Reinsurance brings substantial relief
The insurance industry faces enormous changes in the future as companies will have to gear their capital more closely to the risks assumed. This is the fundamental principle of the EU's Solvency II directive, which includes investment decisions as well as underwriting in measuring a company's risks. Although implementation of the directive will inevitably involve considerable effort, it also offers a variety of opportunities.
Volatile capital markets, falling interest rates, a rising number of large losses and accelerating deregulation of insurance markets have certainly had a significant impact on the equity capital base of many insurance companies. In the light of these difficult conditions and in order to put the insurance industry on a firm footing for the future, the European Commission has launched the Solvency II Project. The objective of this initiative is to modernise solvency rules and to stipulate new capital requirements for insurance companies.
Solvency II completes the transformation from a purely quantitative assessment framework to an approach that now includes qualitative elements of risk management. The new rules will take account of developments in the field of risk management and investment management, and of modelling approaches from financing and actuarial mathematics. Unlike Solvency I, the directive will not only evaluate underwriting risks but also investment risks and other quantifiable risks. Insurers that invest in riskier assets than others will see their solvency capital requirements increase accordingly. Other risk categories such as operational or liquidity risks will be addressed qualitatively.
Maximum harmonisation
In spite of all the uncertainties involved, it is already safe to say that the amount of solvency capital required will be higher than under the current Solvency I regime and will be based more closely on the individual overall risk profile. On the other hand, the minimum capital requirements are likely to remain at around the level of Solvency I. Altogether, Solvency II will cover a much broader spectrum of risks. It will not only permit extensive control of risk exposure but will also provide a risk-adequate basis of assessment for solvency requirements.
Like the Basel II process for banks, the project is based on the three pillars of "solvency assessment", "supervisory review" and "market discipline" (transparency and disclosure). A fundamental objective of Solvency II is to harmonise European supervisory rules and to eliminate the coexistence of inconsistent national supervisory systems — with far-reaching consequences. Unlike Solvency I, this will involve more than formulating minimum requirements to be subsequently translated into each respective national law. Rather, the Commission's objective is to seek maximum harmonisation and to create a level playing field which will go a long way to removing competitive distortions within the EU. This would make it unnecessary for individual countries to introduce their own additional regulations.
The more accurately a model represents the actual risk position, the easier it will be to ensure optimal use of capital and effective management of a company.
The first pillar of the system concerns the holistic, quantitative assessment of insurance companies' risk situation. This chiefly involves examining the reserving and solvency situation of an insurance company. Reserving practice is to be standardised by means of methodological requirements and certain risk margins. In order to regulate overall solvency, the different risk classes and their specific features will first be examined individually and then aggregated to form an overall risk. The second pillar involves qualitative requirements. Insurers will have to meet specific standards regarding investment and risk-management processes, but supervisory processes will also have to comply with certain requirements. The main components of the third pillar are transparency and disclosure. In establishing Solvency II, it will be vital that all participants are clear about all measures applied by the supervisory authorities. Transparency is not just a requirement placed on the insurance companies but a fundamental component of the entire Solvency II initiative.
In the future, insurance companies will be able to choose whether they want to determine the solvency capital requirement (SCR) by means of a standard formula or on the basis of an internal model. Generally speaking, an internal model provides a much more accurate reflection of the risk situation and of the effects that risk transfer measures may have. The EU Commission's plans reward the use of internal models with lower capital requirements, thus providing an incentive to develop such models. However, the development, implementation and incorporation of individual company models will involve significant cost and effort. Internal models might be worth the effort for large and medium-sized companies but most European companies are likely to start off using a standard formula to determine solvency.
Internal models do have the advantage, though, of being able to identify risk drivers and reveal business segments that add or destroy value. The risk model will therefore become a significant competitive factor. The more accurately a model represents the actual risk position, the easier it will be to ensure optimal use of capital and effective management of a company. Insurers that decide to use internal risk models will have a clear edge in this regard.
The greater transparency of risks will bring structural changes which will require insurance companies to critically analyse not only individual products but also entire business segments. This process will also affect other areas such as product design, marketing and sales. At the same time, asset-liability management tools acquire increasing importance as well. This is because the EU Commission has stipulated that risks which arise as a result of a mismatch of assets and liabilities must also be given explicit consideration.