The Solvency II insurance project can't wait for the accounting rule-makers, say regulators.
And they are optimistic about 2010 as a start date, despite the doubts. By David Keefe
Europe's complex Solvency II regime for improving the safety of insurance companies will probably need a further instalment - Solvency 2.5 - to resolve the accounting hassle enmeshing the project.
That's the opinion of Paul Sharma who heads banking, insurance and securities policy at Britain's Financial Services Authority (FSA), the financial sector watchdog that oversees Europe's largest national insurance industry.
Sharma was expanding on remarks he made in March at the bi-annual conference in London of the Association of British Insurers, the UK's main insurance industry trade body. Both he and a top European Commission insurance regulator, Karel Van Hulle, expressed optimism at a break-out meeting from the main conference that Solvency II could be in force by 2010. Doubters in the industry have said a start-date of up to several years beyond 2010 is more likely.
Hard evidence wanted
Sharma also called on insurers to come up with hard evidence to justify the risk diversification benefits they seek from the risk-focused Solvency II regime, which is modelled on the three-pillar structure of capital requirements, supervisory review and market discipline embodied in the Basel II upgrade of international capital adequacy rules for banks.
Van Hulle said the Commission "can't postpone the accounting issues (in Solvency II) for the sake of a perfect regime," referring to the delay in developing a global accounting rule for valuing insurance contracts, the insurance policies that form the bulk of insurer liabilities. Van Hulle heads the insurance and pensions unit of the Commission.
Solvency II's accounting problems stem from the lack of an agreed way of valuing insurance contracts - the property, casualty and life insurance policies that are the chief liabilities of any insurance company.
Earlier hopes had rested on the International Accounting Standards Board (IASB), the London-based accounting rule-maker, coming up with a way of measuring insurance contracts that could be used as a common basis for developing a Solvency II approach.
But a finalised IASB standard on insurance contracts won't be in place until at least mid-2008, with some accounting experts not expecting it before 2010.
The issue is important because the valuation of insurance contracts plays a crucial role in determining the solvency ratios and capital requirements that insurers need as buffers to absorb losses from the risks they face.
Insurers have as a result been left in an accounting vacuum that both regulators and companies fear could lead to asset-liability mismatches in firms' accounts.
Two phases
That's because the IASB's new International Financial Reporting Standards (IFRS) that came into effect in many countries, including the 25 member states of the European Union, in January will apply to insurers in two phases. In phase I, which started in January, most of the assets of insurers will be measured at fair value, or current market prices, as per IFRS rules. But their liabilities, including their insurance contracts, will continue to be measured on local accounting rules, which generally means at cost and in some cases in a very opaque fashion indeed. IFRS rules will apply to liabilities in phase II, which will operate from the time that the IASB finalises its insurance contract standard.
Meanwhile the Brussels-based European Commission will have to decide on an accounting approach for Solvency II.
The problem for both the Commission and the IASB stems from the lack of a liquid secondary market in insurance policies that could provide benchmark prices for valuing the policies in insurer accounts.
Back to drawing board
Industry analysts say that could be a difficult task because the IASB, which initially intended to develop a fair value model for insurance contracts, is going back to the drawing board and is studying all the valuation options, including measurement at cost. This radical review is prompted in part by the Board's decision to link up with the Financial Accounting Standards Board, the US accounting rule-maker, to develop a common insurance contract standard.
IASB member Gilbert Gélard told a break out meeting on accounting at the ABI conference that the Board is completely open minded on the best way to value insurance contracts and added nothing was likely to emerge before three years at the earliest.
"Measuring an insurance liability is the most difficult thing we've encountered in our lives," Gélard said of the IASB's labours.
"And we're not going to be driven by the regulators on this," he added.
The FSA's Sharma says it all means there will probably have to be a Solvency version 2.5 at a later date. This would formally incorporate the final IASB standard into its framework.
Van Hulle said the Commission is in talks with member states on a best way forward on the accounting impasse which would anticipate, if possible, the likely shape of an eventual IASB solution.
In developing its own line, the Commission has as many options as the IASB. But two methods seem to be among the front-runners: the so-called total balance sheet approach and a valuation model developed by Australian regulators.
Any method would have its difficulties, and would be much less preferable than having an IFRS standard as a common basis for calculating solvency protection needs across the 25 EU nations, say Commission officials.
The Australian model is based on best estimates of the value of insurance contracts, plus a provision for adverse deviation. This, of course, is open to arguments about the calculation of both the best estimates and, crucially, the deviation provision, say analysts.
Sharma says the total balance sheet approach is akin to what in effect will happen under the Basel II bank rules. The method works by calculating the total protective ratios and capital requirements needed by an insurer to guard against risks, and then offsetting those numbers by the provisions for expected losses made in accounts.
Doctrinal arguments
However, the approach would doubtless be subject to the same doctrinal arguments about incurred losses and expected losses that developed, and are still to be resolved, in the Basel II context. These arguments arise because to accountants an expected loss is a loss that's already been incurred for which provisions have to be made, for instance, out of reserves. It doesn't encompass the regulators' concept of providing against expected losses in the future - losses from a future economic downturn, for instance, that could be estimated on the basis of past experience.
Meanwhile, the Commission's concerns were reflected in its third wave of calls for advice directed to the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), the grouping of insurance supervisors and experts from the 25 EU states that advises the Commission on the development and implementation of Solvency II.
The Commission asked for solutions to be proposed for the accounting treatment of items in the Solvency II capital requirements that might not fit with rules devised by the IASB.
A new fundamental discussion of the accounting principles is necessary, the Commission said in early March in the last of its three scheduled calls for advice on Solvency II from CEIOPS.
The third wave of advice calls covers the elements making up capital, the independence of supervisors and cooperation between them as well as so-called pillar 3 issues aimed at improving the action of market discipline on insurers by getting them to give information about their risk management practices and policies.
The Committee's Frankfurt-based staff are already working on two previous calls for advice on pillar 1 (capital requirements) and pillar 2 (supervisory review).
The Commission's Van Hulle said a 2010 date for the coming into effect of the Solvency II regime for making Europe's insurance industry safer is not an unreasonable target. He acknowledged the timetable pressures exerted on the development of Solvency II.
Regulators fear gap
The recent one-year postponement to end-2006 of plans to issue a draft Solvency II framework directive (law), which sets out the general principles of the regime, has increased speculation that implementation could be many years away. The Commission has never set a formal implementation date for Solvency II. But previous `pencilled-in' dates, including one envisaging a 2007 start-date, have slipped.
But Van Hulle said 2010 "wasn't too far out" of line with reasonable expectations. The FSA's Sharma hopes implementation will be closer than 2010.
Analysts say one incentive driving regulator keenness for an early as possible date is the fear that a large gap between the coming into force of Basel II and Solvency II will create opportunities for regulatory arbitrage by financial conglomerates coming under both regimes. Basel II will apply to all EU banks and investment firms when it starts coming into effect in the EU from January 2007 via the Capital Requirements Directive.
Van Hulle said it was quickly clear to him when he took over as unit head in November that plans to have a draft directive ready by the end of this year were too optimistic, given the amount of work involved.
New roadmap coming soon
He said a new roadmap for the Solvency II project would be published soon. October 2006 is the new planned date for the appearance of the draft directive, although if this were to slip it would not be disastrous. "We've got to get Solvency II right," he added.
He calculated there would be two years or so of negotiation over the draft, leading to a finalised directive in 2009, ready for implementation in 2010.
Nevertheless, some insurance industry analysts have said they believe a draft directive won't be ready until late 2007. Van Hulle said the Commission's aim is to create a good solvency regime for the insurance industry and not simply a Basel II for insurers, which are generally more complex institutions than banks.
But Basel II's three-pillar structure is essential for Solvency II. Pillar 1 solvency and capital requirement's aren't enough, they have to be supported by the pillar 2 supervisory review process, he said.
Sharma, who chairs a CEIOPS working group on pillar 1 issues, said he expects the final Solvency II to contain elements of the leading existing risk-based insurance regimes, namely the Dutch, Australian, Canadian and UK systems - and probably in that order of precedence.
But Sharma fears Solvency II's pillar 3 will be underdeveloped "and not take us further than accounting disclosures".
The greatest technical challenge in Solvency II is to "deliver the goods" on risk diversification, he said. This means ensuring that capital requirements reflect the fact that risk diversified around a group as a whole is lower than the sum of the risks in each component part of the group. It's an issue that's still to be resolved within Basel II.
