Regulatory frameworks on capital adequacy for insurance firms were first introduced in the early 1970's and since then more complex and sophisticated risk management systems have been gradually introduced, the latest of which being the European Commission's upcoming regulatory directive Solvency II. The concept of capital adequacy is based on solvency margins; the amount of regulatory capital an insurance firm is obliged to hold against unforeseen events to protect policyholders, reducing the likelihood of consumer loss or market disruption. In the 1990's it was acknowledged in the third generation of EU Insurance Directives (which established a license for insurers based on single requirements) that the rules on solvency margins required significant amendment. Solvency I was a limited reform agreed by the European Parliament in 2002 following the Commissions initial review.
Consolidation of regulations across Europe
Solvency I is currently considered inadequate as it is interpreted and implemented in different ways by insurance companies in each country, furthermore many member states consider the current EU minimum requirements as insufficient and have subsequently initiated their own reforms, leading to a ‘patchwork' of local standards which has hindered the development of a single EU market for insurance services. Solvency II will be a much more fundamental review of solvency margin requirements and risk management standards putting in place a comprehensive EU-wide framework for the insurance industry and will replace Solvency I.
The two primary aims of Solvency II are to consolidate regulations for insurance firms across the EU into a single standard making business much easier between member countries, whilst ensuring adequate levels of consumer protection. Due to become fully operational in 2012 it is the largest ever initiative to draw all EU insurance firms under a single regulatory regime governing what constitutes an acceptable level for solvency margins. Solvency II is often referred to as ‘Basel for insurers' as it mirrors the Basel II requirements that unite banking regulations across the European Union. Solvency II will require firms to measure their assets and liabilities consistently across the European market against risk-sensitive capital requirements which will be much stricter than other regulatory regimes in place for insurance firms worldwide.
Overall the tight regulations on capital will greatly reduce the risk that insurers are unable to meet claims, provide an ‘early warning system' for insurance supervisors if solvency margins fall below a certain threshold, increase market transparency and should bolster consumer confidence in the financial security of the insurance industry. Solvency II will be an integrated regulatory framework consisting of three main pillars. Pillar 1 (Quantitative Requirements) sets out a firm's minimum solvency capital requirements or margin which may be calculated using either a standard formula or if it meets supervisory approval, an internal model based on the risks faced by the individual firm. Pillar 2 (Qualitative Requirements) outlines the regulations for evaluating the adequacy of governance and risk management systems and processes along with measures for effective supervision of the insurance industry.
Firms must ensure that controls are in place to maintain the solvency margin calculated as necessary and supervisors will assess the need of firms to hold additional capital to offset risks not covered sufficiently by the quantitative requirements of Pillar 1. Pillar 3 (Disclosure Requirements) ensures transparency and requires firms to disclose publically details of their specific risks, capital held and risk management processes relevant to market participants, the aim of these disclosures is to enhance market discipline.
Solvency II will be enacted under the Lamfalussy process, which means that agreement for the new regulatory framework will be obtained in stages prior to specification and implementation of the full directive in all member states. The Framework Directive setting out an overview of the new regulations was published by the European Commission in July 2007; however the European Commission then proceeded to miss its target for adopting the Framework Directive into law by November 2008 and now aims to adopt the directive before the European Parliament elections in June 2009. Decisions on the full Solvency II framework are currently being made and the Directive and implementation regime are expected to be fully specified towards the end of 2010 to give member states adequate time to implement Solvency II by 1st October 2012.
Implementation date may have to be moved to 2013
However, if current delays continue, the implementation date may have to be moved to 2013 or possibly later to give member states enough time to comply. The European Commission is being assisted by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) a body which consists of representatives from a range of supervisory authorities across Europe in developing the implementation processes and setting out the supervisory standards. CEIOPS is also conducting regular directive reviews throughout the stages of the Lamfalussy process.
Solvency II will bring major changes to the regulation of the UK insurance industry, and market experts believe insurers should be starting to make effective implementation plans now. Firms need to assess where they will be placed in the new competitive landscape in Europe that Solvency II will create, assess whether under the new stricter controls on solvency margins the capital they hold currently will be adequate and also whether they wish to make valuations based on the standard formula or adopt an authorized internal model. In general the insurance sector has stood up well to the current financial crisis however this does still highlight the urgent need for tighter regulation, transparency and stricter risk management across the financial services industry. Standard & Poor's sometimes controversial report on the new Directive: "One in Four of Europe's Insurers Could Face Major Strategic Decisions Under Solvency II" concluded that Solvency II would cause profound changes across the European insurance sector and felt that the greater harmonization across the markets would lead to accelerated consolidation within the EU. Competition between insurers will likely increase as the playing field is leveled-out by tighter controls and greater transparency, competitiveness of European insurers with those outside of the EU should improve significantly under what will be the strictest regulations in force worldwide, however non-EU insurers operating within the EU could be pushed out by the new regulations.
Standard & Poor also concluded that the largest insurance groups would be the ones to benefit significantly from the changes brought about by Solvency II whereas smaller specialist firms would suffer as the Directive creates an emphasis on diversification. Firms which are unable to respond quickly enough to the new regulations requiring the holding of additional capital, implementation of new risk management tools and the investment in people to manage and maintain these tools within the deadlines may be forced out of business and this could lead to a temporary rise in risk premiums. Instability in the insurance market as the regulations are implemented will also have a knock-on effect and actually increase risk for re-insurance companies that are also governed by the Solvency II Directive and will be undergoing changes themselves.
Improving the robustness of the European insurance industry
The long-term effects of Solvency II with its tighter controls around capital and risk management should have an overall positive result greatly improving the robustness of the European insurance industry, giving greater protection and increasing confidence amongst policyholders, easing the EU insurance trade and increasing market transparency. Insurance firms however can easily run into difficulty if they have not carefully taken all risk into account and maintained adequate capital, as proven by the case of AIG who suffered a severe liquidity crisis in September 2008 when the company's credit rating dropped and the importance of financial security has been highlighted during the course of the ongoing worldwide financial crises. Short term instability and the weeding out of insurance companies which are already weak, with inadequate capital or insufficiently prepared for the new regime should give way to a more level playing field, enhanced business relations between European firms and increased European competitiveness on the world stage. With the European Commission still working to ensure the initial Directive is adopted in law 6 months on from the deadline it appears unlikely that Solvency II will be fully operational by 2012. This should not however lead to complacency and UK insurers must grasp the opportunity to start planning for the changes now to ensure they emerge from the current financial instability and benefit from the long term changes being introduced.