October 11th, 2011

Impact of Solvency II on Primary Insurance Companies: Cost Considerations

Posted at 12:00 AM ET

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 Solvency II 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. A November 2010 PricewaterhouseCoopers LLP (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). Lloyd’s 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 United Kingdom 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 United Kingdom, 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 per unit of risk 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 information technology (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.

Costs May be Exacerbated by Potential Regulatory Inefficiency

To the extent regulators and others cannot meet their enforcement obligations in a timely manner, the delay will add to the opportunity and hard costs for the industry.

In order to fully implement and maintain Solvency II regulation, the European Economic Area (EEA) supervisors and foreign regulators seeking equivalency must dedicate much larger teams of analysts than they currently have available. Even with the expanded deadlines contained within the Omnibus II directive, it is unlikely that the supervisory authorities will have a sufficient number of trained staff without their hiring large numbers of new analysts. The costs involved with staffing-up ultimately will be passed to policyholders and cedents.

The regulatory staffing shortfall will particularly impact the many companies that wish to develop full or partial internal economic capital models rather than adopt Solvency II’s standard formula.

To estimate the size of the dedicated regulatory staff required to oversee Solvency II, we look to Standard & Poor’s (S&P), the credit rating agency. S&P has a dedicated staff of about 45 insurance financial strength rating analysts in and around Europe. These include actuaries, financial analysts, economists and modelers with extensive experience in the (re)insurance industry. Between them, these analysts maintain insurer financial strength ratings - which entail about the same level of work as monitoring a company under Solvency II - on approximately 280 companies, a fraction of the overall European (re)insurance market.

Under these economics, the EEA supervisory authorities would need to build and maintain a dedicated professional staff totaling about 600 analysts, in addition to support personnel, to regulate the approximately 3,680 (re)insurers that fall under the scope of Solvency II (2). This is a generous estimate, considering that S&P is a for-profit organization driven towards capital efficiency by shareholders. Regulators have already begun to grow their ranks of skilled insurance investigators. In M arch 2011, the FSA announced plans to hire an additional 460 staff to assist with the implementation of Solvency II.

Notes:

1 European Commission, Impact Assessment Executive Summary, page 6, July 10, 2007.

2 EIOPA, Report on the Fifth Quantitative Impact Study (QIS 5) for Solvency II, March 14, 2011.

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