Analysis of Insurance Undertakings Preparedness for Solvency II October 2010 Contents Introduction...2 1. General...3 1.1 Analyses in insurance undertakings and schedule of preparations...3 1.2 IT systems preparedness...3 1.3 Problem areas identified by insurance undertakings...4 1.4 Cooperation within the group...4 1.5 Cost of harmonisation with the Solvency II Directive requirements...4 1.6 Expected institutional changes...5 1.7 Fifth Quantitative Impact Study...5 1.8 Expected support from Národná banka Slovenska...5 2. Technical aspects...6 2.1 Quantitative requirements...6 2.1.1 Valuation of technical provisions...6 2.1.2 Valuation of assets and liabilities (except technical provisions)...6 2.1.3 Valuation of recoverables resulting from reinsurance contracts...7 2.1.4 Calculation of the solvency capital requirement (SCR)...7 2.1.5 Preparation of databases...7 2.2 System of governance...8 2.3 Internal models...8 1
Introduction Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II) was published in the Official Journal of the European Union on 17 December 2009. Under this Directive that will substantially change the exercise of supervision and the regulatory environment of the European insurance market, the Slovak Republic is required to harmonize, by 31 October 2012 at the latest, the legislative framework of the Slovak insurance market with Solvency II. In this connection and with view to ensure a smooth transition to the new regulation, Národná banka Slovenska has drafted an analytical document, which is based on a survey sent to insurance undertakings and focuses on mapping the current status as to the preparedness of insurance undertakings supervised by Národná banka Slovenska for Solvency II. All 20 insurance undertakings 1, i.e. 6 life insurance undertakings, 2 non-life insurance undertakings and 12 composite insurance undertakings participated in the survey. All insurance undertakings, except one, have already commenced preparations for the new regulation pursuant to the Solvency II Directive 2. This insurance undertaking reported that the preparations are in progress at group level (the insurance undertaking is part of a multinational insurance group, where the preparations are progressing significantly). Project teams have been set up in 17 insurance undertakings. The insurance undertakings did not employ new experts but in most cases they are staffed by employees of various departments, who deal with Solvency II, along with their regular duties. In one insurance undertaking, the team is totally identical with the existing risk management department. The teams have the following co-ordinators: member of the Board of Directors 4 insurance undertakings, risk manager 4 insurance undertakings, actuary 4 insurance undertakings, strategic projects manager 1 insurance undertaking, financial controlling manager 1 insurance undertaking, external consultancy and audit company 1 insurance undertaking, and group 2 insurance undertakings (some groups of insurers co-ordinate the Solvency II project only on a central basis). Two insurance undertakings have so far not established a local project team. In total 97 staff members deal with Solvency II, i.e. 4.85 employees per one insurance undertaking 3. The workload of employees differs across the insurance undertakings, while in two of them there are employees who deal only with the preparations for Solvency II. In two other insurance undertakings, the respective employees spend about 50% of their activities 1 In the evaluation of the information from the survey, it should be considered that the insurance undertakings could be less self-critical and the answers need not correspond with the real situation of the insurance undertakings. 2 Directive 2009/138/ES of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II). Link: http://eur-lex.europa.eu/lexuriserv/lexuriserv.do?uri=oj:l:2009:335:0001:0155:sk:pdf 3 An estimate of Národná banka Slovenska based on the data from insurance undertakings. 2
dealing with Solvency II. Employees of the remaining insurance undertakings deal with the preparations partially, as allowed by their workload. The scope of work on Solvency II can be influenced by the ongoing 5 th Quantitative Impact Study, which fact was explicitly mentioned by one insurance undertaking. 1. General 1.1 Analyses in insurance undertakings and schedule of preparations With respect to the transition to the new regulation, it is necessary to identify deficiencies, irregularities, material differences against the current status and areas which have to be improved or changed. Such gap analysis has been carried out by all insurance undertakings except one, where the participation in QIS 5 is its priority with regard to Solvency II. Reply from this insurance undertaking clearly indicates, that the differences, deficiencies and necessary changes will definitely be analysed. The analysis is still ongoing in eight insurance undertakings, the results are already known in nine insurance undertakings, while in some insurance undertakings only particular areas are covered for the time being. The results of the analyses are used for harmonisation with the new regulation, whereas according to the insurance undertakings the strongest efforts are necessary in the following areas: application of modelling techniques, documentation of processes, and modification of IT systems mainly in connection with data quality and volume. Some of the insurance undertakings have already started the process of harmonisation with the new regulation, for example introduction of the new risk management system, change of organisational structure, gradual introduction of the internal model, modification of process documentation, and implementation of new actuarial and database software. The schedule of preparations has been approved in 14 insurance undertakings; however, no details were revealed. Five insurance undertakings, which have not yet fixed their schedule, plan to do so after the internal analysis is completed (e.g. QIS 5). Those insurance undertakings, which have not yet started their gradual adaptation to the new conditions, might experience problems at time of application of the Directive, for example due to the time demands of the preparation of adequate databases and evaluation models. 1.2 IT systems preparedness IT systems have not been analysed in four insurance undertakings; in one of them the analysis is planned while in another the IT equipment is considered to be adequate, after minor modifications, for the Solvency II purposes. In one insurance undertaking, the preparation of IT systems has been performed only at group level; an actuarial system has been implemented that would allow better data quality control and improved company management. The analysis of IT systems was completed in 12 insurance undertakings and in three insurance undertakings it is still ongoing. As a result of the findings, the insurance undertakings have commenced modifications of their systems and introduced new software (e.g. in order to apply internal models, improve internal databases and adjust valuation models). Seven insurance undertakings have reported no significant deficiencies in IT systems. 3
The adequacy of IT systems will greatly depend on the product complexity of insurance undertakings; for example in the case of life insurance undertakings with embedded options, modification of IT systems will be a necessity with the internal model and risk management applications. As a result, we are of the opinion that the statements made by the insurance undertakings with regards to the adequacy of their existing IT systems should be re-examined. 1.3 Problem areas identified by insurance undertakings Of 20 insurance undertakings, 15 made a statement in this respect and identified the following problems: geographic concentration of investments (investment concentration in the SR); increased requirements for data quantity and quality (e.g. data on catastrophic risks; separation of risks within one contract, information from third parties more detailed structure of investment funds from asset management companies); IT systems modelling, accounting, administrative; valuation of assets and liabilities (particularly the stochastic modelling of technical provisions); necessity to achieve processes efficiency improvements; staffing and financial requirements; application of own risk and solvency assessment (ORSA); and reporting. 1.4 Cooperation within the group All insurance undertakings that are part of an insurance group participate in joint meetings, workshops at the group level and utilise consultations and know-how of the parent company. The coordination and schedule of the Solvency II implementation are controlled more or less centrally, while in some groups other activities are also centralised, e.g. risk management, actuarial activities and reporting. The support from the group in the preparations for, and application of, Solvency II appears to be of importance for local insurance undertakings, as a significant dependency can be observed between the coordination intensity by the parent company and the level of preparedness (as to staffing or technical aspects) of the undertakings for the new regulatory requirements. 1.5 Cost of harmonisation with the Solvency II Directive requirements The cost of Solvency II implementation has not yet been quantified by all insurance undertakings. As concerns their structure, the expenses cover mainly the following areas: IT systems, reporting, documentation, increased staffing capacities, employees training, and external consultancy. 4
Insurance undertakings have identified the cost of additional employees to be the highest fixed annual expense. The expenses 4 have not been specified by any of the insurance undertakings, but according to Národná banka Slovenska s estimates based on available data, the overall expenses amount to 270,333 per one insurance undertaking on average, covering the following: consultancy services: 97,500, IT: 88,200, employees training: 10,500, and new employees: 150,000 5. Considering the inconsistency of the data from insurance undertakings, the quantifications have only informative character. Moreover, the expenses may differ with the size of the insurance undertaking, as well as the type and complexity of the activities performed. 1.6 Expected institutional changes One of the insurance undertakings stated in the survey that the group intends to transform it into a branch of an insurance undertaking from another Member State. No institutional changes are expected in seventeen insurance undertakings. According to one insurance undertaking, decisions concerning institutional issues will depend on final requirements of the European legislation. One insurance undertaking could not provide its final position on the question of institutional changes, while another insurance undertaking is considering several options. It must be stressed that in the case of insurance groups (except for some cases), the strategic decisions are made at the headquarters. 1.7 Fifth Quantitative Impact Study (QIS 5) Fifteen insurance undertakings are supposed to participate in the fifth Quantitative Impact Study. Five insurance undertakings will not participate in QIS 5 on the following grounds: insufficient staff capacities, launching of preparations for Solvency II. Two insurance undertakings will join QIS 5 at group level only. From the NBS viewpoint, the expected participation may be assessed very positively as seven insurance undertakings joined the QIS 4 testing and only five insurance undertakings joined the QIS 3 testing. 1.8 The expected support from NBS 4 The numbers represent an average for those insurance undertakings which quantified the respective items. 5 This expense item will be permanent. 5
The insurance undertakings indicate the following areas for cooperation with NBS in implementing Solvency II: improved quality of translation of the European legislation, information on legislative requirements beyond the Solvency II framework, organising of regular workshops and trainings in Slovakia, consultations on open issues, specific problems of insurance undertakings and the Slovak market, communication in implementing the Solvency II Directive into Slovak legislation, consultations as part of the internal model approval, and additional guidelines, simplifications and interpretations. Furthermore, the insurance undertakings would welcome the publication of results of the fifth Quantitative Impact Study QIS 5, or other impact studies, as well as collective reading of EU legal rules, participation of the Regulator at the meetings organised by the insurance market, etc. 2. Technical aspects 2.1 Quantitative requirements 2.1.1 Valuation of technical provisions At present, the majority of insurance undertakings recognise their insurance liabilities on the basis of their market value and they started implementing the valuation principles pursuant to the Solvency II rules (e.g. new segmentation of insurance contracts, approach to future premiums, contract modelling period). Three insurance undertakings intend to implement stochastic valuation, and according to available information, two insurance undertakings have already applied this approach. The insurance undertakings are not able to evaluate the need for simplifications and at present they analyse the possibility of their application. One insurance undertaking intends to use simplifications for less important insurance classes and two insurance undertakings stated that they would use simplifications for the risk margin valuation. The insurance undertakings identified the determination of time value of options and guarantees and the determination of limits for contract modelling to be the problem issues. With respect to the complexity of the calculation, a broader application of the risk margin simplified calculation is expected in comparison with the information provided in the survey. In the case of insurance undertakings with insufficient technical background for stochastic valuation, it will be a problem to determine the time value of embedded options and guarantees, which may gain importance in the future and cause problems for the insurance undertakings in keeping in line with the Solvency II rules. 2.1.2 Valuation of assets and liabilities (except technical provisions) As the insurance undertakings have already valuated their assets and liabilities on the basis of their real value in line with the international accounting standards IAS/IFRS, no significant problems have been identified so far. Some insurance undertakings will analyse in detail the problems pertaining to the valuation after the conclusion of QIS 5 and the adoption of implementing rules to the Directive. The data granularity and the non-existence of a complete 6
stochastic model have been identified as problems so far. One insurance undertaking highlighted the assistance from the parent company. In spite of this, serious problems may arise in the insurance undertakings as to revaluation of certain assets and liabilities, for example in the case of deferred taxes and participation in other companies, which have already been identified during QIS 4, as well as the ongoing QIS 5. 2.1.3 Valuation of recoverables resulting from reinsurance contracts The insurance undertakings do not expect any significant impact on the valuation of recoverables resulting from reinsurance contracts. Problems with the valuation were identified only by one insurance undertaking, which consisted mainly in the estimate of future cash flows of reinsurance claims and time mismatch between an entitlement to a claim benefit and the payment by reinsurer. One insurance undertaking emphasised that it would use simplification. So far, majority of insurance undertakings has not modelled the recoverables arising from reinsurance contracts in accordance with the Solvency II methodology, namely the expected loss in the case of the reinsurer s default, while it is the results of QIS 5 that will be relevant for the estimate of the impact of the new regulation on their amount. An important impact of the revaluation can be expected in the case of non-life insurance undertakings which have reinsurers without a rating assigned. 2.1.4 Calculation of the solvency capital requirement (SCR) Sixteen insurance undertakings will use the standard formula for calculating the capital requirements 6 ; three of them plan to switch over to the internal model later on and seven of them plan to apply the partial internal model. Two insurance undertakings intend to use the full internal model and two insurance undertakings did not state which method they would use to determine their capital requirements. Majority of insurance undertakings, which will calculate their capital requirement using the standard formula plan to take advantage of possible simplifications (e.g. for the health risk module), but they cannot yet determine precisely the modules or sub-modules of their use. Only one insurance undertaking stated that it would use the standard formula without simplifications (in parts not covered by the internal model). So far, five insurance undertakings plan to use their own parameters. Though the formula is a standard one, the determination of capital requirements in individual modules and sub-modules is complicated and interconnected with the valuation of assets and liabilities, and therefore problems can be expected in using it in practice. 2.1.5 Preparation of databases Nine insurance undertakings regularly carry out the data collection and data quality checks and they consider the databases created in this manner sufficient for the purposes of Solvency II. Databases created at group level are used by one insurance undertaking, while six insurance undertakings started adjustments to their databases. One insurance undertaking has not started the creation of statistical databases for Solvency II yet, but it expects that the 6 If the insurance undertakings use the partial internal model, they will also use the standard formula. 7
currently registered data will be useable also for the valuation and calculation of capital requirements in accordance with Solvency II. One insurance undertaking identified a data set, specific for Solvency II, which will require more attention, namely the data for calculation of CAT risk (division according to CRESTA zones, identification of insured buildings concentration, and concentration of insured persons in life insurance). It can be expected that all non-life insurance undertakings will face the problem of data quality for determining the CAT risk. 2.2 System of Governance According to statements by the insurance undertakings, a majority of them have already established an organisational structure that is close to the requirements for the key functions pursuant to Article 44 and Articles 46 to 48 of the Solvency II Directive. This relates to the Insurance Act (which requires that insurance undertakings create an internal audit department within the system of governance, and recognizes the institute of a responsible actuary), but in particular to the internal requirements of the European and global insurance groups, which have internal guidelines in this area. The problem lies in the fact however, that the qualification requirements for persons eligible for fulfilment of these tasks in the insurance undertakings, as well as detailed descriptions of these functions, are currently being specified at the EU level. Very strict criteria may result in difficulties in the future with finding such specialists on the Slovak labour market. In the case of smaller entities, where one person will very likely be performing several functions, it will be crucial to properly define competencies in order to prevent the conflict of interest. As far as the preparations for the process of own risk and solvency assessment (ORSA) are concerned, a majority of the insurance undertakings does not currently use a process similar to ORSA or is in the stage of its preparation and development. Some insurance undertakings have already included into their management and applied a system which, after certain modifications, could later be accepted as the ORSA system. None of the insurance undertakings plans to use external outsourcing (in broader extent than up until now) in connection with the implementation of Solvency II. Nine insurance undertakings admit or expect the option to use internal outsourcing to a greater extent (centralisation of certain operations within the group), for example in the case of internal model development. Fulfilment of these expectations will in our opinion depend mainly on the degree of harmonisation of the regulation achieved, for example in reporting contents and IT solutions. Moreover, a greater extent of internal outsourcing can result from high requirements relating to individuals performing certain functions, e.g. the actuary function. 2.3 Internal models For the purpose of the capital requirement calculation according to Solvency II, nine insurance undertakings plan to use the internal model. Three insurance undertakings admit using this option, however, in the upcoming years they will use the standard formula. 8
The insurance undertakings plan to use the internal model which will be based on the group internal model, the main development (methodology) of models therefore takes place in their parent companies. According to the insurance undertakings, three insurance undertakings actively participate in the creation of a group model, namely through cooperation mainly with the concern risk management unit and with a group established in order to implement Solvency II. Two of the insurance undertakings plan to use a full model, the remaining seven insurance undertakings plan to use a partial model, while at the moment, the insurance undertakings do not intend to switch over to the full model (it will depend on the decision by the group). All insurance undertakings, except one which could not specify the deadline, plan to apply the internal model as of when the new Solvency II regulation comes into force. The insurance undertakings partial internal models are planned to cover the following risks: all risks except the operational risk 2 insurance undertakings, underwriting risk in the case of motor vehicle third party liability (MTPL) and other motor insurance 1 insurance undertaking, non-life underwriting risk and market risk 2 insurance undertakings, and non-life underwriting risk 1 insurance undertaking. At present, six insurance undertakings use (partially) internal models created within a group for example in the following areas: economic capital calculation, risk assessment and management, new product development and valuation, assets and liabilities management, stress testing, and investment policy. 9