Lessons learned: European insurers can draw from their experience carrying out Basel II to ensure a smooth ride to fulfilling Solvency II.

Regulators worldwide are focusing on insurers' solvency and capital adequacy. In its effort to create a solvency regulation framework which is more tuned to the insurers' actual risk exposures, the European Commission has put together Solvency II--a risk-based approach to solvency regulations. Currently, the framework's details and implementation guidelines are being drafted and discussed. European insurance companies are preparing to comply with the regulations that go into effect in 2009.

Evolution of Solvency II

The existing approach to solvency is based on fixed ratios. This system doesn't match the true risk exposures of an insurance company. Basel II-the regulatory framework accepted by the Basel Committee of the Bank for International Settlements--has made a positive impact in the banking industry as far as risk management and capital adequacy regulations are concerned. Basel II is built on a three-pillar approach that has received recognition from the financial services industry. Solvency II also follows a similar three-pillar approach for insurance solvency.

Beyond Pillars

Though the Basel II framework has been accepted as the basis for developing Solvency II, the comparison does not go much beyond the pillars. The driving force for both of them is the need to create a prudential framework for risk management and solvency control. This similarity makes the three-pillar structure common. However, a host of reasons, including the inherent differences between banking and insurance industries, have led to some key differences in the framework.

* The focus of pillar I of Basel II is on credit, market and operational risks. Insurance companies, however, are more complex than hanks from the risk perspective and hence pillar I in Solvency II encompasses a much wider range of risks--underwriting, claims and catastrophic exposures. The goal is to have a comprehensive coverage whereas Basel II aims at working on select risks. The canvas for Solvency II, hence, is much wider and more challenging. It also should be more comprehensive from the perspective of capital adequacy because of the inclusion of a wider range of exposures.

* Solvency II adopts a "ramp" approach rather than a "step" approach. The capital requirements are defined in two levels. Solvency Capital Requirement is the target point, but a Minimum Capital Requirement is defined as well. This allows the regulator and the players to operate over a "ramp" rather than move down a "step" at the tip point. This proactive approach handles difficult situations before they move to a crisis stage. The objective is to "manage" the capital needs well, rather than identifying tipping points which could be too late for effective remedial action. The "ramp" approach also helps in systematic escalation to different levels--from internal action to regulatory intervention.

* Basel II gives local supervisors the flexibility to build capital requirements on top of pillar I minimum. Solvency II aims at having a more comprehensive set of pillar I rules and thus a higher level of harmonization.

* Unlike the banking sector, insurance industry risks are more susceptible to short period variations. This has made the approach to defining the calibration levels different. Basel II looks at a level of 8% of risk-weighted assets as capital requirement, whereas Solvency II has the goal of directly correlating capital requirement to the probability of insolvency. This is certainly a more practical approach in the insurance scenario.

* One of the areas where there is a fundamental difference between banking and insurance is where company liabilities are estimated. Bankers use mostly standard conventions to determine the exposure. However, best estimates are unavoidable in several insurance liability calculations--most of the claim-related reserves are examples for such estimates.

* The risk management tools available and deployed in the insurance and banking industry are very different. For example, insurers use reinsurance to spread risk and to reduce the impact of catastrophic losses. Such mechanisms are not in vogue in the banking industry.

Basel II Experience

The lessons learned from implementing Basel II provide interesting and useful pointers for a smoother passage to Solvency II.

Basel II has provided the environment for banks to think about enterprise-level risk management. The regulations provided the much needed impetus for companies to work toward ERM. Solvency II should bring about a similar effect in the insurance industry. This would mean a fundamental shift in the approach to risk management.

One of the biggest challenges faced by the banking industry during Basel II implementation was handling of data. Many organizations struggled with identification, collection and management of data. Pillar I is purely data-driven. The success of the implementation depends on the quality and consistency of the data that could be obtained. The mix of various types of data and a host of different sources makes collection and validation a tall order.

The changes in data management trigger changes in the information technology systems. The banking industry made substantial investments in data management and quality control to lay the foundation of an enterprise level data management infrastructure.

Time to Act

A quick comparison between the current status of organizations and their being Solvency II compliant indicates there is a long way to go for most of the traditional insurance carriers. The longer the company has been established, the more difficult the implementation would be because of disparate systems, unintegrated processes, quality of data and multiplicity of sources.

With the current expectation of Solvency II's implementation in a 2009-to-2010 timeframe, there is not much time left for European insurers to commence their preparations.

There are many finer elements to be ironed out in the Solvency II framework before it is rolled out. However, the direction is well set and accepted. At an operations level, the data and information management should scale up to meet the risk-based capital supervision requirements. At a strategic level, it is imperative for the European insurers to prepare to change their risk management strategy to one that operates at an enterprise level, to be compliant in due course. Learning from the experiences of Basel II would be a great advantage for Solvency II implementation.

Key Points

* In order to create a solvency regulation framework that is more tuned to the insurers risk exposures, the European Commission has put together Solvency II--a risk-based approach to solvency regulations.

* The Basel II framework has been a strong influence in development of Solvency II.

* Solvency II has the goal of directly correlating capital requirement to the probability of insolvency.

Contributor S. R. Warrier is an associate vice president with the Domain Competency Group of Infosys Technologies Ltd. He can be reached at [e-mail]

Basel II--Solvency II-The Three Pillars
Pillars

Pillars        Base II                      Solvency II

Minimum        Based on consistent          Setting up minimum
Capital        approach to similar          capital requirements
Requirements   risks across the             on a risk-based
               organization-credit,         approach. Insurers can
               market, operational          use internal models.
               risks. Internal models
               can be used.

Supervisory    Supervisory review of        Supervisory assesment
Review         bank's risk management       of the risk management
               policies and processes       of insurance companies
               for determining capital      and determination of
               adequacy.                    capital adequacy.

Market         This is based on the         Under this pillar all
Discipline     need to keep market          the processes and
               participants                 measures for risk
               informed--aimed at higher    assessment and
               transparency.                management should be
                                            transparent.