March 15th, 2011

Succeeding Under Solvency II: Pillar One, Capital Requirements; Part I

Posted at 1:01 AM ET

Introduction: An Evolving Issue

Despite its nominally European focus, Solvency II presents a wide range of considerations - and opportunities - to insurance entities worldwide. This new regulatory framework will enact a fundamental change in the way the European insurance industry looks at risk and risk management practices, as it will force the convergence of all aspects of risk quantification with those of business decision making. All businesses that have operations, subsidiaries or affiliates in Europe, write coverage in Europe or do business with insurers in Europe should be preparing now for these wide-ranging changes.

While the final form of Solvency II has yet to be ratified, much preparatory work and analysis has been completed. It is clear that the framework will be built on three fundamental pillars. Pillar I addresses the quantification of capital requirements for insurers. Pillar II focuses on governance and risk management and Pillar III deals with disclosure and transparency requirements.

This paper is the first in a series of Guy Carpenter briefings examining Solvency II and its attendant issues as they are finalized over the next several months. This paper focuses on Pillar I, while subsequent briefings will cover Pillars II and III as well as the special counterparty risk considerations for reinsurers.

While the new framework will impose sweeping changes that will affect virtually all insurers doing business in Europe, companies that are dedicating resources to understand the new requirements and make the necessary preparations can succeed - even excel - under the new regulatory regime.

Timeline: Transitioning to Solvency II

While the official implementation date isn’t until January of 2013, the process for defining and adopting these sweeping regulations is already well underway (see Figure 1).

Solvency II is being developed under the European Union’s (EU) Lamfalussy process (1). The different stages of this process have been managed by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS, now known as EIOPA, for European Insurance and Occupational Pensions Authority), which has met with the different stakeholders and developed recommendations. These recommendations are then reviewed by the European Commission (EC), which has the authority to define the final principles and is set to enforce the directive in January of 2013.

Alongside this, companies and regulators are heavily engaged in digesting Solvency II’s fifth Quantitative Impact Study (QIS 5). This is the last in a series of test studies used to develop the standard formula, which will be the basis for determining the Solvency Capital Requirement (SCR) for EU insurers and reinsurers. The results are expected to be released in March of 2011.

Final implementation measures are still being discussed and will determine the ultimate form and impact of this new regulation.

Companies need to address several key issues to ensure that they are ready for Solvency II. These may include building and documenting an internal model that is embedded within the entity’s enterprise risk management (ERM) framework to meet the use test requirements.

Figure 1.

solv-ii-wp1-fig-1

The implementation of Solvency II is likely to be executed transitionally. On January 19, 2011, a provisional draft of the so-called Omnibus II directive was published, which will, if adopted, amend the Solvency II directive to provide for a phased rollout. Omnibus II proposes a number of areas where the EC may adopt transitional measures and sets out the maximum duration of those measures (Figure 2).

Figure 2.

solv-ii-wp-1-fig2

Moody’s Investors Service called the Omnibus II proposals “broadly credit positive” for the European (re)insurance sector, allowing a smooth transition to the new Solvency II regime that avoids market disruption. Still, the transitional approach should particularly benefit smaller companies, as they were likely to face the biggest challenges in fully meeting the new solvency capital requirements in January of 2013. The Omnibus II proposals buy them more time; in some areas, up to ten years.

In February of 2011, Dominic Simpson, senior credit officer at Moody’s, said: “Transition measures should enable smaller companies to progressively adopt the new standards. Conversely, larger, more sophisticated groups who are already well prepared for the switch would lose a potential competitive advantage.”

Industry-wide preparations for Solvency II are not consistent for all companies or across various European jurisdictions. A PwC survey published in November of 2010 (2) indicated that there is a fairly even split between the respondents who have Solvency II projects underway and those who are just at the initial stages. Activities typically done in the early stages are the gap analysis and the implementation plan. Companies still in preparatory stages are generally smaller firms, or smaller entities within groups (not material to the overall group). Geographically, the most advanced respondents (defined as those who range from 51 percent to 75 percent complete) are based in France, Germany and Belgium.

Notes:

[1] The Lamfalussy Process is an approach to the development of financial service industry regulations used by the European Union. The four-level process includes the following - level 1: framework principles; level 2: implementation measures; level 3: guidance regarding day-to-day supervision; level 4: enforcement.

[2]Getting Set for Solvency II: Comparing Goals And Benchmarking Progress On Solvency II Implementation Across Europe, PwC, November 2010.

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