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The Three Pillars of Solvency

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The Solvency II Directive is reshaping the entire insurance sector at huge expense to the industry.

Markit Magazine - The Three Pillars of Solvency II

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The Three Pillars of Solvency

The Solvency II Directive is reshaping the entire insurance sector at huge expense to the industry reports Richard Willsher

The first major regulatory overhaul of the insurance sector since Sol- vency I in 2002, Solvency II is scheduled to become effective in January 2014. However, insurers who use their own so-called “internal models” for calculating and reporting their solvency positions will have to operate them for 12 months before this date.

The heat is therefore well and truly on for those firms that have yet to finalise their models. The big picture benefits of the direc- tive are, in the words of the UK Financial Services Authority, that it “will set out new, stronger EU-wide requirements on capital adequacy and risk management for insurers with the aim of increasing protection for policyholders. The strengthened regime should reduce the possibility of consumer loss or market disruption in insurance.”

Liabilities and assets
Like banking’s Basel II and III capital ade- quacy regulation, Solvency II is built around a three-pillar structure covering respectively: capital requirements, governance and supervision, and disclosure (see panel p44). At its heart is the issue of risk management and how to quantify and report on risk in terms of data. A nonprofessional thinking about what insurance companies do could imagine that they are likely to be good at understanding the risks they cover and the containment of resulting claims.

This is generally the case. If they cannot manage the liability side of their balance sheets, insurers may quickly go out of busi- ness. Solvency II brings increased rigour and reporting requirements to this in order to calculate how much capital they need to hold vis-à-vis the risks they write. However, quantifying and analysing risk on the asset or investment side of the balance sheet is more challenging for many insurers.

“A lot of firms are really struggling on the asset side. Many of them are geared towards the liability side and the asset side is highly fragmented,” explains Daniel Simpson managing director at Markit EDM. “We’ve seen two approaches: first, head offices [of large insurance groups] publish- ing data guidelines for their subsidiaries to follow, defining an in-house standard and pushing it down to the group. The other approach is to say, ‘send us what you’ve got and we’ll scrub this at the group level.’ Both have their pros and cons, and differ- ent challenges.”

Insurers may hold a variety of assets including cash, bonds and equities, alter- natives such as commercial property,private equity, hedge funds, exchange traded funds and derivative positions. Their hold- ings may span the whole gamut of asset classes. Not only that, but they may be held in different jurisdictions, some within the EU forexample, others else- where, such as off- shore locations. Gath- ering and collating disparate data across a large, federated inter-national insurer can bea challenge if this has not been necessary in such detail before.

Risk concentration
Understanding and analysing risk exposures is unlikely to be straightforward. Aggregation of risk can easily occur. For example, an insurer may hold the equities of a particular company, but through different subsidiaries and through listings on different markets. It may hold corporate bonds in the same firm. It may invest in property occupied by the same corporate. It may also effectively have a risk exposure to the same name through holdings in various funds.

In addition, managers of those funds may buy and sell the funds’ holdings at any time and in any quantity. The task facing the insurer is to know their exposure at any one time and being able to report on them both internally and externally to regulators when they need to. This has been dubbed their “co-mingled look through” capability.

“There are no common standards across the industry and across jurisdictions for things such as counterparty identifiers and issuer hierarchies for example,” says Daniel Simpson. “In the world of over the counter instruments, such as various derivative financial products, there are no market iden- tifiers. So when you’re given very disparate sets of data at head office, where historically there has not been a data management team or an IT team responsible for aggregat- ing this, there is now an inordinate amount of data and there is no systems infrastruc- ture in place to consume and manage it.”

One fear across the industry is that all insurers would need to produce the same level of data and granularity of reporting. What might be appropriate for a large general insurer such as an Allianz, Aviva or Axa to report might be also be required of a small insurer with nothing like the same size, spread of business, geographical foot- print and risk exposures.

Fortunately, for smaller businesses a set of updated reporting guidelines and tem- plates were released in early July. Their effect was to exempt smaller insurers from some of these requirements. Arguably, however, smaller firms have an easier job of managing their risks and their data anyway, simply because they would hold fewer assets and these might also be more liquid. However, the industry view is that, eventually, all firms are likely to be faced with the same reporting requirements and so will be forced to face up to the same data gathering and management challenges.

Cost and industry restructuring
Solvency II’s requirement for more rigorous risk management has meant significant cost burden’s across the industry. An early Euro- pean Commission estimate of the overall cost to the EU’s insurance sector was in the range of €2-3 billion over a period of five years. In fact, some of the larger European insurance firms have reportedly earmarked between €100 million and €120 million each for their Solvency II projects. The chief infor- mation officer of one company says, “As a comparison, we know from [the banking industry’s] Basel II experience that IT resources and budget should not be under- estimated. The reality from Basel II is that the banks spent between three to six times more than they originally budgeted for and 70% of that was on IT.”

IT spend includes consultants and other expert human resources, rather than just boxes, cabling and monitors. Peter Gatenby, who leads the actuarial practice of account- ant and adviser, Mazars, in the life, pensions and healthcare sectors, says that the largest firms, such as Aviva, Prudential, Zurich and Standard Life, resourced their Solvency II teams while good people were more readily available. However smaller firms tended to get started later and some now face a lack of expert staff, which in turn means they must pay more for the expertise they need.

One response to these cost pressures has been to outsource IT services in part or altogether. This is particularly the case with smaller firms that prefer to concentrate on the business of insurance, which they know best. Solvency II costs, though, are also driving consolidation in the sector. Again smaller firms are taking the view that they need to gain scale economies in order to make their businesses worthwhile. Joining with a larger enterprise or forming partner- ships with other, smaller firms can be more economical. Liverpool Victoria and Thread- needle’s combination is an example of this in practice.

“There is definitely consolidation with the smaller players who just can’t get the costs of running an insurance company or asset management business to work without scale,” says Markit EDM’s Simpson. “We will see more consolidation. We are seeing more firms looking to outsource the pieces that are not their core competency in the middle and back office. This model is now proven. I think this trend will continue.”

There have been similar moves on the asset side of the balance sheet specifically. Faced with the challenge of developing suf- ficient scale in asset management to draw the most from the costs of tooling up for Solvency II, some insurance firms have chosen to make asset management a service that they can operate commercially. Aegon’s rebranding of its asset management operation a year ago was based upon its intention to boost its asset management operation in this context. Firms such as Aegon might have followed such a path anyway in due course, but Solvency II may have quickened the process.

At the same time, asset custodians have been quick to recognise a role for them- selves in the asset data space. Firms such Bank of New York Mellon, HSBC, Northern Trust and State Street, which are in all prob- ability administrating the bulk of insurance company assets, either directly or as service providers to asset management firms and funds, are well placed to draw upon the data they already hold. Importantly, they have made considerable technology investments in their very large-scale global operations. They can draw on their own systems and capabilities to meet the data needs of insur- ers and reap additional income at marginal extra cost.

If Solvency II is forcing change and reshap- ing the insurance industry in the aftermath of the financial crisis, we should not imagine that the effects are all cost producing with little benefit other than that of achieving compliance. It also offers opportunities and business benefits.

Better risk management on both sides of the balance sheet is one obvious gain. In addition better asset/liability matching lowers the probability of insolvency. These are achieved largely through improved IT systems and data management and less possibility of human error. Streamlined systems producing consistent internal and external data makes reporting easier and management information quicker, more accurate and more useful.

“Most people in financial services are in data management to a greater or a lesser extent,” says Simpson. “The better you do that the more resource you can free up... Moreover insurance company investors are more concerned to know that their investee companies are well structured from an infor- mation technology point of view. This is being carefully scrutinised by chief operat- ing officers and chief risk officers.

“The reputational risk of having a break or a breach is too high” Simpson says. “Unless they have confidence in a firm’s IT, investors may prefer to invest elsewhere... However the flip side is that if you are getting it right, if you do a good job of managing your risks it will free up capital to do other things. And this is, after all, what this is designed to do.”

Therefore, Solvency II is not just another piece of regulation. It is a root and branch spring clean for an industry that some now recognise was long overdue. Whether it will enable the industry to avoid another AIG-like catastrophe and government bailout remains to be seen.

The results will not be fully quantifiable for some time to come and in any case, even the regulators themselves see this as an evolving story. Solvency III, IV or V looks highly likely in light of successive iterations of other financial sector regulation such as Basel, the Capital Requirements Directive itself, MiFID and UCITS. For the moment, however insurance businesses across the EU are still coming to terms with Solvency II and time is short if they are all to achieve compliance by January 1, 2014.