Now 18 months from implementation, the EU’s Solvency II Directive has put the heat on Europe’s insurance sector, which is begrudgingly preparing for this massive game-changer. It will alter the way firms assess their own risk, heighten transparency requirements and enforce a minimum threshold for capital. After numerous delays and an arduous period of consultation, the regulation will enter into force on January 1, 2016, despite the final text not yet being made public. Essentially, Solvency II updates the approach taken to determine the capital insurers should hold against their risk profiles. It will introduce a common approach to prudential regulation based on economic principles for the measurement of assets and liabilities.

Key to the regulation are three pillars, each governing an aspect of the Solvency II requirements and approach, including: quantitative requirements; supervisor review; and market discipline. Pillar 1 sets a valuation standard for liabilities to policyholders and the capital requirements firms must meet. This includes two solvency requirements, the Minimum Capital Requirements (MCR) and the Solvency Capital Requirements (SCR). If the available capital lies between the SCR and the MCR, it is an early indicator to the supervisor and the insurance company that action needs to be taken. An insurance company can choose whether to calculate the SCR using a standard formula or whether to develop its own internal model to reflect specific risks. If an insurer’s resources fall below the MCR, the European Commission has stated that ‘ultimate supervisory action’ will be triggered. This means transferring an insurer’s liabilities to another insurer and withdrawing the firm’s licence or closing and liquidating the business.

Pillar 2 deals with qualitative aspects of a company’s internal controls, risk management process and supervisory reviews. It includes the Own Risk Solvency Assessment (ORSA) and the Supervisory Review Process (SRP), which all firms have to produce. Crucially, the directive stipulates that if supervisors are dissatisfied with a company’s assessment of the risk-based capital or the quality of the risk management arrangements under the SRP they will have the power to impose higher capital requirements.

The last pillar is concerned with enhancing disclosure requirements to increase market transparency. The onus is on firms to interpret disclosure requirements, develop a strategy for disclosure, and educate key stakeholders on the potential impact of such reports.

Together, the pillars force the insurance industry to make forward planning for capital adequacy and risk management a key part of new strategic ventures. The embedding requirements mean all the above practices must become part of business as usual. This will affect hedging and reinsurance strategies, product development and pricing, underwriting and investment management, bridging the gap between current standards and those required for January 2016.

“There’s still a lot of work for firms preparing for Solvency II,” said David Kells, the head of KPMG’s Solvency II activities in an exclusive interview with World Finance.

“Preparations for Pillar 1 have settled down as most firms have set out standards for their capital requirements, are submitting dry-runs to regulators, and only a small list of uncertainties remain. Pillar 2 is slightly less progressed, but we know that everyone is frantically focusing on Pillar 3, where there is still a lot to do in order to get all the reporting requirements in place,” said Kells. He added that, because there is continuing uncertainty about the final wording of the regulation and how firms are interpreting it, “there is a degree of nervousness across the industry”.

Implementing the directive
Solvency II has been underway since before the financial crisis; the insurance industry should have come to terms with the requirements. Nevertheless, a prolonged approval process of the final directive, as well as lack of clarity on when the regulation would be implemented and how firms should proceed, has made Solvency II incredibly unpopular within the insurance industry. A recent survey from Grant Thornton showed only one third of respondents consider the directive an appropriate way to run their business. The aim of Solvency II is to align Europe’s insurance regimes, which is considered one of the most complicated sectors to understand. Essentially, it is supposed to be a move towards better regulatory management and risk oversight, with the overarching benefit being the increased transparency Pillar 3 will provide. And despite a majority of the industry being cynical towards the directive, 44 percent believe Solvency II is a ‘necessary evil’.

Potential issues
One of the key contention points is the capital requirement stipulated in Pillar 1. Because Solvency II is a risk-based system, capital requirements are aligned with the underlying risks of the company. This has created uncertainty as to how much capital insurers need to hold to meet long-term promises to policyholders, particularly because many insurers invest their assets. However, in November 2013, EU politicians agreed Solvency II requirements must reflect the fact insurers’ liabilities tend to be illiquid and long-term, meaning they should not need to sell assets before they mature, to comply with the new rules. Politicians also agreed to a 16-year phasing-in period.

Another key component is the firms’ own risk and solvency assessment (ORSA) in Pillar 2, which is basically a set of processes and procedures used to identify, assess, monitor, control and report internal and external long-term and short-term risks that an insurer faces or could face. These risks are used to determine the company’s capital requirement to ensure its solvency at all times.

“Basically, Pillar 2 is about formalising the risk processes that they already have in their head,” said Kells. “Assessing the firm’s tolerance for risk and reporting on this is something that most good firms have already had in place. This is just about locking it into the day-to-day work.”

To this end, almost two thirds of the industry has already begun implementation of its ORSA process, according to a recent Solvency II study by SunGard and insurance forum Leipzig. What is more concerning though is the fact that 30 percent of respondents have only begun preliminary considerations when it comes to ORSA. Given the sheer magnitude of the risk assessment process and that EU regulators expect firms to complete a full ORSA report in 2015, insurers should worry about their implementation schedules.

Pillar Three
There is an entire pillar of the directive that the majority of the industry seems to have forgotten. With most insurers focusing on the first two pillars, many have ignored the large-scale reporting requirements stipulated in Pillar 3, which includes public and private reporting components such as a massive solvency and financial condition report outlining a financial assessment of the insurer.

“With uncertainty about the implementation date, many insurers took their foot off the pedal and put Pillar 3 last in the queue. Now we’re seeing a rush to the end. But it’s important that firms be confident in their data, so they can do at least one dry-run before submission in 2015,” explained Kells.

According to a recent European Solvency II survey by Ernst & Young, three quarters of the industry are yet to meet most or all of the reporting requirements. Critically, only a quarter of insurers said they had already selected a system to meet these requirements, while two thirds said their existing data and systems were not designed to support longer-term ORSA assessments, forcing many firms to meet next year’s transitional reporting requirements manually.

“As companies become more realistic about their implementation readiness, it is clear that some are less prepared than they had expected. They have a long way to go in terms of reporting, data and IT readiness,” said Martin Bradley, Head of Global Risk and Regulation for Ernst & Young.

Insurers have blamed regulators for not providing sufficient support in the run-up to implementation of the new regime. The industry has found it hard to interpret regulatory requirements, and been unsatisfied with feedback from regulators on company-specific implementation. A lot of this comes down to regulators having insufficient staff to handle the significant supervision requirements, said Bradley. This is a common problem among European regulators, as the slew of financial regulation has made compliance heads a hot and hard-to-find commodity in recent years.

Volatility concerns
The lack of clarity aside, another concern looms over implementation of Solvency II, as the insurance industry becomes more transparent. The greatest change will be the requirement to provide markets with robust information on the entire firm and its financial condition. This annual report will give the public and regulators a unique insight into all aspects of insurers’ business and is aimed at assuring shareholders of the firm’s solvency.

Essentially, the onus is placed on the firm to design the information, which through public disclosure, will be available to regulators, analysts, rating agencies and shareholders. However, industry analysts have said the sheer amount of data may cause volatility in the insurance market and tackling this therefore needs to be a priority for complying firms.

“This new regime means that there’s a new machinery producing numbers and firms need to prepare themselves in order to manage this disclosure so they can give market analysts a heads up on what these numbers mean and have confidence in their own reporting. It’s important to have a robust explanation for this financial report in case numbers have changed significantly, so firms can gage against volatility,” explained Kells.

What’s more, the costs of Solvency II are mounting as more firms move through Pillar 3 and can see the end result of their efforts. With insurers on average using six departments in preparations for the directive, the costs of resource allocation have been extensive. According to the Grant Thornton survey, only six percent of respondents believe the costs are reasonable, while more than three quarters consider them disproportionate, arguing that the value added does not justify the expense.

According to Kells, estimates of final costs are hard to gauge, but tens, and even hundreds, of millions of pounds spent at the end of line would not be a surprising outcome for major insurance firms, he said. It is therefore unsurprising that a majority of the industry finds Solvency II a bitter pill to swallow. The process has not been made easier by a growing majority of firms suggesting the founding principles of the directive have been ruined by the implementation. Compounded by the uncertainty surrounding the interpretation of Solvency II, the industry is begrudgingly doing as they’ve been told – albeit at a snail’s pace.