Purposes of Solvency II and Its Implications for Insurers - Case Study Example

Purposes of Solvency II and Its Implications for Insurers Student’s Name Grade Course Tutor’s Name Date: Introduction Solvency II is a directive by the European Union, which was issued in 2009 for purposes of codifying and harmonising insurance regulation within member countries. The main motivation for the directive stemmed from a need to minimise the risk of insolvency among insurance companies in the region. The directive is scheduled to take effect on January 01, 2014. According to Financial Services Authority (FSA) (2012), Solvency II is a major improvement of an earlier directive (Solvency I), which was issued in 1973 for purposes of revising and updating the solvency regime in the EU. The current direct is cited as being better suited for reducing the risks of an insurer becoming unable to meet claims; reducing the loss-exposure to shareholders; providing early warnings to supervisory agencies regarding trouble insurers; and promoting confidence among the public regarding the insurance sector’s financial stability. The purposes of Solvency II Solvency II adopts a three-pillar approach, which its framers felt were important in meeting the aims of making the insurance sector more stable and risk-averse. The three-pillar approach is illustrated in the figure below, and as can be seen, it proposes the use of ‘quantitative requirements’, ‘qualitative requirements and supervisory review’, and ‘reporting, disclosure and market discipline’ as the three pillars that would anchor the insurance sector. Figure 1:The three pillars of Solvency II Source: FSA (2012, p. 7). According to Buckham, Wahl and Rose (2010, p. ix), Solvency II targets insurance and reinsurance firms whose turnover exceeds €5 million and through the three pillar approach, holds the promise that the insurance industry will be more transparent in future, and will have a buffer, where interventions can be made to prevent the occurrence of crisis in the industry. Specifically, it would appear that there is room for regulatory intervention once a problem has been detected, something that would ultimately stem a crisis. The Own Risk and Solvency Assessment (ORSA), which is included in pillar II requires an insurer to assess its solvency needs by considering its risk profile and the strategies it uses to conduct business. According to the Council Directive (2009, act. 45), the ORSA process is set to be assessed regularly by regulators. The process is illustrated in the figure 2 below: Figure 2: The ORSA Process Source: FSA (2012, p.50). As illustrated in the figure above, the management commences the ORSA process, with the red area codified as ‘ownership’ indicating the management’s responsibility to set general objectives for the report. In the blue area codified as ‘process’, the management identifies the right methodology to use, and identified the roles and priorities that will be met during the process. The greed are codified as ‘report’ signifies the output stage in the process where the management releases a report indicating its business plans and strategies among other things that it is doing or intends to do in order to prevent policyholders from experiencing losses. While ORSA is a good process on paper, its inclusion in Solvency II has attracted some criticism to the effect that it is a subjective process since the management conducts self-evaluation and makes a report regarding the same. It is thus argued that the process creates the probability of self-bias. Johansen (2011, p. 32) for example observes that the management may be reluctant to reveal critical information thus leading to asymmetrical information between the management of insurance firms and the regulators. Council Directive (2009, act. 45), specifically observes that the incentive of using ORSA in pillar II is low considering that the process is not directly used to calculate or make adjustments to an insurer’s capital requirements. CEA (2011, p. 10) even argues that ORSA may be perceived as just some additional work especially among small and medium-sized insurers, and as such, the perception of it being a strategic management tool may be eroded. Like other regulatory systems, Solvency II is not foolproof. With its ultimate goal being the need to protect policyholders, it has been noted that its use of expected shortfall (ES) methodology has some shortcomings especially related to the accuracy of its estimates (Weindorfer 2012, p. 5). Critics of ES argue that the additional data input that is necessary for the calculation of expected losses brings in complexities. Specifically, Eling and Holzmuller (2008, p. 51) observe that obtaining precise costs and making what would be considered accurate estimations is a challenging undertaking for any regulator. On his part Ayadi (2007, p. 27) states that scarcity of ‘tail’ data may subject the corresponding ES measure to a modelling error. Whether such criticism is valid, especially considering that there is no conclusive evidence that ES is a less-superior risk measurement approach compared to Value-at-Risk (VaR) when used at a regulatory level is a debatable issue. Another criticism of Solvency II (and especially its ES approach to measuring risk) is founded on the argument that both direct and indirect costs that an insurer is exposed to need to be measured when determining its level of risk exposure. Barth (2000, p. 404) observes that while as ES is able to measure the severity of insolvency, it underestimates the actual costs through its failure to consider the insurer’s indirect costs. Johansen (2011, p. 23) cites the case of Lehman Brothers and AIG as examples of consequences that an industry is likely to experience if indirect costs are not considered, or are deliberately ignored. As such, it is argued that the estimation of direct and indirect costs as used in ES, ‘conflict with the risk based capital standards’ (Ibid.). Based on the three pillars indicated in figure 1 above and the requirements imposed on insurers, the next section of this essay discusses the impact that Solvency II will have on the insurance sector THE IMPACT OF SOLVENCY II ON INSURERS Proactive management of risks The framing of Solvency II was inspired by the realization that ‘reducing the risk of insurer failure requires much more than holding a minimum amount of capital’ (Weindorfer 2012, p. 5). Such realisation by different stakeholders in the EU’s insurance industry thus led to the framing of a directive that would not only ensure that adequate capital requirements were met, but also that other risk-prone areas such as investments, pricing of insurance products, business growth, reservations and risk management were adequately regulated. For that reason, Weindorfer (2012, p. 7) observes that adequate capital requirements will now and in future only serve ‘as a cushion against losses arising from poor management of the business’. Through the requirements set forth in Solvency II, insurers will have no choice but to adopt effective governance systems. As indicated by the European Commission (2007, p. 2), Insurers, are for the first time in EU’s history required to allocate resources for purposes of identifying, measuring and proactively managing risks. Perhaps the most pronounced effect of Solvency II on insurers related to Pillar 2, since as indicated by Deloitte (2012, p. 6), insurers are now forced to ‘analyse the risks they run across their organisations and to determine the level of capital held accordingly’. While analysing risks gives the insurers a better chance at managing the same risks, it comes with additional responsibilities for the insurers. For example, the insurance firms have to put in place new ways of identifying risks and mitigating the same. Additionally, a significant number of insurers may have to restructure and/or reorganise their products and prices in light of the new requirements. Other options for insurers include changing investment strategies, changing the product mix, redesigning existing products, launching new products, or even re-domiciling to locations outside Europe (Deloitte 2012, p. 7). Mergers, acquisitions The Directorate General for Economic and Financial Affairs (DG ECFIN) (2007, p. 27) holds the opinion that Solvency II ‘should improve risk management and therefore enhance risk-adequate pricing in the EU insurance sector’. Among some of the reasons that the insurance sector is expected to become better at managing risks is the fact that most firms will become more adept at aligning risks to capital requirements, thereby attaining greater financial stability. Firms that may fail to align risks to capital requirements may however become the target of supervisory authorities and may therefore be forced to shut down operations, consolidate with other firms facing similar challenges, and/or relocate to overseas locations where regulatory guidelines are not as stringent (Ernst & Young 2011, p. 6 Should consolidation materialise as the scenario, it would be expected that the EU will have fewer but larger insurance firms, and this may in turn affect the pricing of insurance products for the consumer market especially if the law of demand and supply was to be considered. In other words, the Solvency II may bring about a scenario where small and medium size insurance providers may consolidate and by so doing, may create a less competitive environment, where the insurance firms may act as oligopolies, in which case the consumer may not be able to access the price advantage that comes with a free market. In a rejoinder to the above cited observations, Annex C.11b (n.d., para. C40) indicates that Solvency II is based on the proportionality principle. Expounding the issue, the European Parliament and the Council of the EU (2009, p. 33) observes that the proportionately principle’s inclusion in Solvency II is based on the requirement that the requirements of the directive ‘should not be too burdensome for small and medium-sized insurers or for insurers that specialise in providing specific types of insurance or services to specific customer segments’. In other words, a small insurance firm would be expected to have a simple risk profile when compared to the larger counterparts. Additionally the quantitative requirements (i.e. capital requirement and technical provisions) will be determined based on the nature, complexity and scale of risks that a firm is exposed to) should correspond with its size and ability to use mitigating measures to avert such risks. The proportionality principle notwithstanding, it is firms which don’t have the capacity or sufficient resources to meet the capital and operational requirements may still opt for mergers and acquisitions thus leading the oligopoly situation (Ernst & Young 2011, p. 6). Profits Insurers are also likely to take a hit on their profitability as indicated by Ernst & Young (2011, p. 11). Changes in risk weighting of assets, the cost of compliance and the cost of implementation will all require financial resources. Additionally, the diversification benefit and the reduced free surplus are other factors that will most likely decrease the profits that insurance companies make. As business enterprises however, insurance firms will most likely pass some (if not all) additional costs associated with implementing and complying with Solvency II to policyholders. Even if policy prices will need increase in any significant manner, Ernst & Young (2011, p. 9) predicts a situation where the quality of insurance product will be low as insurers attempt to protect their respective profit margins. Business-as-Usual On a less-technical perspective, O’Donovan (2011, p. 16) observes that Solvency II will alter the ‘business as usual’ environment that insurers in the EU are used to. Specifically, the insurers will need to adopt ‘a more formal approach to governance, organisation and decision-making’ in order to comply with the directive (Ibid.). In governance, the board and executive management in insurance firms will need to demonstrate an understanding of their firms’ risk appetites when compared to capital. O’Donovan (2011, p. 17) observes that in addition to demonstrating the knowledge regarding risk appetite and capital requirements, the governance mechanism will need to refer to the same in their decision-making processes. Additionally, the governing team in such firms will not only need to prove the competence and suitability of members therein, but will also be required to ‘ensure that financial and regulatory disclosures are compatible, and where they are nit, be able to explain why not’ (O’Donovan 2011, p. 17). Reserving Under Solvency II reserving risk cannot be done without backing from capital charge (KPMG 2011, p. 16). Reserving risk refers situations where an insurer has outstanding liabilities in claims (Deloitte 2009, p.4). Reserving risk occurs when an insurer has not settled all claims in full, has claims events that have happened but are yet to be reported, and/or is exposed to claims re-emergence in future (Ibid.) Going forward, Solvency II makes it necessary for firms to factor reserving risk into their respective solvency calculations, since by so doing, firms will make better estimates regarding the volatility and value of future payments (KPMG 2011, p. 16). Consistent valuation of reserves in the market will also have an effect on the transparency of the same (reserves), and would be expected to make insurers understand reserve risk better. The likely effect of such understanding is that insurance products that attract higher reserve risks may attract an increase in price or in some cases, may need to be redesigned (KPMG 2011, p. 16). The competitive environment globally With Solvency II being cited as a benchmark directive that will change the insurance industry for the better in Europe, KPMG (2011, p. 17) notes that the lack of an equivalent regime in other global locations may improve the competitive nature of the Europe’s insurance industry. Similar sentiments are expressed by Schwedel and Turner (2011, p. 3) who observe that in a bid to ape their European counterparts, it is likely that international insurers who are under no obligation to comply with Solvency II will try to so, at least for purposes of measuring up to the competition posed by the European players. In addition to the blanket effects that Solvency II will have on the insurance sector in Europe, below are specific impacts that the directive will have on specific segments: Small and medium-sized insurers Aside from the likely consolidation of small players and the formation of oligopolies as explained elsewhere in this paper, it is likely that the small and medium-sized insurers will consider other alternatives for raising capital requirements. One alternative will most likely be reinsurance, and as such, it would be expected that the reliance on reinsurance companies will increase among the small and medium-sized companies (Guy Carpenter & Company LLC, 2011, n.pag). The small and medium-sized companies are also likely to use other risk transfer mechanisms such a hedging and securitization (KPMG 2011, p. 16). When utilising such mechanisms however, and for them to be accepted by the regulator as valid risk mitigation instruments, the insurers will need to quantify their contributions towards them for purposes of risk reduction. If successful among most small and medium-size insurers, the use of the above identified risk transfer mechanisms will probably give the firms incentives to optimally use the risk transfer mechanism, something that may end up intensifying competition among the same firms. Mutuals To receive benefits associated with geographical diversification, mutuals may have to consider regrouping across geographical borders as indicated by Swiss Re (n.d., n.pag). Additionally, mutual insurance companies may be forced to consider utilising reinsurance as a way of meeting the high capital requirement benchmarks set in Solvency II. Notably, the business model used by mutual insurance companies exposes limits their access to capital markets, something that may disadvantage them in attaining capital. The captive industry Captives operating in the EU, or those domiciled in other continents will need to attain the regulatory equivalence which is indicated in Solvency II. Captives will also need to balance the need to remain attractive to captives, and the need to obtain equivalence (Denton 2011, n.pag). Conclusion From the above sections in the paper, it is evident that the purposes of Solvency II were well meaning and intended to protect policyholders from risks that insurers often expose themselves to. With the new directive however, insurers will not only need to manage risks well, but will also be required to invest in good corporate governance practices. Evidently, Solvency II will have an impact on the insurance and overall, the European Union may become more competitive for insurance services. This in turn may mean that other global locations may try to ape the Solvency II directive, if only for purposes of retaining their respective market shares. While it is evident that all insurers will be affected by Solvency II, it is also evident that small and medium-scale insurers may feel the effect more than their large scale counterparts. The proportionality principle notwithstanding, it is likely that small and medium-sized insurers will merge or be acquired by others, and/or will utilise reinsurance services more. The effect of solvency II will also be felt by the mutual insurance companies who may have to regroup across geographical borders. Captives on the other hand will need to balance the need to remain attractive to captives, and the need to obtain equivalence. Overall however, and despite the criticism that Solvency II has attracted from some quarters, it is agreeable that the directive will make the insurance industry more stable and less-riskier for the policyholders. By so doing, the directive will have contributed to the stability and security of the larger financial sector not only in the Euro region, but also globally. 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Weindorfer, B 2012, ‘Governance under Solvency II- a description of the regulatory approach and an introduction to a governance system checklist for the use of small insurance undertakings’, Working Paper Series, no. 71, pp. 1-32. Read More