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The Solvency II directive is set to harmonise diverse supervision and regulation for insurers across Europe. But, as Paul Barrett warns, it is far from a done deal

Solvency II is a directive under development by the European Commission, which will provide a comprehensive new framework for insurance supervision and regulation. It should introduce a more sophisticated, risk-based approach to supervision and capital assessment across the European Union.

So why is Solvency II a big deal? This regime will replace more than a dozen existing directives and introduce a far more harmonised approach across Europe. And it is happening right now - the commission is currently finalising the 'Level 1' directive, which will set out the principles for Solvency II and thus its direction of travel. The European Parliament will then start considering the text.

An advanced-stage prototype for Solvency II will shortly be tested and the third Quantitative Impact Study (QIS3) will run from 2 April to 29 June this year. The Association of British Insurers is strongly encouraging all UK insurers to participate to ensure their views are taken into account. We are holding a conference on 6 March to explore the progression from the Financial Services Authority's existing Individual Capital Adequacy regime to Solvency II, which will include a briefing on QIS3. And to give firms practical help in completing QIS3, we are holding more in-depth workshops on 16 and 19 March. For all three events, go to www.abi.org.uk/events.

The supervision and capital assessment of insurers across the EU is currently very much a 'patchwork' of different regulatory requirements. For example, the UK has introduced its own more sophisticated approach on top of the basic EU requirements in many areas.

Solvency II will change this. One of its core objectives is to achieve one harmonised approach across the EU. So, regardless of where a firm is in Europe, its capital requirements and supervisory assessment should be the same. This is no small task and some countries are further advanced in their thinking than others. We believe that the introduction of the ICA regime has given the UK some valuable experience, in particular its greater reliance on firms' internal models to set their capital requirements. However, it is by no means a 'done deal' that Solvency II will adopt such a progressive approach. We must set out the case for change, to ensure Europe has an insurance regulatory framework fit for the 21st century.

In the ABI's opinion, Solvency II must pass five 'key tests' if it is to deliver a globally competitive insurance industry providing high-quality, good-value protection and investment products.

Test One: Market-based valuation

The first test is whether Solvency II will use market-based methods to value assets and liabilities and we ought to see a decisive move in this direction. Under existing European rules, volatility and uncertainty in the estimated value of liabilities is addressed in a way that often does not reflect the underlying risk. Insurers are obliged to include additional, undefined prudence in their valuation of liabilities, coupled with simplistic capital requirements.

Instead, we need a more sophisticated framework using market-based methodologies, including the cost-of-capital approach for 'non-hedgeable' liabilities - those liabilities for which a market value cannot readily be identified. This should enable firms and supervisors to better understand the risks insurers are taking and the degree to which these have been mitigated.

Test Two: Appropriate capital requirements

Under Solvency II, supervisors will monitor two important capital thresholds. The Solvency Capital Requirement will be the normal target level of capital for an insurer. Firms may derive this either through their own capital model or through a prescribed standard formula. The Minimum Capital Requirement, on the other hand, represents the regulatory minimum level of capital needed by an insurer. MCR should be set at an appropriately low level to reflect its role as a trigger for the most severe regulatory action - for example, a suspension of new business or a winding up of the business (if the firm cannot present a credible recovery plan).

Between SCR and MCR there will be a 'ladder of intervention', where regulatory action will escalate according to the severity of the firm's capital position, including its proximity to the MCR, and the time-share needed to restore capital to the SCR level.

It is important that Solvency II provides an incentive for firms to use their own internal models to calculate the SCR. Therefore the MCR must be set low enough (in relation to the standard formula SCR) for it not to interfere with the SCR as derived from the firm's internal model (in many cases likely to be somewhat lower than the standard formula SCR). Equally, if MCR is too close to SCR, a 'ladder of intervention' will not work appropriately.

Test Three: Streamlined group supervision

Solvency II presents an opportunity to develop a new approach to supervision for large cross-border groups. The current legal requirements are based at the individual legal entity level and, for groups operating across Europe, this can result in a significant degree of duplication in the regulatory process. It also constrains the efficient use of capital across the group.

The new regime should recognise the economic reality of large, cross-border groups by introducing a single lead supervisor. This supervisor would assess the entire group using a consistent approach to capital assessment and supervision. It is also imperative that Solvency II takes diversification effects properly into account, provided the group can demonstrate it has the freedom to move capital around according to need between different legal entities.

Test Four: Risk management incentives

Solvency II should also offer an incentive for insurers to use modern risk management practices - including reinsurance, derivative contracts or securitisations - in order to transfer risk.

The ABI also believes that the new regime should see a much greater role for insurers' internal capital modelling, helping insurers to manage their business and providing a significant input into the supervisor's assessment of the firm. Therefore, Solvency II must not impose arbitrary criteria or unduly burdensome tests for insurers to satisfy before their model can be validated.

Test Five: Principles-based regulation

Solvency II should mark a significant shift away from detailed, prescriptive rules and instead adopt principles based on market-consistency and economic and market realities. That means regulation should complement and not undermine the ability of insurers to manage their own business. It should also ensure senior management own and understand the approaches used to assess and manage the risks in their business. If Solvency II adopts a principles-based approach, it will help deliver a more streamlined and proportionate regulatory regime.

So, if the end directive passes all five of these key tests, it should deliver a world-class regulatory regime that will help the insurance industry to continue to meet the needs of consumers across the European Single Market.

- Paul Barrett is policy adviser for financial regulation and taxation at the Association of British Insurers. He will be speaking at the ABI Solvency II conference on 6 March at One Great George Street, Westminster, London SW1P 3AA.

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