With just under 15 months from the implementation of the new, European Union-wide insurance regulatory regime Solvency II on 1 January 2016, many firms, large and small, still have much to do to be ready.
In fact, in our experience, the smaller firms are much further behind in their implementation timetable than medium-sized or large firms. Many decided to put their Solvency II projects on hold during 2013, and even though it became clear in November 2013 that the implementation date would be January 2016, many have taken a long time to get their Solvency II projects out of mothballs and reactivated.
Information is coming out from Eiopa and the PRA in regular intervals now, and there are a multitude of conferences and seminars designed to inform and educate. The problem, however, for many small firms is lack of resource. The larger and medium-sized firms generally have teams of actuaries, risk experts, accountants, IT resources and others to work on project teams looking at the various strands of Solvency II. For small firms, however, multiple functions are often held by a few individuals and to expect these small teams to keep fully up-to-date with the legislation, delegated acts, implementing technical standards, regulatory technical standards, guidelines, consultation papers and literature from advisory firms is asking a lot.
The chart below shows the main elements of the various pillars of Solvency II. Although the three pillars can be separated into quantification, governance and disclosure, there are many overlaps, and it is much better for a firm to consider its Solvency II project as a whole rather than separating it into the pillars. For example, the disclosure and reporting requirements in pillar 3 rely on the quantification work in pillar 1 and the risk management, assurance and governance elements of pillar 2.
The chart below shows a brief timetable from a legislative point of view with level 1, level 2 and level 3 measures still being published throughout 2014 and 2015.
There is much for the smaller firm to still grapple with. Most will have opted to use standard formulae to calculate their solvency capital requirement (SCR) and minimum capital requirement (MCR). Although this is a much simpler and much less onerous approach than using an approved Internal Model there is still much to be done to put the processes and functionality in place to be able to calculate the SCR on a regular basis. Under pillar I there are also, still, important decisions to be taken on how to deal with long term guarantees with variations to consider of the matching adjustment, volatility adjustment and transitional measures. Further challenges include: developing economic capital models and other tools to assist with embedding risk and capital management; confirming that the standard formula approach is appropriate for the firm given its risk profile; understanding the drivers of capital requirements under standard formula risk models; enhancing existing capital models, and developing an integrated modelling capability to set risk appetite tolerance and limits.
Pillar 2 also deals with the qualitative elements and focuses on the internal control and risk management processes of the company and the supervision process. Firms are required to demonstrate sound operational and financial risk management practice by submitting an onerous Orsa (own risk and solvency assessment). Standard formula firms may be penalised with capital add-ons if supervisors feel that it does not reflect the actual risk profile of the business.
Some of the major challenges of implementing pillar 2 requirements include: redesigning the target operating model across risk, actuarial, finance, compliance and audit; implementing polices and procedures for Orsa; enhancing and integrating the existing control environment and developing an enterprise risk management strategy in line with Solvency II requirements and establishing a process for setting a risk appetite framework.
Pillar 3 requires firms to provide information necessary for effective supervision and effective market disclosure and transparency in respect of their solvency and financial condition. Both of these requirements will test the effectiveness and capability of firms to report and disclose timely and accurate financial, risk and governance information to supervisors and public stakeholders.
The major challenges include: understanding the disclosure requirements for quarterly and annual reporting; implementing a process to source all the required asset data; educating key stakeholders on the potential impacts, and developing a strategy for disclosure; designing the reports to be disclosed to regulators, analysts and any other interested bodies; developing the processes and systems to produce the reports to agreed standards both internally and externally; and designing and maintaining an effective data management system to allow all information to be calculated in a timely manner.
One of the most important elements of Solvency II for the smaller firms to focus on is the Orsa. There are three main components of the Orsa.
• The Orsa policy defines what the business should do to perform the Orsa process. This will be used by the business to provide guidelines to perform the process.
• The Orsa process sets out how the firm will assess its capital requirements and demonstrates how these are linked to the risk assessment and decision-making processes.
• The Orsa report ‘tells the story’ of the firm’s current risk and capital management practices. It demonstrates that the firm has the necessary available level of capital to sustain significant negative impacts now and in the future, and should help to shape the firm’s business plan.
The Orsa represents a continuous process which:
• starts with the business strategy;
• captures and quantifies all material risks in the business strategy, ultimately dictating the firm’s risk appetite;
• subjects potential business plans to stress and scenario tests;
• determines the economic capital required to support business plans;
• compares economic capital with regulatory capital requirements and available capital;
• integrates the projection of overall solvency needs into the business planning process and projected profits; and
• produces a clear plan for continuous compliance with capital requirements.
The reason why the Orsa is so important is that it is a key way to assess the current operation of risk management and (carefully) integrate developments in risk and capital modelling into business decision-making. It provides one system for processing information relating to key risk and strategic aspects of the business.
It will lead to improved management information:
• detailed balance sheets and projections;
• risk capital by class or line of business;
• profit and loss estimation;
• cashflow projections; and
• identification of key risk indicators (KRIs) by risk category.
Better risk and capital information should mean better risk and capital decision-making, and provide comfort to the board on the level of capital required now and in the future. The Orsa provides an analysis of risk profile and gives an indication of exposure against risk appetite, tolerance and limits.
The Orsa also provides evidence of compliance with corporate governance procedures and will provide comfort to the regulators who will use the Orsa in their supervisory review process.
There is much for smaller firms to grapple with over the coming months, and the cost of implementing Solvency II will be a burden. However, if the risk culture that Solvency II seeks to embed in firms is embraced then it will lead boards and decision makers in firms to be better informed about the key risks and financial consequences of their decisions.
Peter Gatenby is a partner of Mazars
