It’s been a long process, but, according to Paul Fisher, deputy head of the Bank of England’s Prudential Regulation Authority (PRA), who supervises insurance and regulatory risk, the introduction of the EU’s Solvency II regulations is nearing completion.
In his address to the Economist’s Insurance 2015 conference in London in March, Fisher summarized developments and remaining problems. While he discussed the specifics, the overall problem with Solvency II is the time it has taken to thresh out the details. It was officially launched in 2007, but the preliminary work on it goes back to at least 2003.
The world has changed greatly since then. The phenomenal growth of technology has made regulation a whole new ballgame. In a sense it has been like “moving the goal posts,” as it has required regulators to work on supervising an expanded and constantly changing industry.
Technology, however, is only part of the problem. The financial crisis that began in 2008 hasn’t yet run its course. Interest rates are still at an all-time low, economies, especially in Europe, are struggling with stagnant growth and high unemployment. Banks are stretched for resources, and lending has consequently been reduced. The continuing economic and social turmoil, which has led to open warfare in parts of the world, certainly doesn’t help form a clear picture for regulatory authorities to work with.
In addition Solvency II has faced a “bridge too far” problem from the beginning, as it is designed to regulate both life and property/casualty insurers. As far back as 2011 a growing number of analysts expressed their belief that grouping them together under one set of regulations may be fundamentally unworkable.
Chris Boggs, the IJ’s Director of Education and the head of its Academy of Insurance, explained why. “P&C insurance operates on the basis of indemnification, returning the injured party, as closely as possible, to the same financial condition that existed prior to the loss, or would have existed had no loss occurred (without unjust enrichment).
“Life insurance pays a face amount that may or may not have any relationship to what has been lost by the death of the person; the amount may have little or no basis in fact. Face amounts in life insurance are a function of the amount of coverage someone is willing to purchase and, to a much lesser extent, perceived need.”
He explained that life insurance is fundamentally an investment, the death benefit, if the insured dies before the policy matures, is an add-on. As such, the rules regarding capital and risk for life insurers are more aligned with the regulations governing banks, than they are with P&C insurers’ regulations.
Shirley Beglinger, a former managing director at Swiss Re, and an acknowledged expert in analyzing regulations and their effects, who is now a director at Shires Partnership Limited, an insurance and risk consultancy, explained that Solvency II is “basically addressed to the life insurance industry, as P&C (or non-life) is ‘too difficult’ for them [regulators] to understand.”
The rules “were written as the financial world was blowing up,” she said. They “anticipate a worst case scenario.” The life insurers were the principal driving force – through batteries of actuaries, accountants and lawyers – who shaped the Solvency II regulations. They did so in the midst of the financial crisis, even though, with the exception of AIG, the insurance industry was pretty much unscathed.
As a result the regulations are more applicable to life insurers than P&C insurers, and the fallout from this situation has introduced onerous requirements on the non-life industry that are neither wanted nor needed.
“They [life insurance ‘geeks’] were convinced that they could make it [Solvency II] work.” Beglinger said. The rules they came up with, however, are “unworkable and impractical [for non-life insurers], as they are designed around life [insurance policy] renewals, investment yields and pensions.”
Some of those contradictions have been addressed, and some are still being tweaked. The Life/P&C problem has been further complicated by the fact that most of Europe’s larger insurers sell both. Of the top 10 (by gross written premium) eight, including Allianz, AXA, Aviva and Zurich sell life and benefits products; only RSA and France’s COVEA Group (GMF, MAAF and MMA – all mutuals) don’t.
A second concern has also surfaced following the financial crisis, as insurers, including P&C insurers, are being included as systemically important insurers (SII’s). Jim Wyrnn, the former New York State Insurance Supervisor, and currently a partner with the law firm of Goldberg and Segalla, pointed out that “with the exception of AIG,” whose troubles, Wrynn noted, didn’t stem from its insurance activities, “most insurers came through the financial crisis reasonably well.
“With insurance you don’t have the liquidity and the leverage issues that you have on the banking side,” he added, “and really with the traditional business of insurance, which is a very conservative business with reserving and capital solvency requirements, it does not have the potential to generate or amplify systemic risk.”
This difference is one which particularly concerns captive insurers, who for the most part have only one client. They have challenged the notion that they should be required to file fully completed Solvency II compliant declarations. They haven’t been totally successful in getting captives excluded from Solvency II, however, as captives do have a responsibility to handle the claims filed against the companies they insure.
The costs of assuring compliance with Solvency II’s regulations are also a problem. According to a survey conducted by Deloitte in 2013, Europe’s 40 largest insurers spent as much as €4.9 billion ($6.5 billion at the time) in 2012 complying with new regulations. The cost is equivalent to a one percentage point reduction in return on equity, a measure of profitability, the accounting firm said. Those figures are from three years ago, while regulators were still working on Solvency II. The cost can be expected to increase when it’s officially adopted.
Despite the delays and complaints the European Union’s Solvency II regulations, continue to move forward. While most of the industry is primarily concerned with Pillar I – the regulations governing capital requirements; Pillar II – governance, risk management and supervision, and Pillar III – transparency requirements, are also part of the regulations, and will no doubt further raise the costs of compliance.
While technological breakthroughs are part of, the problem, they are also a good portion of the solution to managing all of the data Solvency II requires in order to monitor the industry. Most large companies have already developed, and received approval for, business models designed to comply with Solvency II. Producing such models, however, is expensive, which puts smaller companies at a disadvantage.
Fisher explained that one of the PRA’s responsibilities is to examine the models to “see if they are sound.” He sees this as part of its larger mandate to “adapt to changes in the long term, to supervise innovation, and to manage risk(s).”
The most recent announcement from the regulator underscores this position; indicating that UK insurers will be regulated “proportionately,” in response to concerns that the Bank of England might seek to add some extra regulatory provisions for UK companies.
Proportionately, or not, the regulations will have consequences, as managing assets and assessing risks becomes more complicated. One of those consequences, Fisher acknowledged will be “further consolidation” within the insurance industry, which “favors larger players.” That is one of the major concerns of smaller regional carriers and also for mutuals, who by definition cannot issue shares to acquire other companies, making it more difficult for them to expand.
Solvency II will also require CEO’s, CFO’s and risk managers (CRO’s) to more precisely determine their cost of capital with regard to the business lines they offer. At the panel discussion which followed the regulation presentation Swiss Re’s CIO Justin Excell described it as a “regulatory clash with unintended consequences.” The decision could result in “isolating the separate parts of a business;” thereby limiting the ability to diversify risk and to effectively benefit from being able to allocate capital to its most productive uses.
Stephen Wilcox, Chief Risk Officer at Allianz UK stressed the need for “stability to understand Solvency II,” but with “3000 pages of regulations” differences in interpreting them would become a problem, citing the differences in UK and German interpretations.
Will Solvency II finally be enacted next year? In all probability parts of it will be, but certain parts won’t be. Upon formal adoption and ratification by the European Commission (EC), it will then require enabling acts by the 27 EU member states to harmonize their regulations with the strictures of Solvency II.
Unfortunately many of the regulators who drafted Solvency II and their counterparts in EU member states who will be working on harmonization share the same vision. They are like the proverbial guy with a hammer, who sees everything as a nail. It’s therefore quite probable that more regulations will be imposed on the insurance industry before the process finally ends.
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