Towards a better reflection of risks

Perfect solution or dynamic process? Henrik Bjerre-Nielsen, chairman of CEIOPS and Director General of the Danish Financial Supervisory Authority, is convinced that the willingness to compromise and a pragmatic, step-by-step approach are the key success factors for implementing Solvency II within the targeted time-frame.

Bjerre-Nielsen met with Munich Re's Dr. Rolf Stölting to discuss changed capital requirements, internal risk models and the potential impact of Solvency II on the insurance industry.

Dr. Rolf Stölting: CEIOPS celebrated its second anniversary in November 2005. What do you consider to be the committee's most important milestones?

Henrik Bjerre-Nielsen: Most importantly, we have been able to respond to the European Commission's Calls for Advice almost within the set deadlines, providing recommendations on the cornerstones of the future solvency rules. We have made a lot of progress, but there are still big challenges ahead. Many questions have not even been asked, and we will have to explore them in great depth if the Commission is to meet the 2007 target for submitting a proposal for a directive.

Stölting: Do you think this time-frame is realistic?

Bjerre-Nielsen: It is a very ambitious goal. All parties involved — the Member States, the European Parliament, the Commission, and, of course, the insurance industry, have to be willing to compromise. Obviously, we also need some luck, because it is a complicated process. But it also depends on our approach and ambitions. Do we see this as a dynamic process? Or do we want to build something perfect from the start? In the latter case, it would be very difficult to meet the deadline. Solvency II is a giant step forward. We also have to be aware that risks are dynamic, and that you cannot design a prudential system that never needs to be amended.

Stölting: Will Solvency II be implemented in 2010 as planned?

Bjerre-Nielsen: I hope so, because we urgently need to get this done. If we do not succeed, some countries will try to improve their systems from a national point of view. We already see this in the UK, the Netherlands and my own country, Denmark. The present system is outdated, and the longer we have to wait for the new one, the more difficult it will be to find a common solution. And we need to have a common solution in order to have a common insurance market.

Stölting: What does Solvency II mean for the supervisory authorities and the insurance industry as a whole?

Bjerre-Nielsen: The new system will be more risk-sensitive, i.e. capital requirements will provide a better reflection of an insurer's individual risk profile. And it will also be more dynamic. Moreover, we'll no longer have a "one fits all" system. We will encourage major insurers to develop internal models, while smaller companies will have the option of using a standard formula. So insurance companies will have some choice as to which rules they are going to apply. I suppose that on the supervisory side there will be a need for more competences in risk assessment, particularly in the assessment of financial risks. If we want to have a common European insurance market, supervisory practices will have to converge too.

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Stölting: There are some signs that solvency capital requirements will probably be higher than today. What does this mean for individual insurers and for the industry in general?

Bjerre-Nielsen: That is difficult to say. On the one hand, you might assume that solvency requirements would increase because there is a better reflection of risks. On the other hand, insurers are aware that today's solvency requirements do not adequately fit the risk profiles. Hence many insurers already have a level of capital that far exceeds the level of capital required by regulation. Finally, we are also trying to find a more harmonised approach for evaluating technical provisions. Some countries require a lot of prudence in the assessment of technical provisions — at least that is what they claim — while others are more realistic. If the level of prudence in technical provisions is lowered in some countries, it means capital will be freed up. Overall, I do not think there will be a lot of need for additional capital in the insurance sector. There may be a need for a different allocation of the available capital.

Stölting: How do you expect capital allocation will change?

Bjerre-Nielsen: Smaller insurers may decide due to higher capital requirements to keep less risk on their own books, and buy reinsurance cover. In this way, the risk is transferred within the industry to other (re)insurers whose capital requirement may be lower due to their internal models.

Stölting: Do you expect consequences for insurance products and prices?

Bjerre-Nielsen: That depends on how the individual risks are reflected. Changes in capital requirements may have an impact on the pricing of some products. However, in this area too the relationship is not simple, as insurers may base their pricing decisions on their own capital requirements which may exceed the capital required by regulation.

Stölting: Many insurance companies are developing internal models that will have to be certified. Are there criteria in place for this process?

Bjerre-Nielsen:We are working on this issue. Let me refer you to our response to Call for Advice No. 11. I must emphasise it is a very difficult issue. It is a delicate matter to clearly divide responsibility between the company management and the supervisor. However, supervisors should encourage the use of internal models for calculating solvency capital in order to enhance risk management. Consequently, we should also be willing to approve them to be used for calculating the solvency capital — provided the models fulfil certain criteria.

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Stölting: The supervisory authorities can intervene if an insurer fails to meet the stipulated solvency margin. Have you already considered what measures will be taken in such cases?

Bjerre-Nielsen: In my country we have a traffic light system: green, yellow, red. In supervision, the world is not only black or white. This is why a traffic light system is also being envisaged for Solvency II. As long as a company exceeds the Solvency Capital Requirement, there is no need for supervisory action as such. Once it goes below the SCR, the supervisor and the company itself are required to review the situation and take action. If the company moves further away from the SCR and approaches the Minimum Capital Requirement (MCR), the supervisors become increasingly impatient. They will strongly insist on the management taking additional action. Between the SCR and the MCR, there is what may be called the "yellow zone", where there is already a high risk. If a company reaches the MCR or moves below it, the traffic light switches to red. The supervisors' patience is exhausted. They will take "ultimate supervisory action", which in practice means that the company's licence to write new business is withdrawn.

Stölting: Does this mean that the future MCR will inevitably have to be lower than today's solvency capital under Solvency I?

Bjerre-Nielsen: Yes — probably, if we ignore the amount of prudence in technical provisions. We have given the MCR some thought, but it is too early to give definitive answers.

Stölting: CEIOPS is in favour of fully recognising a range of risk-reducing instruments. The EU Commission has stated that reinsurance is one of the key tools for this purpose. From a primary insurer's point of view, is reinsurance under Solvency II sufficiently acknowledged as a riskreducing measure?

Bjerre-Nielsen: As regards reinsurance, CEIOPS continues to follow the view of the IAIS (International Association of Insurance Supervisors). For the supervisor, it is most important what kinds of risk a company assumes, regardless of whether it is a primary insurer, a reinsurer or a company active in both areas.

Stölting: How can it be ensured that the supervisory measures are handled consistently in all the different countries?

Bjerre-Nielsen: Again, this is a dynamic process. At the initial stage, we start out with a minimum level of convergence. As time goes by, there will be more and more convergence in firstly insurance regulation and secondly supervisory practices. However, it is not realistic to expect that complete harmonisation between supervisory authorities will be attained from one day to the next when Solvency II is implemented in 2010.

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Stölting: Quantitative impact studies are very important in view of the assessment of technical provisions. Should CEIOPS's role as an adviser to the EU Commission be expanded?

Bjerre-Nielsen: Yes, because I think that most of these data can only be collected by national supervisors. They are in the country and can collect and analyse the data and ensure that they are treated with the required secrecy. believe that insurers in most countries would rather share the data with their national supervisors than submit them directly to the Commission.

Stölting: As head of an authority responsible for banking and insurance supervision, how would you compare and contrast Basel II with Solvency II?

Bjerre-Nielsen: This is difficult to answer at this point because we do not know exactly what Solvency II will look like. But I think that according to the Framework for Consultation, the Commission wants to have a system which is consistent with Basel II — to the extent possible and necessary. As the head of the Danish supervisory authority, I do not have any problem with that, and of course we are trying to find solutions in line with our political mandate.

Stölting: Is the underlying objective of Solvency II the same as in Basel II, i.e. protecting the customer, in this case the policyholder?

Bjerre-Nielsen: It is a matter of presentation. In Solvency II, we are trying to develop a system where the probability of an insurer defaulting on its obligations over the next 12 months does not exceed 0.5 percent. Perhaps this is expressed differently in banking. But the underlying principles are the same. And in order to achieve this goal, you need to have capital requirements which are an adequate reflection of the underlying risks. At least with respect to internal models, the banking rules and Solvency II have a lot in common. The same holds true for the relationship between the home and the host supervisor, and the approval of internal models. Conceptually, such models, which are part of Basel II, are something which actuaries have been doing for decades in other areas. As the head of an integrated supervisory authority, I have the advantage that I do not have to make a sharp distinction between insurance, banking and securities supervision — I am in charge of all three.

Henrik Bjerre-Nielsen is Director General of the Danish Financial Supervisory Authority, which is responsible for banking, insurance and securities supervision. He chairs the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), based in Frankfurt.

Dr. Rolf Stölting is an actuary and expert on solvency issues at Munich Re. He is Munich Re's representative on many European committees involved in Solvency II, such as the Consultative Panel, the European actuarial association "Groupe Consultatif", and the International Actuarial Association.

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