Worth the effort

I have read Carl Leeman’s comments on Solvency II and feel that a response is merited–not least because he is the incumbent president of IFRIMA. Carl makes a number of points with which I wish to take issue. My comments are only meant to express a contrarian point of view from an independent risk management practitioner.

Closer attention

Carl says he finds it surprising that Solvency II has not received the attention it deserves from brokers and risk managers.

Solvency II has been close to the centre of attention of many European insurers, intermediaries and risk managers for some time now – not only from the perspective of impact on captive insurance companies.

As far back as October 2006, the Swiss national risk management association devoted a half-day of its annual conference to the impact of Solvency II. There have been dozens of insurance company and intermediary-sponsored seminars and workshops addressing the impact of Solvency II since then – not to mention risk manager involvement in the various Quantitative Impact Studies (QIS).

Articles published in the trade press on Solvency II can be measured in column metres rather than column inches.

Consumer protection

I am not convinced that consumer protection is the primary driver behind Solvency II.

From what I have read and learned over the last five years, the overarching motivations for the Solvency II initiative are not so much consumer protection as those of efficiency, resilience and the creation of a competitive, level playing field in a recently expanded European Union.

There has been little history of insurance company failure in Europe affecting consumers since the Second World War. National regulators have played an important role in contributing to this commendable record. However, the existing Solvency I regulations represent no more than a glorified rule of thumb as far as capital requirements are concerned and are clearly no longer appropriate or adequate.

Panic reaction

It is a bold person who states categorically that the insurance industry has no exposure to systemic risk.

While significantly less than the systemic risk exposure of the banking segment, the insurance industry is exposed on the asset management side and an increasingly connected world can also lead to unexpected claim ripple effects on the liability side.

Negative impact

There will no doubt be additional costs involved in the implementation of such a radical initiative as Solvency II.

A quantum change from past practice necessarily involves material testing and implementation costs. The implementation will not be flawless and there are a few important design features still to be resolved.

However, the move to a risk-adjusted solvency calculation is totally compelling and will inevitably lead to a more resilient and capital efficient insurance industry – both key attributes for insurance purchasers over the medium to long term.

The availability and price of some commercial insurance may well become less accessible. However, this will tend to affect the more problematic or marginal areas of commercial insurance that are known to be difficult to underwrite and price.

This will be felt by commercial insurance purchasers who are pushing the envelope of insurability rather than most of the mainstream. There is little evidence that the material overcapacity in the marketplace for mainstream insurance products will evaporate.

Higher premiums

It may well be that some of the more complex liability exposures are currently underpriced and should be reappraised on the basis of the risk-adjusted capital required to underwrite them.

Is it in the interests of the corporate insurance buyers to encourage inadequate technical underwriting in a low-interest rate environment and with the spectre of not insignificant inflation on the near horizon?

If the real concern with long-tail liability claims is the insurance company’s ability and willingness to pay claims down the line, shouldn’t more attention be spent at inception reviewing the technical aspects of the exposure to try to ensure that intelligent cover, pricing and claim response services are agreed. Even if this means paying an appropriate price?

Overcapacity in the insurance industry often leads to irresponsible pricing. This may be acceptable in the area of short-tail commodity purchases, but is not a recommended approach to more complex, bespoke, long-tail exposures. And there is a price for sound technical underwriting – that Solvency II will encourage.

Carl repeatedly focuses on premium cost as the key metric in the complex Solvency II equation. What should matter much more than short-term premium cost to a commercial insurance buyer is (a) the predictability of the premium cost over a number of financial periods, and (b) the dependability of the claim payments if and when cover is triggered.

In a materially cyclical business such as commercial insurance, risk managers who focus on short-term premium expenditure as a primary performance metric are misguided – and so are their CFOs if they permit it.

Most corporate risk managers that I have met are much more concerned by the quality of cover, the stability of the capacity commitment, and the dependability of the claim management and settlement process. Any initiative that purports to make the capital base underwriting the risk more robust should be viewed as a positive development in an industry that is selling a promise to make contingent payments sometime in the future.

Deaf ears

European regulators are listening to many different stakeholders, including insurance buyers and captive owners.

The Solvency II discussions, and design process, have been subject to a host of public debates, meetings and lobbying of all kinds from national politicians, risk management associations and the insurance industry.

The aggressive time deadline suggests that not every stakeholder will be fully satisfied by the launch date in January 2013, but it would be incorrect to state that the effect of intensive stakeholder lobbying has not produced – and will not continue to produce - some positive effects.

Pride before the fall

Finally, there appears little evidence to support Carl’s suggestion that the Solvency II initiative represents some form of quasi-jingoist EU attempt at global insurance domination.

With the relatively-recent enlargement of the EU from 14 to 27 countries, there was a clear necessity to address the business of insurance within the economic community.

Solvency II represents a significant step in the direction of ensuring a competitive and robust insurance industry – which can only be beneficial to the insurance buyer (large or small) over the medium to long term.

A consequence of such a bold step may well be to make EU insurance companies a more attractive investment bet than insurance companies in other jurisdictions where the nettle of risk-based capital has not been so comprehensively grasped.

Enlightened (albeit expensive and not flawless) regulation such as Solvency II is designed to improve the quality of underwriting by direct reference to risk-based capital and to level the highly-competitive playing field within the EU.

Furthermore, the timing of the Solvency II introduction will coincide with a equally-bold, yet highly-challenging, evolution in insurance company accounting – designed to render an opaque industry segment easier to understand and more appetizing for investors.

Taken together, Solvency II and the new IASB standard will create something of a revolution – but which should bring significant benefits to the insurance purchaser in the medium to long term.

Chris Lajtha is the owner of ADAGEO, a Paris-based risk and insurance management consulting company.