Solvency II - proportionality: A sense of foreboding

scared

After a promising start, Solvency II is increasingly being viewed as a heavy burden after proposals to gold-plate the rules and increase capital requirements. Neil Coulson examines its progression.

The approval of the European Union's Solvency II directive in April 2009 was mostly greeted with relief that an important step in taking forward the future regulation of insurance in Europe had been made. Its perception of being the way forward for insurance regulation has led to similar approaches evolving elsewhere in the world.

But after this promising start, there has been an increasing sense of foreboding among many insurers, as the Committee of European Insurance and Occupational Pension Supervisors put flesh on the bones of the directive during 2009.

Ceiops issued several consultation papers regarding the detailed implementation measures to be applied for Solvency II. Although largely sound in principle, many of the consultations drew adverse comment from insurers regarding excessive prudence in capital requirements, the potentially heavy burden within the processes to be followed, and the extensive reporting requirements. Although some of these concerns were addressed by amendments in the final recommendations to the European Commission in early 2010, many of the criticised proposals remain.

Heightened capital calls
The most headline-grabbing aspect of the escalation in Solvency II requirements has been the potentially significant increases in capital requirements arising from the detailed implementation measures proposed by Ceiops. These came to a head with the proposals on how to calculate capital requirements for Quantitative Impact Study 5, set to commence in August this year. Press comment started to reflect fears that if the proposed factors were used in QIS5 the calculated capital requirements would increase by billions of Euros across the market and cause problems for many insurers.

Such fears may be overstated as most large and medium-sized insurers are likely to use their own models to calculate capital requirements and, therefore, should not be forced to adopt the standard formula percentages. However, even where an insurer uses its own model there are a number of elements where the calculation is increased by regulatory requirements, such as by the mandated discount rates to be applied and restrictions on how much credit can be taken for diversification across classes.

The potential use by most major insurers of their own models and the uncertainty as to whether regulators will approve such models without requiring significant modifications, makes estimating the extent of any final increase in capital requirements very difficult.

The EC in various recent statements appears to have recognised that Ceiops may have been erring on the side of excessive caution. This is most clearly demonstrated by the fact that the technical specification for QIS5 issued in April contained a number of factors that were reduced from those proposed by Ceiops in their level two implementation advice to the EC.

Despite these reductions the Commission has noted that the overall balance of the factors to be used in QIS5 is higher than those required in the QIS4 dry run during summer 2008. The final QIS5 specification to be issued on 1 July may contain further amendments, as the Commission will continue to consult on the specification up to its issue. The results of QIS5, which should emerge in late 2010, will then be used to refine the final calibration of capital requirements.

In addition to reducing the factors for QIS5 the Commission has made various statements to the effect that it does not consider the European insurance industry is in need of vastly increased capital across the board. It believes that the primary aim of Solvency II is for better risk management from insurers and that, if this is achieved, it should not also require a major increase in capital, other than where additional risks are identified.

Accordingly, the level two implementation measures proposed by Ceiops also have detailed requirements regarding risk management behaviour and reporting. Unfortunately, the proposed requirements as currently framed are in many cases an extensive and potentially onerous interpretation of the EU directive.

Within these requirements, the question of proportionality is a major uncertainty. Throughout much of the proposed requirements proportionality to the size and complexity of insurers and their risks is made reference to, but what exactly this means and examples of its application are unclear. What is clear is that the level of risk management and the amount of reporting in the public domain should be different between a major global insurance group and a small domestic mono-line insurer.

What remains unclear is just how much the obligations under Solvency II reduce for the lower risk entities and what the minimum requirements are that all insurers must meet irrespective of size and complexity. This is in addition to many requirements under Solvency II that, although reasonable, are required to be applied by all insurers irrespective of size — internal audit is one example. Such measures are likely to have a disproportionate effect on costs for smaller insurers.

Confidential information
The draft rules for disclosure by insurers regarding their risk management to be put into the public domain are also very extensive. These potentially include information insurers would wish to keep confidential. Many question whether the heavy cost and effort that would be required to produce this information is justified by the likely low level of interest in these disclosures from the public.

As Ceiops has now completed its level two consultations, any changes to the final implementation standards are in the hands of the Commission. The result of findings from QIS5 and the effect of insurers and others lobbying the Commission will influence the final requirements.

It is to be hoped that the Commission will listen and ensure the original hope of a common system based upon principles of improving risk identification and management are not lost in a burden of capital loadings, process and documentation. Hopefully the initial rationale for Solvency II to lead to a more effective insurance market — rather than merely a more burdened market — will prevail.

Solvency II: Too heavy a burden to bear?

Neil Coulson is a partner specialising in the insurance sector with accountancy firm Littlejohn

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