Press article: Solvency II - A structural challenge for insurersDOWNLOAD
About a year ago, the European Commission published the proposed Solvency II framework directive. This sets out a framework for a new economic risk-based solvency requirement that will apply to all insurers in EU Member States.
The more detailed implementation measures are expected to be published in 2010, while the Commission is aiming to have the new system in operation by 2012. There have been many publications and several Quantitative Impact Studies (QIS) on Solvency II. We have sought here to build on those studies by presenting an updated view of the current status of insurers’ implementation of Solvency II and by outlining a concrete approach for its further implementation.
The Solvency II framework consists of three pillars, each covering a different aspect of the economic risks that insurers face. At the heart of Pillar 1 is the requirement for insurers to understand the nature of their risk exposure and to hold sufficient regulatory capital to ensure that, with a 99.5% probability over a one-year period (i.e. a one in 200 year occurrence of an event of insolvency), they are adequately protected against adverse events or scenarios.
Solvency II identifies two levels of capital requirement: the minimum capital requirement (MCR) and the solvency capital requirement (SCR). Under Solvency II these requirements will be compared to the actual available capital, which effectively corresponds to the available economic capital.
Pillar 2 deals with the qualitative elements and focuses on companies’ internal control and risk management processes, as well as on the supervision process. This pillar requires insurers to demonstrate that they have appropriate amounts of capital for all the risks they face. Supervisors may require additional capital to be held if they feel that the level of capital determined is not sufficient for the specific organisation.
Pillar 3 deals with market transparency and discipline in the insurance industry. It aims to improve both transparency and discipline, and provide better insight into insurance companies’ actual risk and return profiles. This pillar is designed to harmonise reporting to supervisors, and goes beyond the notion of financial reporting rules by including various different types of information needed by supervisors and information not normally available in the public domain.
Many leading insurers, including practically all the CRO Forum members,1 are currently in the process of establishing their Solvency II change programmes. As part of this process, many of them took part in the fourth Quantitative Impact Study (QIS 4), which was held this summer. QIS 4 can be regarded as the most recent try-out of Solvency II for insurers, and its results can be used as input for the final version of the Solvency II Directive and implementation measures. The CRO Forum members are also sharing the QIS 4 results so as to develop industry best practices for Solvency II. The fact that both small and large companies seem to be taking QIS 4 so seriously indicates that they are increasingly aware of the significance of Solvency II, but even more importantly that they are increasingly interested in financial risk management in general. Solvency II can be seen as an element of enterprise risk management.
Insurers’ interest in fi nancial risk management in a broader sense is also being driven by actions of national governments and supervisory authorities in mature European insurance markets, where elements of Solvency II and fi nancial risk management have already been incorporated into existing regulations. Realistic balance sheets, the explicit valuation of options and guarantees and risk-based solvency requirements, for example, are becoming more and more part of local regulations (e.g. MA risk in Germany, the Wft legislation in the Netherlands, ICA in the UK, the Swiss Solvency Test and the Individual Solvency Requirement (ISR) in Denmark).
While some insurance groups, including ING and Generali, already disclose their economic capital, others are still in the transition phase and are working on large projects to implement market value-based reporting frameworks. All frameworks, whether existing or currently being developed, face huge challenges in ensuring that Solvency II models and processes are aligned with other reporting frameworks, assigning ownership of and responsibility for these frameworks, and in meeting the need for proper and auditable data management.
As stated earlier, Solvency II focuses on the market valuation of assets and liabilities and on a risk-based approach. Two other frameworks that are currently being developed – IFRS 4 phase II and Market Consistent Embedded Value (MCEV) – also essentially concentrate on market valuations and are risk-based.
IFRS 4 phase II (for insurers) is currently expected to be mandatory for the fiscal years from 2012 onwards and will replace the current IFRS 4 on insurance contracts. It is expected to resolve the issues surrounding the current method of accounting for insurance contracts, including, for example, the mismatch created by assets being shown at fair value, while liabilities are valued in accordance with local GAAP guidelines. MCEV will be mandatory for CFO Forum members for the fiscal years from 2009 onwards. It is the successor of European Embedded Value (EEV) and is designed to achieve greater transparency and consistency in the reporting of the embedded value of an insurance business. MCEV can be seen as best practice in embedded value calculations.
Without our going into detail, the fact that Solvency II shares both the market value and risk-based approach with IFRS 4 phase II and MCEV means there is potential for achieving synergies when implementing the frameworks. This applies not only from a modelling perspective, but also when gathering data and ensuring their soundness and consistency. When trying to achieve synergy, it is crucial to have a top-down view rather than focusing on complying with all the frameworks in different projects.
As stipulated in the Directive, ultimate responsibility for Solvency II lies with the insurance company’s board and cannot as such be delegated. The ongoing trend to appoint a Chief Risk Officer (CRO) as head of enterprise risk management and the fact that the CRO’s role tends to vary between insurers (the CRO may report, for example, to the CEO, the CFO or the Board) give rise, however, to the question of who is ultimately responsible.
The Directive does not state that ultimate responsibility for Solvency II should be with one function. The CRO and CFO may consequently both take on certain aspects of responsibility. However, joint responsibility for such an important part of ERM may not play out well in practice. Indeed there is considerable debate within the industry on the roles and responsibilities of a CRO and CFO, and the required background for a CRO. A similar discussion is currently ongoing in the banking sector, where the Institute of International Finance recently published its report on principles of conduct.2 One important principle highlighted with respect to risk management governance in this report is that, in order to ensure a strategic focus on risk management, every firm should assign senior management responsibility for risk management across the entire organisation. This responsibility can be vested in the CRO, who should have independence and sufficient seniority to affect decision making in the firm and have access to the Board when needed.
Although we already have an overview of Solvency II, we also need to remember that part of the iceberg is still hidden. In other words, the European Directive is still under construction, while EU member states will start transposing it into national legislation in 2009! This does not mean, however, that companies can postpone kicking off their implementation projects! Indeed, looking at the Solvency II timetable and the substantial work still to be done, it is important to start without delay.
Deloitte’s past experience in regulatory projects has shown that the transition from project mode to operational mode can be very costly and time-consuming. Takings steps to anticipate a smooth transition is the Key Success Factor for your Solvency II initiative, and a way of ensuring such a transition is to define a Target Operating Model (TOM) at the earliest stage of the project.
Defining a TOM involves identifying the way people, technology and processes interact to deliver a common objective, as well as identifying where these resources are located and who owns them.
Without a Target Operating Model, the outlook for the project will often be unclear, and there can be significant problems gaining consensus for any changes during the programme. A TOM will ensure that all stakeholders share a common understanding of the deliverables and targets, while also helping to leverage on potential synergies (IFRS, for example) and opportunities such as management reporting.
Deloitte has identified the following five key points that insurance companies need to tackle as a priority when designing a TOM:
We have presented a brief overview of Solvency II and discussed three major challenges facing insurers in the process of gearing up for it. A feasible approach, with a proven track record in regulatory projects, is to use a target operating model to answer the following questions:
Features specific to Solvency II can be summarised around the following three dimensions:
Now is the time to start. Using a TOM to create a Solvency II vision takes time. There is no need to wait for the EU or member states to define the final details as the major challenges and constraints are already evident.