Solvency II and the Law of Unintended Consequences

The latest attempt to regulate the European insurance market is well intentioned but could have profound repercussions for the industry.  

Solvency II will apply to all 27 member states of the EU including the UK, with the reporting requirements due to come into effect on 1^st January 2016. Many industry insiders believe that the legislation will have a major impact on the sector.

The Directive has four key objectives: improve consumer protection; modernise supervision by moving from old-style compliance monitoring to a more risk-based approach; deepen EU market integration; and improve the international competitiveness of EU insurers.

It has been a long time coming with the original EU insurance legislation dating back to the 1970s, although the process of creating a single market in these services was only completed in the early 1990’s with the third generation Insurance Directives, which established an ‘EU passport system’ for insurers. A limited reform in the guise of Solvency I was agreed in 2002, but it soon became clear that there were still some remaining weaknesses, hence the need for Solvency II.

One of the main problems was that key sources of risk such as market, credit and operational were not being properly quantified and there were inadequate supervisory reviews of these sorts of qualitative areas. It was also felt that a move towards an economic risk-based approach would bring the requirements into line with the rest of the industry as well as other sectors such as the banks.

The new Directive addresses these issues by requiring insurance companies to set aside sufficient capital to cover all the claims that they are likely to receive. In order to do this it has established standards in three main areas covering: the valuation of assets and liabilities along with the imposition of minimum capital requirements; the quality of corporate governance and risk management functions; and the introduction of new reporting and disclosure requirements.

Recent stress tests conducted by the European Insurance and Occupational Pensions Authority (EIOPA) were designed to assess the resilience of the industry and identify its main weaknesses. The results led them to conclude that in general the sector was sufficiently well capitalised in Solvency II terms.

The industry is currently in the preparatory stage ahead of the adoption of the Solvency II reporting requirements on 1^st January 2016. There will then be a three year transitional phase during which firms will benefit from extended reporting deadlines until the Directive becomes fully operative on 1^st January 2020.

Many European insurance companies still have a lot of work to do if they are to be compliant from day one. Smaller businesses in particular may struggle and will have to assess the costs and benefits of meeting the new requirements. Some believe that this could lead to further consolidation in the industry.

The legislation is based on the principle of proportionality, which takes into account the size of the insurer in an effort to make sure that the provisions are adequate without going beyond what is necessary to achieve the objectives. In spite of this Fitch believes that smaller companies will find the rules more burdensome than their larger peers and will be less well prepared.

Another possible implication of the new requirements could be the increased sale of assets especially around run-off. A recent survey by PWC estimates that the European run-off market is worth €242bn and forecasts that it will peak this year ahead of the implementation of the Directive in 2016 with the UK and Germany likely to be the most active.