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Solvency II — the journey ahead

Over the last five years insurers have faced significant reporting challenges, which look set to continue for the foreseeable future. These challenges are due to a number of factors at the centre of the financial agenda:

Regulation — regulators and standard-setters have introduced a range of new solvency and reporting measures, including International Financial Reporting Standards (IFRS), European Embedded Value (EEV) and Individual Capital Assessments (ICA). The next phase of development is now imminent, with Market Consistent Embedded Values (MCEV), Solvency II and ultimately IFRS phase II.

Business needs — insurance markets have become increasingly open and price-competitive during this period; at the same time many insurers have had their free capital eroded by increased reserving requirements and adverse markets.

The market place — even before the current crisis, external stakeholders, principally analysts and rating agencies, were looking for more robust, more detailed and more consistent information about the performance of insurers.

Insurers who integrate these factors, embedding them within the business, will maximise the business benefits through enhanced insights, communication with stakeholders and efficient compliance with reporting requirements. A company’s approach to implementing Solvency II will form an important role in developing a common platform and data sources for future reporting measures and, in turn, will provide a link to performance, capital and financial risk management.

The Solvency II directive, which has finally been approved, will be a significant catalyst for change in firms’ operating models. This will be felt most acutely in the finance, actuarial, risk and compliance functions, as these areas are directly affected by the requirements to evaluate, report, manage and monitor the risks within companies. However, other requirements such as the ‘use test’ and the ‘own risk solvency assessment’ will have a broader impact on many other processes within the business and, potentially, even the culture of the organisation itself.

Stages to implementation
We see two stages in the development of any implementation plan for Solvency II.

1 A clear vision.
The first is having a clear vision of your destination: the ‘Solvency II vision or response’. This is an important consideration, as the Solvency II Directive allows firms to implement the rules in a number of ways. It is important that senior management consider the decisions a firm will need to make as it embarks on its Solvency II journey and links these to what the firm should achieve as a business, as this will influence the approach to implementation.

2 A gap analysis.
The second key component is a clear understanding of the gaps that exist between current practice, that required by the Solvency II Directive and, just as importantly, by the desired future state or vision. This is the Solvency II gap analysis. As the impact of Solvency II is wide-ranging, it is vital that all major stakeholders are involved in the process of understanding the options and designing the solution and is not just seen as a compliance exercise.

A current challenge is the existing degree of uncertainty around what exactly is required by Solvency II, which makes it difficult to obtain the clarity needed to have a proper debate. Examples of where Solvency II will have some impact are:

>> Solvency II will require close co-operation between finance, risk and actuarial functions. For firms that currently operate these functions separately, to a large degree this may require a review of organisational design principles.
>> Significant changes to non-life reserving methods (discounting liabilities), reinsurance accounting, capital add-on and, for both life and non-life, the consistency of framework between reserving, pricing and capital modelling teams, all need to be addressed.
>> Changes to capital requirements present both opportunities and threats to an insurer’s strategy, particularly in relation to product mix and geography. Due to the focus of both Solvency II and MCEV on market consistent valuation, annuities tend to look less profitable. Significant innovations in these products may be required to ensure they can still be seen as ‘profitable’ within these frameworks.
>> Changes to rules will provide opportunities for insurers to optimise their risk management strategies, which should be a consideration as part of the Solvency II adoption strategy.
>> Processes may need to be re-engineered to deliver financial and capital reporting on a more frequent basis and to potentially shorter timescales.
>> An increased focus on compliance, governance and controls may mean some firms need to upgrade their processes and resources significantly.
>> IT systems may need to be upgraded to deliver new requirements within appropriate timeframes. This may include modelling, data collection, analysis and reporting changes.

Once you build it, use it
For those companies that intend to go down a partial or full internal model route, the ‘use test’ is a key requirement to consider as part of the Solvency II vision. The requirements of the use test are fairly straightforward at first sight: ‘the internal model is widely used and plays an important part in... their system of governance’. However, upon closer inspection, this short statement has some potentially significant impacts. The main consideration for the use test is that, if management does not use models for its decisions, why should regulators have any confidence in them as part of the regulatory review?

For many organisations, this will raise big cultural as well as practical issues, such as getting the information from their models fast enough. To make effective decisions, management needs current information, not numbers that are months out of date. However, having the confidence to base decisions on the information is potentially an even bigger problem. How many board members really understand the ICA results and model sufficiently well to really challenge the results or to use them to make crucial decisions?

To enable an organisation to solve these issues effectively, it would be beneficial for firms to take a step back and design what the future process will look like. This will involve decisions such as centralised versus decentralised, or speed of calculation versus accuracy. Once these decisions are made, the project team needs to work out how to move current processes towards the desired future state. This could mean a re-design of the target operating model, for example. A number of global insurers have started to move down this route to ensure they are well-placed to get the most from Solvency II and MCEV developments. Figure 2 highlights a potential route map through Solvency II.

2012 is not far away
Some of the changes discussed above are likely to take time to implement. This is why a number of the biggest European firms are moving down these lines already and, in some cases, are a few years into their projects. They accept that not everything is known about the details and that they might need to change their approach in some areas, but have taken the view that waiting for the requirements to be concrete will be too late. The level of impact for smaller firms should also not be underestimated.

In many cases, the requirements will need not only a change in the mindset and processes that people use, but also a consideration of the best approach to the IT and data issues. For many companies, one of the ‘blockages’ to getting quick answers from their models is the speed of getting the right data in the right format. Often this can be caused by legacy administration systems that were not designed to produce the required information. Significant IT changes always involve a long process, so an early understanding of the requirements is needed. We expect the level of effort firms will be making in Solvency II to increase dramatically over the coming months and Figure 3 shows this mapped to Solvency II milestones.

In conclusion, there is a lot to think about and to do in the coming months and years, but we believe an integrated approach with clear objectives at the outset will be important to the success of Solvency II projects.

Ash Ruparelia and Richard Care are directors of the Financial Sector Advisory, Non-life Actuarial at KPMG LLP