guidance and the results of the Quantitative Impact Study (QIS) 4 conducted in 2008, the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) issued detailed technical advice on Level 2 implementation measures on Solvency II in three waves of consultation papers. The consultation papers covered a broad range of technical implementation details ranging from valuation of assets and liabilities, calculation parameters for the Minimum Capital Requirements (MCR) and the Solvency Capital Requirements (SCR). They included the impact of risk mitigation, admissibility of own funds and risk models, governance systems and reporting and supervisory procedures.

Based on the feedback that the various industry stakeholders provide(d) on their views of the consultation papers, CEIOPS prepares various sets of advice to the European Commission (EC), the political body responsible for conceiving the final Directive. The final set of advice from CEIOPS to the EC is expected in early 2010 followed by the final set of quantitative tests - QIS5, scheduled for August through November 2010. Finalization of the Solvency II directive is expected by the end of 2011 with mandatory implementation of the regulations in the various EU countries by the end of 2012 (see chart “Time Table: Solvency II”).

Time Table: Solvency II

solvency_timetable_december-big2009

 

 

The global financial crisis has inevitably raised questions about whether Solvency II is appropriately focused and sufficiently conservative to adequately protect European policyholders. The thrust of the last two waves of CEIOPS consultation papers showed a general trend towards increased capital adequacy requirements. The industry has quickly grasped the consequences of these more rigorous CEIOPS’ recommendations and in the last few months intensified significantly the lobbying efforts over the proposed implementation measures.

Insurers worry that the new regulatory regime will become excessively conservative, cumbersome to implement and invasive in day-to-day business practices. The industry’s main lobbying body, the European Insurance and Reinsurance Federation (CEA), warned that the suggested implementation measures tend to understate true economic capital resources available and to overstate capital requirements.

The latest proposals of CEIOPS appear much more conservative, putting companies under severe pressure from both sides: increased capital requirements and a more rigid definition of capital available. In particular, the compliance bar has been raised substantially in the following areas:

- Own Funds: The amount of hybrid capital eligible in Tier 1 as core capital is to be reduced from 50 percent to 20 percent. Furthermore the admissibility of assets is defined more strictly, e.g. the exclusion of deferred tax assets.

 
- Reserve Measurement: The calculation of technical reserves is made more conservative with no deviation allowed from a risk-free interest rate. Specific to non-life reserves, the proposed reserve factors within the standard model have been increased for all lines of business, suggesting a higher underwriting capital charge. According to Fitch Ratings, European insurers are less likely to find capacity available for long-tail lines of business if the latest set of reserve capital charges are accepted as suggested.

 
- Correlations: Significant changes in correlation parameters from those set in QIS4 result in expected higher capital charges. For instance, CEIOPS proposes to increase the correlations in the market risk module sharply from a range of 50 percent to 75 percent, compared to 0 percent to 25 percent in QIS4. In the non-life underwriting risk module, the assumption of non-correlation between the premium and reserve sub-module is no longer valid. A correlation of 25 percent is suggested, resulting in an elevation of the non-life underwriting capital charges of approximately 7 percent.

 
- Diversification Benefits: A material reduction in diversification benefits available within the standard formula will result in a substantial increase in capital requirements. For instance, the overall capital requirement is expected to rise by 13 percent for non-life insurers due to a reduced credit for diversification benefits.

Although it is unlikely that the current proposals will be implemented unchanged in the final Directive, it is expected that European risk carriers will be under greater pressure to prove that they hold sufficient capital and that risk is appropriately understood, controlled and integrated into their overall business strategies.

As a consequence, Guy Carpenter expects in the next 48 months a movement in Solvency II activities from a pure compliance-focused measurement towards a more pro-active management of the economic and (therefore supervisory) capital position, including revision and adjustment of the risk mitigation strategy.

 

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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