28 April 2010

Published in: Regulation - supervision

Insurers must not be over-regulated

The more voluminous the guidance, the more rigid a legislative framework becomes, says Hitesh Patel. And Solvency II's complex rules and capital requirements could make the insurance industry less transparent to investors and the general public.

As insurers rush to meet the 2012 deadline for Solvency II implementation, questions have been raised as to whether the European Commission can produce level 2 rules which will be effective without being burdensome.

There are significant concerns that the requirements recommended by CEIOPS may harm rather than help insurers. Uncertainty remains whether or not Solvency II is capable of delivering on its promise to provide a robust, cost-efficient and consistent solvency methodology -- and one which does not lead to over-capitalization of the industry.

There is also a danger that the fallout from the banking crisis will serve to increase capital requirements under Solvency II. The insurance industry has not had similar issues to the banking industry. However all signs are pointing to the regulatory authorities imposing high capital requirements. The results of QIS 5 later this year are likely to lead to economic inefficiencies where resource allocations are concerned, and to the erosion of a healthy and competitive insurance industry.

"The new pillar 3 disclosure requirements are needlessly detailed with the risk of producing too many boiler-plate disclosures of little value." 

Capital-intensive products such as annuities may suffer more than others, much to the detriment of consumers. The additional capital burden may also place European insurers at a disadvantage to other players in the international market that are not subject to such stringent requirements, and there is a risk that capital will not be invested in the EU.

The level of detail prescribed by the level 2 guidance has so far been overwhelming. Small and medium-sized companies in particular may find that even keeping up with new publications can be draining on their resources.

It is often the case that the more voluminous the guidance, the more rigid a legislative framework becomes. In an industry as diverse and complex as the insurance sector, there is a need to accept that the broader set of requirements of a principles-based approach may be more cost-effective in terms of both implementation and supervision.

The new pillar 3 disclosure requirements are needlessly detailed with the risk of producing too many boiler-plate disclosures of little value. Although enhanced transparency is beneficial to investors and the public, it is doubtful if the benefits of these new disclosures outweigh their costs. The key to transparency is to have the right balance between qualitative and quantitative disclosures.

There appears to be considerable regulatory focus on areas such as validation of capital models, technical provisions and the solvency capital requirement (SCR) with detailed and arguably complex requirements. Rules that are prescriptive will only impose additional burden on businesses and supervisors without adding value.

For businesses, especially the smaller players in the market, the implementation of these detailed models may prove to be cost-ineffective and could result in resources being diverted from the actual running of the business.

"Implementation of detailed models may prove to be cost-ineffective and could result in resources being diverted from the actual running of the business." 

Indeed, one of the key concerns on the implementation of Solvency II is the availability of resources. Regulators would do well to stand back and consider the most effective approach, focusing on supervising the key risks. Cutting down on the volume of detailed rules and guidance would be a good start.

Experience from recent financial crises reinforces the view that reliance on models can be dangerous. The inherent complexity and diversity of the insurance business entail considerable judgement in the model's assumptions and mean that the validation of risk models will be difficult and time-consuming in practice. There is a huge raft of rules and guidance setting out the criteria of internal model approval. Is all such effort is cost-efficient and will it enhance the quality of regulation? The individual capital assessment (ICA) requirements introduced as part of the Tiner review (published by the Financial Services Authority in 2005) have been well received. The question remains why more detailed requirements are necessary.

From a regulator's standpoint, there is a danger that resources are being diverted towards the review of internal models. Over-complex processes for reviewing models may result in the key risks facing a business -- such as the mispricing of business -- being overlooked.

In addition senior management and board time will also be diverted to reviewing and challenging the processes and documentation. Time spent by supervisors in meeting companies and challenging them on business issues and risk management is perhaps more important to prevent failures of insurance companies.

"The ICA requirements introduced as part of the Tiner review have been well received. The question remains why more detailed requirements are necessary."  

Practical issues in implementing the new regime need to be considered. In particular, a framework that successfully caters for the diversity of the European-wide insurance industry may need to consist of a number of different tiers based on the size of insurers. Smaller insurers would not be required to comply with the more detailed requirements, for example model approval or disclosures. Whilst the concept of proportionality does go some way to addressing issues faced by smaller firms, other options to improve flexibility may need to be explored.

There are also considerable practical issues relating to the quality and ease of use of the models. In many cases, data availability may be an issue, necessitating a high degree of judgment both in the assumptions made and in the interpretation of the results. This limits the ability to use such models in a regulatory context.

Solvency II could potentially achieve the benefits of harmonization that the European member-states have always envisaged, but only if it does not try to enforce a one-size-fits-all policy on a sector as diverse and as complex as the insurance industry. The insurance industry has been more resilient than banking and the need for flexibility in supervision is also important.

The level 2 rules proposed by CEIOPS could mar the competitiveness of the European insurance industry and lead to increased premiums and regulation which will disproportionately increase compliance costs and the cost of capital. Detailed and complex rules and capital requirements imposed by Solvency II could also make the insurance industry less transparent to investors and the general public. Perhaps more time is needed for the European Commission to reflect on the detailed implementation issues.

Hitesh Patel is Finance Director at Lucida, an insurance company focused on the annuity and longevity risk business. Previously he was a specialist partner in KPMG's financial services audit practice, a member of KPMG's global insurance leadership team and a member of the IASB insurance working group. He led the Solvency II study for the European Commission into methodologies for measuring solvency in the insurance sector.

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