[Skip to content]

Sign up for our daily newsletter
The Actuary The magazine of the Institute & Faculty of Actuaries
.

Solvency II: Theory and practice

On 1 October 2007, Karel Van Hulle delivered his lecture, The Challenge of Solvency II to the Faculty of Actuaries. With UK actuaries now actively preparing for the new solvency regime, this offers a good opportunity to revisit what a Solvency II expert had to say back when Lehman Brothers was still a creditworthy counterparty, and to compare this with where we are today and where we are heading. In a word, the (slightly mischievous) intention is to ‘back-test’ Mr Van Hulle’s speech.

The objectives of Solvency II
The lecture started with a reminder of the objectives of the new solvency regime: a deeper, more harmonised single insurance market, enhanced policyholder protection, improved competitiveness and better capital allocation.

Since 2007, however, there has been increased concern about whether all these objectives can credibly be met in practice. In particular, concern has recently been voiced over the consequences of reform on the availability of some insurance products and their affordability. It is hard to argue that excessive capital requirements would not ultimately lead to higher premiums and decreased demand for insurance. The typical opposition between market penetration and consumer protection (remember subprime mortgages?) could very well apply to insurance and even ultimately force some policyholders out of the insurance market altogether. This could work against the original objectives and could also potentially discredit European lawmakers.

On competitiveness, when asked whether European insurers could end up being less competitive abroad than their American or Asian counterparts, Mr Van Hulle reframed the question into the wider context of an international move towards risk-based solvency requirements, and so reduced this eventuality to a mere timing discrepancy. In brief – everybody will move to similar standards sooner or later, and so competition is nothing to worry about. Nearly three years later, the rest of the world does not appear very eager to follow Europe, and the risk of being less competitive globally still seems very much alive. Full recognition of geographical diversification could help to mitigate this.

The global downturn
Some of the words used in the lecture have, in the light of subsequent events, perhaps taken on slightly negative connotations. The terms ‘not rules based, but principle based’, ‘nobody knows their business better than the companies themselves’ or ‘there will be no more detailed investment rules’ are now closely associated with the excesses observed in the banking industry. Throw in ‘we want to achieve a cross-sectoral convergence between insurance and banking’ and you get one of the main current challenges of the UK insurance industry: how to manage its association with banks in the eyes of the general public and decision-makers.

Andrew Hiscox’s recent reaction to the announced abolition of the FSA under a Conservative government (Guess what, the FSA does Insurance too, and the insurance industry has behaved very well) is an example of the efforts that insurers are currently making to keep a good distance from banks and avoid an intertwined fate. The credit crunch seems to have pushed cross-sector convergence out of fashion.

Arguably, the same could be said about securitisation and derivatives, both mentioned by Mr Van Hulle in the lecture when questioning the industry on its capacity to fully understand risk-mitigation techniques. Lloyd’s 2010 Strongest Insurance Business Superbrand award and the announced revival of the New York Insurance Exchange are testimonies to the dramatic comeback of syndication as a preferred business model.

This is largely a consequence of the credit crunch, through dried-up credit sources and a mix of mistrust and genuine concern about the intricacies of security-based risk mitigation. We have, after all, just witnessed its extraordinary power of devastation when fully unleashed. Mr Van Hulle’s questions on our full understanding of the economic effects of certain risk mitigation techniques were, and still are, very relevant.

Mr Van Hulle also justified the need to create an early warning mechanism for capital inadequacy (hence the MCR/SCR structure) and to disclose capital add-ons. All those involved certainly welcomed the introduction of these measures at the time, and the recent extreme economic episode is yet another incentive to adopt these measures. Nonetheless, recent events will certainly not help to shorten the transitional phase for “people to get used to the idea that a company might be required by its supervisor to add on more capital”.

The Solvency II process
In 2007, Mr Van Hulle predicted the adoption of the Framework Directive by late 2008 and the enforcement of the new regime by 2012. The adoption of the Framework Directive in fact took place in March 2009 and the date for the new regime to come into force was left unchanged. It is only fair to admit that the announced timeline has been broadly in line with expectations so far, especially given the tendency of some EU projects to slip behind schedule. This is encouraging for the future and can only reinforce the strength of CEIOPS’ statement that October 2012 is a definitive date.

In his lecture, Mr Van Hulle also described the 1,000+ pages produced by CEIOPS during the call for advice as a ‘tsunami of pages’. This could be interpreted in a few different ways.

>> Pessimistically: if producing a thousand pages can be described with catastrophic vocabulary by an EU official, then clearly all internal resistance against further cataclysmic devastation has now been wiped out. Watch out for level 3 guidance.
>> Optimistically: not all members of EU bodies produce an unthinkable number of incredibly thick papers or reports. Like us mere mortals, some of them are also just recipients and have to read them all.
>> Thought-provoking: compared to a tsunami, one cannot help but wonder what words would most accurately describe the volume produced by CEIOPS since 2007. Wait. Did I just hear ‘binary event’?

Something else mentioned by Mr Van Hulle is the regime of group support, which has now been adjourned to 2015. What is most notable is not that Mr Van Hulle already identified one of the main reasons behind this delay (i.e. resistance by “companies which are not part of a group and which believe that therefore they have a competitive disadvantage”), but rather the decision to delay the decision. This serves as a useful reminder of the inherently political nature of the Solvency II project and of its susceptibility to consensus-based decisions. The bottom line: while everyone has been busy lately on the Solvency II front, attention should not be diverted away from monitoring the political aspects and agenda.

One aspect Mr Van Hulle spoke proudly of (and rightly so) in his lecture is the process driving the emergence of Solvency II regulation, which he describes as bottom up regulation created with the full participation of stakeholders. This was true in 2007 and still holds today, with maybe even greater strength.

Increased participation in the Quantitive Impact Studies(QIS) and the large number of responses to consultation papers are just a few examples of how the industry has embraced the open approach to the process and made full use of it. Still, a number of stakeholders generally seem to remain distant from the project, including insurance and reinsurance captives, run-off entities and (internally) underwriters. There are a number of different reasons for this, such as pending uncertainty, remoteness down the chain of impact or strategic behaviour towards regulators.

A word to the insurance industry
Mr Van Hulle also challenged the ability of current IT systems and data processes to deliver on the high requirements set by the new regime. One cannot help but compare this with the painfully slow passage of Lloyd’s to the electronic era and the rumour that the competing New York Insurance Exchange project will take full advantage of the latest technology to create viable competition. This illustrates how progress and innovation in information technology can also lead to increased competition. Considering that Solvency II ignited a arms race on the IT front, anyone can imagine the undesirable consequences that inadequate systems (or inaction) could have on one’s competitive position.

Mr Van Hulle defined the calculation of market-consistent technical provisions as a major challenge to the industry. It is interesting to note that more effort has generally been put into building capital modelling expertise in the last three years than into managing the transition to a fully cash-flow based, discounted best estimate assessment of future liabilities.

In many ways, the new rules for reserving will differ quite materially from the current practice, one example being negative premium reserves. However, the focus for most companies carrying out QIS exercises has tended to be on the capital calculation, with less attention paid to how the reserves will differ in a Solvency II world (even though these reserves are, in themselves, a key input into the capital calculation).

This may be due to the complexity of adjusting existing reserving procedures for the new rules, particularly where this requires putting in place new systems and processes. It may also be due to a lack of clarity on the reserving calculations contained in the QIS guidelines. However, a clearer picture has now emerged from the level 2 guidance, and companies should now think very seriously about preparing themselves for any last-minute (bad) surprises.

A word to the Actuarial Profession
In the presence of actuaries, Mr Van Hulle could not avoid a number of good old actuarial jokes (equally applicable to lawyers, his original profession), and, more seriously, to touch on the fate of actuaries under the new regime.

He justified the decision to merely require the presence of actuarial skills rather than actuaries to carry out the tasks assigned to the actuarial function with the following three arguments: wanting to avoid overburdening small and medium-sized insurers, not handing a monopoly to actuaries and, finally, there may not actually be enough actuaries.

These reasons remain perfectly valid today. Given the recent high level of recruitment activity (and subsequent musical-chairing) observed in general and life insurance and considering that the UK probably has the largest pool of actuaries in the EU, a shortage of actuaries in some continental European countries is a realistic scenario.

The challenge of improving communication by actuaries was also mentioned by Mr Van Hulle. One has to admit that the UK Actuarial Profession has taken this objective seriously and increased its emphasis within the education syllabus over the last few years. However, transforming actuaries into strong communicators remains an ambitious target, which will take time to achieve.

Last but not least, Mr Van Hulle challenged actuaries “not to get lost in formulae and models”. This comment takes on a new dimension in the light of the global banking crisis. The FSA’s Turner Review identified misplaced reliance on sophisticated maths as one of the key features in increasing systematic risks, by providing false assurance that other indicators pointing to increasing risk could be safely ignored.

The insurance industry is about to go down a similar path to that taken by banking 10 years ago and move to an environment where models will be at the centre of decision-making (not least because of the ‘use test’). It is possible that the level of diversity between models could end up being reduced, perhaps due to the recommendations of rating agencies or by following best practice (which tends to encourage copycat behaviour) or the provision of off-the-shelf models by third parties. Model risk (including for the standard formula) should be a key concern here.

If our profession wants to be successful under Solvency II, it is crucial that we understand the wider ERM framework and where our traditional skills fit in. Mr Van Hulle’s comments serve as a reminder that we should get acquainted to ERM sooner rather than later and start to widen our view of risk now.

______________________________________________________________

The author would like to thank Michael Garner for his helpful comments upon reviewing this article.
______________________________________________________________

Further reading:
The transcript Mr Van Hulle’s lecture can be found in volume 14 (part 1) of the British Actuarial Journal, now freely available online to members of the UK Actuarial Profession at http://www.actuaries.org.uk/knowledge/annals_baj/baj_vol_144_contents.

The accompanying presentation and mp3 sound file are available on the Profession’s website at http://www.actuaries.org.uk/knowledge/sessional_meetings/2007-2008

Yves Colomb is a Property and Casualty consultant for Towers Watson. The views expressed in this article are his own and not necessarily those of his employer.