Basel II model cannot be cloned for insurers
Europe's Solvency II insurance regime is modelled on the new capital framework for banks, but is this causing confusion?
The limitations of the Basel II bank safety rules as a guide for Europe's Solvency II project for bolstering the soundness of insurers have recently been spelled out by European regulators and in a study of solvency models.
"Although Solvency II uses the same pillar terminology as Basel II, this does not imply the content is the same. Basel II is an important source of inspiration, but is not to be copied without further discussions," European Commission staff said in notes prepared for the April meeting of the Commission's insurance committee.
This could help to reassure some in Europe's insurance industry who fear that regulators simply want to transpose the Basel II framework onto insurance companies, generally regarded as more complex corporate organisms than banks.
The Solvency II regime currently being developed is modelled on the three-pillar structure of capital charges (pillar 1), supervisory review (pillar 2) and market discipline (pillar 3) as embodied in the complex, risk-focused Basel II capital adequacy rules for supporting the solvency of the world's banking system.
But the staff note says some elements of Solvency II are not covered by Basel II, which will start to be applied by law to all banks and investment houses in the EU from January, 2007 via the Capital Requirements Directive.
This is so, for example, in pillar 1 where Solvency II covers a wider range of insurance and related risks than does Basel II in terms of banking risks, which are restricted to credit, market and operational risks.
Pillar 2 and pillar3
The scope of pillar 2 - supervisory review - in Solvency II relates not only to supervision of an insurer's evaluation of its capital requirements, but also to all the risks that it faces. The scope of pillar 2 also relates to the harmonisation of supervisory activities and therefore includes both quantitative and qualitative aspects.
Solvency II's pillar 3, which seeks to improve the action of market discipline on firms by getting them to give more information about their risk management and policies and practices, includes the harmonisation of supervisory reporting.
The Commission staff also note that the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) has already been asked to look at work not yet undertaken by the Basel Committee on Banking Supervision, the body of senior banking supervisors from North America, Europe and Japan that devised Basel II. This includes looking at the revision of eligible capital, which the Basel Committee is scheduled to tackle but is yet to move ahead on. CEIOPS is the grouping of insurance supervisors and technical experts that advises the Commission on the development and implementation of Solvency II.
The remarks on Basel II as a model were part of a note on developing policy issues for Solvency II, and possible amendments to the approach to consultation, for study by the insurance committee, which comprises government-level officials from the 25 EU countries.
Also part of the papers for the committee was the revised roadmap for Solvency II, which confirmed that the Commission, which as the EU's executive arm is responsible for developing financial regulation in the bloc, plans to issue a draft framework directive on Solvency II in October, 2006 (see page 15). That's a year later than envisaged in the Solvency II roadmap issued in July/August last year.
There's no formal date for the implementation of Solvency II. But senior Commission officials have recently said they believe the regime could be in place by 2010, although some industry analysts believe that's a tough target to meet.
Meanwhile, a study of insurance solvency assessment models notes that Basel II does not specify a common target confidence level for all risks in the capital requirement calculation - something that's contrary to the objectives of Solvency II.
The report*, issued in April, echoes the Commission staff in saying that pillar 1 of Basel II is narrower than that needed to take a full balance-sheet or comprehensive approach in insurance. Basel II does not cover insurance liability or underwriting risks, of course.
Basel II does not explicitly capture interest-rate dependencies within pillar 1. "It is not clear whether Solvency II will be in line with this," says the report, which was prepared jointly by risk management consultants Mercer Oliver Wyman and the Comité Européen des Assurances (CEA). The CEA is the Paris-based umbrella body for Europe's national insurance industry trade associations.
Basel II requires all material subsidiaries or sub-groups ultimately to use the same approach to measuring risks. For credit risk, for instance, the approach must be either standard, foundation or advanced. However, this might be contrary to the set objectives under Solvency II, depending on type of model, says the report.
The study also says its worth noting that with the advanced or internal models for credit risk, the advanced internal ratings-based approach allows internal models to be used only to calculate the inputs into the credit risk calculation. It does not allow changes in the calculation itself, even if internal processes better reflect the risk to which the company is exposed. For market and operational risks, however, full internal models are used to calculate the capital for these risk types.
On a broader level, the study says the key principles underpinning the newer national insurer solvency regimes are converging. But there are still a variety of approaches used in applying the principles, says the report which is intended to provide groundwork for the Solvency II project.
In particular different regimes have chosen different trade-offs between sophistication and simplicity. The study compares various solvency assessment models in the world's insurance industries. It's part of the CEA's input into the development of Solvency II framework directive.
The CEA is finalising several documents on Solvency II, including one on structural issues and another on why care must be taken in using Basel II as a starting point for the insurance regime.
A range of models
The MOW study looks at a range of current solvency models, including Solvency I, Europe's current `stopgap' regime. Others are the regimes in the Netherlands, Britain, Switzerland and Germany as well as the US risk-based capital forecasting model developed by the National Association of Insurance Commissioners. The Jukka Rantala model developed by the former chairman of the CEA's Solvency II working group and credit rating agency Standard & Poor's European insurance capital model are also reviewed. Aspects of the Australian, Singapore and Canadian are drawn on and, for completeness, the Basel II framework is included.
Emerging common areas among the models include applying a so-called total (assets and liabilities) balance sheet approach as well as a trend towards `economic' or market value based measurement of the balance sheet rather than relying on existing accounting measures.
A value-at-risk approach to determining capital requirements is also increasingly common, as is the inclusion of a wide range of risks within the pillar 1 capital charges. Calibration of capital requirements to a specific confidence level over one year, generally above 99.5%, is also frequent.
Static versus dynamic
The study distinguishes between static, accounting-based models and dynamic cash flow-based models. In the static approaches, capital requirements are arrived at by calculating them on a static, fixed-at-a-given due date, accounting basis.
The dynamic models rely on cash flow projections, rather than fixed positions. Calculations are applied to the cash flows to arrive at the capital requirements. The cash flows can be of varying granularity and differentiation.
The static models are broken down into simple factor-based models, so-called because they apply only a small number of factors to the static accounting positions to arrive at the capital positions, and risk-factor models.
A prime example of the simple factor-based model is Europe's current Solvency I regime. Life insurance capital requirements, for instance, are arrived at by multiplying a factor of 4% to the mathematical reserves of participating businesses, plus a factor of 0.3% to the sum-at-risk.
Risk factor-based models are the most prevalent. They apply fixed ratios to select accounting positions, frequently calibrated to cover the underlying risk to a certain confidence level. A classic example is the German 2002 supervisory model which provides a series of risk factors that are applied to the underlying accounting positions in order to arrive at the various risk capital numbers, which are later aggregated.
The study describes both types as rules-based, where there are clear rules on what positions the factors are to be applied to.
The dynamic models are divided into scenario-based models and purely principles-based models. Scenario-based regimes rely on the insurance company measuring the impact of scenarios on its net asset value. The Swiss solvency test model is an example.
In purely principles-based models, no rules have either been specified for the risk measure or for the valuation, but the insurer is asked to arrive at its own view of the capital requirements on the basis of internal modelling. An example is the UK Financial Services Authority's requirements for insurance companies to arrive at the Individual Capital
Assessment (ICA).
*Solvency Assessment Models Compared, jointly produced by Mercer Oliver Wyman and the Comité Européen des Assurances.
European Commission working papers are available on: http://europa.eu.int/comm/internal_market/insurance/solvency/solvency2-workpapers_en.htm
