A Plain Person’s Guide to Solvency

2nd July, 2008

You have no doubt heard about Solvency II, but do you know what all the fuss is about and what it means for you and your company? Sooner or later it will affect virtually every aspect of the insurance industry. Alex Booth of Elborne Mitchell explains its significance.

When the FSA decided to go it alone and introduce a new system of solvency regulation, it was taking a calculated risk – or gamble, as some would see it. And it was doing so on behalf of the entire UK insurance sector.

There had long been agreement that the old system of regulation was out-of-date, based as it was on fairly arbitrary criteria for assessing whether or not insurers and reinsurers had enough capital to conduct their business.

A switch to something closer to the banking industry’s system of regulation had been on the cards for some time. The banking industry system essentially measures the risk (of all different types) inherent in a bank and then requires them to demonstrate that they are sufficiently well capitalised to handle it. This fundamentally different way of doing things should, in theory at least, greatly reduce the danger of re/insurer insolvency.

So far, so good. And there has also long been consensus right across the European Economic Area (the EU plus Norway, Iceland and Lichtenstein) that this was to be the way forward. The process became known as Solvency II and has been driven by the European Commission.

Given the complexity of the subject and number of countries involved, it should come as no surprise, therefore, that progress has been positively snail-like, with deadlines for completion continually pushed back. Against this background, the FSA obviously decided it could wait no longer and, no doubt spurred by public disquiet over insurance company failures and the perception of inadequate risk management, it opted to go it alone with its own version of Solvency II.

Preparing for the new system of regulation has been very expensive for the insurance sector, in terms of both money and diversion of management time. It requires companies to produce their own Internal Capital Assessments, which are time-consuming and often require, for example, far-reaching changes to IT systems.

And the FSA’s “gamble” is that they are banking on Solvency II being sufficiently close to their own regime that UK firms will already be prepared for it. With just an odd tweak here and there, our industry will then be able sit back and watch its continental counterparts going through the same agony.

The danger, of course, is that the new world diverges significantly from the FSA’s chosen route. In that case, we would have to do it all again.

So, what are the prospects?

Firstly, Solvency II is taking a lot more time than originally intended. When the European Commission published its Solvency II road map this July, it became clear that the proposed legislation had been delayed yet again. The first draft of Solvency II legislation is now expected in October 2006 with a final version scheduled for February 2007.

The formal adoption date is then expected to be in July 2007, a year from the original intended date of mid-2006, although the Commission has indicated that the delays should not affect implementation of the directive, currently pencilled in for 2010. This may well be optimistic.

In the meantime, the Commission has already set out their overall approach, which is based on three pillars, the gist of which will be familiar to FSA-regulated firms. In some respects, they go beyond the current requirements for banks.

Pillar 1 contains two capital requirements, the Minimum Capital Requirement (MCR) and the Solvency Capital Requirement (SCR). The MCR reflects an absolute minimum level of required capital below which supervisory action will automatically be triggered. The SCR, on the other hand, will require calculation of capital based on a formula, as yet undetermined, but intended by the Commission to produce capital requirements at a level enabling firms to absorb significant unforeseen losses. The risks to be addressed will include underwriting risk, credit risk, market risk, operational risk and liquidity risk.

Pillar 2 will focus on supervisory activities of regulators with the aim of identifying firms with a higher risk profile. Those firms may be required to hold capital at a higher level than the amount suggested by the SCR calculation and/or to take steps to reduce identified risks.

Pillar 3 requires disclosure of additional information that supervisors feel they need in order to perform their regulatory functions.

These pillars do not in themselves answer the fundamental question of whether Solvency II will mean higher capital requirements for UK insurers that will have to wait at least until the first draft is published in about a year’s time. The unofficial smoke signals, however, are encouraging. The talks appear to be moving in a direction that the UK would find comfortable, though it is still far too early to start counting chickens.

Whatever the outcome, it is clear that there will be winners and losers. In a special report, albeit now a couple of years ago, the rating agency Moody’s believed that potential winners would be those insurers with conservative claims reserves and diversified business and geographic profiles.

In the view of Fitch, insurers that have already taken steps to move to more sophisticated measures of solvency will benefit from this head-start. Those who have not taken any action so far, on the other hand, may struggle as they will face risk-based capital requirements for the first time when Solvency II is implemented.

To that extent, perhaps UK firms will reap some benefit from the FSA’s decision to move ahead of Solvency II.