October 26th, 2016

Solvency II: An Era of Greater Risk-Driven Management

Posted at 1:00 AM ET

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Andrew Cox, Managing Director; Matthew Eagle, Head of GC Analytics® - International; and Eddy Vanbeneden, Managing Director

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On January 1, 2016, the Solvency II regulatory regime took effect. Some celebrated; others were weary from the months and years of preparation.

But, to borrow a turn of phrase from Winston Churchill, this is not the end of Solvency II, it is not even the beginning of the end, but it is the end of the beginning.

The impact of Solvency II goes well beyond its strict regulatory assessment. Solvency II creates an environment for greater risk-driven management of the (re)insurance companies doing business in and with Europe.

While the solvency capital requirement (SCR) and minimum capital requirement are the thresholds used by regulators to trigger action on specific entities, the solvency ratio (own funds over SCR) is fast becoming an important metric for comparing companies.

Today, many companies publish their solvency ratios without being required to do so, and some others actually specify target solvency ratio ranges as part of their risk appetite and financial targets. Solvency ratios are another metric for investors to use when assessing the relative financial strength of companies - and (re)insurance buyers can do the same when assessing counterparty risk.

Some larger quoted companies use the capital regime to strengthen their self-regulation. By setting target ranges and minimum levels well above 100 percent, these companies create their own parameters for self-intervention in instances when they will buy back shares or simply cut the dividend. We have seen examples of companies recapitalizing after their SCR moved below a minimum range, illustrating the focus investors may start to have on this metric.

However, the effectiveness of a single ratio as the basis of comparisons should not be overstated. For example, how comparable is a standard formula-based ratio to one calculated on an internal model? What about different use of transitional arrangements, or matching adjustments? As Solvency II is still being introduced at different rates, various stakeholders have to pay attention to individual company standards for reporting solvency ratios.

Volatility

Another shortcoming of a single ratio is that it provides no insight into the resilience of an entity’s capital position. This became relevant when market volatility spiked in the first quarter of 2016 and companies disclosed how much their Solvency II ratios fell in the period.

This environment produced varying outcomes in the first half of 2016, with an additional sharp increase in volatility caused by catastrophe losses. Timely and accurate reporting of this volatility has increasingly become a management responsibility.

Today, reinsurance as an alternative form of capital is more at the center of risk management. Insurers have increased efforts to understand and quantify all material risks and are using reinsurance not only as a tool to manage capital and their SCR ratio, but also to manage earnings volatility as reflected in their risk appetite statements and risk tolerance levels.

Risk Management and Risk Profile

With the transition from Solvency I to Solvency II, insurers have to contend with a more complex and comprehensive risk management framework than just premiums and reserves. This new framework encompasses the full range of risks exposing a (re)insurance portfolio, including an examination of existing risk mitigation frameworks.

Insurers are more heavily focused on reviewing their diversified risk profile with more active risk and portfolio management, with each portfolio segment examined on its own merit.

The stronger focus on risk management is pushing (re)insurers to review the varying contributions to capital needs and earnings. For those companies that have decided to develop an internal model, the alignment with all requirements can be challenging. There is a need to provide a clear view of the risk for a range of risk classes not just limited to the most obvious.

Solvency II is not limited to the calculation of the required capital. It creates an environment for a more global and robust approach to risk, from risk selection and pricing to capital needs and allocation.

Solvency II and Equivalence

The concept of equivalence under Solvency II determines to what extent (re)insurance entities outside Europe can operate within the European Union (EU) while relying solely on their local solvency standards. The ability to operate in the EU is a significant issue that impacts multinational (re)insurance companies and groups.

For operations in equivalent countries, the recognition of their local solvency regimes is more straight-forward.

However, non-equivalence imposes a more complex solvency management for groups operating in these environments and who wish to transact European business.

Some (re)insurers have been pushed to locate their operations in the European Economic Area (EEA) when they previously had no presence in any country subject to Solvency II.

The objectives of Solvency II include improved consumer protection and modernized supervision that shifts supervisors’ focus from compliance and capital monitoring to evaluating insurers’ risk profiles and the quality of risk management processes.

While Europe initiated the ideas embodied in Solvency II, other jurisdictions have taken this example and implemented their own risk driven regulatory regimes. As a result, Solvency II has led to a new global solvency standard. The Own Risk and Solvency Assessment (ORSA) principle has created a framework for the risk and risk mitigation environment, which is now accepted globally, from the United States and Bermuda and extending to Asian countries.

The Solvency II Directive sets out three distinct areas for equivalence:

1. Reinsurance

2. Group Solvency

3. Group Supervision

The European Commission (EC) has adopted a number of equivalence decisions for third countries under Solvency II, which set out rules to develop a single market for the insurance sector.

After receiving equivalence, third country insurers are able to operate in the EU in compliance with all EU rules. The United States, in addition to Australia, Brazil, Canada, Japan and Mexico, has been granted provisional equivalence regarding group solvency calculations for ten years. Switzerland and Bermuda have been granted full equivalency, while Japan has received equivalence for reinsurance.

Based on these guidelines, achieving equivalence has taken on significant importance for an EEA (re)insurer. For example, a positive equivalence allows EEA insurance groups permitted by their group supervisor to adopt local rules regarding their own funds and capital requirements.

Equivalence status has both strategic and capital management implications. For EEA firms operating inside non-equivalent countries, these firms may be required to change or alter their strategies.

Non-equivalent EEA firms may face higher capital requirements, which could deter their expansion into new territories, or their ability to offer and write new products, or even delay the payment of dividends.

The US and Solvency II Equivalency

Separate but related negotiations continue between the EC, European Insurance and Occupational Pensions Authority, and in the United States, the National Association of Insurance Commissioners (NAIC) and the Federal Insurance Office (FIO).

The 2012 NAIC model law on credit for reinsurance has been adopted by regulators in 35 states in the United States. While this law reduces collateralization requirements for seven countries, it has not yet been fully adopted by all 50 U.S. states.

As such, it remains a point of contention for European and London reinsurers and others who favor the EU’s single-market approach, and have been seeking reductions in their collateralized obligations in the United States for decades.

The United States and the EU have announced negotiated agreements that would address such collateral issues, including a covered agreement between the United States and one or more foreign governments, authorities or regulatory entities regarding prudential measures with respect to insurance or reinsurance.

Most recently, trade representatives for the United States and the EU met in May and July 2016 to negotiate a bilateral covered agreement on regulations for insurers and reinsurers but have yet to reach a final agreement.

If adopted, the covered agreement could make it easier for EU reinsurers to operate in the United States and may also be a stepping stone towards Solvency II equivalence, easing the way for US reinsurers to operate in the European market under permanent, rather than provisional equivalence.

Asia Pacific Solvency II Equivalence

Solvency II’s reach and influence extends to Asia Pacific, as Japan and Australia attained provisional third country equivalence status for Group Solvency (Article 227). This status is valid for ten years and reduces the administrative burden for the Solvency II calculation of subsidiaries in the EEA.

Japan further attained temporary equivalence for Article 172 until 2020, which allows for reinsurance contracts between EEA (re)insurers and Japan-based companies to be treated in the same way as reinsurance contracts enacted between EEA firms. Although Japan has been recognized as Solvency II third country equivalent, the JFSA continues to review and refine the framework.

The regulatory issues facing (re)insurers with international operations require highly specialized expertise. Guy Carpenter’s Strategic Advisory┬« has a team of professionals who can help companies navigate the Solvency II realm and the risk-driven approach to management.

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