January 12th, 2011

Industry Issues and Trends: Regulatory Activity Remains a Central Focus, Part I: Solvency II: a Global Issue

Posted at 1:00 AM ET

141x141jan1thumb7We enter 2011 with forces at work that are poised to reshape the global reinsurance industry. While the largest of them - Europe’s Solvency II regulatory framework - will not become fully effective until 2013, preparations for its sweeping changes will be an important agenda item for many firms in the year ahead.

Solvency II: A Global Issue

We are closing in on the implementation of Solvency II in January 2013, and while there are still many issues that need to be resolved between now and then, its introduction will not be further delayed. While the January 2013 date appears very firm, the European Commission has agreed that a phased-in approach is required. Details on how this will work are not yet available.

The main purpose of Solvency II is to protect policyholders by ensuring capital adequacy. Most insurers will be required to hold more capital per unit of risk. This new regulatory framework will enact a fundamental change in the way European insurance underwriters quantify risk and undertake risk management practices, as it will force the convergence of all aspects of risk quantification with those of business decision making. This may be an opportunity for insurers to improve their operating models while possibly developing competitive advantages in very challenging economic and overall market conditions.

The main difficulties in implementing such a regime within any organization are driven mostly by the shortage of resources available to measure risks and manage
regulatory measures. Solvency II is not only a change in risk management practices but also in management information systems - with a substantial burden resulting
from documentation, transparency and disclosure requirements.

The resource costs associated with Solvency II’s implementation are putting significant pressure on companies at a time when market conditions and underwriting results are less than optimal. As a result, smaller companies and niche players will be most at risk, which could potentially lead to significant consolidation in the insurance industry.

The latest Quantitative Impact Study (QIS5) on Solvency II’s potential industry effects was completed in November 2010, with its results expected to be published in April 2011. A significant increase in participation is expected to be seen in the report, with approximately 2,500 companies taking part in QIS5 compared to some 1,400 under QIS4. The outcome of QIS5 is likely to be the last opportunity for insurance companies to influence the makeup and final calibration of the new regulatory framework. Given that each comprehensive study takes between 18 and 24 months to complete, there is unlikely to be another QIS before the implementation of the new regime.

Solvency II has been developed in the EU for EU insurers, but the regulatory impact will affect our industry on a worldwide basis. This has been addressed by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) in its final advice on the topic of equivalence, which was issued in August 2010. In October 2010, the European Commission accepted CEIOPS’s recommendation to include Bermuda and Switzerland in its first wave of assessments for all three levels of
equivalence. These levels can be summarized as:

1. Reinsurance considerations

2. Group solvency calculations

3. Group supervision

It was also agreed that Japan would be considered for inclusion, but only for
reinsurance considerations.

The United States, given the size of its reinsurance market, is a prime candidate for consideration, but its state-based regulatory environment poses significant hurdles. Under non-equivalence, the European supervisors would have the power to require that US companies would have to pledge collateral in support of any reinsurance
transaction - whether internal or external - of an EU entity.

The topic of equivalence could create a significant disadvantage for insurance groups with meaningful subsidiaries domiciled outside of the EU and has caused several entities to review the potential implications of their current corporate structure.

Solvency II will continue to make headlines for the next 24 months as insurance entities get ready for its implementation and, in particular, continue to develop their model documentation (which is not insignificant and includes risk management processes and use tests, Own Risk and Solvency Assessments (ORSA), procedures for
transparency and disclosure and catastrophe model vendor documentation).

Click here to read the Executive Summary of Guy Carpenter’s report: Global Reinsurance Outlook: Points of Inflection; Positioning for Change in a Challenging Market >>

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