Cicero Policy Briefer

Issue 26, July 2008

Lessons for businesses on Solvency II

By Janne Lipponen, Manager, Solvency II Office, FSA

The FSA has supported the development of a modern EU regulatory standard for insurance from the very start of this project. Although in the UK we moved to a more risk-focused, market-consistent assessment of solvency some years ago, Solvency II is still needed to allow both the regulators and the regulated to be freed from the unhelpful limitations of Solvency I, the current EU standard. First set up over 30 years ago, it has not kept up with the developments in financial markets and financial theory, and now stands in the way of the adoption of modern methods and the spread of best practice.

The Commission Proposal, published in July 2007, contains several key elements that the FSA believes are essential for a modern solvency regime: a strong focus on risk management supported by market-consistent valuation of assets and liabilities, with the responsibility for the running of the firm on the shoulders of senior management. The Commission Proposal delivers on all these counts.

The Proposal is currently undergoing its first reading both in the Council of Ministers and the European Parliament and we hope that the parties are able to come to an agreement on the Level 1 Directive by the end of this year.

Agreement on the Level 1 text is, however, only a part of the actual development of the eventual rules that firms will have to deal with. The proposed Directive sets out the high-level principles, or philosophical foundations, to underpin the new regulatory regime. The detailed rules that are needed to actually put the new regime into operation will be developed after the adoption of the Directive, through the so-called Commission ‘implementing measures’. And after that, the supervisors are expected to work on further guidance to assist in even implementation across all the Member States.

The eventual success of the new regime is very much dependent on getting this detail right. The Commission has tasked the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), to advise it in the development of these implementing measures, and its thinking is already progressing in a number of areas. It recently published advice on the practical application of the ‘proportionality principle’ and on the supervision of groups. CEIOPS will be publishing a number of issue papers this year covering a wide range of areas, such as governance, Own Risk and Solvency Assessment, and a stock-taking report on internal models.

CEIOPS has been asked to deliver its final, fully consulted advice to the Commission by Q4 2010. This should then enable the Commission to draft and adopt the necessary implementing measures so that the new regime can be ‘switched on’ by the end of 2012 or early 2013. Our priority over the next 12 to 18 months is to work with our European colleagues in CEIOPS and with the Commission in getting the detail right.

Although it might look like there is still plenty of time to prepare for the eventual regime change, there are, in our experience, a number of lessons that can be learnt from the implementation of the Basel II rules in the Capital Requirements Directive. One of them is that the change programmes involved tend to take longer than one expected and, if left too late, can also cost more than they otherwise would have. So whether businesses are planning to use the new European Standard Formula or an internal model, the least they should be doing now is improving their understanding of the differences between our existing ICAS standards and Solvency II. In the case of internal models, a typical development cycle can take several years.

The fourth Quantitative Impact Study (QIS) is an excellent opportunity to experience first-hand what Solvency II is about from the point of view of calculations. The QIS4 technical specification is the most tangible articulation of what is likely to be required from firms, and as such it is an unrivalled chance to improve the understanding of the impact for each particular firm. Feedback from firms following QIS3 suggested that the majority discovered a potential issue particular to their business that they had not considered previously. We think QIS4 is a good way to start the Solvency II implementation project.

In order to show that we ourselves practice what we preach, we have already started to scope out our implementation timelines and plans. We will firm these up and communicate them to the industry as we develop them. It is worth keeping in mind that Solvency II is still a moving target, with final rules expected to be in the rulebooks only in 2011. But knowing how long it will take for firms to adapt, we want to give as much warning as possible about the likely direction of the rules.

Open dialogue with industry will be key to ensuring a smooth transition from ICAS to Solvency II. Our next step is to publish a Discussion Paper later this year which will outline initial thoughts on areas such as systems of governance, reporting, internal models and standard formula, based on the Directive Proposal. The Discussion Paper will include suggestions as to what we think businesses might consider doing over the next 12 to 18 months to prepare for implementation. Although ICAS and Solvency II have some similarities, they are not the same, and there are differences that businesses will need to understand and prepare for. Of course, we also welcome feedback as to what the industry would find particularly helpful from us to aid its preparations.

Janne Lipponen is a manager in the Solvency II Office of the FSA and can be contacted here.