Shaping up ahead of solvency II : embedding the concepts of risk and capital management in insurers

Abstract

Insurance is characterised by risk. This risk environment has led to a sector that has witnessed its fair share of failures, originating both in the life and non-life segments. Such failures have a negative impact both on the regulated as well as their regulators and they undermine the economic systemic stability. Against this backdrop of risk, and against a changing risk horizon, regulators felt the need to intervene. The Financial Services Authority of the UK initiated the shift in thought processes and in 2002 the European Union included a major regulatory project as part of its Financial Services Action Plan: Solvency II. The aim of the Solvency II regime 1s for insurance companies to determine their solvency capital requirement according to their true risk profile. In simple terms, Solvency II is a move to replace arbitrary statutory capital by economic capital. In light of this, it is envisaged that an economic framework such as Solvency II shall create direct incentives for insurance companies to better measure, monitor and manage their risks. Those insurers who do so will have an immediate capital advantage. On the other hand, the companies that do not understand, measure or manage their risks adequately will be directly penalised through larger capital requirements. Indeed, the sophistication of risk and capital management practices as they are embedded within insurers will be crucial to the success of insurers under this new regulatory regime. Insurers should therefore seek to enhance these practices in advance of Solvency II. Risk and capital management may be described as a unified framework that combines the aspects of risk management and the aspects of capital management through the use of an important common risk measure: "economic capital". Economic capital is the capital that is considered necessary as a buffer against potential losses inherent in business activities. It may also be called "risk capital" or "risk-based capital". The sophistication of risk and capital management practices varies across insurers in the different European jurisdictions as does the preparedness ahead of Solvency II. The UK is perhaps the most advanced due to the introduction some years back of the Individual Capital Adequacy Standards (ICAS) framework. Risk and capital management and the preparedness ahead of Solvency II are firmly on the agenda of Maltese indigenous insurers. The sector is making strides in improving its practices, showing commitment in keeping abreast of developments and in enhancing the existing knowledge of the core risks, namely underwriting and market risk. However the sector exhibits a number of weak areas which need to be addressed by local insurers since they are key to functional risk and capital management frameworks. In particular, local insurers are to instil within their organisations the much needed philosophy of risk and a change in their committee framework is called for in order to allow a move away from a silo approach to risk management. This necessitates the creation of new structures and new executive positions within local insurers. These changes need to be supplemented by improved processes for risk identification as well as enhanced risk measurement techniques. It is also important that insurers look to embed these processes within their day-to-day operations in order for them to be able to enjoy the benefits that such frameworks bring with them. A critical challenge being faced by local insurers is that of the lack of availability of skilled resources, mainly experts who understand risk management but within the context of insurance. This calls for a concerted effort between all interested parties in Malta to ensure that these resources are nurtured and are made available to the sector. An improvement in this respect would also help the Maltese indigenous insurers to improve their capital modelling capabilities, something which they should seek to do in advance of the regime such that they will reap the benefits of the new regime from a capital perspective. The efforts of local insurers should be supplemented by advancements in the expertise and preparedness of the local regulator, which undoubtedly remains a focal point for the local sector, a key player, providing undisputed guidance to the entire sector. With Solvency II on the horizon, local insurers would do well to enhance their risk and capital management practices. Under a regime that is being touted as merciless in its ability to expose weaknesses in insurers, local insurers should seek to not be among those players in the sector who will be termed losers under Solvency II. Their level of preparedness ahead of the regime will effectively decide their fate.