The benefits vs the costs, risk appetite, the ORSA, strategic opportunities, diversification benefits. These were just some of the points covered by a group of risk and Solvency II experts during a lively discussion hosted by Deloitte and InsuranceERM.
Note: this is the first part of the discussion; the second will follow very shortly
Kevin Borrett, Head of Risk/CRO, Unum
Anthony Collins, Head of Actuarial, MMA Insurance
Toby Ducker, Solvency II Programme Director, Brit Insurance
John Hume, Chief Financial Officer of Reinsurance Operations for the XL Group companies
Rick Lester, UK Solvency II Lead Partner, Deloitte
Justin Skinner, Enterprise Risk Management Director, QBE European Operations
Peter Field, Partner, InsuranceERM (chairman)
Benefits of Solvency II
Peter Field: What would you consider to be the main value of Solvency II? Some people have made the point that it has driven many companies to implement a much better risk management system, which is to the ultimate benefit of all.
Toby Ducker: I would say large companies were, in the main, already walking along that path. Most of us around the table have enterprise-wide CROs who work closely with the business. Maybe it is at a bit of a faster pace, but one of the difficulties or risks with that is that you then start to straitjacket all those companies into looking at it in a very similar way and that has its hazards. Companies were looking at risk in their own way and, provided it was a sophisticated, intellectual view of the risk being taken on, you want that diversity, because that gives breadth and avoids any contagion.
Anthony Collins: In terms of the value, we are much less likely to see a Quinn go down. The education for smaller companies is very important and also for captives. Certainly for smaller and medium-sized companies, they would not have had the same level of risk awareness and risk assessment that the larger companies had.
Given that most of the companies in the industry are smaller across Europe, it has got to be beneficial for the whole industry. And there will be a better relationship with the regulator, because the regulator is having to get themselves up to speed and understand more about the business, rather than just ticking boxes and following rules, which is what happened in pre-ICA [individual capital assessment] days.
Justin Skinner: Another benefit jumps out at me. As a company, we have got loads of underwriters who are very good at their jobs, they have brought in huge profits and they are very good at making risk decisions in a silo basis. One of the things that Solvency II forces people to do is actually evidence that risk process. Evidencing, although painful, does actually make sure you get a consensus view and education and awareness as to what is happening in business.
Costs of Solvency II
Peter Field: Are the benefits of Solvency II worth the money you have spent on all of this?
Justin Skinner: It is a very easy equation. If you look at the downside of the standard formula capital versus internal model capital. it is a very easy argument to win.
John Hume: I will play devil's advocate and suggest that it is inappropriate for those companies that are already doing pretty well most of it to have the additional spend to comply with slightly different standards around documentation, validation, etc in a soft market when you have got other key strategic initiatives where you need to spend the money.
Justin Skinner: I fully agree with that. That is what regulation is.
Toby Ducker: It comes back to your earlier point, John, which is that a lot of these things were being done anyway and actually the advancement of them was relatively natural. Equally, I think everyone sneakily knows that the documentation probably isn't as good as it should be. And to be able to demonstrate validation to the board of the answers that you are giving them is actually quite powerful.
Kevin Borrett: There is no doubt in my mind that if you looked at a cost-benefit analysis for Solvency II in isolation, on a three- or a five-year payback, then you would not have undertaken the project. Julian Adams last November acknowledged that, particularly for medium-sized firms, the costs involved were disproportionate to the short-term benefits.
Certainly, what the industry needs to do over the medium to long term is look at how it can use the improved knowledge it has through management information and improve its competitiveness. That means there will be winners, but there will also be losers. Ultimately, that should be in the best interests of customers and shareholders as well.
Rick Lester: One of the other areas where firms have been trying to seek benefit is infrastructure, in which there is a huge investment. IFRS 4, phase 2, can perhaps mitigate some of the cost associated with complying with those future legislative and regulatory requirements. Also, firms will be looking at ways in which they can leverage and do analysis around that more complete data, be it underwriting, claims, etc, to improve business decisions.
Standard formula/internal model
Peter Field: If you're a firm opting for the standard formula, do you feel the regulator is less interested in you?
Anthony Collins: My company is now going the standard formula route, having originally intended to use an internal model for regulatory capital purposes but, because of a group decision, we had to go with the standard formula to be consistent with the wider group.
Definitely, there will be a different level of engagement anticipated in the future, although, at the moment, there is still the ICA regime in place, so we still have to keep doing what we have been doing.
Peter Field: Have you experienced the challenge that was referred to from the FSA as to why you switched from internal model to standard formula?
Anthony Collins: I think they have probably been too busy to challenge - so not as yet -- but we have as we have aligned with our international group parent, we have a clear reason.
Peter Field: Would you have been doing something similar to the ORSA (own risk and solvency assessment) if Solvency II hadn't required it?
John Hume: Yes, not in exactly that format, but that probably is one of the areas where there has been some useful pressure to condense it into a form that becomes a good working document for the board. Our board would normally receive most of the information but in a miscellaneous delivery, sometimes voluminous and sometimes difficult to appraise. I think this brings it together in a shape that can make more sense.
Toby Ducker: That is absolutely right. We did our first full run, if you like, having done a number of drafts last year to the board in the fourth quarter, and the response was very positive. Yes, they had seen a lot of it before, probably about two-thirds in various guises, but not all together and not in the way that the ORSA asks you to present it.
Peter Field: Has the need for an ORSA under Solvency II increased the engagement of the board?
Toby Ducker: The thing that worries the board at the moment, certainly for the non-executives, is that the regulation, if taken to an extreme, forces them almost to behave like executive directors, and that was not really what they signed up for.
John Hume: There is an increasing requirement on them to know far more. They need to have a deeper understanding of the internal model, although in reality boards of directors already had that depth of knowledge before Solvency II came in.
Toby Ducker: I think part of the value for them as well has been their interaction with the risk appetite of the group as well and how they can then see that all join up, and then how that translates through the organisation in terms of the actual underwriting and back into capital.
Kevin Borrett: My interpretation has been that with full engagement it really is a holistic approach. Gone are the days where you had a board composed of individuals bringing individual key skills only and being expected to contribute on those areas alone.
Nowadays, there needs to be a much higher-level playing field in terms of the understanding of the model; the key risks; the calibration of the capital model; the enterprise risk management framework; the key facets of governance both at operational and board level; and an ability to articulate that as well and challenge.
Peter Field: So greater appreciation of the role of risk appetite within a firm would be a benefit of Solvency II?
Rick Lester: I think that a real benefit of Solvency II and the ORSA has been in terms of forcing boards to actually reflect and achieve consensus around risk appetite; also being able to monitor exposure and potential headroom, in terms of unused risk-bearing capacity, and feeding that into the ORSA process. From what I have seen at board levels, this has resulted in much more challenge and discussion.
Justin Skinner: It is one of the added-value parts of Solvency II. If you understand your risk appetite properly and you understand your risk profile properly, you know where your gaps are. As soon as you have got a gap, you can take more risk for increased return, usually. I think that is a huge benefit of Solvency II, albeit a thorny, difficult subject to have got through.
Consistency of approach
Peter Field: Do you think Solvency II is driving consistency of approach?
Justin Skinner: I am not convinced the regulation is actually driving consistency of approach. It drives consistency of reporting. When I speak to my peers in the capital modelling area and the risk management area, I find there is still a huge diversity as to what we actually do.
John Hume: Do you not find, if you do something slightly differently to what another six of your peers do, then there is quite a difficult challenge from the regulators? You may still end up with that different approach, but it forces companies to look at things in a rather similar way.
Justin Skinner: Having spent a year and a quarter with Lloyd's, looking at everything we do and a good six months with the FSA looking at what we do around the internal model, I do not think they are actually shoe-horning companies too much. They are pushing companies to do more and more validation but that is not going to drive consistency in approach.
Toby Ducker: The same charge was levelled at the ICA when that was rolled out, and I know, from some of the feedback that I have had from the regulators, that no two ICAs look the same across the industry. Therefore, it is hard to believe that all internal models will look the same.
For me, I think this comes back to the heart of the use test. Evidence-based decision-making has been used by doctors for some thousand years or more, and I do not see any reason why the insurance industry should not be using more of it to drive their own businesses to improve decision-making.
Kevin Borrett: I do share John's concern though. We have a situation where the FSA have got a difficult challenge. They will want to assess individual firms, based on their own risk profile and their own model, but, on the other hand, they will have one eye on capital allocation and broad industry benchmarks.
Justin Skinner: But most capital requirements, particularly for the UK non-life industry (though I am sure it is the same for the life industry), is not driven by regulatory capital. Regulatory capital is almost an aside that you have to calculate. It is all driven by rating agency capital. So there is already consistency as to how much capital you have, x premium in x type of class, driven by the rating agency.
Peter Field: What are the strategic opportunities of Solvency II?
John Hume: It has been suggested that there certainly is going to be a significant amount of M&A arising out of this but up to now there is limited evidence of this. The market is relatively soft at the moment and in large measure companies can get the business that they want without having to go through an M&A-type process.
Rick Lester: If anything I think some of the uncertainty has stifled M&A.
Toby Ducker: We are on the cusp of the internal model being approved and we don't know what the answers will be. You don't know who the winners and losers are and nobody is going to be brave enough at the moment to anticipate those outcomes. So, I think M&A is for a little bit further down the road.
The other thing is the fact that barriers to entry increase as a result of Solvency II and what does that mean? Again, I don't think there is a clear answer at the moment because there is still too much uncertainty, but as that emerges, there will be winners and losers in certain sectors and markets as well as en masse.
Justin Skinner: I think it is actually a good thing that barriers to entry are going up, because I think it is necessary for the industry to make sure we can actually have the credibility to make claims as they fall due.
Toby Ducker: That is one view, but the consumer view would be that barriers to entry mean less competition, mean generically higher prices for the end-client and they don't necessarily enjoy that as much. So, it is about trying to find that balance.
Anthony Collins: MMA Group purchased Provident Insurance last year and is now having to merge the two organisations. In theory it is much better having the two organisations working and having a capital requirement as one, because you get a definite capital saving, but the amount of re-work related to integrating two separate programmes does mean that practically it is actually quite difficult to have a merger in this period.
Kevin Borrett: The complexity of the UK insurance industry means that we do have quite a number of these niche insurers operating in only a small number of product lines. There is certainly a capital challenge for companies like that. Once we go through the Solvency II process, I do wonder whether we are going to see either mergers or specialist niche companies becoming acquisition targets.
Peter Field: Will the prospect of diversification benefits drive some of this activity?
Anthony Collins: Because diversification is a significant benefit, for a monoline to team up with another monoline writing a different line of business means the sum of the two is massively improved because of capital savings.
Toby Ducker: Although, strategically, under the internal model and the standard formula, you do get diversification benefit, S&P don't actually offer that much diversification benefit between lines of business. To my mind, some of the opportunities for actually merging companies or buying companies is operational efficiency because your rating agency capital is going to be not quite the sum of the parts.
John Hume: What is frustrating is that the group support regime was not implemented since this would have respected the global characteristics of our business and industry and possibly avoided complex arrangements to restructure operations.
Kevin Borrett: We are a relatively small firm so that is quite a challenge. It is a basic infrastructure point that should have been sorted out, because it has detracted from the real thrust.
Toby Ducker: It requires the cooperation of multiple European regulators and there are always going to be some challenges in there.
Kevin Borrett: I think there are other headwinds which might lead to companies dropping certain lines of business beyond Solvency II. I am thinking here in terms of RDR [Retail Distribution Review] and gender discrimination. There are a number of external legal pressures which may result in companies reshaping their portfolios.