Solvency II Staggers to the Finish Line: International Editor Looks Back

March 24, 2015 by Charles E. Boyle

It’s been a long process, but, according to Paul Fisher, deputy head of the Bank of England’s Prudential Regulation Authority (PRA), who supervises insurance and regulatory risk, it is nearing completion.

In his address to the Economist’s Insurance 2015 conference in London early this month, Fisher summarized developments and remaining problems. While he discussed specifics, the overall problem with Solvency II is the time it has taken to thresh out the details. It was officially launched in 2007, but the preliminary work on it goes back to at least 2003.

The world has changed greatly since then. The phenomenal growth of technology has made regulation a whole new ballgame. The financial crisis that began in 2008 hasn’t yet run its course. Interest rates are still at an all-time low, economies, especially in Europe, are struggling with stagnant growth and high unemployment. Banks are stretched for resources, and lending has consequently been reduced. The continuing economic and social turmoil, which has led to open warfare in parts of the world, certainly doesn’t help form a clear picture for regulatory authorities to work with.

In addition, Solvency II has faced a “bridge too far” problem from the beginning, as it is designed to regulate both life and property/casualty insurers. As far back as 2011 a growing number of analysts expressed their belief that grouping them together under one set of regulations may be fundamentally unworkable.

Chris Boggs, the IJ’s Director of Education and the head of its Academy of Insurance, explained it as follows: “P/C insurance operates on the basis of indemnification, returning the injured party, as closely as possible, to the same financial condition that existed prior to the loss, or would have existed had no loss occurred (without unjust enrichment).

“Life insurance pays a face amount that may or may not have any relationship to what has been lost by the death of the person; the amount may have little or no basis in fact. Face amounts in life insurance are a function of the amount of coverage someone is willing to purchase and, to a much lesser extent, perceived need.”

He explained that life insurance is fundamentally an investment, the death benefit, if the insured dies before the policy matures, is an add-on. As such, the rules regarding capital and risk for life insurers are more aligned with the regulations governing banks, than they are with the P&C insurers’ regulations.

Shirley Beglinger, a former managing director at Swiss Re, and an acknowledged expert in analyzing regulations and their effects (now a director at Shires Partnership Limited, an insurance and risk consultancy), explained in 2011 that Solvency II was “basically addressed to the life insurance industry,” suggesting that P/C insurance was “too difficult” for regulators to understand.

The rules “were written as the financial world was blowing up,” she said. They “anticipate a worst case scenario.” The life insurers were the principal driving force—through batteries of actuaries, accountants and lawyers—who shaped the Solvency II regulations. They did so in the midst of the financial crisis, even though with the exception of AIG, the insurance industry was pretty much unscathed.

As a result the regulations are more applicable to life insurers than P/C insurers, and the fallout from this situation has introduced onerous requirements on the non-life industry that are neither wanted nor needed. Beglinger said: “They [life insurance ‘geeks’] were convinced that they could make it [Solvency II] work.” However, the rules are “unworkable and impractical [for non-life insurers], as they are designed around life [insurance policy] renewals, investment yields and pensions.”

Some of those contradictions have been addressed, and some are still being tweaked. The life vs. P/C problem has been further complicated by the fact that most of Europe’s larger insurers sell both.

A second concern has also surfaced following the financial crisis, as insurers, particularly casualty insurers, are being included as systemically important insurers (SII’s). During a September 2013 interview, Jim Wyrnn, the former New York State Insurance Supervisor, and currently a partner with the law firm of Goldberg and Segalla, pointed out that “with the exception of AIG”—whose troubles, Wrynn noted, didn’t stem from its insurance activities— “most insurers came through the financial crisis reasonably well.

“With insurance you don’t have the liquidity and the leverage issues that you have on the banking side, he added, “and really with the traditional business of insurance, which is a very conservative business with reserving and capital solvency requirements, it does not have the potential to generate or amplify systemic risk.”

The simple cost of assuring compliance with Solvency II’s regulations is also a problem. According to a survey conducted by Deloitte in 2013, Europe’s 40 largest insurers spent as much as €4.9 billion ($6.5 billion at the time) in 2012 complying with new regulations. The cost is equivalent to a one percentage point reduction in return on equity, a measure of profitability, the accounting firm said. Those figures are from three years ago, while regulators were still working on Solvency II. The cost can be expected to increase when it’s officially adopted.

Despite the delays and complaints the European Union’s Solvency II regulations, continue to move forward. And technology has helped insurers manage all of the data Solvency II requires as time has passed. Most large companies have already developed—and received approval for—business models designed to comply with Solvency II.

At this month’s conference, Fisher explained that one of the PRA’s responsibilities is to examine the models to “see if they are sound.” He sees this as part of its larger mandate to “adapt to changes in the long term, to supervise innovation, and to manage risk(s).”

The most recent announcement from the regulator underscores this position; indicating that UK insurers will be regulated “proportionately,” in response to concerns that the Bank of England might seek to add some extra regulatory provisions for UK companies.

Proportionately, or not, the regulations will have consequences, as managing assets and assessing risks becomes more complicated. One of those consequences, Fisher acknowledged will be “further consolidation” within the insurance industry, which “favors larger players.” That is one of the major concerns of smaller regional carriers and mutuals, who by definition cannot issue shares to acquire other companies, making it difficult for them to expand.

Solvency II will also require CEO’s, CFO’s and risk managers to more precisely determine their cost of capital with regard to the business lines they offer. At the panel discussion which followed the regulation presentation, Swiss Re’s CIO Justin Excell described it as a “regulatory clash with unintended consequences.” The decisions of insurance leaders in response to Solvency II requirements could result in “isolating the separate parts of a business,” thereby limiting the ability to diversify risk and to effectively benefit from being able to allocate capital to its most productive uses.

Stephen Wilcox, Chief Risk Officer at Allianz UK stressed the need for “stability to understand Solvency II.” With “3000 pages of regulations” differences in interpreting them would become a problem, he said, citing the differences in UK and German interpretations.

Will Solvency II finally be enacted next year, in whole or in part? If it is, then upon formal adoption and ratification by the European Commission (EC), it will require enabling acts by the 27 EU member states to harmonize their regulations with the strictures of Solvency II.

Charles E. Boyle is the International Editor of Carrier Management and Insurance Journal.