Solvency II: Aiming for Adequacy

With American International Group’s spectacular collapse due to grossly inadequate risk management and shady accounting practices serving as a grim example of what can go wrong, European Union regulators devised the Solvency II framework to prevent any future inability on the part of a major insurer to cover client claims.

The regulation entails three pillars, in Basel II fashion:

Pillar One contains quantitative capital requirements, the first of which is the Solvency Capital Requirement, which covers all quantifiable risks a firm takes and may be calculated using either internal methods or the European Standard Formula.

The second is the Minimum Capital Requirement, which is the threshold an insurer must not breach, lest it lose its authorization to operate in the EU.
Pillar Two involves more qualitative requirements for risk management and supervisory activities.

Pillar Three mandates reporting and disclosure requirements to regulators, as well as data that must be made public to ensure market discipline and internal stability within insurance firms.

Within the broad parameters set by those three pillars, more specific requirements target investment practices of insurers and their buy-side subsidiaries, and how much capital they will need to set aside in order to cover those investments. Capital requirements for insurers’ investments will be based on the level of risk associated with individual assets within their portfolios.

“This means that the more volatile a particular asset category tends to be over the one-year regulatory time horizon, the higher the capital charge,” states the EU’s official website.

At the same time, the new directive removes external limits on how much exposure insurers can take in terms of derivatives and other higher-risk asset types, provided they maintain adequate capital reserves to offset potential losses.

The EU website explains, “Requiring insurers to hold capital against such adverse scenarios arising out of their investments not only mitigates against insurance failures, but also incentivizes insurers to consider the appropriateness of their investment portfolio and the risk associated with it.”

In short, Solvency II appears to give insurers a freer hand when it comes to their investment decisions, but with significant strings attached: appropriate capital reserves, stronger risk and data management, and more rigorous reporting and disclosure requirements.

Holding Pattern
With deadlines nearly two years out, Solvency II requirements still present no fixed target in terms of compliance. Although general ideas of how processes and technologies will be affected are apparent, insurers and their buy-side units will not tackle specific implementation projects until a more solid regulatory framework emerges.

“The details of how regulators want Solvency II to be implemented continue to be actively discussed across the EU with strong emotions for and against the current state of understanding,” says Sarah-Jane Dennis, consultant at London-based buy-side technology consultancy Investit.

“This process will continue into 2011 with expected final implementation by October 2012. Therefore, insurance firms have Solvency II on their radar, but as with other investment managers, before large investments in development are committed, we are in a holding pattern while regulation around the globe settles into something clearly defined enough that it can be implemented.”

Strategy and Process Affected
Although Solvency II specifications may not be fully nailed down yet, insurers and their service providers can infer the regulation’s likely impact on them. The loosening of prescriptive requirements coupled with greater accountability in terms of capital reserves and data management will have both front- and back-office implications for asset management units of European insurers, according to both buy-side and insurance industry analysts.

Jacques Kornic, a partner at KPMG in Paris and head of the firm’s insurance advisory team, anticipates insurers’ investment management subsidiaries to feel Solvency II effects on both their strategies and their processes.

“Solvency II issues will impact both investment strategies and investment processes,” says Kornic. “Regarding investment strategies, the cost of capital is very different for equities than for bonds and other asset classes. Insurers may have to rebalance the breakdown of their investment portfolios and divest from stocks in favor of bonds. This has already started, and companies are looking to reduce the cost of capital associated with shares.”

Regarding processes, Kornic cites the directive’s less strict risk limits, but says the onus to prove the soundness of their own internal risk processes will be in turn much greater for managers.

“There will be no more explicit limits, but each company will have to prove that it has its own process in place to set limits and follow those limits,” he says, adding that managers will have to embed management of their risk limits within all of their investment processes, as well as prove to regulators that those limits are well monitored.

“They need to ensure that risk management is imbedded in their investment processes, and linked to the cost of capital,” Kornic advises. “In insurance companies, there is a lot of asset and liability management, but that is not always linked to the cost of capital.”

Familiar Threads
While Solvency II focuses on the insurance industry, its requirements for asset management operations are mostly in line with other US and European regulations pushing greater transparency and disclosure.

Aite Group senior analyst Denise Valentine says there are several familiar areas where insurers’ buy-side subsidiaries will need to focus for Solvency II, but adds that compliance is a combination of process and technology.

“A lot of the issues brought up in Solvency II are the same issues we’ve been talking about, like valuation,” says Valentine. “Valuation systems will be much more important, because insurers will basically have to conduct capital adequacy tests across their portfolios, and that means they’ll need to make sure they have appropriate valuation models for derivatives, which they use a lot.”

Insurers will also have to deploy models for risk analytics in order to measure their entire portfolios in order to determine capital requirements, Valentine says, as well as ensure validity and timeliness of their data. “If the regulatory authority can poke holes in any part of an insurer’s valuations, that means its capital adequacy is off,” she says.

“Some of these issues go beyond just technology and are process-driven—how do we handle information in our organization, and how can we prove that it’s correct and up to date? This is all tied back to being able to put aside enough money to cover your policyholders,” Valentine says. The actuarial pools of all these insurance provisions change over time, with some pools going more into the red than others. Therefore, carriers have to make constant tweaks and adjustments to their portfolios to ultimately support whatever they have committed to for their policyholders, says Valentine.

Portfolio optimization will also prove a crucial tool under the Solvency II regime, given how prominent asset liability matching is in insurers’ investment operations.

“We’re talking about asset liability matching, and insurance companies are active in derivatives, in securitization, and sometimes in reinsurance,” Valentine says, adding that insurance carriers require highly diversified portfolios—which can make it difficult to source off-the-shelf optimization technologies to support them.

“They’ve got to have diversified portfolios, but in terms of being able to tie all these things together, there’s probably no technology that can do all of that,” she says. “That’s why they have to build custom models for themselves.”

The more sophisticated an insurer’s models are, the more likely regulators will feel comfortable with that firm. “If the regulator does not feel comfortable with an insurer’s controls and risk models, that insurer will have to put more capital aside,” Valentine says

Data Demands Front and Center
Tackling data-related technology and process issues ahead of Solvency II’s implementation date has taken on greater urgency among insurers. Although each insurer’s investment strategy, portfolio composition, subsidiary structures and technology framework all require highly tailored development efforts, buy-side data management software providers have also stepped in to help clients address coming regulatory requirements.

According to Stuart Plane, director at enterprise data management (EDM) software provider Cadis, the vendor’s insurance clients feel the most comfortable meeting the Pillar One requirements of Solvency II; for the less tangible mandates of Pillars Two and Three, however, those firms are relying more on Cadis for support.

“What aren’t tangible are tiers two and three, which have to do with transparency and audit traces and other data governance aspects,” says Pane.

He explains that Cadis clients have developed their own “kernels,” or core calculation engines, to determine capital requirements, and have now begun trying to determine how to populate those kernels with relevant data from their asset management subsidiaries.

“How are they going to ensure that the data they put into their kernels is the correct data? If they spot anomalies in the data submitted by their subsidiaries, how do they then alert those subsidiaries and take action on anomalies?”

Plane characterizes these as “classic bread-and-butter” data management issues. Insurance holding companies often act more as administrative hubs unaccustomed to performing core operational processes, which their buy-side subsidiaries usually handle.

“So the administrative and accounting operations at the parent level are now trying to grapple with these data issues previously handled by their asset management subsidiaries,” Plane says. “They need to decide whether to address this at the parent or the subsidiary level, and how they’ll communicate with their subsidiaries about exceptions, timing and audit factors.”

Benoit Colin, product manager of Linedata’s asset management back-office business in Paris, also reports efforts by the vendor’s insurance clients to build better controls around their data management processes ahead of Solvency II deadlines. To support those efforts, Linedata is developing a decisional database dedicated to Solvency II requirements.

“Each insurer will have to provide their own limits and build their own systems, so to support those systems they’ll need to report on the data they use and control all their calculation methods, meaning that if you are providing your own algorithms and your own way to deliver data to the regulator, you must prove that you know all the ways to calculate your models,” says Colin. “That means that we need to work on a decisional database—a database dedicated to Solvency II. It will be linked directly to our Chorus back-office system. It will store all necessary data to support reporting and algorithms.”

Limits to Third-Party Support
In addition to vendor support, insurers also have the option to outsource some of their compliance functions to their administrators. But such options can only go so far—the more customized an individual insurance client’s compliance requirements are, the harder third parties will find it to commoditize services to support those clients.

“Solvency II sets out specific guidelines for outsourcing operations to third-party administrators, so outsourcing is a credible option for asset management operations to consider,” says Dennis at Investit.

“However, from the perspective of the third-party administrator, Solvency II demands—which include highly transparent processes, potentially intra-day provision of operational risk-related data, the right of the insurance asset manager to redesign processes they deem essential, and the need to evidence appropriately skilled staff—are markedly more difficult to commoditize as they are so client-specific and therefore markedly more difficult to support as a viable service,” Dennis says.