Countdown to Solvency II

While the European Commission’s Solvency II directive, which is scheduled to go into effect in October 2012, is primarily aimed at European insurers, the investment management industry will feel its impact too. Key to successful Solvency II implementation will be quality data and IT processing systems.

by Michael Metcalfe, Co-Editor of the Journal of Applied IT and Investment Management

Click here to assess the impact of new regulations on your investment management system

Solvency regulation for insurance companies in the EU is in the process of being fundamentally reformed. The European Commission’s Solvency II directive will introduce a new solvency regime, based on an integrated risk approach, with provision for these risks in the form of solvency capital. Solvency II is an evolution from Solvency I, adopted in 2003. Implementation of Solvency II is currently planned for October 2012 (Figure 1).

The objectives behind Solvency II are consumer protection for policy-holders and assessing overall solvency of insurance companies using measures of solvency which, it is argued, better reflect the risks an insurer is exposed to. It is foreseen as leading to greater harmonisation across financial sectors and harmonisation of supervisory methods across Europe. It is based on a similar approach encapsulated in Basel II, which was introduced for the banking and securities industry in the EU from the beginning of 2008 through the Capital Requirements Directive.

In the view of analysts and senior idustry executives, Solvency II signals a fundamental shift towards a comprehensive enterprise risk management (ERM) culture. It requires risk management to be integrated into day-to-day business decisions, supported by quality data processing systems and enhanced IT infrastructures. “Preparing for Solvency II may seem a daunting prospect. An effective and integrated solution will encompass all aspects of business and demands a systematic, structured and practical approach. Successful delivery of a Solvency II programme needs the right partner,” says Frank Sommerfeld, Managing Director of the German operations of non-life actuarial software provider EMB.

CHALLENGES AND OPPORTUNITIES

Solvency II represents both challenges and opportunities alike for the European investment management industry, not least in terms of reviewing IT infrastructures to ensure they are capable of dealing with the host of additional reporting and regulatory requirements arising from Solvency II. “In this context, the implementation of Solvency II should not be seen purely as a compliance exercise, but as a tremendous opportunity to improve business performance. The greatest competitive advantage will be achieved by those companies that position themselves early to take advantage of the coming regulatory changes,” says David Hush, Technology Infrastructure, PricewaterhouseCoopers.

The onus will be on investment managers to map out a policy on data quality that meets their information needs. Many companies have some form of data quality policy and associated monitoring procedures in place. However, the formal mapping of sources, ownership and other key aspects of data governance may be lacking. Among the supplies of and users of information there is also varying understanding of what is meant by data quality, the tools in place to measure it and what should be done when deficiencies are detected.

“Those investment management companies willing to take advantage of the challenges posed by Solvency II should focus on aligning their IT architecture, treating data as a strategic asset of potentially high quality, enabling advanced IT risk management tools, and promoting frictionless communication,” recommends Nicolas Michellod, senior analyst at research and advisory firm Celent.

The Solvency II project was initiated by the European Commission in 2000 to implement a fundamental change to the current capital adequacy regime for European insurers. It is intended that Solvency II will produce a more harmonised, risk-orientated solvency regime across insurers and across the European region whilst also resulting in capital requirements that more reflect the risks being run by insurers.

After intense negotiations, the European Parliament and Council finally reached agreement, with the Solvency II Framework Directive officially adopted in April 2009. There is now no reason to expect any delay in the targeted implementation date of October 2012. The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) is currently in the process of publishing three waves of advice on various topics, including calculation of technical provisions, calibration of the standard formula for the Solvency Capital Requirement (SCR), and further details on the requirements for internal model approval.

SETTING OUT A ROADMAP

Solvency II aims to establish a framework of capital adequacy, valuation techniques and risk management standards for European insurers and reinsurers. The proposed risk-based approach will transform the way insurance companies do business and revolutionise the industry by replacing multiple existing directives with one single global standard.

In initiating Solvency II projects, insurers may want to develop detailed plans for each work stream and recognise that their investment will deliver not only regulatory compliance but also the benefits of a common framework for risk, capital, value and corporate governance. The directive was approved in April 2009, so companies must begin planning immediately if they are to meet the October 2012 implementation date.

“Companies need to understand the scope of changes that will accompany Solvency II so that they can look beyond capital adequacy and focus on governance and broader business implications,” stresses Martin Bradley, who is responsible for Solvency II-related issues at advisory group Ernst & Young. For him, companies need to address the following critical points:
• preparation – develop a clear understanding of the necessary workflows and resources needed to develop Solvency II and align it with strategic vision;
• governance – establish responsibility for the delivery and executive sponsorship of Solvency II;
• impact studies – understand the requirements to put in place the systems and processes to report the Solvency Capital Requirement (SCR) annually and the Minimum Capital Requirement (MCR) quarterly, and use projections to assess compliance prospectively in real time;
• internal models – decide whether to use an internal model to assess regulatory capital requirements and notify the regulator of internal model intentions;
• business case – determine granular plans, resource requirements, timeline and budget.

“Solvency II places as much stress on the evolution of a company’s risk management and governance framework as it does on the quantitative calculation of the capital,” argues Mr. Michellod. Companies need to establish a risk management function, an actuarial function, a compliance function and an internal audit function. They must also demonstrate that they have an adequate and transparent organisational structure with clear allocation and segregation of responsibilities, an effective system for ensuring the transmission of information, and documented roles and responsibilities.

In addition to the annual reports stipulated by the regulations, there is also a need to consider management information requirements across the company as part of the risk management framework. Typically, risk information is spread widely across the organisation and is not always held electronically. Data integrity is crucial, and yet, not only integrating but also identifying the required data in the first place can be a challenging and complicated process.

LIKELY CONSTRAINTS OF SOLVENCY II

Investment managers will have to offer alternatives to equities if they are to guarantee the best possible return for their investors under the likely constraints of Solvency II, the author of a recent survey of French institutional investors claims. Richard Bruyere, president of asset management consultancy Image & Finance, warned French investors would not increase equity allocations despite strong 2009 performance because of the possible ramifications of Solvency II.

This could lead investment managers to search for other means of return, away from equities, he argued. “It is up to investment managers to regain the trust of clients and to be able to provide and propose innovative solutions,” notes Mr. Bruyere. He lists liquid alternatives, absolute return products and more flexible investment products as possible sources of new opportunities.

Reflecting many companies' doubts over how Solvency II will be implemented, Germany’s Allianz chief executive Michael Diekmann, while welcoming the framework in principle, has warned the proposals being considered risk burdening insurers with an exaggerated level of capital. Many of the leading players in the insurance sector hope to avoid the extra capital requirements by using more sophisticated iternal models to manage risks and capital. The Solvency II rules for insurers are similar to the Basel II rules for banks in that companies that can demonstrate sophisticated risk management are treated differently to those that rely on a standard formula.

CREATING THE RIGHT FOUNDATIONS

The key foundations of improved decision-making and more efficient use of capital are reliable valuation systems, clear processes and sound controls. With Solvency II’s valuation bases moving in the same direction as the latest fiscal developments in IFRS Phase II for insurance contracts, companies are facing a fundamental and potentially costly overhaul of their reporting systems, which will inevitably compete for resources with other equally pressing demands.

If approached holistically, however, the parallels between Solvency II and IFRS Phase II should enable companies to realise valuable synergies in data, modelling and information systems. This would improve the consistency of both internal and external reporting, while avoiding needless costs and disruptions. While synergies exist, companies need to anticipate and explain the new numbers, along with any differences between the IFRS and Solvency II assumptions and results, to possibly unfamiliar or even sceptical analysts and investors.

Solvency II will also cast the spotlight on riskier and capital-intensive products. This may require significant modifications in prices and make-up of the product portfolio, as well as modifications to existing IT platforms. However, it may also provide opportunities for portfolio optimisation, keener pricing and enhanced product profitability among companies with superior IT systems and well-embedded ERM capabilities.

Addressing these issues will require a shift in the culture and mindset of the investment management business with important implications for strategic planning, management skills, incentives and organisational behaviour. Running what could be a much more elaborate infrastructure of risk, governance and capital management will lead to heightened competition for qualified personnel, leading to further pressure on the availability of already scarce talent as the deadline for implementation draws nearer.

According to Mark Batten, Partner, PricewaterhouseCoopers, the timeline to achieve full compliance by 2012 is tight. “Companies would be wise to press ahead with initiatives designed to ensure robust plans are in place to meet the deadline as the new rules bring significant change. A well-planned approach could provide optimal capital, organisational and structural solutions,” he added. If the framework directive is adopted as planned, he anticipates that time is running out for identifying and implementing the measures companies need to have in place by October 2012.


Figure 1. Solvency II at a glance: three-pillar approach, key features and timetable

Michael Metcalfe is a German-based financial journalist who has worked in the Luxembourg financial sector for more than 15 years.