The credibility of financial regulation, and indeed services, has taken a battering in recent years, but in the insurance industry the Solvency II capital adequacy regulations hope to learn from past mistakes, establishing a gold standard for many years to come. Justin Quillinan looks at the latest developments ahead of the 2012 start date and assesses whether the industry is on target to meet it, and investigates the likelihood of a long lasting gold standard being agreed across the European Union

A run on a bank is far more likely than a run on an insurance company because, apart from mortgages which can run for 25 years, banks have a combination of short-term deposits, current accounts and cash on their books and such liquid investments are far more volatile. Motor insurance apart, which expires from year to year, much of the insurance industry depends on long term assets on the life side, enabling firms to use different business models in terms of the sources of funding they rely upon and the subsequent investments they make with their customers' money. For all these reasons, commentators are confident that the Solvency II insurance capital adequacy regulations, due to come in during 2012, will be more effective than the discredited Basel II capital regulations, which certainly failed to save the banking industry during the meltdown in October 2008.

Teddy Nyahasha, director of group solvency at Aviva, explains that: "The insurance industry is now moving towards a total balance sheet approach and Solvency II is going a step further in terms of measuring everything on the balance sheet, requiring capital to be put against every single item." Such proof of funding should theoretically establish a gold standard but similar hopes were expressed for the Basel II banking capital adequacy regulations and we all know what happened there. The focus became too fixated on using 'dynamic' measurements of 'real-time capital' to enable firms to utilise their capital bases more fully in the market. The danger of such real-time analysis will have to be factored in to any new regulations, although the insurance sector's long timeframes protects it somewhat from these dangers anyway.

Background
Solvency II is a European Commission (EC) initiative being guided by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), a body made up of high level representatives from supervisory authorities across Europe, which has the power to make changes to the original EC draft mandate if it so chooses, and even extend the 2012 deadline if necessary.

The aim for Solvency II is to provide the EU with enhanced consumer protection, a single market for the insurance sector and better economic principles for the measurement of assets and liabilities to prevent firms collapsing. The capital adequacy rules could also, of course, potentially be used to enhance efficiency and operating practices by early adopters.

At the moment, the process is at the Level 2 stage in the Lamfulussy timeframe, where CEIOPS responded to the EC's draft text in the autumn of 2009, and their advice is currently being considered, as is an impact assessment study being carried out by Deloitte on behalf of the EC. Any alterations will be added to the final framework text prior to it being sent out for EU members to vote on it later this year. The main difference between Solvency I and II is expected to be a shift away from requirements that merely focus on the liabilities and insurance risk, towards asset-side risks, providing more of a comprehensive overview of the balance sheet
- something that is sorely needed post credit crunch. There are still some outstanding issues over how the regulation will cope with the specialist reinsurance market, if there will be an illiquidity premium, and so on, which should hopefully be resolved this year. Any delays in resolving these matters could however lead to the 2012 start date being pushed back.

National boundaries
Regulators in individual EU countries will enforce the new rules and, in the UK, the job falls to the Financial Services Authority (FSA), which is working closely with insurance firms to assess progress. Kathryn Morgan, FSA technical specialist, is upbeat about this process claiming that many firms have already completed the necessary work: "One of the really encouraging things we have seen is firms' treating Solvency II as a value adding exercise rather than merely a compliance one. Firms are using their projects to revisit and improve their risk and capital management practices - it's merely good practice for insurers," she says.

Like Basel II, Solvency II is based on three regulatory pillars to protect firms and their customers. The first is the amount of capital a company should hold; the second sets out requirements for risk management and effective supervision; and the third focuses on disclosure and transparency requirements.

Aviva's Nyahasha, reckons that there is actually a 'silent' fourth pillar - the duty of member states within the EU to ensure that they are policing the rules to make sure that there is a level playing field across the industry, continent-wide. There seems to be a lot of confidence within the insurance industry that the rules can be met and that they will help rather than hinder progress. But the FSA believes there is a lot more work to be done
because there remains a lot of focus on internal business models rather than a broader view.

Potential problems - Reinsurance & illiquidity
The FSA believes that more thought should be given by firms to the balance sheet, technical provisions of Solvency II, governance and reporting requirements. One potentially problematic aspect of this could involve the impact of the fifth quantitative study (QIS5), under the aegis of CEIOPS, which is scheduled for August 2010 and aimed at the specific Solvency II framework for reinsurers; traditionally a troublesome area to regulate. The EU has identified a number of issues for the reinsurance industry to address, particularly relating to illiquidity premiums and discount rates for technical provisions, which is why the FSA believes that the supra-national CEIOPS body has more work to do.

According to the FSA's Morgan: "The EC has set out a pretty demanding timetable to resolve these issues this year. CEIOPS is taking this forward by talking to stakeholders, including Groupe Consultatif, representing the actuarial profession, and other industry forums. To this end a joint task force has been set up and we are actively involved."

Aviva's Nyahasha elaborates further on the illiquidity issue explaining that it's all down to risk and timeframes. "You can adopt a buy-and-hold strategy to maturity and it's less variable because the policy holder doesn't have an option to get out of it. More variable products mean that you have an asset that you can sell, but you are exposed to market volatility and you are ultimately at the policy holder's mercy." He does not believe that Solvency II will be solely of benefit to large insurance firms. "It depends on how risky you are. If you happen to be a large insurer with a high concentration of very risky investments and assets you'll be penalised, but if you're a small insurer with well mitigated risks you'll benefit from this - it's all about risk."

As the industry manages the changes ahead a new buzz phrase 'ORSA' - Own Risk Solvency Assets - comes to the fore. The emphasis here is that regulators will not just expect annual reports to show insurers are playing within the rules, but that they do their own independent risk assessments to prove that capital is aligned to the structure of the business.

UK readiness
Balancing risk is what Solvency II is all about. It will replace a simplistic regime (Solvency I), which has been kicking around since the 1970s. Sophie Lloret, policy advisor for financial regulation, at the Association of British Insurers (ABI), comments: "In Solvency I we have a weak regime at the moment and it isn't robust enough." However, she points out that in the UK, insurers operate under an Individual Capital Advocacy System (ICAS) which is much more developed than Solvency I, giving the UK a 'jump start'.

"Solvency II will be a Europe-wide directive and will take some of the ICAS measures to become a new kind of gold standard." But will the new regulations confirm fears that individual countries are being pushed around by an ever more powerful European Commission? "No," says Lloret. "In the UK we've been great supporters of the Solvency II directive and we've been pushing hard for this to be implemented across European level as we want to see a more advanced regime in other countries."

Currently the UK is in the middle of level two of the three-pillar process instigated by CEIOPS. A consultation process within the industry has so far yielded 20,000 comments - many of them critical about a particular aspect of the directive about group supervision and group capital allocation. This resulted in the removal of the section in spring 2009.

"We were happy with the first draft of the directive, with this exception," says the ABI's Lloret. "When CEIOPS issued its more detailed advice we were very disappointed. On top of that CEIOPS asked for higher capital requirements for much tighter rules at level two and this triggered the 20,000 comments which were mostly critical I have to say." The matter now seems to be resolved thankfully.

Technology investment
Accenture predict that Solvency II will be good news for the IT industry. Sanjiva Perera, the consultancy's industry lead on the topic, says that under investment in IT has occurred previously due to a lack of tangible benefits for a business case. "But Solvency II regulation makes the investment a necessity," he says. "Many insurers have fragmented technology environments that inhibit risk and capital management. The ability to model capital requires data from hundreds of underlying systems, with each system recording data in a different way. This will need to be resolved in a timely and automated manner, with standardisation, in the way it is recorded."

The next couple of years could be fruitful for data integration software vendors. "But so far I haven't seen executives applying budget and pulling teams together so we don't have that central coordination yet. There's a lot of work still to be done," says Informatica's financial services specialist, Mark Dunleavy. "Whether Solvency II hits the 2012 deadline or whether the requirements will change between now and then, I honestly don't know. But I predict that those who start now will benefit most."

There is, of course, still a long way to go over the next two years before the planned start date, with politicians and industry chiefs battling out the fine details. But the broad consensus about Solvency II is now in place. It may change a little bit and it may even be a bit late, but it's going to happen and there's enough information out there now to start preparing.

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