Solvency II is the name given to the European Union's fundamental and wide-ranging review to establish a solvency system that better matches the risks of insurers. It reflects a trend throughout the EU towards the convergence of the economic and regulatory management of insurance companies. Solvency II is based on the realization that ultimately, companies that are profitable and well-managed are those most likely to remain solvent.

Certain European countries, most notably the U.K. and Switzerland, are already farther ahead in evolving their solvency systems. In the U.K., the regulator is anticipating the arrival of Solvency II and adopted the Individual Capital Assessment (ICA) regime, making it effective in January 2005. Under ICA, a company has to assess its capital needs using robust modeling and be prepared to discuss it with the regulator on demand. Meanwhile, Swiss companies are in the process of adhering to their unique solvency regime, since they are not a part of the EU. Insurance companies with gross premiums exceeding a half-billion (nonlife) or a billion (life) Swiss Francs have to conduct solvency tests by year-end 2006. The revision to the Risk-Based Capital model in the United States (C-3 Phase 2) has also served as an example for companies that are looking to focus on the EU's pending solvency requirements.

What is driving Solvency II?

Risk awareness and risk management are crucial to economic stability in all countries. People in Europe even joke that the chief risk officer is now more powerful than the chief executive officer. But risk alone is not the primary driver of Solvency II. Particularly in Europe, more sophisticated capital requirements have long been needed. Prudence had always been regarded as a virtue, but strength today is more often associated with transparency and realistic assessments. Policy-holders, investors, regulators, and other users of financial statements need to know how well a company can weather difficulty.

Different approaches for different-sized companies

Solvency II does not assume one-size-fits-all solutions. Small and medium-sized companies will use relatively simple standard models. Large and specialist companies are more likely to rely on internal models. Ideally these models will be "nested stochastic" in nature, meaning that they will involve thousands of "what if" scenarios. Nested stochastic, as the name implies, are stochastic models inside of other stochastic models. They are extremely computer intensive. For example, a 1,000-scenario model with reserves and capital based on 1,000 "what if" scenarios at each valuation point for a 30-year monthly projection requires the cash flows for each policy to be projected 360 million times.

The ability to run these types of projections and analyze the resulting information will require significant changes in the hardware and software infrastructure at most companies. Ultimately, a solution for many of these challenges will involve grid computing (linking many PCs together under common control). Some companies are already running stochastic and nested stochastic projections on grids with as many as 1,500 PCs. Considering these complications, even some larger companies may not have nested stochastic models at their disposal at the advent of Solvency II.

Small companies, on the other hand, will use standard models prepared by company associations and which probably will not utilize stochastic calculations. However, the use of standard models does not mean that they require any less vigilance on the part of management. Companies cannot abdicate responsibility for understanding their risks.

Solvency II is part of a broader movement toward convergence that is affecting all financial services institutions. For example, the Basel II banking rules, regarding the adequacy of a bank's capital, provided one point of reference.

The strategic impact

Solvency II is not just an academic exercise required to fulfill regulatory requirements. Solvency II will create an environment where companies with better risk management will be able to hold less capital. This creates the potential for significant competitive advantages:

• Holding capital costs money; therefore holding less capital will create a pricing competitive advantage.
• Companies with poor risk management will need to hold more capital, leaving themselves open to acquisition threats from better risk-managed companies.
• Companies using standard models will likely, by necessity, hold more capital than they need because the models will not be customized to their unique situation.
• Larger companies will have capital advantages through the presence of risk diversification within their larger portfolios of business (although they may need to reorganize their group structures in order to benefit from this diversification).
• Small companies will be able to employ more focused risk management techniques in niche product areas.
• Solvency II is of strategic concern, and companies better able to manage risk will have a competitive advantage.

Gradual adoption

While some larger European multinational companies have made considerable progress in developing stochastic risk capital models, most are just beginning to invest the energy and money needed to develop their own internal capital models. Many companies are watching and waiting a bit longer to see how this new paradigm develops.

Insurers looking to speed their adoption to Solvency II have options. Before they can move forward, they need to understand the operational and systems requirements of internal capital models. A short list of preparation priorities includes the following:

• Investigate and assess company-wide hardware needs to accommodate the new modeling techniques.
• Explore specially developed software tools that support the type and number of calculations involved, not just for compliance with the new reserve and capital requirements, but to properly reflect the requirements in pricing, business planning, and risk management.
• Review implications for internal planning and controls as they relate to regulatory tracking and third-party auditing of findings.
• Consider additional management actions, such as risk identification and mitigation strategies.

If the experience of companies in the U.K., Switzerland, and United States is a sign of things to come, then European insurers are in store for many challenges as they work toward Solvency II compliance. The regulations require companies to shift their thinking—away from pricing as the primary driver and toward solvency as a business end in itself.

Edward Morgan and Marc Slutzky are consulting actuaries and principals with the Milan and New York offices of Milliman, respectively. They have coauthored several papers on Solvency II, including "Preparing for Solvency II-Theoretical and Practical Issues in Building Internal Economic Capital Models Using Nested Stochastic Projections," which was presented at the 2006 International Congress of Actuaries in Paris.