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A perspective on Solvency II


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Solvency II was introduced with a view to protect policyholders by setting stronger requirements for processes like capital adequacy, risk management and governance. This has far-reaching implications for insurers in the European Union (EU) in terms of the models they employ for capital calculation, setting and streamlining supervisory processes, as well as keeping abreast with reporting requirements.

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A perspective on Solvency II

  1. 1. White Paper A Perspective on Solvency II - Divya Prakash, Kaza Sree, Malini Pandi, Amit Khullar Business and Technology Impact on the Insurance Industry Solvency II was introduced with a view to protect policyholders by setting stronger requirements for capital adequacy, risk management and governance processes. This has far-reaching implications for European Union (EU) insurers in terms of capital calculation models, setting and streamlining supervisory processes as well as keeping abreast with the reporting requirements. With the deadline for implementing Solvency II at the horizon, insurers need to take stock of the situation and come up with a sound implementation plan. Infosys believes that technology can be a key strategic enabler for not only providing tactical solutions; but also helping insurers revamp their entire risk infrastructure.
  2. 2. Introduction A European Union (EU) directive, Solvency II seeks to codify and harmonize insurance regulations across the 27 member states, including the UK. The directive provides guidelines on solvency capital calculations based upon standard as well as internal models. However the directive is not limited to solvency capital calculations but also encompasses and stresses on internal governance, the risk management framework and reporting protocols.Key Objectives of Solvency IISolvency I was introduced in early 1970s with a view to facilitate the development of a single insurance market across Europe. It wasprimarily focused on prudential standards of the insurers and did not include requirements for risk management and governance. Incontrast, Solvency II has a much wider scope as it introduces a comprehensive risk management framework for defining required capitallevels and implementing procedures to identify, measure, and manage risk levels. The key objectives of Solvency II are: • Upholding Consumer Protection: Protect the interests of the most vulnerable stakeholders in the insurance ecosystem, which are the policy holders. Solvency II will ensure uniform policyholder protection polices across the EU. • Heightened Supervision: It has been observed that the recent corporate failures have been a product of poor risk management and governance, rather than insufficient capital to back the firm. Hence, Solvency II stresses on increased supervision and better risk management processes. • Single Reporting Template: Standard quantitative reporting templates will be replacing a majority of the existing templates. This will significantly reduce the reporting burden by eliminating 27 different reporting frameworks. • Prudent Person Principle: This will help insurers widen the scope of their investment portfolios. The Prudent Person principle introduced in Solvency II, removes restrictions on the asset types that an insurer can invest in. This freedom is balanced by the higher scrutiny of the investment portfolios. • Reduced Ad Hoc Reporting: Detailed reporting on a more regular basis as stipulated by Solvency II will reduce the number of ad hoc report requests and the associated costs. 27th July, 2011 Amendments to transitional measures, illiquidity premiums, 3rd country equivalence and reporting requirements recommended 1st March, 2012 Regulatory technical standards laid down for calculation of Solvency Capital Requirements (SCR*), Minimum Capital Requirements (MCR**) & internal models 1st June, 2012 Complete the implementation phase for technical standards 1st July 2012 Complete the implementation of remaining standards such as information delivery to supervisors 1st Jan, 2013 Supervisory review of funds classifications, ancillary own funds, full or partial internal models and calculation method of group solvency 1st July, 2013 Insurers expected to start calculating SCR, MCR and be compliant with Article 35 1st Jan, 2014 Full implementation of Solvency II 1st Jan, 2016 Last date when member states can allow insurers to comply with certain phase-in elements of Solvency II (e.g. compliance with SCR, provided their balance sheet is less than EUR 500 billion)* SCR - Is calculated by aggregating the impact of an array of stress tests categorized by type or risk, called ‘risk modules’** MCR - Is considered to be a level below which the company will not be permitted to operate. It shall neither fall below 25 % nor exceed 45 % of the undertaking’sSolvency Capital Requirement02 | Infosys
  3. 3. Solvency II FrameworkThe Solvency II framework rests on three foundational pillars, which have been elaborated in the following table. These pillars have beenpostulated with a view to establish a sound risk infrastructure covering aspects such as risk profile authorization, corporate governance,supervisory reporting, market disclosures and solvency soundness. Pillars Salient Features Description Capital • Sound Financial • Regulators would expect insurers to have comfortable surpluses in the Requirements (I) Numbers event of catastrophic losses. Insurers will have to spend considerable • Solvency Capital efforts on valuation of assets and liabilities. Requirements (SCR) • SCR is a new solvency standard which will be calculated on an annual • Minimum Capital basis. Requirements (MCR) • SCR is calculated with a more risk-sensitive approach compared to the MCR formula, which is considered as a lower solvency standard. • SCR can be calculated using standard as well as internal models. Governance & • Governance & • Governance processes will involve a supervisor who will assess the capital Supervision (II) Supervision solvency condition, technically as well as subjectively. • Own Risk & Solvency • ORSA is designed to be an internal risk assessment tool that should be Assessment (ORSA) incorporated as part of the insurer’s business strategy. • ORSA will continue to be enhanced and is likely to evolve as one of the best practices in the insurance industry. Disclosure (III) • Solvency & Financial • Solvency and Financial Report (SCFR) would have to be published Reports publically, which would provide a qualitative as well as quantitative • Supervisory & picture of the firm. Quantitative Reports • Regular Supervisory Report (RSR) is meant for the supervisor and would focus on qualitative and quantitative aspects of the undertaking. • Quantitative Reporting Template (QTR) is meant for the supervisor as well as public disclosures. It would provide technical details like MCR, SCR, asset valuations and technical provisions. Infosys | 03
  4. 4. Business Impact on Insurers Pillar I Pillar II Pillar III Impacts Impacts Impacts • SCR calculation will have to be • Insurers will have to design • In compliance with public done on a continuous basis and their internal risk programs and disclosures, insurers will have to should reflect the changing risk structures, in case they do not showcase its annual report on profile of the insurer. already exist. solvency and financial conditions. • Calculations should reflect risks • Insurers will have to set-up • Reports will cover aspects such as under various categories such supervisory processes and hire risk exposure, concentration and as: non-life, life, special health corresponding personnel who risk sensitivity. underwriting, market, credit and will be responsible for evaluating • The Reports will also cover capital operational. the soundness of the risk management details on MCR, • Insurers will have to choose management frameworks. SCR, Provisions, Assets and Funds. between a standard and an • Each insurer will also have to • There will be a big impact in internal model, which depends ensure compliance with ‘Own the way data is collated and on the sophistication of risk Risk and Solvency Assessment’ aggregated. Thus, insurers calculation models. (ORSA) taking into account its will have to revisit their data • It is expected that large unique risk profile, risk appetite management systems. insurance companies would and business vision of the firm. • Insurers will have to start building need only 80% of their existing • Technology controls and checks strength in reporting capabilities capital requirements. On the would have to be set to ensure from a personnel, technology and other hand, small insurers would compliance with the above process perspective. see their Return on Capital (ROC) requirements. adversely impacted.04 | Infosys
  5. 5. Impact of Solvency II across the Insurance Industry Spectrum Profitability =High, Capitalization = Fully Capitalized Consolidated • Already profitable and fully capitalized. • In a position to acquire attractive but weaker competitors. leaders • Capability to invest in innovative products that will boost pricing. • Have the financial muscle to expand into diverse customer and geographic segments. Profitability =Moderate, Capitalization= Moderate Complacent performers • Majority of these players are policy holders’ owned mutual fund firms. • These firms may find their future growth slowing down due to capital constraints. under • Profitability post Solvency II implementation can be improved by moderating the riskiness of the portfolios Profitability =Low, Capitalization = Under Capitalized Re structuring • First priority would be to fix the capital requirements above the solvency II’s threshold requirements. candidates • Additional Solvency II capital requirements could worsen the profitability of the already undercapitalized firm, leading to the possibility of the firm being ousted from business • Raising new equity capital would be difficult due to high cost of capital. Profitability = Moderate, Capitalization = Moderate-Insufficient Border Liners • These insurers would be able to boost profits if they are willing to take additional risks. • Would require additional capital to remain solvency II compliant • Ironically, they might end up with lower profitability if they try to reduce capital short fall by withdrawing from high risk - high return businesses. Infosys | 05
  6. 6. Implementation ApproachSolvency II appears to be a complex directive that will have to be implemented with sound planning and a great strategy. While, itwill equally influence business processes as well as technology investments, insurers will have to prioritize in order to optimize theirspending. Get Your Act • Insurers will have to work on more effective ALM strategies as the solvency ratios are expected to fall Together from around 200% (under Solvency I) to around 135% with Solvency II coming into force. • Some of the suggested approaches are restructuring products with emphasis on life products, diversified portfolio, cleaning out sources of unrequired risks. • Big players can take advantage of the consolidation wave, where small insurers might sell off, as complying with Solvency II capital standards becomes tough. Sensitizing Finance Units • The finance and actuarial units will have to be sensitized towards the Pillar I requirements, with the choice between the internal/standardized model being the first step. • Insurers will have to choose between the home-grown and off-the-shelf calculation engines. Nevertheless, some IT expenditure will be inevitable, where the insurers will have to test run the technology platforms and solutions before the compliance deadline. Dedicated Focus on Data • Insurers will have to assess the impact of Solvency Pillar III requirements on their existing data collection and movement processes. • Data management will take center stage with insurers having to verify that their data sources are correct. Insurers will need to deal with a lot of data on assets, claims, reinsurance, and risk events. Cover the Reporting • All the above mentioned efforts should finally be streamlined to meet the reporting requirements of Fronts Solvency II. Insurers will have to invest in reporting dashboards for supervisory, regulatory as well as market disclosures. • Reporting should be backed by compatible analytics to derive meaningful insights for benefit of the senior management. • Insurers will also have to start ramping up their XBRL knowledge, which is a widely accepted standard reporting language. Finally, insurers will have to make sure that their culture, people and business processes are in sync with the approach that is taken for Solvency II implementation. Technological solutions should be considered as value enablers, which would help in removing the bottlenecks while implementing this directive.06 | Infosys
  7. 7. Technology Enablers for Solvency II IT Enablers for Pillar I IT Enablers for Pillar II IT Enablers for Pillar III Actuarial, capital modeling, and Risk management, data models, Reporting and analytics risk management tools and integration These tools help insurers Data integration and Business intelligence and perform valuation of assets and management would become reporting applications are liabilities. In comparison to Basel the cornerstones for the success essential to provide reporting II, the liabilities play a significant of Solvency II implementation. capabilities and dashboards role for the insurers. Capital Insurance firms would need to for decision makers. Moreover, invest in data integration tools to modeling and risk management the reporting tools should extract, transform and load data tools support identification of be flexible enough to allow from disparate sources. Data risk dependencies and allocation integration would have to be users to generate customized of economic capital at different of optimum quality to support reports and should be able to levels and risk types. functions like reporting, audit, support reporting at different security and control. aggregations.ConclusionSolvency II has a much wider scope than Solvency I and hence, is viewed astedious and complex by the insurance industry. In reality, it should be viewedin the light of pre-emptive efforts taken by regulators globally to avoid areoccurrence of the 2008 meltdown. Insurers should look at Solvency II as a pieceof the Enterprise Risk Governance infrastructure, which is becoming a realityin many organizations. The regulation provides an opportunity for insurers toreview the financial, process, governance and data health at an organizationallevel, which may help them plug inefficiencies that exist within the system.Technology would be a key enabler in the entire exercise providing solutions forimplementing the 3 pillars of Solvency II. Insurance players with their vision wellahead on the Solvency II implementation trajectory can benefit tremendouslyby overhauling their technology around business and reporting processesenabling them to build their insurance enterprise of tomorrow. References • Solvency II – Understanding the Directive - An EMB report • Solvency II IT Vendor Spectrum – A Celent Report • • Solvency 2: Quantitative & Strategic Impact – A Morgan Stanley Report • • Infosys | 07
  8. 8. About the Authors Divya Prakash Tarey is a Consultant with the Risk and Compliance practice for the FSI (Financial Services & Insurance) vertical. She is a major in Finance with FRM Level I certification and has worked on areas like top-of-house reporting, credit risk data warehousing and risk management in treasury operations. She can be reached at Kaza Sree Ram is an Associate Consultant with the Risk and compliance practice for the FSI (Financial Services & Insurance) vertical. He has completed his PGDM from TAPMI with a major in Finance. Prior to joining the Risk and Compliance practice, he has worked for Infosys’ Enterprise Solutions vertical (Amdocs Clarify /Telecom domain). His areas of specialization include brand equity research and compliance practices in the Asset Management industry. He can be reached at Malini Pandi is a Consultant with the FSI (Financial Services & Insurance) vertical and works for the Insurance practice. She has done her MBA majoring in Finance and has previously worked for an Insurance company in the capacity of an analyst. She has experience in General and Life insurance, healthcare payer, new business, underwriting and claims. She can be reached at Amit Khullar is a Senior Project Manager with FSI Risk & Compliance practice. He has close to 13 years of IT industry experience and all of it in financial services and insurance domain. He has lead major transformation and consulting projects and programs for clients across the globe. He can be reached at amit_khullar@infosys.comAbout InfosysMany of the worlds most successful organizations rely on Infosys todeliver measurable business value. Infosys provides business consulting,technology, engineering and outsourcing services to help clients in over30 countries build tomorrows enterprise.For more information, contact© 2012 Infosys Limited, Bangalore, India. Infosys believes the information in this publication is accurate as of its publication date; such information is subject to change without notice. Infosys acknowledgesthe proprietary rights of the trademarks and product names of other companies mentioned in this document.