March 16th, 2011

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

Posted at 1:00 AM ET

Pillar One’s Impact on Insurers

The first pillar of Solvency II is the quantitative component of the new regulations. It deals with the capital requirements of insurers wishing to provide coverage in the EC markets.

Minimum Capital Requirements (MCR) and Solvency Capital Requirements (SCR)

Solvency II contains two levels of capital requirements: the Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (MCR). The SCR is a target level of capital, while the MCR is a minimum threshold below which companies will no longer be permitted to trade. If the available capital lies between the SCR and MCR, it provides an early indicator to the supervisor and insurance company that action needs to be taken.

To comply with Solvency II, companies may calculate SCR using the standard formula that is provided within the requirements themselves, or they may demonstrate to the regulators that their internally developed, bespoke models meet the regime’s requirements. This internal model versus standard formula distinction is a major consideration for all companies preparing for Solvency II. The option that is chosen will vary on an individual company basis, but in general terms, we expect larger companies - with more in-house administrative, legal, compliance and clerical resources - to opt for the internal model, while smaller companies with limited resources likely will adopt the standard formula or a partial internal model.

Resources Are a Major Factor

Greater pressure in preparing for Solvency II falls on companies that may be smaller, less diversified and with more limited resources. The information technology (IT) support, for example, may not be available to all companies who need to demonstrate sufficient data quality in the process of obtaining regulatory approval for their internal models. These companies may also have lower levels of diversification and potentially more volatile or insufficient data to develop and use internal models. This may be exacerbated for companies such as mutuals without easy access to additional capital.

Resources are also an issue for the regulators themselves, who are charged with enforcing Solvency II and must have proper levels of capacity to audit and sign off on the models. It is likely that these needed levels of resources will not be fully achieved by the time Solvency II comes into effect.

Implementation Issues Differ By Insurer Category

Solvency II’s impact and implementation process depends on the size, sophistication and business mix/level of diversification of a given company. There are three classes of insurers that may encounter different experiences in the implementation and the impact of Solvency II.

Niche Players - Niche insurers are companies that may be monoline players or are less diversified in terms of lines of business or geographic coverage. For these companies, the standard formula may be quite punitive, creating an incentive - or even an absolute need - to put in place a partial or full internal model. Depending on their size, they may also have lower levels of resource availability to address Solvency II, further complicating the situation.

Companies that do not implement an internal model are expected to face higher capital charges. They may need to take steps to mitigate these requirements. They can opt to bring in additional capital (at a cost) or strategically divest certain lines of business through the purchase of reinsurance protection. These options may include loss portfolio transfers, adverse development covers or other types of run-off protections. They can also choose to enter new lines of business in order to diversify their writings and consequently achieve lower marginal capital requirements.

Small to Mid-Size Players (revenues below EUR5 billion) - These companies are generally expected to use the standard formula for the short term and will later begin a concurrent implementation of their own internal model. Using the standard formula spreadsheet, the calculation of capital requirements can be done fairly quickly without a large resource dedication. Development of an internal model, as discussed, requires a larger resource commitment from both staffing and financial perspectives.

There are other factors that may steer a company away from development of an internal model. For example, Solvency II may be seen as a purely regulatory requirement with no resultant impact on profitability. There may also be uncertainty related to receiving approval of the internal model and the length of time required to receive the approval.

In some instances, it may be beneficial for certain companies to opt for the standard formula permanently. The risk charges behind the standard formula are by definition meant to be conservative, but this may not turn out to be the case for all companies. In fact there may be cases where this approach will actually provide lower capital charges than those produced through an internal model. (This overly positive assessment, however, may lead some companies to make inappropriate decisions about risk and capital management, which potentially could create directors and officers liability exposures for these companies.)

Large Global Players (multiline, reinsurers, revenues over EUR5 billion) - Large global (re)insurers are typically opting for an internal model approach, and many are already in a pre-application phase with regulators as part of the Internal Model Approval Process (IMAP).

These companies are currently facing Solvency II-related resource burdens, particularly around documentation requirements and transparency of the model. They will also face choices about which facets of the implementation work should be outsourced versus performed in-house.

Quantitative Impact Studies (QIS)

A series of field tests have been implemented to help companies and regulators preview the impact of Solvency II on capital levels. In the latest of these (QIS 5), preliminary feedback from companies revealed a need for further refinement and improvements to the Solvency II regime. This led the CEA (the European insurance and reinsurance federation) to call on European regulators in February of 2011 to effect the necessary adjustments.

The test results revealed the complexity of certain calculations and requirements. They showed that the standard formula has become so complex that it would no longer be feasible for some companies to implement.

The tests also demonstrated a need to ensure the correct treatment of short-term market volatility, an issue of particular concern to life insurers - and a key consideration regarding the capital charge for non-life underwriting risks, especially catastrophe risks. Solvency II is expected to create greater volatility to non-life earnings and balance sheets, as non-life liabilities will be marked-to-market and calculated on a best estimate basis. Many of the conventional smoothing mechanisms used by non-life insurers may no longer be effective or possible.

The QIS 5 exercise further showed that Solvency II may put pressure on mutual insurers, many of which may have benefitted from the low capital requirements under Solvency I, in addition to the earlier regime’s being less dependent on rating agency models.

QIS 5 results are to be released in March of 2011 and many stakeholders hope they will provide new and valuable insight into the aspects of Solvency II that may need to be amended and improved.

Cost Considerations

Solvency II is more than a regulatory process; it represents for insurers the need for a new perspective on how to manage their businesses. It undoubtedly also will have an impact on the competitive landscape by affecting different companies, lines of business and geographies in different ways.

Ultimately, Solvency II will present a huge capital burden to the industry. Implementation costs are a major additional expense in an environment where insurers are already struggling to maintain profitability during an inopportune time in the underwriting cycle. The ultimate goal of the initiative is to create a more secure and safe environment for policyholders, however, the substantial costs to the industry as a whole are such that the more immediate impact may be the exact opposite of what was intended.

Indeed, the overall implementation costs for Solvency II are difficult to overstate. The November 2010 PwC survey indicates that the industry-wide Solvency II implementation cost is on course to exceed the European Commission’s estimate of EUR3 billion  (1).  Lloyds of London is expecting to spend GBP250 million in total on implementation, with annual ongoing Solvency II related expenses of about GBP60 million to GBP70 million. Multinational insurers in the UK have set aside roughly GBP100 million for Solvency II implementation.

Adding to the expenses associated with implementation, (re)insurers must also consider the following additional Solvency II-related costs:

Model Approval and Ongoing Compliance Costs

The expenses incurred by regulatory bodies in enforcing Solvency II will, naturally, be passed on to the industry.

In the UK, for example, the Financial Services Authority (FSA) will levy over GBP34 million in fees against insurers in 2011 and 2012 to cover its costs of implementing the Solvency II regime. The fees aim to cover the expense of approving insurers’ internal models as well as other related costs. The total FSA cost of implementing Solvency II over the lifetime of the program remains in the anticipated range of GBP100 million to GBP150 million. The FSA’s proposed annual funding requirement for regulated firms in 2011 and 2012 is GBP500.5 million.

Cost of Additional Capital Levels

The cost of maintaining required levels of capital will rise substantially under the Solvency II regime.

The capital requirements promulgated by QIS 5 for non-life insurers (before diversification) have been raised overall by approximately 15 percent over QIS 4 and are approximately three to four times greater than Solvency I capital requirements. The increase reflects the risk-based nature of Solvency II (as opposed to the simple premium/claims-based factors of Solvency I), and, not surprisingly, varies greatly by line of business. For example, capital requirements for nonproportional lines are five to six times greater than those for Solvency I levels. Those for motor insurance are one to two times greater.

For life insurance, the change in capital requirements also differs across product types. Consequently, the relative profitability and economic attractiveness of specific products will change under the new solvency regime. Higher capital requirements are expected for participating products in contrast to other life products. In general, the total resource requirement (the sum of technical liabilities and SCR) for traditional participating life products increases. At a company level, however, the impact depends very much on the capital surpluses and buffers available for participating/with profit policies. .

Other Costs

Various recruitment firms have stated that cost overruns may be driven in part by a severe shortage of actuarial staff, forcing insurers to pay 20 percent more than usual to attract and retain skilled personnel for the project. Meanwhile, the PwC survey indicates that over 20 percent of respondents believe that most of their costs will relate to the IT infrastructure spend required to meet Solvency II requirements.

In addition to hard, quantifiable costs, companies also are likely to incur significant opportunity costs relating to the staff resources that will have to be diverted from the ongoing work of the company to focus on this compliance initiative. Development of the internal model, especially, will necessitate high levels of dedicated staff resources. The cost in human capital - and lost opportunity - will be considerable.

Note:

[1] Page 6 of the European Commission’s impact assessment executive summary (July 10, 2007).

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