FSA Solvency II reminder a short sharp shock for UK insurance industry

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Leading accountant and consultant Moore Stephens says the latest guidance from the Financial Services Authority on the Solvency II regime contains some new and challenging tasks for the UK insurance industry and it warns that the governance arrangements in some sectors of the business may not be capable of reacting to external events such as the current credit crunch, and may therefore not comply with Solvency II requirements.

Simon Gallagher, head of the Moore Stephens Industry Group, said: “Some aspects of the requirements relating to Solvency II are really very demanding, and new to the insurance industry. Some firms may struggle, without professional help, to bridge the gap between their current levels of preparedness and the requirements, which take effect in October 2012. This may particularly be the case with smaller companies, which are affected in the same way by the requirements as are larger firms.”

The FSA has recently published a discussion paper entitled, ‘Insurance Risk Management – The Path to Solvency II’, which outlines the key challenges which are likely to arise for UK insurers from the implementation of the Solvency II directive. And it warns that, to ensure that the new regime is successfully implemented, it is essential that senior management consider now the implications for their business and start planning immediately.

The FSA says that firms and groups should ensure that they currently have in place appropriate governance arrangements for implementation of Solvency II, with an accountable individual nominated at board or senior management level, responsible for ensuring effective implementation. In March 2009, where it has not already done so, the FSA will be asking firms about their implementation planning and progress. By June 2009, those firms wishing to adopt internal capital models will need to have made that decision and informed the FSA. Effective risk management procedures are the cornerstone of the proposals and there is also a requirement for all firms to have access to effective internal audit resources.

Simon Gallagher added: “The governance arrangements that the FSA is suggesting will be required under Solvency II must be capable of reaction to external market events such as the current worldwide credit crunch and the acute state of the financial markets. But a recent Moore Stephens survey on Internal Audit preparedness in the UK insurance industry suggested that the focus in many firms was not sufficiently outward-looking, nor suitably focused on the sort of asset risk which is inherent in any service industry operating during a credit squeeze.

“Also, data management – and therefore IT assurance and security – is essential to successful compliance with Solvency II, not least for the effective operation of internal models. Modelling and data risk are key areas of emerging exposure for firms, and ones that, at present, may not be sufficiently well addressed in the insurance industry. The new rules will likely require more focus on governance and effective internal model approval processes exercised by senior management. Directors and those charged with governance will need to demonstrate, through documentation and due process, that they are in command of both the principles and the detail concerning capital planning and modelling,” he added. 

The move to Solvency II will involve a change in emphasis or approach for many insurers. This will have implications for actuarial, finance and IT functions. Firms intending to seek approval to use an internal model will be required to demonstrate compliance with several mandated tests and requirements. Activities such as sensitivity, stress and scenario testing will also need to be evidenced. The FSA said: “Our own work with industry suggests that even the best-prepared firms are still some way short of Solvency II standards in at least some of these areas”.

Simon Gallagher stressed: “Regulatory approval of internal models is a massive area, ripe with practical difficulties for the insurance industry. Models must pass a so-called ‘Use Test’, which requires the insurer to demonstrate that there is sufficient discipline in its internal model development and application to the extent that it is widely used – and plays an important role – in the management of the firm. Demonstrating compliance with this test is a condition of model approval. The FSA says, ‘Now is the time to act on these long lead times to develop, test and refine capital models and systems’. But Moore Stephens’ experience of the market suggests that there is a great deal of work to be done in this respect, and indeed that some firms will simply not be able to meet these requirements, without professional, independent help.”

The FSA requirement for all insurance businesses to have an actuarial function as part of the Solvency II regime will also represent a change for many UK firms. To date, actuarial expertise has been stressed more in the life rather than the general insurance sector. The requirement is explicit about the roles that the actuarial function is required to undertake, some of which may not traditionally be within the remit of the actuarial work within some firms. The FSA says that UK insurers should be preparing to introduce an actuarial function if they do not currently have one. Simon Gallagher added. “It is not clear whether UK firms will be required to have qualified actuaries on their staff, or whether those with statistical qualifications and experience will continue to be considered to be an appropriate means of fulfilling the obligations. Either way, it could be a daunting task for those firms that have to strengthen internal resources.”

Gallagher concluded: “The latest FSA guidance on Solvency II should serve to focus the collective mind of the UK insurance industry on the major undertaking needed to comply with the regulations. Although 2012 may seem a long way off at the moment, it may yet come too soon for the unprepared.”