April 12th, 2011

Succeeding Under Solvency II, Corporate Governance (Pillar Two) and Disclosure (Pillar Three): Preparation

Posted at 1:00 AM ET

David Flandro, Global Head of Business Intelligence, Claude Lefebvre, Head of GC Analytics EMEA Region, Eddy Vanbeneden, Head of GC Analytics France and Benelux and Frank Achtert, Managing Director
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Preparing for “Pillar V”

Implementation of the Solvency II regime is approaching rapidly. The directive is expected to take effect in January 2013 and will mostly affect, but not be limited to, (re)insurers operating in or covering risks in Europe. It is 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.

While the final form of Solvency II has yet to be ratified, a great deal of preparatory analysis has been undertaken and the likely effects of the directive are becoming understood. Pillar I will have a profound impact on capital requirements, potentially affecting company-wide strategic decisions. Companies will also likely increase investments in areas related to the determination and reporting requirements of Pillars II and III: specifically, corporate governance and disclosure. These elements of Solvency II could create a significant increase in workload and management for European (re)insurers.

The previous report in our Succeeding Under Solvency II series focused on the capital requirements associated with Pillar I. In this briefing, we concentrate on the second and third pillars - which we refer to as a combined “Pillar V” (Pillar II plus Pillar III) requirement. In addition to a potential increase in expenses for carriers, the Pillar V requirement may also instigate the adoption of an underlying business and capital discipline that leads to a clear competitive advantage in a marketplace that is already mature. Mastering Pillar V, therefore, means more than mere compliance: it translates to a leading edge in a competitive environment where there are few operational opportunities to stand out.

An extensive series of preparatory steps leading up to Solvency If’s official inception is already underway (see Figure 1). Developed under the European Union’s (EU) Lamfalussy process , the different stages of this process have been managed by the European Insurance and Occupational Pensions Authority (EIOPA, formerly known as the Committee of European Insurance and Occupational Pensions Supervisors, CEIOPS). EIOPA has met with the various stakeholders in the risk supply chain and developed recommendations that will be reviewed by the European Commission (EC). The EC has the authority to define the final principles and is set to enforce the directive in January 2013.

Figure 1

solvency-ii-2-fig-1-small

Source: EIOPA, Guy Carpenter & Company

At the same time, both companies and regulators are assessing the results of Solvency II’s fifth Quantitative Impact Study (QIS 5), the last in a series of test studies used to develop the standard formula and ultimately the basis for determining the Solvency Capital Requirement (SCR) for EU insurers and reinsurers. The results were released in March 2011. The results demonstrated that the financial position of European (re)insurers remains relatively comfortable when assessed against the QIS 5 Solvency Capital Requirement. Insurers’ eligible own funds resulted in an excess by EUR395 billion over the SCR amount implied by the QIS 5 study.

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 (see Figure 2).

Figure 2

solvency-ii-2-fig-2-small

Source: Draft Omnibus II Directive, Guy Carpenter

Under Omnibus II, the EC has the option to apply different measures to support the transition of the (re)insurance industry to Solvency II for up to ten years after the introduction of the directive in order to accommodate several areas.

Still, the transitional approach would likely benefit smaller companies, as they are expected to face the biggest challenges in meeting the new capital requirements by January 2013. Some components of the Omnibus II proposals may give these carriers more time.

QIS 5 results revealed variations in the SCR values obtained when using an internal model against the standard formula across all individual insurers. Large and medium-sized insurers tended to achieve greater capital benefits from using an internal model than smaller insurers - 289 individual insurers out of the 309 who responded to the question stated that they were currently working on implementing an internal model for Solvency II. For groups, however, internal models showed a capital requirement of 80 percent of that calculated using the standard formula, where best results in capital reductions were obtained by well diversified groups. Nonetheless, only 29 out of 167 groups that participated in the QIS 5 exercise claimed to be developing an internal model. Philippe Guijarro, a partner at PwC, states that, “QIS 5 demonstrates there are still a number of areas where insurers face implementation challenges.” He added, “The low use of internal models in QIS 5 suggests insurance groups may not be as prepared as they could be.”

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