The chief executive officers of Lloyd’s, Munich Re and XL Group had a frank exchange of ideas about how Solvency II will affect the insurance and reinsurance industry at the Property/Casualty Insurance Joint Industry Forum in New York earlier this week.
Richard Ward, CEO of Lloyd’s, believes the principle behind Solvency II of hamornising capital setting across the European market is “to be applauded”. He said it would be good for the insurance industry if Europe, the world’s largest trading block, could harmonise its approach to capital and regulation.
But he added: “Unfortunately Solvency II did get somewhat sidetracked by a little banking crisis that turned out to a full scale economic crisis and all regulators want to respond and try and stop you doing anything going forward. So there are aspects of Solvency II that have become far too burdensome. But from a Lloyds perspective on the P&C side we have embraced Solvency II. We have most of the pieces in place. It encourages a more disciplined approach to capital setting from the modelling that you do. It encourages a more disciplined approach to risk management and risk appetite – which I think is a good thing – so it encourages the market to come off risks where it is not within their appetite, where they are concerned about too much aggregate exposure or the price is wrong.
“So it does encourage that behaviour, but of course as we all know it is not going to be implemented
Nikolaus von Bomhard, chairman of the board of Munich Re, said most European companies already ran their companies along the lines of the principles of Solvency II. But he noted that life companies in particular would struggle to implement Solvency II now following the financial crisis.
“The key question here is the economic risk on both sides of the balance sheet, many had it on the asset side, few had it on the liabilities side,” he said. “It’s close to rocket science at least for smaller companies, I admit that, it’s a stretch and it will change the way we do business in some regards, not so much P&C but certainly life and dramatically so. The timing was extremely unfortunate. The life companies in Europe have major issues because the business they have on the balance sheets was written at the time when this economic view was not common. So if you now take the brutal economic view you are practically insolvent. This of course should not happen because they didn’t have the chance then to do the right thing because it was not the way to run business.”
Von Bomhard said that question now is whether regulators breach the principles before they have implemented them by taking actions such as bailing out the back books of those life insurers or carving them out and making sure the new business is written appropriately.
“These discussions are going on, they will do impact studies and as Richard said the likelihood of seeing something coming up in 2016 is relatively high,” said Von Bomhard. “But let’s just assume the crisis stays for longer, that means extremely low interest rates, and then they will push it out further. If you meddle too much with the principles that support Solvency II you destroy the model. Then I would also rather say let’s not do it at all.”
Mike McGavick, CEO of XL, also agreed that the idea of Solvency II was good in theory, but said he was concerned with how it is shaping up in practice. One area of particular concern is that of group supervision.
“I think the core ideas behind Solvency II remain very much worthy of support,” said McGavick. “However, as Solvency II has become closer to reality it has revealed a lot of work still to be done to make it fulfill the promises that were initially made. A good example is in the area of group supervision, where there was a thesis that there would be some kind of grand trade between the use of more refined models through the second pillar, where there would be some new layer of regulation by the group regulator that would allow you to no longer have the same level of activity with the other regulators.
“This trade is clearly not going to happen. Anyone who bought into that trade I can tell you right now it won’t happen. It’s a very simple idea why not: if the part of the insurance company that is in the UK fails due to some event and the group regulator was out in the Netherlands, do you think that the citizens of the UK are going to blame the Netherlands regulator or the local regulator? Once you answer that question you know why they would not make the deference. Regulation is local, it is local for a reason and for a history and as a result this notion that there was going to be a trade for one supervisor unless there is extensive interaction locally is just false. It is not going to happen.
“Once you take that piece out I think you have some other problems. The capital requirements are very high, we are an industry already not earning its cost of capital and the challenge we have to make to the regulators is: ‘OK, fine, we will look at your model but what is the problem you are trying to solve?’ Insurers did well during the crisis and we are a bulwark against its contagion. So what is the problem you are trying to solve? Ever more, Solvency II reminds me of an overbuilt aeroplane rumbling down the runway and as it fails to take off they just keep laying more runway. They need to look at the design of the plane.”
Ward pushed back on McGavick’s thoughts by pointing out that Solvency II is trying to make companies take responsibility.
“Let’s not lose sight of what Solvency II is trying to encourage business to do, that is to develop their own capital models to determine the capital they need to run their business,” the Lloyd’s chief said. “If you don’t want to do that and you take the standard model then, as Mike has just suggested, absolutely you are going to get hammered on the capital side for complex business. Solvency II is trying to encourage businesses to take responsibility for their own business and justify the decisions they take to the regulator. So from a capital perspective I have no concerns for the Lloyd’s market. It is not going to push up our capital requirements.”
McGavick responded: “That is true but, first, for smaller companies it is almost impossible to do anything other than pick the standard model, which means they will be at a price disadvantage from day one. Second, and even more important to me, is that would be fine if my group regulator were able to take my internal model and make that the one for my capital requirements but my local regulator will not because my local regulator will continue to want an extra dollop of security for that ring-fenced capital. By the time you are done with that, all I got was an additional capital, an additional regulator and the same capital level requirement so I didn’t even get a relief. If I got the relief, Richard you are right.”
Von Bomhard pointed out that the rules are not set yet.
“Within Europe I would dare to say we might see parental guarantee schemes or something like that that addresses your concern because you are right – if you are a politician and you have your constituency you are looking after your electorate first and rightly so,” said the Munich Re chief. “But I think there are ways round this as long as you stay with some sort of a jurisdiction, otherwise it will not work.
“Our experience as reinsurers is sometimes we have a little bit of an easier life because our clients need protection but from us, not from the regulator. So the FSA in the UK for example in reinsurance says: ‘Well if you folks are German let me see what you do but I will not ask for the same type of papers myself even though you reinsure UK companies.’ That is for me the testing ground for then going one step further into the retail business.
“But I admit we are not yet there. Let’s get Solvency II right first. I am not too afraid that that will kill us. The question is: do we get calibrations of the standard model right first?”
McGavick was at pains to stress that he, Ward and Von Bomhard were in agreement over Solvency II most of the time. “But having worked with governments for too long I spent all my time believing that the only chance we are going to get to get close to our ideas is before it is in, not after it is in,” he said.
Ward said: “I agree with that comment. But we have an opportunity right now to shape some aspects of Solvency II, to get it right before it goes in. There are clearly deficiencies in the standard model that if you are a diversified business writing globally and you understand the model, you have problems. If you are a monoline business writing in the Czech Republic you might not have problems so it does depend on the business you are actually in. The real issue is: what will the regulators take for your internal model versus the standard? That is my real concern. I think the regulators have come out and stated publically that they expect internal models to deliver a different capital number to the standard model but how that play out in reality is another question.”
McGavick concluded with a warning to the US audience.