21 May 2009

Published in: Capital - models, Risk governance, Regulation - supervision

Get your priorities right in preparing for Solvency II

Don't start with a gap analysis, argues Charl Cronje. Work on the statutory capital requirement first, then move on to how risk is managed throughout the firm.

With the Solvency II framework directive now approved by the European Parliament and European Council, many insurers are already planning in earnest how to tackle the vast new regulatory requirements. But with so much Solvency II preparation needed, what areas should you work on first?

Many insurers are currently being told to conduct a "gap analysis". This is management consulting-speak for determining how far the company falls short of the expected Solvency II requirements. This is clearly an important part of getting to grips with the new regime, but should it really be the number one priority? Indeed, there is a risk that this detailed work could be misdirected if it is not put within the correct context.

Solvency II reality check

For many insurers, the first step should be to calculate a ball-park figure for the statutory capital requirement that will apply to them under Solvency II. For insurers with capital constraints, this could trigger the need to plan now for raising capital or otherwise modifying business strategy over the next few years.

Step two is to think about ways of reducing the statutory capital requirement, either through risk mitigation or through better modelling of risks.

Step three is to start a broader process of reviewing how risk is managed throughout the firm. This is important because unless a regulator is satisfied with the risk management system, they will not approve the company's internally-modelled solvency numbers, and will impose the potentially penal standard solvency formula instead.

It is worth looking at each of these steps in a bit more detail.

Step 1: how much capital, how much of a problem?

The job at the top of the list should be to get a handle on the likely Solvency II statutory capital requirement, and to develop - quickly -- the capability to measure and track this number over time. Surprisingly few insurers currently have this capability.

This issue is so important because it puts all other Solvency II work into perspective. For some insurers, their financial strength is such that statutory capital levels are not a key driver of the business. However, for other insurers, statutory capital constraints have a much greater chance of affecting the strategy or even the viability of the business.

For most UK insurers, there is an annual exercise to determine the capital requirements under the Individual Capital Adequacy Standards (ICAS) regime. However, the Solvency II capital requirement may differ significantly from the ICAS number, depending on the circumstances of the company. In addition, many insurers lack the ability to update the capital figure easily during the year.

As a minimum, an insurer needs to be able to calculate what the Solvency II capital requirement would be on the "standard formula." The method for doing this was most recently set out in the Quantitative Impact Study 4 (QIS4) calculations, which some companies produced last year. Even producing these standard calculations can prove a time-consuming affair, and insurers reported spending an average of three man-months on the exercise.

It is important to get an understanding of the amount of "diversification credit" that is likely to be available under the standard formula, as well as how much diversification credit the company might be able to justify using its internal model. The effect of diversification credits can be surprisingly significant.

In addition, for many insurers, it will be crucial to be able to calculate the statutory capital requirement using their own model of the business (an "internal model"). This is partly because the standard formula is expected to be somewhat penal, and also because, by its nature, the standard formula may not be able to give sufficient credit for certain features of the business (for example, the use of non-proportional reinsurance).

It is not just the bigger insurers who will want to use an internal model. Many smaller niche insurers and captives will find the standard formula unpalatable and will therefore need to use an internal model to justify a level of regulatory capital that they can afford.

In the UK, many insurers have an internal capital model for ICAS purposes. However, they will not necessarily be able to use an internal model for Solvency II. Unlike ICAS, where any shortcomings in internal models are often dealt with by the FSA applying a simple capital loading, under Solvency II an internal model cannot be used for setting statutory capital unless the model achieves formal regulatory approval. This is a major change, and there is the possibility of an insurer which has become accustomed to using a capital model for ICAS purposes having to revert to the standard formula in 2012.

The sooner the "standard formula vs internal model" debate can be completed within the business, the better. An internal model may be the only acceptable way forward, but the work required to achieve this by 2012 may be uneconomic or unrealistic unless significant action is taken. Only by facing these critical issues now can the business ensure that the right work is done, with the right resources and time-scales, to prepare for Solvency II.

In addition, insurers need to bear in mind the FSA's published timescales for internal model approval. These include notifying the FSA by June 2009 of their intention to seek model approval and qualification for the first dry-run exercise in June to November 2010. Insurers not forming part of the first dry-run have been warned that they will not necessarily receive model approval before 31st October 2012."

Step 2: reducing/mitigating capital requirements

Once you have a handle on the size of the problem, the next step is to think about how it can be reduced.

At the most basic level, an insurer will need to consider the underlying profile of the risks that it underwrites. For example, how big are the line sizes relative to the overall volume of business being written? What concentrations of risk are there and how big are the key catastrophe exposures? To what extent are these risks mitigated by the reinsurance programme, and at what cost?

It is important to identify which features of a particular book of business are likely to drive the capital requirement. If it is catastrophe exposures, then it is worth thinking about how these can be reduced or diversified before considering other aspects of the business.

At a higher level, there is the issue of diversification of risk, for example, across classes of business, geographic locations and currencies. It is important to get an understanding of the amount of "diversification credit" that is likely to be available under the standard formula, as well as how much diversification credit the company might be able to justify using its internal model. The effect of diversification credits can be surprisingly significant.

Some insurers do not have access to detailed data on some of their insured risks because the data is controlled by brokers, cedants or insureds. This may need to change if the insurer is to demonstrate suitable control and understanding of its risks, and to justify its internally modelled capital requirements.

The degree of exposure to the financial security of other parties (e.g. reinsurers or brokers) is also important. For example, it may be that, by using reinsurers with stronger credit ratings, the company's capital requirement in respect of credit risk could be reduced. However, this would need to be weighed against the likely higher cost of obtaining reinsurance in those markets.

For any potential action to mitigate risk, a key question is how much this would reduce the capital requirements, either on the standard formula or by the use of an internal model.

For insurers wishing to use an internal model, a fundamental issue is the quality of their data and the ability to use the data to justify the modelling results. This is where gap analysis becomes important. For example, some insurers do not have access to detailed data on some of their insured risks because the data is controlled by brokers, cedants or insureds. This may need to change if the insurer is to demonstrate suitable control and understanding of its risks, and to justify its internally modelled capital requirements.

Step 3: reviewing the way that risk is managed throughout the firm

Solvency II has been called "a more grown-up way of running an insurance company." Much of Solvency II involves doing things that are good practice regardless of regulatory requirements. The FSA has been at pains to point out that the quality of risk management throughout the firm will be a key prerequisite for the approval of any internal model. This is an important fact that is sometimes overlooked when the "six tests" for internal model approval are discussed (see Regulation/supervision, 4 March, "Prepare your models for the six tests now"). It is an additional, encompassing requirement and could prove onerous for some insurers to meet.

Of course, all insurers spend a lot of effort on risk management -- it is fundamental to their business. However, there is usually room for improvement, and the bar is certainly being raised, both as a direct result of Solvency II and in reaction to the global financial crisis.

In addition to reviewing risk management practices, it will be necessary to consider how regulators will evaluate the quality of insurers' risk management under Solvency II. Even for the best-run insurers with the best-developed attitude to managing risk, a lot more documentation and justification of decisions is likely to be required.

Again, this will at some stage involve detailed gap analyses. However, what is much more important is that there is a discussion at a high level in the business about the overall approach that the company wishes to take.

Next steps

Solvency II is here to stay and it is time to grasp the nettle. However, there is a real risk that an insurer's "Solvency II project" turns into a time-consuming, expensive, unmanageable beast if it is not properly managed with the right sense of proportion.

To ensure that any Solvency II work is directed effectively, insurers first need to understand the likely financial impact and the main "levers" within the business that can be used to mitigate that impact. Only then can the key decision-makers establish an appropriate overall approach to improving and formalizing risk management practices.

Charl Cronje is a partner at consulting actuaries Lane Clark & Peacock LLP in London.

The views expressed in this article are those of the author and not necessarily those of Lane Clark & Peacock LLP as a firm. The firm is regulated by the Institute of Actuaries in respect of a range of investment business activities.

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