Solvency II

One of the lessons we have learnt from the credit crisis is that once consumer confidence is lost, it is incredibly difficult to regain. Not only the banks have learnt this the hard way. Companies operating in the insurance market have also suffered damage to their reputations due to a lack of transparency. Fortunately, insurance companies have followed in the banks’ footsteps by embracing the risk management creed. ‘Solvency II’ is the new buzz word in the insurance industry.

The general public have become rather suspicious of financial service providers. Scandals involving investment products are just one of the reasons for the loss of public confidence in the insurance industry. In other words, Solvency II could hardly have arrived at a better time. This new European supervisory regime is intended to generate clear information on risks and make them easier to assess – not just for regulators, but also for the market players themselves. All insurance companies, earning an annual premium income of at least five million Euros, will be obliged to adopt the Solvency II guidelines by 2012. This seems a long way off, but considering the time-consuming nature of an implementation project, time is of the essence. The main problem lies with the adjustments of computer systems, a complicated business that takes a considerable amount of time. At least, this is the lesson learnt from the introduction of Basel II, a similar system of solvency planning used by banks all over the world.

Transparency is good news for everyone

The objective of the Solvency II framework is clear: to guarantee the financial foundations of insurance products, so that insurance companies can survive a spell of stormy weather. Obviously, the aim is to safeguard the interests of policyholders and hence to protect the continuity of the financial system as a whole. The degree of transparency demanded by the system (Solvency II) should help the insurance industry regain the trust of consumers. One of the pillars underlying the framework is the mandatory publication of annual reports on each company’s solvency and risk profile. The higher level of transparency created in this way enables market parties to make better assessments of insurance companies’ performances. In the long term consumers will benefit, as the market discipline forces insurers to put consumers’ interests first.

The industry itself has also been given new opportunities. Insurance companies who have established state-of-the-art risk management systems are not required to maintain as much capital as competitors who have neglected their risk management. Moreover, they are free to allocate their capital in order to obtain the optimum risk-return ratio.

Similarities with Basel II

As an experienced consultant at Ordina, Toon Kool has spent recent years closely involved in the implementation of the Basel II capital adequacy rules. Banks apply these rules to calculate how much buffer capital they need to hold to offset any unexpected losses caused by their financial and operational risks. As far as the pitfalls are concerned, Kool draws a number of parallels with Solvency II: “When Basel II was introduced, we saw that banks had underestimated the scale and impact of the implementation process. The need to calculate the risks stemming from each individual contract and the duty to disclose clear information on these risks had a massive impact on the banks’ IT systems and reporting procedures. They suddenly found that they needed much more data and far more detailed data. Another aspect that proved tremendously time-consuming was the validation of risk models.”

Tightening up Solvency II?

Imposing the Solvency II rules on the insurance industry means more than just altering a few risk models and changing the way in which companies calculate their capital reserves. Companies will have to devote considerable attention to aspects such as documentation, internal and external reporting, internal control, IT systems and data quality. Everything needs to be documented, formalised and submitted to the regulator. It is up to individual insurance companies to decide whether to use the ‘standard approach’, provided for in the Solvency II directive, to calculate their risk capital or to devise their own models – with a lower capital requirement. Toon Kool: “Despite the fact that the ink has hardly dried on the draft directive and we are currently facing a financial crisis without parallel in recent history, several insurance companies are claiming that they are well on their way to full compliance. It is highly likely that additional requirements will be imposed by the European Union and/or the regulatory authorities. They are already considering whether their mandate is sufficient and whether the necessary information will be provided to them. This may lead to Solvency II becoming more stringent in order to bolster the regulatory authorities’ position.”

On the radar

“There is a risk that certain organisations already believe that they are in control as they have some initiatives in place, but take it from me: the devil really is in the details. If we assume that there is no material difference between banks and insurance companies in terms of the quality of the data and processes they use, it is safe to conclude that the implementation of Solvency II is going to require a huge amount of resources”, Toon Kool reckons. He stresses the need for close interdisciplinary co-operation. When Basel II was introduced, this proved to be a vital aspect for Finance and Risk.

“Fortunately, my impression from talking to clients in the insurance industry is that more and more players have noticed and registered Solvency II on their radar. The industry is also prepared to allocate significant budgets to implementation programmes. This is prudent, but it is important to remain alert as banks ended up paying far more to implement Basel II than they had originally planned. Much of the work that still needs to be done will revolve around the adjustment of computer systems. Something that has to be done step by step, because the subject matter is so incredibly complex. IT services are definitely going to play a key role in the implementation of Solvency II. Insurance companies will be wise to select an IT supplier with a proven track record.”

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