A backward step
Last week’s vote by EU national representatives to change the way groups are treated under Solvency II threatens to cause delays and increase the regulatory burden for the European insurance industry, says Mike Wilkinson of EMB.
When will Solvency II finally come into force and what will it look like? You may have thought until last week that you knew the answer to that question, in which case it is time to think again.
With such an ambitious reform, embracing as it does a vast range of insurance companies, compromise and delay have never been far from the surface of Solvency II. It did seem, however, that the EU and CEIOPS (the body supervising the process) were fixed on the course set out in their original Framework Directive proposal of July 2007. After the initial haggling, we were left with a good, radical proposal and all the signals coming from Brussels indicated that those in charge were determined to see it through without any further fundamental changes.
However, it has become evident more recently that further compromises were likely. The recent decision by the EU’s 27 national regulators to remove the group support proposals from the version of the Solvency II Framework Directive going for approval by the EU Council of Economic and Finance Ministers in December (with only Britain, Ireland, Finland, Denmark and the Netherlands voting the other way) leaves the process in disarray.
Importantly, the overall principle of co-ordinated supervision of international groups remains. However, the effect of this vote will be to remove the ability of international groups to maximise capital efficiency on a group-wide basis. Not only is this a fundamental departure from the principles of effective risk and capital management, but it heralds a period of debate that could cause Solvency II to be pushed back from its planned 2012 implementation.
It is clear that this decision has not gained universal support, with disagreement being voiced by the CEA (the European insurance and reinsurance federation) supported by the ABI in the UK, the European Commission and European Parliament members who are likely to try to have it reversed. They may ultimately be successful, but this is no time for unnecessary distractions; everyone should be working together towards what is already a demanding timetable.
If there is a desire to protect well established local insurers, who no doubt perform an admirable job in their own differing ways, then that is understandable. In our view, however, well run SMEs that have a genuine rapport with their markets have always had little to fear from Solvency II. Indeed, many of them are nimble, highly capitalised and well placed to prosper under the new regime.
The decision may also create anomalies. Imagine two hypothetical insurers that are identical in all aspects except that one is domiciled in just one country whilst the other straddles two. The second company could have to hold more capital even though its risk profile is absolutely the same apart from the domicile. This does not make economic sense in a single integrated market.
After all the issues in the banking sector, regulators would be expected to favour a more internationalist approach. To quote the CEA in a paper published earlier this month: “The financial turmoil demonstrates the need for appropriate supervision of financial institutions at group level…This supervision should be able to identify the consolidated exposure of the group and assess the risk profile in line with its economic reality.”
The uncertainty created by this decision has already caused some insurance groups to hesitate as far as Solvency II is concerned. Compliance is expensive and time-consuming, and firms want to know what is required before taking the necessary steps. In some respects this is entirely understandable but there will always be an element of uncertainty and hesitation is not the way to deal with it.
The fundamentals of effective management of risk on a group-wide basis remain. The national regulators may have signalled a compromise, but enterprise risk management (ERM) remains best practice. It continues to be the most effective way to align business strategy and capital to risk, and its wider management benefits have already been well demonstrated. Anyone who doubts this needs only look at the UK where the ICAS regime, based on the principles of ERM, is widely believed to have driven up management standards since its introduction almost four years ago.
For these reasons, large insurance and reinsurance groups will increasingly develop and use their internal models on an integrated, group-wide basis. Even if group support disappears, Solvency II will still require them to establish an Own Risk and Solvency Assessment (ORSA) which will provide better guidance on the right level of capital to align with entities’ strategy and risk appetite. For instance, this could take into account a desire for a better credit rating. Furthermore, the ORSA process should give companies a better idea of the economic capital they need to hold in each territory than any prescribed regulatory basis minimum.
In the meantime, we are faced with a change of course that has, even if unintended, all the hallmarks of a protectionist measure. In the process, it threatens to water down the overall effectiveness of Solvency II as a pan-European measure and delay its implementation. Let’s hope this U-turn proves to be a short-lived diversion from the business of having a 21st century regulatory framework for European insurers.
Mike Wilkinson leads the risk management consulting team at EMB, the actuarial and management consultants.