Taking Measure of Solvency II

As Europe readies to rewrite the rules on risk management, U.S.-based insurers should take note.

Insurance Networking News, 08/01/2010

While there has been no shortage of action on the regulatory front here in the United States, some of the most profound changes to how the global insurance industry will operate are percolating abroad. The pending Solvency II requirements of the European Union are likely to have global reverberations when implemented in 2012. Intended to better align capital requirements to a company's risk profile and to instill risk awareness into governance and operations, the requirements may act as a harbinger of future requirements in the United States. Insurance Networking News asked Stuart Rose, global insurance marketing manager, for Cary, N.C.-based SAS, what carriers can expect.

INN: What does Solvency II entail for insurers?

SR: It is a fundamental review of the capital adequacy regime for the European insurance industry. The purpose of this legislation is to ensure the financial stability of insurance companies, taking into consideration an insurers' assets and liabilities, and it will replace the current Solvency I requirements. Inspired by banking's Basel II legislation, Solvency II will use a similar three-pillar structure that will cover both quantitative elements and qualitative aspects that influence the risk standing of an insurer. Pillar 1 will consist of the quantitative requirements; Pillar 2 will cover the supervisory activities; and Pillar 3 handles the reporting and public disclosure requirements. Some observers have termed Solvency II as "Basel II for insurers." Solvency II's primary objective is to protect policyholders and beneficiaries. It strengthens policyholder protection through capital requirements, which can provide early warning of deterioration in solvency levels.

While the impact of Solvency II is likely to vary from company to company and from country to country, it has the potential to bring huge improvements to the insurance industry. It will provide a level playing field by ensuring consistent regulations across Europe. It should also improve the solvency of the industry, which means better protection for consumers.

INN: Will Solvency II matter much for U.S.-based insurers?

SR: Although the scope of Solvency II is restricted to insurers conducting business in the EU, the success of Solvency II may have greater implications globally. A number of regulators in other countries, including Japan, are reviewing the regulations and planning to introduce similar risk-based capital (RBC) regulations.

Of course, this type of regime is not new to the U.S. insurance industry. In the 1990s, the National Association of Insurance Commissioners (NAIC) introduced a four-level, early-warning system for U.S. insurers based on RBC formulas. Over the years, these formulas have been updated to introduce internal, models-based components for life insurers.

In addition, best practices in risk management have developed rapidly in recent years. Solvency II will provide incentives to encourage the insurance industry to adopt these practices. Also, Solvency II will enable competitive advantage in the global insurance marketplace by giving insurance companies the freedom to choose their own risk profile as long as they hold adequate capital. More efficient capital allocation leads to lower prices for consumers. A lower risk of company failure leads to greater confidence in the industry and financial stability.

In June 2008, the NAIC announced the formation of the Solvency Modernization Initiative that would consider global developments, in particular Solvency II, and their potential use in U.S. regulations. This initiative is still a work in progress; however. If U.S. carriers continue to ignore Solvency II, there is an opinion that it could weaken the American insurance industry. It will certainly limit the opportunities for U.S. insurers to expand into the European insurance market. At the same time, ignoring Solvency II might increase the likelihood of U.S. carriers being acquired by European counterparts that are better capitalized and financially stable.

INN: What does Solvency II tell us about larger risk management efforts?

SR: According to Thomas Steffen, Chairman of the European Union's Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), "Solvency II is not just about capital. It is a change of behavior." Insurance companies that view Solvency II as just another regulatory requirement will be at a competitive disadvantage compared to those that embrace the legislation to improve their business and long-term future. The same philosophy applies to the U.S. carriers. They cannot sit back and wait for U.S. regulations to catch up, whether at the state or federal level. U.S. insurers must begin implementing risk management systems to ensure that they are competitive in the global insurance market space.