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The next stage: Solvency II, the fifth Quantitative Impact Study results and implications for U.S. insurers.

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The global solvency environment is about to undergo major changes, moving toward a more principles-based approach with incentives for sound risk management.

In Europe, Solvency II will be the new reference regulatory framework from 2014 onward that will provide a risk-, economic- and principles-based framework for the supervision of European reinsurers.

There is a growing recognition that data and technology are on the critical path for Solvency II development--and that the greater the risk management ambition, the greater the challenge. Despite the initial difficulties in adapting to this new regime, complying with Solvency II also provides incentives for sound risk management practices and enhanced transparency.

In conjunction with the proposed changes to global solvency standards by the International Association of Insurance Supervisors, the effects of Solvency II will be felt worldwide as external disclosure of economic capital and risk-adjusted performance become more common and stakeholders around the globe, particularly those in the United States, will be requiring enhanced financial risk disclosure.

In this context, U.S. companies should start benchmarking their current risk management framework with leading European practices and enhancing their communications to stakeholders to offer more financial risk disclosure. Solvency II could also impact the geographic flow of capital and create opportunities for U.S. insurers by assisting European companies in the improvement of their solvency capital requirement through reinsurance solutions to mitigate certain risks.

Therefore, Solvency II could have implications with regard to the competitiveness of domestic U.S. reinsurance companies, and it should not be viewed as a regulatory framework affecting only European companies.

In fact, stakeholders would want to assess their capital and risk management and compare it to that of insurance companies across the globe. Solvency II public disclosure will include business overview and performance, the bases and methods used for the valuation of assets and liability together with an explanation of any major differences with other financial statements. In addition, a description of the system of governance and an assessment of its adequacy for the risk profile of the insurer should be provided. Risk disclosure will include a description of the risk exposure, risk mitigation and sensitivity as well as a detailed description of the management of capital.

The completion of the fifth Quantitative Impact Study by the European Insurance and Occupational Pensions Authority in March 2011 marked a major milestone in the full implementation of Solvency II. The purpose of QIS5 was to test the practicability, implications and impact of Solvency II on the financial aspect of reinsurers subject to Solvency II. Almost 70% of the European insurance industry participated in the study, making it the most comprehensive test of Solvency II proposals to date. The results (which apply to insurance balance sheets at the end of 2009) indicate a reduction of surplus of 56 billion [euro] (US$81 billion) compared to the current Solvency I regime.

The study shows that 15% of European participants could not cover their SCR and would prompt regulator action. Five percent of the participants could not cover their minimum capital requirement and would trigger major regulatory intervention.

In addition, there are many areas about which firms have expressed their own concerns, ranging from the type of method to the calibration or the simple practicality of performing the calculations.

Major highlights included:

Overall financial impact. There was a decrease in the level of surplus (in excess of capital) overall. This is the combined impact of an average increase in the level of own funds compared to Solvency I; a decrease in technical provisions; and, depending on the current local accounting regime, an increase in value of assets, as well as an overall increase in capital requirements.

On average, the solvency ratio (ratio of the eligible own funds to the capital requirements) changed from 310% under the current regime to 466% under the MCR and 165% under the SCR.

Valuation of assets. There was a wide variety in the treatment of deferred taxes and affiliates, as well as difficulty in determining the valuation of intangibles. QIS5 showed that in those countries where a market-consistent valuation of assets existed for international accounting standards requirements, little difficulty was experienced in the valuation principles as specified under QIS5.

Technical provisions. An overall decrease of 1.4% in net technical provisions was observed for all lines of business. Key issues included broad use of simplifications in the risk-margin calculation; lack of clarity in the definition of contract boundaries; inconsistent application of the illiquidity premium buckets; and limited value from detailed segmentation by line of business for life companies.

Minimum capital requirement and solvency capital requirement. Main risk drivers were market risks--equity, spread and interest rates--followed by nonlife underwriting risks.

Internal models. Groups' internal model results showed a capital requirement of about 80% of the size of the capital requirement based on the standard formula calculation.

Overall, 234 companies (including solo entities and 29 groups), or approximately 10%, provided SCR results using an internal model.

Own funds. Ninety-two percent of own funds were classified as Tier 1 capital. The average contribution from Expected Profits in Future Premiums to the own funds amounted to 20% of Tier 1 and, in some cases, EPIFP contributed 50% or more of the own funds.

Groups. Areas where groups have encountered major difficulties relate to the valuation and absorbing effects of deferred taxes and future discretionary benefits at group level, the treatment of ring-fenced funds and intragroup transactions.

European Feedback

Following the publication of the QIS5 report, leading representative groups of the European insurance industry issued a letter to the European Commission to highlight the objectives of Solvency II in terms of an economic and risk-based approach.

They identified key outstanding issues that must be addressed, such as the full recognition of the value of in-force portfolio and the deferred tax assets as Tier 1 capital. In addition, they stressed the need for a more-balanced calibration of certain key risks, less pro-cyclicality in the Solvency II framework and a need to address unnecessary complexity.

Finally, the representative groups stated their support of maintaining the Solvency II implementation date of January 1, 2013. However, due to concerns over the preparations from some of the member states, this will likely be further delayed to Jan. 1, 2014.

Status of U.S. Regulations

In 2008, the National Association of Insurance Commissioners formed the Solvency Modernization Initiative task force, whose primary mandate is to work through a critical serf-examination to update the insurance solvency regulation framework in the United States.

This includes a review of international developments regarding insurance supervision, banking supervision and international accounting standards and their potential use in U.S. insurance regulation.

The SMI's main objectives are to enhance the insurance regulatory environment in the United States in the areas of capital requirements, governance and risk management, group supervision, statutory accounting and financial reporting and reinsurance.

As the NAIC works through its SMI process, a key area of focus is the Solvency II Pillar II component of the framework. The NAIC has begun developing a U.S. Own Risk and Solvency Assessment to address the insurance core principles of the IAIS and to explore companies' and/or groups' risk management processes.

This also includes a prospective look at solvency and companies' ability to withstand stresses.

The ORSA proposal was released as an exposure draft in February 2011. In addition, the SMI will have an important bearing on the matter of equivalence.

The question of Solvency II equivalence will have a significant impact on the broader U.S. insurance industry and will result in a number of implications for insurers operating in the United States--particularly with regard to product pricing, capital requirements, group structuring and reinsurance business.

Solvency II is a system designed to create incentives for sound risk management; hence, many European companies are working toward building strong risk management standards.

U.S. insurance companies should benefit from these best practices by benchmarking themselves against their European peers; strengthening their risk management capabilities; creating sustainable products; and remaining competitive in the global marketplace.

The implementation of Solvency II has raised a number of challenges for European insurers, such as the availability, granularity and quality of data. In the United States, insurers should review the proposed ORSA and conduct a diagnostic to evaluate their readiness and risk management practices in relation to emerging leading practices.

Glossary of Terms

Technical provision. The value that is equal to the stun of the best estimate and the risk margin.

Best estimate. The probability weighted average of future cash-flows, taking into account of the time value of money using a specified risk-free interest rate term structure.

Risk margin. The cost of providing an amount of eligible own funds equal to the solvency capital requirement necessary to support the reinsurance obligations over the lifetime thereof.

Own funds. The basic own fund and the ancillary own funds.

Basic own funds. The excess of assets over liabilities plus any subordinated liabilities.

Ancillary own funds. Items other than basic own funds which can be called up to absorb losses, such as unpaid share capital or initial fund that has not been called up, letters of credit and guarantees, and any other legally binding commitments received by the reinsurance company.

Tiers. Classifications for own fund items; the classification of 1, 2 and 3 depend on to what extent the item is available, or can be called up on demand, to fully absorb losses on a going-concern basis, as well as in the case of winding-up (permanent availability). Tier 1 capital is the highest valued form of capital.

Minimum capital requirement. A calculation combining a linear formula with a floor of 25% and a cap of 45% of the SCR (whether calculated using the standard formula or an internal model); the MCR is subject to an absolute floor.

Solvency capital requirement. The risk-based capital requirement under Solvency II; it is calibrated to a 99.5% Value at Risk confidence level over one year.

Internal model. Companies have the option to use partial and full internal models (subject to supervisory approval) to calculate the capital requirement, instead of applying the standard formula.

Key points

* The Situation: The completion of the fifth Quantitative Impact Study by the European Insurance and Occupational Pensions Authority in March marked a major milestone in the full implementation of Solvency II.

* What it Means: The question of Solvency II equivalence will have a significant impact on the broader U.S. insurance industry and will result in a number of implications for insurers operating in the United States.

* Watch For: In the United States, insurers should review the proposed Own Risk and Solvency Assessment and evaluate their readiness and risk management practices in relation to emerging leading practices.

Contributors: Rich de Haan is a principal, Zak Benjazia is an executive and Kush Kotecha is an executive with Ernst & Young's Insurance and Actuarial Advisory Services. They may be reached at rich. dehaan@ey.com
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Title Annotation:Regulatory/Law: Solvency II
Author:de Haan, Rich; Benjazia, Zak; Kotecha, Kush
Publication:Best's Review
Date:Oct 1, 2011
Words:1817
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