Solvency II and capital adequacy for insurers

Feature | 18 June 2012
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PAUL TRAYNOR suggests insurers can prepare for the impending Solvency II requirements 
by partnering with an investment servicing company
 

The challenge facing banks as they have to adapt to new regulations such as the Basel accords has been well documented in TFR and the general financial press. However, the insurance sector is facing its own upheavals in the form of Solvency II – or what is increasingly referred to as ‘the insurers’ Basel III’. As with any legislation, anticipation and preparation are vital for a smooth transition to the new regulatory environment.
 

But the impact of the European Union’s (EU) upcoming insurance directive – designed to increase the capital requirements of insurance firms in order to mitigate risk and bolster protection for policyholders – will be felt far beyond its obligatory operational changes (although these will be substantial). Cash management issues will be felt acutely as insurers seek to balance seamless compliance with successful cash optimisation in a tough environment of continuing low interest rates and high volatility.
 

‘The insurance industry’s Basel III’
Scheduled to come into force throughout the European Union on 1 January 2014, the new solvency regime for insurers, reinsurers and the insurance arm of ‘bancassurers’ (banks issuing insurance) will provide incentives, most likely via reduced capital requirements, for firms to install both appropriate risk management systems and robust internal controls. Alongside enhanced disclosure requirements and a new risk-based capital regime, the directive aims to deliver a supervisory system that is consistent across all member states of the EU, harmonising the risk mitigation efforts of the European marketplace as a whole. Full details of the requirements can be viewed at www.fsa.gov.uk/solvency2 and the core definition is set out in Figure 1.


Figure 1: Solvency II facts

Why is it needed?

Solvency I was a minimum harmonisation directive introduced in the early 1970s. It allowed for differences to emerge in the way that insurance regulation was applied across Europe, leading to different regimes. It was also primarily focused on the capital adequacy for insurers and did not include requirements for risk management and governance within firms. Solvency II aims to achieve consistency across Europe and includes the following key ideas:
  • market consistent balance sheets;
  • risk-based capital;
  •  own risk and solvency assessment (ORSA);
  • senior management accountability; and
  • supervisory assessment
  • Who does it apply to?
The new regime will apply to all insurance firms with gross premium income exceeding EUR5m (US$ 6.3m) or gross technical provisions in excess of EUR25m (US$31.8). Some insurance firms will be out of scope depending on the amount of premiums they write, the value of technical provision or the type of business written. Solvency II principles and rules apply to Lloyd’s of London syndicates in full.

Based around quantitative capital requirements (including the Solvency Capital Requirement or ‘SCR’), a qualitative supervisory review, and increased market discipline – together known as the ‘three pillars’ – the regulation has been structured to simplify the route to compliance. But no matter what the framework, it is clear that the insurance sector is facing its greatest regulatory change in 30 years.

A new regime
 

Certainly, the challenge faced by insurance firms in achieving the obligatory operational improvements is considerable. The direct changes alone will encompass new capital requirements, capital tiering, risk weighting, capital charging of assets, asset de-risking, faster data analysis, improved information transparency and greater reporting efficiency.
 

It should therefore come as no surprise that achieving the necessary robust improvements will require significant investment. For example, and most immediately, there will be the need to provide faster data analysis across all asset valuations – a requirement that, alone, will substantially increase the burden on internal data storage capacities.
 

Keeping control of cash
 

Yet, the impact of Solvency II will extend much further than the initial effort of compliance. In fact, it is the less obvious but equally significant effect of the regulatory changes on cash management that merits equal attention.
 

Once the regulation has been implemented, cash will no longer be as simple nor regarded as the relatively risk-free asset it has previously been. Indeed, the directive will require insurers to develop a capital assessment of cash as an asset class in its own right.
 

In fact all investment choices will need to be re-evaluated. For example, firms holding short-dated paper should bear in mind that, under Solvency II, any paper dated up to 12 months will be treated as one-year paper. In addition, the legislation will most likely lead to an increase in the proportion of cash investments held by firms, whether they be in the form of deposits, money market funds (‘MMFs’), or separate accounts.
 

That said, as great as the impact of the new regulation will be, it is not the only factor necessitating increased transparency and control over the cash side of the balance sheet. Low interest rates have also played a considerable role in affecting market behaviour. For example, both liquidity swaps and repurchase (‘repo’) trades have become a more significant feature of the marketplace – not only do they enable insurers to greater exploit their low-risk assets, they also allow banks to raise long-term funds at a reasonable cost. And as the low yield environment looks set to continue, perhaps until 2015, insurers will be looking for new ways to generate greater investment performance from their existing portfolios of assets.
 

Also affecting the cash investments market is the ongoing European debt crisis and accompanying volatility. The turmoil around sovereign debt has exacerbated the decline of yield at the front end of the curve and induced many insurers to lower their sights away from long-term profit goals to focus on the more immediate need for capital preservation.
 

This spotlight on capital preservation has, in turn, increased the amount of attention being paid to counterparty risk. Not only are we seeing increased due diligence on both sides for even relatively small transactions, but – in an effort to avoid the penalties associated with having too much concentration risk with counterparties – insurers of all sizes are looking to achieve greater diversification in their cash investment strategies.
 

But what is the best diversification strategy? One solution is to spread cash not just over deposits, money market funds and separate accounts, but also across the interest rate curve as well. Certainly, in a long-term low interest rate environment, there is little benefit to be had from concentrating cash investments at the front end of the curve. But by ‘tiering’ cash into three separate pools staggered along the curve (with the first for money market funds, the second for enhanced cash or ultra short paper, and the third for one to three or one to five year paper or matched funding) additional yield can be found.
 

But, regardless of the approach taken to portfolio diversification, it is clear that greater transparency is the key to success. Not only will investment clients require a readily-available ‘look through’ into money market funds, but insurers themselves will need improved transparency if they are to achieve greater control over their cash portfolios and successfully adapt to the market’s dramatic upheavals.
 

A lot to ask
 

Undeniably, market factors such as high volatility, shrinking liquidity, low yields and increasing regulatory pressures have made it apparent that investors of all kinds should take a much more active role in their cash holdings.
 

The question for the insurance sector in particular, however, is how to achieve better cash management alongside preparations for Solvency II. In the light of both current market complexities and upcoming regulations, insurance firms may find it a struggle to combine successful compliance with investment optimisation. In preparation for Solvency II alone, insurers will need to anticipate the cost, both financial and in terms of time, of achieving compliance without detracting from both short- and long-term investment goals. Combine this with a tough investment market in general and insurers could be forgiven for feeling overwhelmed.
 

Investment servicing partners
 

One solution is to join forces with an investment servicing company. Such companies provide tools to assist insurers in, for example, achieving compliance. By making use of these tools – thereby alleviating the burden – insurance companies can gain the freedom to concentrate on their core business. Furthermore, the fact that such administrative activities constitute the core activities of investment servicing firms means that such tasks can be successfully executed with a much greater level of dedication.
 

Furthermore, a leading investment servicing firm will be able to offer a full range of services, from asset and risk management to advisory and asset servicing solutions, in the aim to anticipate and address the entire spectrum of challenges affecting the insurance market.
 

What should insurers look for in a partner? The ability to provide technological solutions that bring transparency to insurers’ treasury flows is of course key, as is the use of highly-rated entities to reduce the cost of capital. But insurance firms should also demand a reliable and well-respected asset servicing company that can offer a full range of solutions. These solutions range from deposits, separately managed accounts, money market funds (MMFs), MMF portals and access to the repo market. They should also include tools to optimise cash management on a more day-to-day basis, for example by reducing mismatches between intra-day inflows and outflows in order to minimise overdraft charges.
 

Market outlook
 

In the wait for Solvency II, and as low interest rates and high volatility levels continue, it is likely that insurers will face a tricky market for some time to come. But as firms look to balance regulatory compliance with the need for greater transparency, they should take heart from the fact there are a wide range of instruments and solutions available – more than they may have previously considered – helping ensure they are in the best possible position to ride the upheavals in the financial landscape.


 The views expressed herein are those of the author only and may not reflect the views of BNY Mellon

Paul Traynor is managing director, head of insurance services, EMEA at BNY Mellon paul.traynor@bnymellon.com

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