The Commercial Benefit of Solvency II

Companies that take a positive view of Solvency II are already seeing the commercial benefit; the rest are losing out, says Andrew McGuinness of EMB. This article first appeared in the Review publication.
Solvency II faces many challenges in the coming year to remain on course for implementation in 2010. Some of the tasks are highly technical, such as evaluation of the results of the second Qualitative Impact Assessment Study (QIS 2): an essential step in making the reforms workable. Then there is the continuing debate over the principles-based approach embedded in Solvency II. Although the largest international (re)insurers fully support it, some companies and national regulators would prefer to retain an element of rules-based regulation. This attitude is prevalent in, but by no means confined to, some central and eastern European states.

In this article, we will concentrate on another type of challenge for the many medium-sized firms throughout Europe that have fallen behind: how to catch up? This question is first and foremost about being competitive, not about complying with the rules. Solvency II is one of those all too rare cases where new regulations can actually improve your business – but only if you adopt them in a whole-hearted manner. The process and disciplines will benefit those firms that embrace them, leaving the rest at a competitive disadvantage.

Our own analysis and experience indicate that the middle market is most at risk: often medium-sized (re)insurers with international aspirations or companies with a big market share in just one or two home territories. For these companies, maintaining a competitive edge is vital, but sadly they often regard Solvency II and the shift towards Enterprise Risk Management (ERM) as a regulatory chore. By contrast, their larger rivals regard ERM as best practice and a means to become more capital-efficient and more profitable.

One reason for this difference in attitude is that the largest companies have more resources and greater levels of in-house expertise. Their smaller competitors are intimidated by the apparent technical complexity of Solvency II. To quote one insurance executive at a recent seminar in central Europe: “There are companies who are still struggling with the Solvency I regime. They simply do not have the capacity to conform with Solvency II”.

In fact, ERM is simpler and cheaper than many people think, more of which later. First, though, let’s take a closer look at the advantages of ERM.

The principle is very simple: if you have a precise understanding of the risks inherent in your business you can address them accurately, allocating resources in a targeted way without wasting capital.

Apart from supporting efforts to make companies more financially secure, this type of exercise assists with a range of core strategic functions. These include:
• Reinsurance/retrocession purchase;
• Capital allocation;
• Product and pricing strategy;
• Business expansion;
• Mergers and acquisitions;
• Investment strategy;
• Maintaining adequate ratings;
• Alternative Risk Transfer mechanisms.

Although ERM is a wide-ranging management exercise, it normally involves the creation of financial models using simulation techniques; this is often the most technically demanding part of the exercise. In simple terms, these models enable you to simulate a large number of possible scenarios and then assess the financial consequences for your business. As the two case histories in the box demonstrate, a model can be a valuable tool in arriving at a strategy that increases profitability whilst reducing risk.

When first going about the exercise, there are two useful rules: do not be too ambitious; and ensure that your model is flexible enough to fit your company. In our experience it is best to start with a small, self-contained project. You can extend its scope once you have gained confidence.

Financial modelling has taken off in recent years, particularly in the UK with the advent of the ICAs regime. It is no longer as time consuming and expensive as it once was, as the market has developed ideas of best practice and the experiences of others can be drawn upon. As with so many other new ideas in insurance, a concept that was once cutting edge and shrouded in mystery has become relatively commonplace. There are now a number of powerful and effective software products to remove much of the time involved, as well as the scope for human error.

Above all, financial modelling is a tool that creates competitive advantage. In today’s cutthroat environment it can make the difference between success and failure. And, in the process, it will make it much easier to comply with Solvency II.

STRATEGIC USES FOR SOLVENCY II MODELLING
This simplified version of a real case history illustrates how financial modelling required under Solvency II should bring wider benefits to any insurance company.

A personal lines insurer with approximately two million motor and two million household policyholders models its risk profile. The exercise will help management make decisions about capital allocation, product pricing and volumes, investment strategy and reinsurance purchase. Annual premium is €1200 million for Motor and €270 million for Household.

The company concentrates on three types of business-critical risk:
• Reserve risk (i.e. the danger of under-reserving);
• Asset risk (including stock market volatility, bonds and broker solvency);
• Insurance risk (including underwriting and reinsurer credit risk).

The analysis produces a number of insights into what was driving the business. The equity strategy (15% equities, 15% cash, 35% gilts, 35% corporate bonds) is unduly conservative. A modest increase in the equity holding would significantly boost long-term returns with only a marginal effect on asset risk.

Reinsurance purchase places undue emphasis on the Motor book when the main potential for volatility lies with Household. Despite reinsurance protection, the company has underestimated its vulnerability to catastrophes, especially beyond a one-in-hundred-year event.

The Household book, being the more capital-intensive, is found to be overweight. By making a suitable adjustment it would be possible to reduce the overall capital requirement, whilst at the same time increasing the expected returns and probability of meeting the target returns.

In response to this information, the company makes the following decisions:
• A 5% increase in equity investments;
• Increased Excess of Loss reinsurance purchase for Household, but less Motor reinsurance.
• Implement a strategy to effect a target 10% increase in Motor premium income and a corresponding reduction in Household;

The combined effect is to make it possible to withstand a one in 200-year event in accordance with likely Solvency II requirements. In addition, the insurer is able to increase its expected profit and the probability of meeting its target return, whilst reducing its overall capital requirements.

REINSURANCE PURCHASE
A key part of Solvency II is to quantify, normally through the use of financial models, all the risks inherent in the business

This graph shows an example of how the smart reinsurance buyer, armed with an internal model and optimisation software, can purchase their cover in order to make optimal use of their capital.

Tied up in this exercise is a calculation of the technical price of the reinsurance contract, which the smart buyer is certain to use in assessing the potential value for money of reinsurance they are offered.