Living with Solvency II; A Top Regulator Gives His Views

By | June 3, 2011

Solvency II, the European Union’s imminent imposition of new and more sophisticated risk based regulation of its insurers, may not be the only elephant in the room It is, however the main focus of a great deal of activity within and without the EU, as the date, January 2013, approaches for phasing the regulations into the legal systems of 27 countries. The timing roughly coincides with the reworked International Financial Reporting Standards (IFRS) as well as discussions among the International Association of Insurance Supervisors (IAIS).

Along with Solvency II “there are two particularly important areas of work that are taking place at the IAS, namely the development of international solvency standards and also this interesting debate on systemically risky insurers,” said Matthew Elderfield, Deputy Governor of the Bank of Ireland at the recent European Insurance Form in Dublin. His office is responsible for overseeing and implementing Ireland’s insurance regulations.

He expressed limited concern that banking regulations could somehow be applied to the insurance industry, saying that it was “a debate prone to exaggeration and distortion. Insurance companies are not banks, so the rules for banks should not be ‘Xeroxed wholesale’ for insurance.”

Elderfield, who formerly headed the Bermuda Monetary Authority, advocates stronger “corporate governance,” starting at the board level and including enhanced risk assessment as well as the oversight of financial transactions, particularly hedging activities.

Ireland, along with the rest of the EU, will implement those standards under the Solvency II regulations. “We will require all of the underwriters to use internal models to insure that solvency standards are appropriately calibrated,” he said. This is being carried out by EIOPA [European Insurance and Occupational Pensions Authority], as it completes the work necessary for the introduction of Solvency II. Elderfield noted that it’s a much stronger body, with “much stronger standard’s setting powers” that will be “binding” on all EU countries. This in turn will limit the “scope for national differentiation.”

He also predicted that the regulations would result in the “convergence of supervisory directives,” and will promote more homogenous European insurance supervision. He added that “Solvency II will provide for a more risk based and market consistent approach to, addressing the results requirements of insurance companies.” He also stressed the increasingly “compressed” time available to make the changes that Solvency II will require.

Elderfield highlighted several issues that still need to be resolved, starting with the “complexity” of the regulations, which he indicated pose a problem for insurers and regulatory supervisors alike, as well as counterparty default risks and the “calibration of non-life underwriting risks,” particularly catastrophe risks. The models used to calculate these types of risks are seen as either “too complex,” or “too blunt and simplistic,” he explained.

The current soft market is another area that weights on the industry. It requires “a relative strengthening of non-life solvency standards,” as well as “vigilance by supervisors to insure that underwriting discipline is maintained, and that reserve releases are not used to factor profitability at the cost of balance sheet strength.”

As far as the use of capital models are concerned, Elderfield defended the implications of the construction of internal models by larger firms as offering a “yardstick” for similarly situated companies, and a way to compare solvency standards in order to identify those that may be deficient.

He also said more accurate individual models would give insurers the possibility to “significantly reduce their solvency requirements,” principally through “diversification” of risks.

He note that Ireland is especially involved with the question of “equivalence” – the process through which non-EU members align their regulatory systems so that they are “broadly equivalent to Solvency II.” There are a great number of non-EU based insurers with operations in the country – notably Bermuda and Switzerland, the first two countries to apply for equivalence.

Elderfield concluded his précis on Solvency II with a forecast that it could lead to a “hub and spokes operating model.” Insurers would have a single legal entity, but would operate “by providing services on a cross border basis, via branches rather than subsidiaries.” It may be “an attractive option as firms consider their ideal structure to take advantage of business opportunities afforded by the directive.”

He added that such a configuration would require regulatory scrutiny of both the main legal entity and the operating branches in other jurisdictions through both local and EU regulators.

Elderfield also discussed the implications of both the IFRS accounting standards and the meetings of the IAIS to coordinate insurance regulation on a more international basis, which will the subject of a future article.

In addition to his international activities, Elderfeld also has a rather big job, at home. There are “308 licensed insurance and reinsurance companies in Ireland, writing some 58 billion euros [$83.636 billion] of gross written premium in 2009,” he said. 110 of them are captives, which are treated on a different basis, and 11 of them are “major institutions.”

Since 2007 these numbers have been relatively stable in the life sector, however, “non-life has grown significantly.” He also noted that despite the difficult economic conditions and the soft market that the insurance sector has had to face, it remains stable and robust, indicating that it “reflects positively on the attractions of Ireland as a financial center.”

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