By José Kuizinga-van Burik,
senior business consultant
Given the combination of investments required to become Solvency II-compliant and the associated time pressure, the obvious short-term approach would be to focus exclusively on compliance. But in a wider perspective Solvency II also offers many opportunities for value creation.
From 2012 Solvency II, the new European insurer solvency framework, will be implemented. Given the combination of investments required to become Solvency II-compliant and the associated time pressure, the obvious short-term approach would be to focus exclusively on compliance. But in a wider perspective Solvency II also offers opportunities for value creation.
As of late 2012 the new European Solvency II regulations enter into force. Stimulating improved risk management within the insurance sector and better client protection are two of the most important goals of these regulations. In essence what it comes down to is that insurers be demonstrably more in control of their own business.
Insurers establishing accepted proprietary models based on demonstrably solid risk management may gain a direct competitive advantage as their capital charge will be more realistic than those based on the so-called European Standard Formula. This capital charge is arrived at through realistic risk calculation based on knowledge of internal operations and proprietary risks.
Insurance companies that fail to comply with the new regulations run the risk (at least in theory) of losing their license temporarily or permanently, with all that entails. However, for insurers it is certainly attractive to enhance internal operations in synergy with becoming compliant. Improvements in risk management, information management and internal control may yield significant competitive advantages. In this connection, Committee of European Insurance and Occupational Pensions chairman Thomas Steffen stated: “Solvency is not just about capital. It is a change of behaviour.”
Solvency II regulations
The regulations aim at protecting the European policyholder by stimulating proper risk management by insurers. Solvency II regulations comprise three pillars.
• The first pillar pertains to quantitative requirements; calculation of the risk capital according to the Standard Formula (partially) based on proprietary models.
• The second pillar concerns qualitative requirements, i.e. the internal organization of the insurer. This is all about managing risks in business processes and developing and maintaining models.
• The third pillar covers transparency: reporting to supervisors and the market.
Solvency II requires that insurers’ extensive information management is demonstrably in order and that risk processes and models are embedded throughout the organization. Given the detailed information requirements of Solvency II, becoming compliant will generally require adjusting current information management systems and processes. By critically reviewing and adjusting the entire information management structure – rather than merely the required sections – it will enable more informed decisions in future. Indeed, more reliable corporate data improves knowledge of the organization and enhances the understanding of risks, value (valuation of assets and liabilities based on Market Consistent Embedded Value (MCEV)), opportunities and requirements.
Reliable corporate data will lead to better-founded short- and long-term decisions and will therefore have a positive effect on the organization’s strategic position. The advantages are further explored below.
The regulation offers two options for the calculation of risks incurred by an insurer. Either the Standard Formula or proprietary models may be used. It is up to each insurer itself to decide which method it prefers. Internal models are developed on the basis of an in-depth knowledge of the insurer’s operations and risks. This may very well lead to a lower capital charge than in the case of the Standard Formula’s relatively high, conservative requirements.
For the development of proprietary models (which are currently not yet available in most cases), extensive and unambiguous data is needed among other regarding clients, in order to determine their risk profile and predict their behaviour. But also pertaining to product groups, for instance, with respect to the calculation of risk (-reward ratios) and profitability. Representative and reliable risk models are not only relevant for Solvency II regulations but virtually indispensable for a healthy business. In order to actually achieve an advantage from the increased insight, models should be optimized regularly and specific business knowledge gained should be put to use within the organization.
At a strategic level, extensive knowledge is important for adequately assessing opportunities and making decisions, including decisions regarding operations, investments and business portfolio management. In addition, the increased insight gained from improved information management could be employed for the optimization of internal procedures. The calculations may be good input for Value Based Management (VBM) and Risk Based Pricing. This allows for tailor-made pricing for individual policyholders.
Proper business insight requires models with adequate data analysis features. Our advice therefore would be to embrace risk reporting as a source of management information.
The aforementioned measures all serve – directly or indirectly – to secure the company’s financial position now and in the future. Given the considerable importance of the financial component we now add a number of specific items.
A significant change from Solvency I lies in the valuation of assets and liabilities. While assets and liabilities were previously valued at book value, under Solvency II fair value is applied. As under IFRS, market value is applied: MCEV. Especially since Solvency II comprises demands in the reporting domain, financial transparency to the market is expected to improve significantly.
When the implementation of Solvency II is combined with the introduction of IFRS Guidelines and the use of rating agencies’ risk models, financial management could be hugely improved. This way not only risk management would be improved, but financial resources could also be deployed optimally.
If, in addition, a lower capital charge is allowed based on proprietary models, more financial resources are available for investments and other business. By optimally applying corporate data for the creation of insight in risks and opportunities, well-founded decisions can be made and financial resources can be deployed where they add the most value and yield the highest returns. Evidently, this would be of benefit to the business in the short and long term.
Consumer confidence is of great importance to market development. As a result of recent developments in the financial sector—like the credit crunch, bank collapses, and insurance policy scandals—consumer confidence is currently particularly low. For the sector as a whole, as well as for individual companies, it is therefore hugely important to work consciously on regaining clients’ trust. “Trust is our greatest ambition. Rarely has the client taken such a prominent place on the agenda. This in itself says enough.”(1)
Regaining trust will require time, investments and renewal. Introducing Solvency II can certainly contribute not only by demonstrating timely compliance with new regulations, but by emphasizing why and what the benefits are for both the client and the company. As cited, the primary goal of the new regulations is protection of the policyholder. This is where the focus should be, rather than mere compliance; compliance with Solvency II is a means to protect the client.
It is important to realize that ultimately clients are the business drivers; clients are the justification of a company’s existence. Hence it is all the more important that the knowledge and insights gained are applied to customer-oriented developments, for instance in the area of product development. Furthermore, better knowledge of the client population enables tailored communication, i.e. making offers the client is actually interested in. This improves service to the customer as well as the efficiency of marketing efforts.
Besides, policyholders demand (financial) transparency, both at policy and company level. At company level insurers should therefore inform the market through comprehensible reports, according to reporting requirements yet to be established by CEIOPS.
Obviously, the first concern now is “comply or die.” And given the size of additional investments – which as usual run ahead of the returns – not all companies will have the luxury to opt for optimal use of Solvency II. Insurers currently unable to gain in-depth knowledge of and insight into their own business should be well aware that it may take a rather long time before they are able to make up arrears vis-à-vis the competition, or even rise to a strategic competitive position. By the time insurers become aware of this undesirable situation, it will be even more difficult to place the issue on their strategic agendas because at that point the pressure of compliance no longer applies.
In short, when looking at Solvency II regulations from a wider perspective than sheer compliance, there are plenty of strategic advantages to be gained. These advantages range from insight into risks, products and client profiles to enhanced operations and better customer service. Thus the financial position is strengthened while at the same time policyholders are offered optimal service. This then leads to restored consumer confidence in the insurer which in turn enjoys an enhanced competitive position. The insurer that first manages to optimize its information management and integrally apply the knowledge gained throughout its business may benefit from the additional “first mover advantage.” This insurer will reap the maximum benefits from the implementation of the new Solvency II regulations.
(1) Statements made by Willem van Duin at the General Assembly of the Dutch Association of Insurers. Van Duin is chairman of the Board at Eureko/Achmea and chairman of the Dutch Association of Insurers.