Implications of Solvency II for European Insurers

Solvency II, the new solvency regime for European insurers and reinsurers, comes into force in January 2013. Insurers have been preparing for some time now, but the new standards have significant implications for a much broader group of financial institutions.

In this video interview with World Finance Magazine, Deloitte Partners Michel de la Belliere, EMEA Solvency II Leader, Rick Lester, UK Solvency II Leader and  Francesco Nagari, Global IFRS Insurance Leader discuss the scope and opportunities Solvency II presents European insurers.

Transcript: Grasping the strategic opportunities from Solvency II

The first Solvency framework is almost 40 years old now, and obviously a lot has changed since then, so what is the new framework expected to achieve?

The new framework’s primary objectives are to enhance, first, the protection of policyholders across Europe and to create a level playing field across member states. While the new regulation is quite comprehensive, and runs to thousands of pages of rules and advice, two key features stand out: first the calculation of solvency requirements will be based on an economic basis, instead of an accounting one; and it will explicitly take into account risks which did not appear in the previous system, such as market and operational risks. This is important because many insurer failures in the past were precisely the consequence of a poor management of these risks. Second, the regulation also emphasises the development of strong risk management processes and tools. And combined together, these features will change the way insurers make decisions and steer their business.

It’s still many months before Solvency II comes into effect in Europe, how are insurers faring in their preparations and do you believe the benefits are significant enough that other countries will follow suit?

Most insurers across Europe have made significant progress in their preparation to Solvency II, having started back in 2009 or even before in some cases.

However, this does not mean that there is neither time pressure nor challenges: Solvency II is probably the most significant change the industry has had to face in a generation, and there are still a number of uncertainties over the final shape of the regulation. For example, we have task forces that are still working on what the cost of property & casualty, health and catastrophic risks should be in the new regime. Likewise, transition measures which are designed to smooth undesirable effects of the shift between Solvency I and Solvency II are still being debated.

Solvency II is a very ambitious reform and it will arguably become the most advanced regulatory framework in the global insurance industry. This is not lost on a number of countries: countries Bermuda, South Africa and many other jurisdictions are moving to adopt equivalent systems.

From your experience what have emerged as the key implications of the Directive on insurers?

Solvency II has three levels of implications. Of course the first one is to implement solvency II: for many insurers, this is one of the largest projects they have undertaken. It puts pressure on internal staff, which can only be partly solved by using external resources because all stakeholders are looking for the same skills at the same time and also because of the need to embed Solvency II into the insurer’s staff habits, practices and processes.

The second level relates to the organisational and process changes that Solvency II brings. Governance as well as decision making processes must be upgraded to ensure that they are clearly accounted for in the way the business is managed, alongside more traditional dimensions such as growth or profitability.

And third, Solvency II introduces new drivers to set capital requirements. This means the existing balance between capital needs, business mix, product features, and investment strategies will have to change to adjust to the new parameters.

That’s quite a heavy burden – Rick, how are insurers acting now to meet compliance requirements

Well, I think insurers are typically looking at it from two dimensions; firstly they’re looking at what they actually need to do to comply with the new regime, but secondly, and no less importantly, they’re also looking at the business impact and therefore what the strategic opportunities are that Solvency II presents to them.

At this point in time an insurer’s level of sophistication, is very much dependent on whether they’re going for a standard formula or alternatively the internal model. Standard formula firms, very much typically, [are] focusing upon the calculation of the regulatory requirements under that formula, the Own Risk and Solvency Assessment, and also enhancing their systems of governance. Internal model firms on the other hand focus not only on the internal model, the governance arrangements around that and in particular validation, but also the use test and the enabling technology to support solvency II.

Okay, so what do you see as the key opportunities insurers can derive through compliance with the Directive?

I think generally we see four areas that insurers are seeking opportunities.

The first one is around improved decision making; so they’re looking to leverage new things that are introduced through Solvency II, things like the internal model, things like the Own Risk and Solvency Assessment, to actually aid the strategic planning process, reinsurance strategy, asset and liability management and the like.

The second is around product portfolio, where insurers are revisiting their portfolio’s with a particular focus on those that are capital intensive, so things like life assurance products with embedded guarantees and options, long tail liability insurances, and actually taking a view as to whether they want to reduce the amount of exposure they write in those areas. Some other insurers are actually looking to write additional product lines to get additional diversification benefit.

The third area’s actually around capital restructuring and optimisation. Insurers are re-visiting their capital [and] particularly what qualifies as the highest quality of capital, so tier 1 with the greatest loss absorbency, and also looking at how they deploy their capital across the organisation to optimise the risk adjusted returns they generate on that.

And fourthly investment strategy, so insurers are looking at their investment portfolio’s, particularly those that carry high capital charges such as equities and property, and revisiting as to whether they want to maintain that current balance and portfolio in a Solvency II World.

Francesco, as Deloitte’s Global IFRS Insurance Lead Partner, can you explain the similarities between the new International Financial Reporting Standards for insurance contracts and Solvency II?

When in July 2007 the EU released the draft framework for Solvency II liability valuation they set it in a way that was closest to the IFRS plans for insurance liabilities that the IASB had published just three months earlier.

The current exit value using explicit building blocks for the valuation was the basis that both frameworks required. The three building blocks are the mean of a probability weighted estimate of cash flows under different scenarios; a market consistent discount rate to reflect time value of money and a margin for risk and uncertainty.

To date, Solvency II has retained the current exit value approach with the all important day one profit that feeds straight into own funds. IFRS instead has moved away from this approach driven by more prudent profit recognition considerations. A fourth building block is created: the residual margin liability. This is recognised where the day one profit would instead have been taken. Subsequent release of the IFRS profit follows the fulfilment of the contract. Indeed the IFRS model is called the current fulfilment value.

Ultimately IFRS is serving the purpose of profit reporting for investors in the insurance sector whilst Solvency II aims at policyholders protection and this is bound to create some differences. Even if the Solvency II regulators have the best intentions to stay aligned with IFRS as much as possible important differences will always remain.

What does this all mean practically? How are insurers meeting the need for change?

Although exit and fulfilment values are different, the building blocks are still there for both models to offer a significant opportunity for implementation synergies.

The systems that both regimes would require are immensely complex and the last thing any insurer wants is to implement an expensive system that needs to be rebuilt when a second set of requirements are overlaid to it.

The first building block, the mean estimate of probability weighted cash flows, is the area where the synergy opportunity is most significant due to the heavy systems that need to be implemented.

The other important practical issue is the implementation timeline. The European Commission stated that they are fully committed to the effective date for Solvency II on 1 January 2013. Pending an official decision on this I expect the new IFRS to be mandatory only from 1 January 2015.

So although compliance isn’t until 2015 there are synergies to exploit in developing processes side-by side?

Absolutely. This two-year gap could be a precious project asset.

This time could offer the opportunity to put in sequence the implementation efforts. Insurers could advance significantly with Solvency II before moving to the IFRS implementation. Recycling experienced resources is just one of the many advantages that could be reaped from such a strategy.

Clearly the two projects must be aligned from a design perspective as soon as possible. Ideally from now. In fact, Deloitte has noted that the most alert insurers have already started this alignment process at the system design level.

Finally, Michel, though it is still many months before Solvency II comes into effect how are insurers positioned to take advantage of the opportunities you’ve discussed?

We are already seeing larger groups considering the impacts of Solvency II on their strategy and their processes, as they move from designing their response to the new requirements to embedding them in their organisation. This is now the time when the business benefits of Solvency II will really be locked in. Achieving such lock-in is a matter of careful planning, focused delivery and a clear understanding of the impacts of Solvency II, both on the insurer and also on their competitors.

Because Solvency II will apply in the same way to all undertakings; winners will be those who adapt best to the new regime. After all, as Charles Darwin put it more than a century ago “It is not the strongest of the species that survives, nor the most intelligent, it is the one that is the most adaptable to change.