Solvency II

Dr. Andreas Schäfer
Business Consultant Principle, Regulatory Center of Excellence, SimCorp CE

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Read the article and learn about:

• Solvency II and changing market requirements
• Investment strategies from a regulatory angle
• The impact of a low interest rate environment

Almost four years after the introduction of a new regulatory framework for the insurance sector in the EU, many market participants still don’t know whether to regard Solvency II as an important and powerful regulation or something less relevant. At the Regulatory Center of Excellence, we can clearly state that we still see Solvency II as both relevant and powerful. However, the focus of the Solvency II community has changed – from regulatory compliance towards Solvency II-oriented investment.

A regulatory framework with changing market requirements

In the first 2-3 years after the introduction of the regulatory Solvency II framework, the focus was very much on fulfilling its compliance and reporting requirements. As an example, an insurance company in the EU must generate and provide more than 70 reports (so called QRTs) to the National Competent Authorities (NCAs) on a quarterly and yearly basis. Besides, the SFCR and RSR reporting requirements, and also the quarterly calculation of the capital requirements, impose additional efforts on the insurance sector. As a consequence, budgets for IT investments have sometimes been “eaten up” by the fulfilment of these regulatory obligations.

Whereas, up until now, insurance companies have worked on getting their internal processes and software systems ready to become Solvency II compliant, the focus is now moving towards creating investment strategies that include the aspect of reducing or minimizing Solvency II capital requirements.

What we also observe is that the processing of regulatory adjustments has become routine – partly because firms are prepared for such changes and partly because software vendors offer support for the analysis and implementation of these changes. The new focus on long-term Solvency II-oriented investment strategies, however, together with the need for attention to simulation and forecasting of capital requirements, put new demands on firms.

These new demands, in turn, put new requirements on the software services needed by insurance firms. In the early days of Solvency II, insurance companies just asked for a piece of software which at a certain reporting date automatically and precisely produces a bunch of pre-defined reports that adhere to a strict formal structure and contain a set of authority-defined fields. The demands nowadays go much further. Today, firms require a software solution which allows for flexible scenario and forecasting analysis and supports client-specific investment strategies.

Low interest rates demand a rethinking of investment strategies

The low interest environment is a driver for insurers to look for alternative investment strategies because classical approaches of buying standard government bonds do not provide competitive returns anymore. Today, simulations of entering new markets and new financial products like alternative investments on the one hand and forecasting of expected returns and risks on the other hand are basic cornerstones for an insurance company to be successful. Also here, appropriate software systems are needed to support the new investment strategies.

In pursuit of investment strategies with low Solvency Capital Requirements

Apart from the curse of low interest rates, the European insurance sector has become very much driven by the need to find investments with capital requirements that optimize the Solvency II ratio, the ratio of eligible own funds to required own funds. Required own funds, also referred to as the solvency capital requirement (SCR), constitute a risk-based buffer, based on the actual risks on the balance sheet. Interestingly, a new and easy to compare benchmark, the Solvency ratio, has been introduced in the EU to enable comparison of insurance companies.

Solvency II-oriented, low capital requirement investing has become a “must” for the European insurance sector. In a low interest environment this leads to a real challenge. Traditional investments like government bonds with low capital requirements do not provide substantial returns and therefore are unattractive to invest in. Return-promising investments like equities demand a high own capital basis and from this point of view are also unattractive to invest in. Moreover, the Type 1 and Type 2 equity classification under Solvency II means that a conservative dividend strategy does not necessarily lead to lower capital requirements than a volatile high-tech equity strategy.

On their path to find good compromises between competitive returns and low capital requirements, the insurance sector is forced to move away from the traditional asset categories and “try something new”. What we have observed is that alternative investments have encountered quite some attractiveness within our client community. On the other hand, at least at mid-size insurance companies, investments in local currency bonds still very much dominate due to the cost of hedging the FX risk if investing in other currencies. Another important aspect for insurance companies is to keep the volatility of the solvency ratio low to demonstrate the stability of the business. The capacity to do simulations and projections of the balance sheet and P&L is key in this context.

Hence, the combination of capital requirement-oriented investing and alternative investment strategies (“what-if” strategies), together with forecasting functionality, nowadays defines the scope for an attractive software product for insurance asset management.

Convolution of ORSA and accounting forecasting

The ORSA (Own Risk and Solvency Assessment) process in insurance asset management is linked to the (accounting) planning process for national accounting regimes like for instance German HGB and Austrian UGB. For Solvency II, this means that the ORSA process and its timelines in particular are strongly determined by the timelines of the accounting forecasting. In general, the accounting forecasting is done prior to the ORSA forecasts which are based on the accounting figures of the “forecasting from date”. This date describes the latest point in time for which real market values and accounting figures are still available. Market values and accounting figures after this date are not real, but forecasted. The convolution of the ORSA and accounting forecasting processes can lead to tight time windows for ORSA, which will put high performance demands on the software systems which carry out the ORSA calculations.

Moving from software on premise to software as-a-service

At SimCorp’s Regulatory Center of Excellence, we see a general movement in the market away from on-premise regulatory setups and configurations towards regulatory services. This tendency has been a driver for SimCorp’s move towards offering regulatory monitoring services, also for Solvency II. The Solvency II service also offers information about regulatory updates when relevant as well as regular user meetings. This way, the service removes the need for firms spending resources on impact analysis and implementation of regulatory changes as this is part of the service.

Taking a strategic approach to Solvency II

Solvency II remains highly relevant to insurance firms’ asset management activities almost four years after the framework entered into force. While managing to comply with the regulatory Solvency II standards has been fully tackled at most firms, work still remains to take a more active and strategic approach to Solvency II. In particular, Solvency II must be better integrated into existing asset management processes like capital-requirement-oriented investment, accounting forecasting, and simulations. The low interest environment intensifies the need for having more focus on simulation and forecasting. Regulatory solutions and services can enable insurance firms to free up resources to concentrate on managing Solvency II strategically.