It is now 18 months before Solvency II, the new solvency regime for European insurers and reinsurers, is due to come into force. Insurers have been preparing for a long time, in some instances many years, to implement the regime which will come into effect on 1 January 2013 and which will have far-reaching consequences for those trading in Europe. Financial institutions will also be indirectly affected as they will need to adjust their businesses to meet the changing needs of their insurance clients.
At its heart, Solvency II aims to implement solvency capital requirements that better reflect the risks insurers face, encouraging them to implement appropriate risk management systems and sound internal controls and introduce improved transparency through consistent public disclosure of capital and risk information. It also delivers a supervisory regime that is harmonised across all members of the European Economic Area, providing a consistent level of policyholder protection.
Its impact will also be felt beyond the EEA, as similar models are being implemented or considered elsewhere, such as in Bermuda and South Africa, because of the perceived benefits in having a regime that is equivalent to Solvency II.
The rules are still being finalised and it is likely that a number of Solvency II's provisions will be phased-in over a number of years to allow an orderly transition into the new regime. But forward planning for capital adequacy and risk management will be vital in order to satisfy the new regime. Investment banks and asset managers should also be considering the strategic opportunities for their businesses to provide products and services that meet the Solvency II requirements of their insurance clients.
A changing strategic landscape
Effective compliance is not the only objective for European insurers: Solvency II has significant strategic implications and presents opportunities for companies to add considerable value to their business. So while companies must not only work to become compliant with the rules, they should also consider the potential long-term impact of the regime, and the strategies necessary to ensure success once Solvency II has gone live. Insurers should therefore, if they are not already doing so, reassess the broader capital and risk implications of Solvency II on their businesses, and plan to harness the opportunities that this new regulatory regime will generate. There are four key dimensions which should be considered.
1 Product portfolio
One area that insurers should be looking at is their portfolio of products. Certain product lines will become more capital intensive under Solvency II, such as annuity business and long-tail liability lines like employers' liability insurance. In order to become more capital efficient, insurers should consider how they allocate capital between the different product lines in their portfolio and the returns they are generating.
This may mean reducing exposure to the more capital intensive lines, or even exiting some of those lines completely, while increasing the emphasis on products requiring less capital such as personal lines.
Alternatively, for some, it may lead to a conscious decision to engage in more capital intensive lines, where risk-adjusted returns on capital are particularly attractive.
2 Corporate structure and location
Companies may also seek to generate capital efficiencies by changing their corporate structure. Groups with subsidiaries in a number of European countries may find that it is more efficient to restructure from a holding company and subsidiary arrangement to a head office and branch structure, which enables capital to be more easily transferred around the group. This may be of particular relevance where a company has grown through acquisition and capital is tied up in legacy companies.
But such restructuring is complex and can be a lengthy process. Furthermore, a branch structure may be less suited to certain types of business, such as personal lines – where consumers may feel more secure, perhaps influenced by their advisers, with a domestic legal entity. Additionally for life insurers, local regulations (such as on how profits are shared with policyholders) may make the transfer to a branch structure a particularly complex task.
The capital demands of Solvency II may lead international insurers to consider the global allocation of their capital, potentially reducing their emphasis on Europe, and instead turn to markets such as Asia where there is potentially a greater return on capital. Insurers should also be mindful of investors' objectives, as Solvency II will increase the level of transparency in relation to the performance of the business.
Some companies have talked about re-domiciling to a non-Solvency II jurisdiction in order to avoid the compliance burden, but whether this is a realistic strategy remains to be seen. Other companies are considering mergers and acquisitions in order to improve their capital position. Mutual insurers, which are prevalent in Europe, particularly in France and Germany, may find this an attractive strategy; these companies often find it difficult to raise capital and, as they tend to be smaller, have a disproportionate cost of compliance and lack the benefits of diversification.
3 Capital structure
Companies may have to reconsider their capital structure. Solvency II introduces a tier-structure model to rate the quality of capital instruments and align this to capital requirements; some existing hybrid debt, for example, will not be eligible as Tier 1 (highest quality) capital and will have to be replaced by new Solvency II-compliant instruments.
4 Investment strategy
Solvency II also has implications for insurers' investment strategies and will lead to a much greater dialogue between an insurer and its investment management function.
Solvency II requires a higher level of capital to be held against certain investment types: equities, property and long-dated bonds attract a higher capital charge than short-dated or EU government bonds. This will particularly penalise life insurers, which tend to use equities and longer-dated instruments to hedge against any inflation.
As a result, companies may need to adjust their investment portfolios in order to make them more capital efficient. An increased use of interest rate derivatives to hedge against inflation could be a possible scenario to achieve greater capital efficiency, although it should be noted that there are capital implications of using such instruments which may offset the potential gains.
The volatility of assets and liabilities is an important issue for insurers as this will affect the capital available for determining an insurer's solvency position.
Solvency II uses a market-consistent ‘economic' approach to valuation of assets and liabilities, which means that a firm's available capital can fluctuate as the market value of those assets and liabilities changes.
Life insurers often hold long-term, illiquid assets which can be subject to big swings in value, and in some European countries embedded guarantees within products can lead to increased volatility in an insurer's liabilities. It will therefore be important for insurers to pay attention to the pricing and management of their assets and liabilities in order to smooth their capital position.
New tools for strategic views
Looking beyond the macro issues, there are also opportunities for insurers to derive significant value from some of the operational elements of Solvency II. One such area is the Own Risk and Solvency Assessment (ORSA), which firms are required to undertake as part of their enterprise risk management process. The ORSA is the mechanism by which the board satisfies itself that it has a process to manage, in line with its risk appetite, the current risks to the business and the future risks arising from the business strategy, and that this process works in practice. It is the firm's economic view of the capital required to run the business, irrespective of the capital requirement set out by the regulators.
The ORSA can be a powerful tool when linked to the strategic planning process, as it provides a forward-looking view of how the risks to the business will evolve. To take full advantage of it as a strategic tool, it is important that the board and senior managers understand it so that they can use it in decision-making. It must also be simple enough to provide answers within a short enough timescale to assist management in their analysis, and it must have the capacity to evolve in response to changes in the company's strategy.
Synergies with IFRS 4 Phase II
A further area where benefits can be achieved is through aligning the reporting requirements of Solvency II with those of the new international reporting standards for insurance contracts (IFRS 4 Phase II). IFRS 4 Phase II is likely to be implemented in January 2015, although this has yet to be confirmed.
The two structures are predicated on a similar model, whereby valuations are based on the present value of expected cash flows and a risk margin liability. Solvency II focuses on capital, while IFRS 4 Phase II focuses on profit.
Both regimes increase the level of reporting transparency, which should make it easier to understand the risks on the balance sheet. This has benefits in that it could help insurers raise capital as investors can more easily understand the company's performance, something which investors have historically struggled to do.
By developing a single, integrated reporting model for Solvency II and IFRS 4 Phase II, insurers can extract significant synergies in data management, modelling and investor relations. For those firms that do not have the resources or expertise to do this, then a model based on Solvency II but validated in light of IFRS 4 Phase II requirements would provide some of the efficiency gains of an integrated model.
Technology as an enabler
There are challenges to delivering a strategic solution to Solvency II and IFRS. The Solvency II programme must be seen as an integral part of the business and be underpinned by an appropriate operating model, which should include technology design, delivery and a maintenance framework. The programme requires a clearly defined and targeted approach, with architecture that can be delivered in segments.
Technology has a key role to play in delivering business compliance with Solvency II and for most organisations this will mean implementing significant IT, process and organisation change. This is an opportunity to invest in a strategic solution that can add wider value to the business beyond that which could be achieved through a tactical response. These benefits can include improved risk-based business planning, more active product governance and superior customer management.
A further challenge in implementing Solvency II is the need to bring together actuaries, finance, risk, business stakeholders and IT teams. There is a tendency for these groups to operate independently, which can make implementation difficult and limit the benefits that can be achieved. To realise real benefits these departments must work together effectively.
While Solvency II may be an insurance regime, it has implications for financial institutions that provide services to insurers, as they will need to respond to the changing needs of their clients. Solvency II presents firms such as investment banks and assets managers with the opportunity to provide tailored Solvency II solutions.
With the changing capital requirements, asset managers will be able to develop products that are more closely aligned with insurers' needs. They should also be looking at the forthcoming data and reporting needs of their insurer clients and should make the necessary changes to ensure their systems can deliver the required information. If major IT changes are required then the work needs to begin now.
Preparing for 2013
So what should insurers be doing now to maximise the value from the Solvency II regime and the investment they are making to comply?
It should go without saying that companies should be doing everything required of them to achieve compliance with the new regime, such as building their internal models and embedding risk management in the organisation. Despite some uncertainties, the rules are known well enough for detailed preparations to be made, but a close watch should be kept on how the regulations are developing, particularly in those areas where clarification is needed.
Insurers should also be assessing how Solvency II will affect their product lines and investment portfolio. Where there are areas of uncertainty in the rules, scenario planning should be undertaken so that the potential outcomes have been considered and decisions can be made quickly once the rules are finalised.
There is a risk that a herd mentality will ensue once the rules are clear, so it is desirable to have planned a course of action to avoid being caught up in a stampede in or out of certain product lines or asset classes.
Solvency II programmes tend to be led by the finance, actuarial or risk teams, so it is important that the commercial side of the business gets involved so it can understand the implications on the organisation.
The extent to which certain aspects of the rules will be phased in adds an additional layer of uncertainty. It is still not clear which areas will benefit from a transitional period and how long each of these periods will be. This uncertainty may not be resolved until Q1 2012, so insurers should consider how the various possible outcomes will affect their decision-making.
It should also be remembered that Solvency II is being developed against a political backdrop, so the rules in certain areas may not be finalised until late in the process. Insurers should take this into account in their contingency planning.
Ultimately, the full implications of Solvency II may take time to manifest. If the economy and the insurance market are healthy in 2013 then capital levels will not be of concern. But if the markets are troubled then capital will be more of an issue. The transitional measures, which could delay elements by as much as 10 years, will also draw out the impact.
Insurers should consider now the strategic opportunities that can be gained from Solvency II, assessing the potential implications on their business model and how best to capitalise on the new regime as its detail becomes clearer.
While it is important to maintain focus on the important operational elements, there are potentially major gains to be had for those firms that take a strategic approach to Solvency II.
Michel de La Belliere is Deloitte's EMEA Solvency II Lead Partner. Rick Lester is Deloitte's UK Solvency II Lead Partner.
Other available media:
Michel de La Belliere and Rick Lester discuss Solvency II with World Finance's Nick Laurance (7m 47s, mp3, 7MB)
Francesco Nagari explains the similarities between Solvency II and the IFRS changes (3m 26s, mp3, 3MB)