One size does not fit all

The deadline for Solvency II, a major overhaul of the existing insurance supervisory system, is less than two years away but many contentious issues have yet to be resolved.

These disagreements could delay implementation of the new risk based capital regime beyond the proposed 2012 deadline, a prospect that does not displease many sections of the insurance market who would like to hold up the regulation for as long as possible.

The new rules will have a significant impact on two areas that could affect risk managers. Firstly, capital requirements under the new regime are likely to be more stringent. This could squeeze some insurers out of the picture, particularly if they are unable to diversify their risks appropriately, increase prices, and restrict the number of products on the market as companies look to allocate capital where it is most rewarding.

Some insurers have already indicated that they will move outside the EU to avoid Solvency II rules that would force them to keep more capital in reserve to compensate their risks. Actuarial consultants EMB say that UK property and casualty insurers face a €15bn jump in capital requirements under Solvency II, given the tougher solvency calculations. In Europe the effects are likely to be worse because the sophistication of risk management techniques and of local regulators is behind the UK.

The treatment of captives under the new regime is the second area of concern for risk managers. If captives are bound by the same rules and capital constraints as the larger and more diversified insurance companies, they could be forced into run-off. As many as 40% of captives could be forced to close as a result of increasingly punitive capital charges imposed by Solvency II, according to ECIROA, the European captive association.

The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) is responsible for producing detailed proposals for the implementation of Solvency II ahead of its coming into force in October 2012. Recent statements by CEIOPS indicate that the regulatory authorities would like to impose even tougher capital requirements on insurers, in light of fears stemming from the financial crisis. CEIOPS’ advice emphasises, in particular, the need for a higher quality of capital.

This has angered the insurance industry, which doesn’t feel responsible for the global financial crisis and, with the exception of a few high profile cases, weathered the storm reasonably well.

Technically speaking, the main bone of contention between the regulators and the insurance industry is over the question of how to calculate solvency capital requirements (SCR).

Under Solvency II, insurance companies have the option to elect the standard model for SCR as defined by the regulations or apply for approval to use internal models. Insurance companies that build their own models internally will generally require less capital, because the basis of the standard model is more conservative.

For a long time, many of the best insurers have realised the benefits and possible competitive advantage of using the internal model option. Such models provide a common measurement basis across all risks and are a powerful tool to enhance company risk management and to better embed a risk culture in the company. And yet, internal models continue to come under considerable criticism and suspicion from the regulatory authorities.

Ferma’s Pierre Sonigo, who heads up the European risk federation’s working group on Solvency II and captives, claims that CEIOPS and the regulatory authorities are trying to push insurance companies to adopt the standard model rather than building their own ones internally.

This could be because assessing whether or not internal models are admissible requires a lot of work from the regulators. Among other things, the supervisor needs to review and accept a number of aspects including management oversight, documentation, internal controls and review systems, as well as whether the model is sufficiently embedded in key business processes.

All this is much more time and resource intensive than accepting the standard model across the board, which is CEIOPS’ preferred approach, according to Sonigo.

“It is much easier for the regulators if everybody uses the standard model,” says Sonigo. “But the capital requirements under the standard model are huge, so it is worthwhile for insurer to do a bit more work to get the internal model approved.”

Risk managers will have to wait until the results of a quantitative impact study (QIS5) are published in April next year to see whether or not the regulators have encouraged most insurers to stick with the standard model. One early indication from the UK is not promising. In the UK just 120 of the 700 non-life insurers bound by Solvency II, have put forward internal models for approval.

Some insurance buyers are concerned that if capital requirements are set too high under the standard model, as is implied by CEIOPS’ advice, some companies may be forced out of business because they won’t be able to raise the necessary capital. These capital problems are only exacerbated by current credit restrictions.

Buyers are also worried that insurers will increase prices or retreat from certain lines of business all together, such as industrial risks, which, because of their risky nature, require large capital reserves.

Therefore, Ferma and the captive owners community is standing shoulder to shoulder with the insurance industry, and facing off against the tough stance of the regulatory authorities. It is in their interest to see a stable insurance sector with plenty of competition.

Adds Sonigo: “It is good that we share the same opinion as the insurers, because we can support each other. If the clients [insurance buyers] and the insurers say the same thing it is difficult for politicians to ignore us.”

“We need the products and also the players,” he continues. “If Solvency II reduces the number of insurance players in the market it is not good for us.”

Over the next two years Ferma will be trying to get this message across to Karel Van Hulle, head of insurance and pensions at the European Commission and the man responsible for Solvency II, says Sonigo.

Cooperation between the two camps is much harder to find in another area of Solvency II that will affect corporate risk managers.

CEIOPS would like to see the Commission restrict the definition of captives so they are only able to write business for their parent company. Naturally, corporate captive owners resent this strict definition and fear that it, along with punitive capital charges, could cause a severe contraction in the operation of captives in Europe.

ECIROA and the captive owners would like to see a special set of rules, which take into account the unique position of captives and the fact that they may not be able to diversify risks in the same way that other insurers can.

Unfortunately for buyers, insurers are not of the same opinion, and are therefore not lobbying the Commission along the same lines. It could be good for insurers if captives were forced to close their doors to new business - because it would mean more for them.

“We think that captives are the future because they allow large companies to retain some of their risks and work with their insurers. We don’t understand why some national associations of insurers, like the French, have decided to say that it should not be easier for captives and that there shouldn’t be a separate set of rules,” comments Sonigo.

Unfortunately for the captives looking for simplification, being a niche industry, their voice is not as loud as that of the insurers. There are only a few large captive domiciles in Europe, including Dublin, Luxembourg and Malta, compared with much bigger traditional insurance markets in the UK, France and Germany. For this reason captive associations complain that it is hard for their voice to be heard.

As it stands now, it will be hard for captives to comply with Solvency II, says Sonigo, who also appeals for assistance. “Insurers should help us, we are helping them on the capital issue they should help us, if they can, on captives.” He called on Airmic, the UK risk management association, and AMRAE, the French equivalent, to step up their Solvency II lobbying efforts in support of captives at a national level.