• Blog
  • 7 Min Read
  • April 27, 2016

Why US Insurers Should Care About Solvency II

The Solvency II directive has been a shadow looming over EU insurers for years. Luckily, with every shifting deadline and completed dry run, EU insurers have had time to adjust, evaluate, and prepare. But in today’s global economy, an ocean isn’t enough to buffer the impact of a directive as big as Solvency II. Here’s what US insurers need to know.

What is Solvency II?

An EU directive that’s been in development since 2009, Solvency II is intended to codify and harmonize EU insurance regulation. The directive’s primary goals are to establish a harmonized supervisory regime throughout the EU, provide robust risk management and governance requirements to protect insurance policyholders, increase awareness of internal risks for insurers, and increase understanding of market risks for European regulators.

Solvency II is comprised of three equally important pillars:

  • Pillar ICalculation of Capital Reserves outlines the Solvency Capital Requirement (SCR) and Minimum Capital Requirement (MCR) formulas insurers use to calculate their capital reserves for all types of risks.
  • Pillar IIManagement of Risks and Governance contains the Own Risk Solvency Assessment (ORSA) requirements for the governance and management of potential risks.
  • Pillar IIIReporting and Disclosure defines the reports that insurers must submit to the national regulator.

At the crux of Solvency II is the Prudent Person Principle, which places the power—and the responsibility—of an insurer’s investment decisions back in their hands. The Prudent Person Principle replaces the individual country restrictions regarding the composition of an insurer’s investment portfolio, and requires that EU insurers invest only in instruments that have risks they can continuously identify, measure, monitor, manage, control, and report.

What are the direct implications?

Solvency II places significantly stricter requirements on EU insurers’ capital holdings, risk awareness, and investment transparency. The direct implications to EU insurers involve risk and capital management changes, along with data management processes and systems adaptations. For US insurers, the implications are less visible, but still formidable.

US subsidiaries of an EU parent: Any significant US subsidiary will need to incorporate aspects of Solvency II. If a subsidiary is in a jurisdiction where the regulatory regime has been certified by the EU to be equivalent to Solvency II, then the business impact will be minimal. However, under the US’s state-based regulatory model, Solvency II equivalency will vary widely. When Solvency II equivalency isn’t met by state requirements, US subsidiaries will have what is basically an additional reporting basis to complete for Solvency II.

A less positive compliance assessment will require the EU parent group to build additional capital requirements. With inconsistent requirements across the regulatory bodies, meeting Solvency II could have a significant impact on US subsidiaries, especially if there is poor data integration or lack of transparency across the global teams.

EU subsidiaries of a US parent: Any subsidiaries that operate or compete in the EU are required to comply with Solvency II. Solvency II’s group supervision requirement protects EU policyholders from risks associated with the wider parent company, even if that parent is not EU-based. Solvency II group supervision focuses on risks relating to the level of group connectivity and inadequacies in readily transferable capital.

US parent companies with EU subsidiaries do not have to submit global group solvency figures on a Solvency II basis; meeting the demanding regulatory schedule of Solvency II would have created significant work for the US parent. However, EU subsidiaries of US parents are required to submit Solvency II filings on the same schedule as the rest of the EU, even as the parent company is allowed a consolidated filing. Some in the industry predict that this complex schedule could cause parents to consolidate multiple EU subsidiaries into one EU entity.

Insurance industry and competitive environment: As US insurers with EU subsidiaries familiarize themselves with Solvency II, they could be in stronger positions to react to economic and regulatory changes. This could significantly change the competitive market in the US, making some insurers more fully integrated across risk, compliance, finance, and strategy than their competitors.

Solvency II requires that EU insurers implement more risk and performance management and analysis. In an insurance environment that increasingly relies on global strategies and multinational M&As, US companies should consider how they will keep pace. While the overall impact is unpredictable, it’s safe to assume that Solvency II might cause capital allocation adjustments, leading to additional changes in the competitive landscape. New, deeper analysis of capital positions could also cause a jump in M&As across the industry.

Regulatory changes: The NAIC Solvency Modernization Initiative (SMI) has been tasked with improving the US solvency framework. There are significant links between this initiative and Solvency II, as the NAIC looks to the example of Solvency II’s enhanced governance and standards.

What are the indirect implications?

EU insurers have been preparing for the 2016 effective date with dry runs and in-depth system evaluations. But Solvency II will also reverberate beyond day-to-day investment operations; overall competitive strategies will also likely need to change as insurers struggle to overcome Solvency II challenges without interrupting their core business. US insurers might also face shifting market competition and new from rating and regulatory expectations.

US subsidiaries of EU parents have additional challenges beyond Solvency II compliance. During dry runs, EU insurers with multinational offices experienced significant communication issues. The final consolidated data was often multiple manual steps away from the original source data, and every global team email, spreadsheet, or data transmission, had inherent potential for errors to be introduced or overlooked.

When reporting on Solvency II readiness, the Financial Conduct Authority (FCA) discovered several troubling issues related to multi-office communication and spreadsheet management. They reported that “spreadsheets provide a key area of risk because they are typically not owned by IT, but by other business or control areas. They may not therefore be subject to the same IT general controls as firms’ formal IT systems (i.e. change controls, disaster recovery planning, security etc.).” So, even as global teams work to communicate investment data via spreadsheet sharing, the homegrown transmission and communication systems are often not controlled or secure, and can easily be lost or corrupted due to the simplest technology malfunction. As data requirements expand and become more complex, reliable and error-free communication becomes even more important. System data integration and communication across global teams can cause significant pitfalls, as Solvency II requires strict data consistency and accuracy.

What’s Next?

The Solvency II directive is transforming how EU insurers govern their data and manage their reporting, which means many insurers will need to examine their data management framework after the first filing deadline, and assess if it is rigorous and robust enough to meet the new requirements.

With ongoing deadlines, Solvency II compliance is a living process. As Solvency II continues to unfold, US insurers best plan of action is to become more familiar with its provisions and implications.

For more information on Solvency II and other regulatory changes, subscribe to Clear Insights and read the posts below.

CLEAR INSIGHTS SOLVENCY II RESOURCES

Solvency II: Not Simply Data Disclosure

EIOPA Updates on Third-Country Branches

Fund Look-Through and Tripartite Update

EIOPA Solvency II Updates

How Did Your Dry Run Go?

REFERENCES

https://eiopa.europa.eu/Publications/Guidelines/GRS_Final_document_EN.pdf

http://www.fsa.gov.uk/pubs/international/imap_final.PDF

http://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:32015D2290&from=EN

http://www.naic.org/index_smi.htm

This material is for informational purposes only. Commentary about the implications of Solvency II regulations and filing requirements are derived from sources that Clearwater Analytics considers reliable, but Clearwater Analytics provides no warranties regarding the accuracy of this information. Readers are responsible for verifying all information and conducting their own due diligence. Further, information contained within this article should not be construed as financial, investment, legal, or tax advice, and any questions regarding readers’ individual circumstances should be addressed to readers’ legal, accounting, or investment advisor.

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