04 November 2009

Published in: Corporate strategy, Risk governance, Regulation - supervision

Assess the business impact of Solvency II now

Also establish the ground rules with regulators, define the risk-measurement architecture and allocate ownership within the company as part of your Solvency II programme, advises Lukas Ziewer

While most agree that insurers need to get a lot done before Solvency II becomes reality, there is still quite some time to go and many in the industry feel little or no urgency. Also, important details are still "work in progress", with some rather fundamental issues being debated between different stakeholders in the industry.

The path to where Solvency II stands now was a political challenge, but the framework directive passed into European law earlier this year is straightforward from the point of view of an insurers' risk and capital management - the only surprise for the industry was that group support was dropped, which would have allowed insurance groups to employ capital across European borders.

The rules that will govern implementation and impact insurers' solvency levels will only be written over the next few months. Unsurprisingly in this situation, many initiatives that insurers have to prepare them for Solvency II lack the focus, momentum and obligation to deliver immediate business benefit that normally distinguish successful projects.

Most insurers have set up their Solvency II efforts pursuing a mix of objectives, ranging from lobbying, internal-model development and knowledge-building to data-gathering. They are only gradually forming these into coherent implementation programmes that deliver regular results and provide a vision of future impact.

We see four areas in a Solvency II programme that insurers should now focus on with urgency:

• establish the ground rules with regulators
• define the risk-measurement architecture
• allocate ownership within the company and
• assess business impact.

Establish the ground rules with regulators

Earlier this year, EU insurance regulators have been publishing their proposals for most of the detailed rules in Solvency II - ranging from the valuation of technical reserves and admissibility of own funds and risk models to governance systems and reporting and supervisory procedures. The industry has quickly grasped the consequences of these recommendations and is worried that supervision will become excessively conservative, cumbersome, and invasive to normal business practices. For instance, the CEA (the European insurance and reinsurance federation), as the industry's representative in Brussels, has warned in a recent letter that the proposals for how to measure value and risk tend to understate true economic financial resources and overstate capital requirements.

Therefore, in addition to their various lobbying efforts over the proposed abstract implementing measures, insurers need to push proactively for the concrete, getting down to business with their respective regulators. Both individually as well as jointly they need to discuss with them how insurers and regulators can best prepare, and what the rules will mean in practice in their market environment. For groups, it is important to work proactively with the regulators in all the different markets in which they are established, to help forge productive and efficient "colleges of supervisors."

While at the moment it is a challenge for insurers to engage their regulators in this debate, they will subsequently benefit from a more aligned and efficient approach of regulators. Also, regulators themselves are increasingly becoming aware that they need to begin facing their industries over Solvency II implementation, rather than referring to the developments at the international level.

Define the risk-measurement architecture

In addition to establishing the ground rules with regulators, insurers need to become clear on their architectures for measuring risk and capital. Most major insurers have been working on developing their internal models for several years. However, surprisingly few have a clear plan for how they will gain regulatory approval for each component, and by when. Even leading groups should not expect to gain automatically full approval to use all components of their internal model group-wide for measuring the solvency capital requirement immediately from the start in 2012.

Rather than the methodologies and model mechanics, which insurers have been focusing on, the real challenge of getting regulatory approval will be meeting the requirements for justifying parameter choices, in particular where expert judgement is needed in the absence of statistical information; using the model results broadly in important business decisions, not as a formal requirement but as entrenched commitment of the organization to the model results; and ensuring consistently high quality of data, production workflows, and documentation.

Insurers should therefore make a realistic assessment of their ambition to achieve approval for the most relevant parts of their internal model, and prepare for using the standard formula for the other parts. After the initial start of Solvency II, the scope of the approval can then be widened gradually, until eventually the full internal model is approved to be used to measure the solvency capital requirement. However, at each stage the company should weigh the benefits of using additional components of the internal model against the costs of meeting the approval criteria.

Allocate ownership within the company

As the third area to focus their Solvency II implementation programmes, insurers need to bundle and allocate ownership for developing all the elements of their Solvency II framework. At the moment, this may be aligned with the structure that will eventually govern compliance in the future, but this is not necessary. For instance, the responsibility for developing the internal model may first rest with the actuarial department, and only later move on to the risk management function to get regulatory approval.

Given the broad scope of Solvency II in the organization, many different functions and stakeholders need to be involved: in addition to top management, the most obvious are the actuarial and risk management functions, finance, and information management & IT. More broadly, product design, underwriting, investments, audit and even operations will all be involved at some point. However, many programmes do not bundle these stakeholders' efforts, and there may even be multiple Solvency II projects. For instance, there may be an actuarial project focused on model development, and a compliance project that looks into aspects such as the "own risk and solvency assessment" (ORSA) and governance structures.

Apart from the obvious inefficiencies that this creates, the issue with such an approach is that some wider developments are being designed in a silo, with little regard for the dependencies with other developments. Information management and IT in particular are areas that will require significant implementation time and expense, and should therefore often kicked off early. However, they also need to be fully aligned with the specifications from the internal model, its uses in business decisions, ORSA, and internal and external reporting. The experience from Basel II has shown that missing this alignment is where the most costly mistakes have been made in the implementation.

A programme structure that allows for the broad scope of Solvency II is one where the ownership for impact and key design decisions is clearly and visibly with the top-management team. This top-level ownership needs to be supported by a programme management that not only owns process and communication, but also ensures that project outputs such as models, process definitions or report designs are "fit for purpose." Feeding into this overall programme, there should be workstreams for risk and capital measurement, business uses and ORSA, governance structures, and reporting. Underlying these developments is the work on the information-management infrastructure.

Assess business impact

As a final focus area for current Solvency II programmes, insurers need to assess the business impact of the directive. Although this impact may materialize only years after the "go live" in 2012, it is important to evaluate it now: On the one hand, having a head start will help companies to move into favourable positions ahead of the crowd. For instance, the reassessment of capital requirements for different investment strategies will in many cases lead to a restructuring of portfolios, which will be costly when the whole industry begins to buy and sell certain assets. On the other hand, showing individual managers in the organization the impact that Solvency II will have in their areas helps to align support for the project, and inspire contributions from potentially unexpected parts in the organization.

The most direct impact of Solvency II will be on the financial strength and flexibility of the insurer. Despite the uncertainties that still exist in the determinants of available and required capital, top-management teams should investigate how their financial position will develop in the future, and how this is likely to affect the corporate objectives such as risk appetite and the required profitability levels. Groups need to analyse this impact not only on the consolidated position, but also on how their major entities are affected, and what that means for internal capital flows. Based on this evaluation, companies should then assess both the tactical as well as strategic impacts on their business.

Initially, many executives are shocked and frustrated by the volatility of the economic balance sheet -- in particular during the current turbulent times. Measured solvency levels may fall from a comfortable excess in one period to a deficit in the next. This may happen not only as, say, interest rates change, but also as many assumptions, for instance, about correlations are updated. Managers therefore need to develop an intuition about the sensitivities of the economic balance sheet, and take control of how the inputs are set.

On a tactical level, the most likely impact of Solvency II will be on the product features that can be offered, on pricing, and on investment strategies. Some features that are currently standard may attract excessive capital charges. For instance, certain natural-catastrophe risks may need to be excluded in the future. In less extreme cases, rates increases will be necessary to compensate for additional capital requirements; for example, many investment guarantees are expected to become more expensive. Lastly, some investment strategies will incur higher capital charges under Solvency II and may not compensate for this by providing higher returns. Many life insurers, for instance, have a duration mismatch -- holding assets with shorter duration than their liabilities -- that looks unattractive in a Solvency II world.

On the strategic level, insurers need to assess how Solvency II will impact competition - not only between insurers but also with banks and other financial-service providers. At a group level, some markets will become more or less attractive, and this effect will be bigger in some markets than in others. Insurers will also reassess size and sophistication. Large entities can benefit from diversification which others need to buy through re-insurance. Also, only some companies will be able to develop capabilities such as internal modelling, or asset-liability management and hedging. And finally, corporate structures impact the ability to use capital efficiently. For instance, merging multiple subsidiaries in one country, or writing business through branches and freedom of service rather than in local subsidiaries, will help to benefit from diversification.

On balance, while most insurers are doing the right things to prepare for Solvency II on a "day-to-day" technical level, they are often not aligning their efforts with what will ultimately impact business success. At the moment, there is still significant uncertainty what the rules will be exactly, but waiting is not an attractive option; delay will almost certainly lead to costly and disruptive ad hoc implementations. Insurers who want to spend their time and money wisely should achieve an alignment over the coming few months.

Lukas Ziewer is a partner at Oliver Wyman in Zurich.

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