Data, the moving regulatory timetable, the IMAP, equivalence with the US and the lack of certainty on key points in the directive are among the challenges faced by re/insurers preparing for Solvency II. Plenty of food for thought and discussion at the roundtable of risk and Solvency II experts hosted by Deloitte and InsuranceERM
Note: this is the second part of the discussion; the first was published on 21 March
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)
Practicalities of preparing for Solvency II
Peter Field: What are the particular challenges each of you faces in preparing for Solvency II?
Anthony Collins: I guess the impact of having all this additional information in financial statements and the wider investment market pillar 3 stuff. There is going to be an education piece required there because market analysts would not be, in my estimation, fully familiar with what a market-consistent balance sheet means and the effect of discounting.
There is going to be a transitional stage where retained profit moves from one year to the next because of the release of reserve moving from undiscounted to discounted reserves. Similarly, there will be tax issues along the way and all of those things still really need to get resolved to enable you to forecast what your balance sheet is going to be and what your financial statements are going to look like in a couple of years time.
Justin Skinner: I think boards probably need a bit more awareness and education around the impact of discounting. We have had it in Australia for years, we are used to discounting and it has been a hard journey to get your head around.
Anthony Collins: And movements in relation to changes in interest rates. We are not getting them at the moment but you can foresee a time where, if interest rates fluctuate, there could be no material change in the business that is being written or the reserve run-off, but the liabilities are moving up and down and profits are being created because of those movements. That is going to be hard to swallow; we want stable results.
Toby Ducker: One of the things that we did, that helped us a little bit on that, is that part of our stress scenario suite of tests includes interest-rate fluctuations. Therefore, you can see in quite an articulate sort of way what the impact would be. Now, that does not give you the full balance- sheet simulations but it has made people more aware. It is certainly one of the things that we have stressed to our board -- that they need to understand that volatility's impact and what they want to do about.
Peter Field: What challenges concern you about the further push back of the implementation date?
Justin Skinner: The FSA and, in particular, the Lloyd's are not delaying their timetables. So from a pure UK perspective, it's quite tough. You have to continue with work as is: meet all the milestones as agreed with regulators.
In many ways, it can be advantageous, because you can almost drop the programme aspect of Solvency II and use 2012 as a BAU [business as usual] aspect of Solvency II, actually embedding the processes.
Toby Ducker: The European Parliament is quite concerned with what is going in the Eurozone at the moment and that has to be - rightly I think - their top priority. The embedding point is really where the value comes from in Solvency II. Those who do march forward and embed quickly will be the ones who can create the competitive advantage from Solvency II.
Anthony Collins: For those companies that are still a little bit behind, 2013 will probably be the year that they use to embed Solvency II. Also, the regulators across Europe need to get up to speed. It is probably more for them that the delays happened rather than for the insurance industry, because the insurance industry could have met the deadline if it had to.
John Hume: We are in a soft market and continued delays can inflate costs. Continued delays also imply that what we are ending up with an overly complex solution.
Toby Ducker: Many UK firms are targeting an IMAP [internal model approval process] in the fourth quarter of this year, and it is over the next six months that they've actually got to demonstrate they are engaged in this project. There is continual uncertainty of, "Is this going to happen?" and, if anything, it is diluting that engagement.
Kevin Borrett: For me there are three issues: two positives and one negative. The first positive has already been mentioned: that firms have longer to implement. Based on the original timescale there was a risk that you would have a good, strong application but very little empirical evidence to show that new processes and changes have been embedded.
The second benefit is that there are still a number of key issues facing the industry where perhaps the UK perspective is different to some of our European competitors, matching premium being a good example. If the delay allows some of those issues to be resolved, then that is a positive.
The negative is the one John has mentioned: we sanctioned a budget for a project, we've now stretched that to one extra year already, and no doubt the board will challenge me to stretch the same number for one further year.
Toby Ducker: I think the fact that there is no firm implementation date is almost an opportunity. It is an opportunity to go out there with the best foot forward and put it out there for the regulator to challenge.
Kevin Borrett: There is undoubtedly going to be a process of ongoing education for the regulator as the IMAP teams go round. We are developing an internal model and we are embracing a risk and capital operating model that best fits the business. It is the responsibility of the organisation to demonstrate that to the regulator and win the argument.
Peter Field: So, are most people sticking with the original schedule then?
John Hume: All the major players appear to have started at the right time and they are pretty well on schedule to implement in line with the original schedule, let alone that initial soft implementation delay of a year.
Toby Ducker: That's right, especially for those who have got operations in Lloyd's, where Lloyd's have driven a pretty harsh timetable over the course of the last year-and-a-half or so -- but I think it has definitely moved the market as a result.
John Hume: This delay is not for those companies; this will also clearly benefit the regulators, allowing them to get up to speed.
Kevin Borrett: Unum is classified into tier two, by virtue of size and nature of market involvement. We're currently scheduled to be one of the earliest tier-two firms to go through IMAP. I have a personal concern, given the level of resources in the FSA, that the tier-one approval process may well drag out longer.
Rick Lester: We undertook a survey in conjunction with the Economist Intelligence Unit at the start of 2011. It was across about 60 companies, and we asked, "Were individual firms confident around achieving the IMAP timeline?" That was obviously prior to the delay being announced. And it was only about 75% of firms who said they were confident. We then asked whether they thought the industry would achieve and it dropped to below 50%. That was an indicator that there was concern around regulatory capacity to be able to accommodate the volume of applications and drive this through.
Justin Skinner: If you rewind time to the start of the ICAS [individual capital adequacy standards] regime back in 2004, the hurdle you had to jump to have the FSA approve an ICA [individual capital assessment] was at one level, in 2005 it was higher, in 2006 it was higher again, and it just got higher and higher. The delay almost makes no difference at all because the hurdle will just get higher and higher the further on in time that you go. There is a set of standards you have to meet, and I think meeting those standards will become tougher and tougher over time.
Kevin Borrett: As we go through a process of approval, you do wonder whether there will be a lower bar set for those who go through the process in 2012 than those who finally get their approval in 2014.
Toby Ducker: But, as the FSA will say themselves, they will find it very tough once they have approved a model to adjust that for further add-ons, or indeed challenge that in the future, assuming that the model remains materially the same.
Justin Skinner: I've never quite understood the concern around the dual running of ICAs and SCRs. In essence, you have one risk profile for your company, you are just taking different risk measurements of ICA versus Solvency II. Admittedly I don't want to be doing two regulatory submissions every year and being quizzed twice on those. You're looking for a seamless move between one to the other. You don't want that situation where one stops and the other one starts.
Toby Ducker: But equally, there needs to be a management of expectation around where that bar is as we move through that transition.
Flexibility and pragmatism needed
Rick Lester: Looking at the experience of the ICAS regime, where we have seen continuous improvement over time and further embedding into the business, it has not been a hard transition; it has been a soft transition over a period and, I think, it should be exactly the same with Solvency II. Any aspiration to be a hard transition on date x is just not going to work.
It would not have even worked in the UK environment, the chances of it working across Europe are even less. So, I think there is a huge dependence on the transitionals and continuous improvement. It will not necessarily be a level playing field from day one and there needs to be some pragmatism on that.
Justin Skinner: I think the regulators are showing elements of pragmatism. They have got internal resource constraints; they're feeling their way through model approval themselves. They haven't got all the knowledge; they just need companies to drag themselves up to the right level. The bar will keep going up and up and the companies will be increasing their capabilities at the same time anyway.
Anthony Collins: To have a vague bar is almost more difficult than having a high bar, because you can either over-engineer or under-engineer your solution just because you do not really know what you are aiming for.
Toby Ducker: Therefore the pragmatism of the regulator, if they get it right, actually can be quite powerful in terms of helping industry lift the bar year on year, but obviously if it goes wrong could create real problems.
John Hume: If you have a bar initially set very high and it is effective on a particular day, that can be excessive. The more you can be open and honest and inform companies about the basis and whether reliefs and concessions are going to be extended, it is a consistent message that we can then put to our boards.
Peter Field: Are you all assuming that you are going to get approval for your internal model from the FSA? What happens if you don't?
Justin Skinner: There is a contingency plan. If models are not approved, there are two specific aspects that the regulators can actually give you capital loadings for. They approve your model subject to doing this and in the meantime they give you a capital loading. The reality is, capital loadings would be pushed into play rather than having to revert back to a standard formula or a partial internal model.
John Hume: On the model approval, how many are going through a restructure? Because my understanding is that the FSA would say, "If you are restructuring and therefore the model is going to be different by the time we get to Solvency II coming in, then you either do the restructure or you have the model approval". You do not get both. Is that an issue for anybody?
Justin Skinner: It depends how you structure it. If you have got one European holding company and you are just shifting things within Europe, it makes no difference.
Kevin Borrett: We have certainly seen the FSA enquire about the extent of change being undertaken within our internal model development distinct from our current ICA model. Obviously, a number of companies are building new models; we are iterating our current ICA model with additional features. Certainly, the FSA is trying to gauge the extent of change to existing models and whether there is greater change coming than firms had previously advised. If that comes through, then they are reconsidering some of their timescales.
John Hume: So nobody is seeing restructuring as an issue for model approval?
Toby Ducker: No, but it certainly is a word of caution, isn't it? Because, if that really is the case, then coming back to our earlier point about M&A, that really could stifle the market there, potentially for all the wrong reasons.
Anthony Collins: I think it is definitely an area where if you have a standard formula approach rather than internal model, you have an advantage.
The model approval process
Peter Field: Are all the regulators struggling, including the FSA?
John Hume: It includes the FSA and other regulators. I think that they are all struggling with resources. They're finding it difficult to get the amount of resources they need to run through this project. I believe they were originally surprised by the number, or percentage, of companies which wanted to go down the internal model route. I think they assumed initially that there would be quite a few who would be comfortable with the standard formula.
Justin Skinner: I think the FSA did acknowledge this right at the beginning. The UK insurance industry is very different from its counterparts in Europe in the shape of it. You've got far more mid-cap companies in the UK than you have in mainland Europe. Generally you have got far more oligopolistic structures; the market is largely driven by the London market. When the FSA received the original 110 applications, they weren't surprised at that point, but currently that's down to about 70 now. So some firms along the way have obviously decided that the standard formula is good enough for the business.
John Hume: The FSA appeared to work on an assumption that only a fraction would actually go all the way through and at one stage it seemed to be as low as 25-35% of those that would be applying. To me, the message was, "Yes, we understood people are applying, but we will wait to see how we respond to that."
What happens though when the FSA requires a company to go down an internal route but they don't have the resources to respond to them?
Justin Skinner: They'll say capital loading -- just like the formula.
Model variations and arbitrage
Peter Field: Is the requirement that all comers to the group have the same sort of levels of governance, with ORSA and board approval and everything? Is that an issue?
John Hume: Well, certainly, if you are embedding it properly, you would expect there to be a very similar standard to be established.
Anthony Collins: My company has developed and uses a model for the ICA in the UK . The European parent also uses models but they are not currently used to calculate regulatory capital.
The European parent intends initially to use the standard formula for calculating capital. The internal model that the UK operation developed will be used for ORSA purposes. The group will take a similar approach but is not as advanced as the UK operation as it didn't have to comply with the ICA regime. So, you can certainly have parent and subsidiaries running at different speeds depending on where they are located and, over time, Solvency II will bring them together, but in the transitional period there may be some difficulties aligning the board, the structures and the governance so that they are all doing the same thing at the same time.
Kevin Borrett: Anthony has illustrated an interesting point as to whether there will be regulatory arbitrage if there is different treatment between different EU territories or inconsistent approaches between colleges of regulators.
Anthony Collins: At the moment it is speculation as to whether it will all work well or whether there will be these issues with different degrees of expertise and the different regulators. There could possibly be regulatory arbitrage, as Kevin suggested, where companies relocate or they change their head office so their lead regulator becomes a different one, for their benefit. Until we have evidence that the regulators are acting a certain way, it is probably best to just stay as you are and see what happens.
Data is a core challenge
Peter Field: Is data as big an issue as everyone says?
Toby Ducker: On the issue of the source systems and the legacy warehouse firms have been working on this for some time now. But actually, the difficulty with the data management framework and its implementation is that, for the last year, most of us have been changing the models themselves. They now require slightly different data to what was there a year ago. Therefore, trying to hit a moving target in terms of putting in management and controls around data has been a challenge.
John Hume: For us, it is a finance transformation process as much as getting the data to conform to Solvency II. Data needs to flow accurately, consistently and speedily through an organisation. For a global company where you have got legacy issues, that can be quite a tough nut to crack, but it is something that companies need to do, Solvency II or not.
Justin Skinner: In QBE, we found that our actuaries were manipulating data or adjusting data for very valid reasons - remediating data deficiencies - for years and years before Solvency II came along and actually pushed the onus on changing the source system data. You change it at source and then it runs through your whole business with no adjustments. Suddenly, you cut down on manual process and manual intervention, which is a huge benefit to the company. I think the London market in particular has been looking at this for three or four years; well before Solvency II data became a big subject.
Rick Lester: We are certainly seeing quite a bit of challenge around areas like data quality metrics, organisations demonstrating accuracy across the entire life cycle of data, particularly where there is a lot of extraction and transformation. I think it becomes even more challenging where there are external providers of data, like asset managers, market information providers, etc.
Equivalence with the US
Peter Field: How important is equivalence with the US?
Toby Ducker: At the direct level, the US has got its own challenges. We saw Obama be quite bullish about the opportunities for a federal insurance regulator when he first arrived. But obviously we are a number of years into that regime now and we have seen it slip down the pecking order in terms of priority.
But it is more the dedicated insurance markets, I think, where equivalence becomes more important -- Bermuda, Switzerland and the Channel Islands -- where it will be interesting to see what approach they ultimately end up with and where they land on equivalence.
John Hume: For me, the big issue is equivalence for the US. You can't not have a market that significant and well run that Europe does not consider equivalent to its standards. It is a little bit arrogant to argue otherwise. I know that it hinges upon having a number of "technical" issues such as federal versus state regulation but there ought to be a way of overcoming this that is not simply a delay.
Peter Field: The move on the reinsurance side; is a step in the right direction?
John Hume: I personally believe so but obviously states are resistant to it and I think it is going to take quite a bit of time to come through.
Toby Ducker: The US is the obvious one, but some of the smaller jurisdictions are querying how quickly they need to move on some of these things and whether they can just spread it out over more years. Also the standard for equivalence is unclear at this stage and maybe that is slowing them down.
Kevin Borrett: One of the principles around Solvency II is around the ORSA and there is considerable debate going on within the NAIC [National Association of Insurance Commissioners] on the ORSA. From our own company's perspective, with 90% of our business being based in the US, we are certainly trying to inject what we think are more beneficial aspects of ORSA through lobbying.
Justin Skinner: We have an Australian parent company so equivalence is quite a big issue for us potentially. We are not 100% certain what the consequences would be if Australia were not found to be equivalent by the FSA for QBE. I think that is true for anyone who has got a Bermudan or American parent.
The Australian regime, in my opinion, is actually broadly equivalent to Solvency II. They have had an internal model-type approach in place for a number of years; there are a very limited number of companies that have applied. They have got something akin to the ORSA. The reporting requirements and the balance-sheet management is very similar to Solvency II balance-sheet management as well.
Toby Ducker: I would actually turn that around and say that a lot of Solvency II borrows from APRA, the Australian regulator, and also the Swiss Solvency Test, so actually it is no surprise to hear that they are broadly similar.
Justin Skinner: But not equivalent yet. My understanding is that the international regulator, the IAIS, is looking at effectively a Solvency II-type regime on a global basis and bringing together all the global regulators. If they are moving in that direction, then it may be on a global basis everything converges without equivalence driving the discussion.
John Hume: That would be a huge step in the right direction. It took Europe a long while to get where we are today and to then turn around to some of the developing jurisdictions and say, "You have got to do this in two to three years," is very demanding.
Justin Skinner: On your comment about the arrogance of Europe: I have heard that repeated from a number of our global companies. Speaking to some of our peers around the globe, they do think that Europe is just arrogant, saying, "You are not equivalent; your regime is not good enough".
Toby Ducker: If the EU uses Solvency II to create trade barriers for insurance companies globally then that could have a very detrimental effect on what is essentially very much a global industry.
Peter Field: Finally, do you have any thoughts on the impact of Solvency II on budgets and resources?
Rick Lester: How are people dealing with the business-as-usual run costs of Solvency II? Boards are becoming increasingly challenging on the budgets; not only the programme budgets, but also the BAU costs. They all seem to be heading in one direction.
Toby Ducker: Over time as the processes are better understood, you can make them more efficient. But necessarily, as you introduce them, you probably are over-egging them slightly on the labour requirement to make those things, because embedding is not something that just happens; it requires planning and effort.
Rick Lester: I sense that there is a lot of challenge around the potential duplication of expensive actuarial resource in the business.
Toby Ducker: I think the actuarial profession has managed the process very well. It takes about seven years to create one and, of course, they limit the supply and the demand has obviously gone up exponentially in recent years as well.
John Hume: Actuarial resources are stretched within the organisation. There is a shortage in the marketplace of talented people.
Toby Ducker: A lot of the consultants have brought resources from all round the globe, Europe as well as Australia and other places.
Kevin Borrett: The other challenge that I would throw out is whether the risk function and the CRO need necessarily be an actuary. You are looking, in many cases, for broad-based business leaders with a high level of financial literacy, but that does not necessarily mean that the right individual is always an actuary - says he, who is an economist.
Toby Ducker: There was that wave of CROs and people being appointed and actually the most natural fits at the time was largely the actuarial profession. Most of them have done very well at it, but over time you can see that broadening out a little bit.
Justin Skinner: If you look at the actuarial CROs (my boss being one of them), they are very effective at speaking to the underwriters because they can understand the business problems and have pricing experience. They can speak to the finance function because they are aware of balance sheets and accounts and they can talk to the top level executives in a company. There is an increasing supply of talented actuaries coming through the marketplace - there are a lot of university schemes doing actuarial qualifications, and there is a move of actuaries out of defined benefit scheme valuation work."
Kevin Borrett: Prices should come down then.