Solvency II Will Raise Governance Issues for Insurers

As a "root and branch reform" of insurance regulation in the European Union, Solvency II will put governance at center stage, according to Naren Persad, a senior consultant with Towers Watson in London.

Solvency II is due to take effect in the 27-nation EU in late 2012. It will replace regulations developed in the 1970s and early 1980s that became known as Solvency I, Persad said. "Things have moved on a lot since then," he said.

The climate in which this new regulatory structure is being created owes much to the advances that have occurred in technology and risk management, Persad said. There is a deeper appreciation of the necessity for good governance in insurance.

"We've seen people realize that it's not just capital that's important for a company," Persad said.

Smaller insurers may face some disadvantages under Solvency II, according to Vasilis Katsipis, general manager of analytics at A.M. Best Co. in London. Katsipis, who specializes in life companies, said large insurers will benefit from being able to use capital models that are suited to their needs, while the smaller companies may have to make do with the standard Solvency II formula that may not fully reflect their capital positions. The larger insurers will also be able to draw on their wider diversity, Katsipis said.

"So it could be that, like for like, the smaller insurer will be required to hold more capital than a larger, more diversified insurer," Katsipis said.

Larger insurers are also better placed to compete for the talent that will be needed in the coming risk-based environment. By contrast, Katsipis said "the smaller insurers may find it difficult to actually put adequate resources on Solvency II."

Companies seeking to diversify may find themselves constrained by a lack of skills and by the perceptions of the market, Katsipis said. Insurers should also focus on processes, because under Solvency II, they be asked effectively to self-regulate.

Whether smaller insurers become takeover targets under Solvency II will depend largely on the economic environment. With their "almost niche" positions, smaller insurers throughout Europe are facing problems, Katsipis said. "Many of them have been very badly hit by the decline in the equity markets in 2008."

While some of that damage has been repaired, these companies "are not where they should be," Katsipis said. This could pose problems in meeting regulatory requirements, he said.

As Solvency II approaches, smaller companies should derisk, diversify and, if they haven't already done so, start preparing for the changes, Katsipis said.

Companies should also focus on processes. This will be more important, as insurers will be asked effectively to regulate themselves, said Katsipis.

Colin Pountney, group actuary for U.K. mutual Royal London Group, said there is wide agreement that Solvency II will, in principle, be good for the insurance industry, regulators and consumers.

"The only slight concern is in relation to how it's actually implemented," Pountney said.

Solvency II will place great emphasis on "calculating the numbers," Persad said. This contrasts with the piecemeal approach found in the United States.

The quantitative requirements of Solvency II depend on a market-consistent valuation of assets and liabilities, Persad said. This represents an attempt to move on from Solvency I, which has been hampered by disparities in valuations across Europe. While some countries were using market value, others were using the more traditional book value.

Solvency II will also create a risk-based formula, said Persad, who noted the biggest criticism of Solvency I "is that it is not risk sensitive." Solvency I, for instance, did not pay much attention to such risk mitigation techniques as reinsurance or securitization, Persad said.

Solvency II focuses more on the risks that are being run than in the size of companies, while recognizing the benefits of diversification, Persad said.

The next indication as to the final shape of Solvency II, Pountney said, will be the fifth Quantitative Impact Study, or QIS5, later this year.

"The objective is for firms to improve their understanding of risks that they're taking on, improve the way they manage those risks, and hold capital against them," Pountney said. "They're all laudable objectives."

Pountney does not see any particular wrinkles for mutuals under Solvency II. Any differences affecting mutuals, he said, are likely to revolve around the admissibility of assets to cover capital requirements. One possible issue for mutuals, he suggested, might be their limited recourse to markets to raise capital. Rather than seeking equity capital, he noted, mutuals use subordinated debt and retained profits from past business as part of their capital base.

If these sources of capital are regarded as being of a lower quality than at present, "that would have a concern for the mutual sector," Pountney said. He is confident that the very large mutuals on the European continent will remain alert to their interests.

"I don't think there's anything on the horizon that's of particular concern for mutuals," Pountney said.

Listen to the full interview with Vasilis Katsipis at http://www.ambest.com/media/media.asp?RC=173486

(By Robert O'Connor, London editor: [email protected])