Complexity and Solvency II

No. 55 , February 2015 Complexity and Solvency II By Tony Silverman+ The regulation of insurers perhaps inevitably involves some complexity. However, stepping back for a moment, the most prominent impression of the documentation for Solvency II is that it is dense, particularly complex and unlikely to be meaningfully accessible to a non -mathematician. Even a simple addition, perhaps applying factors, is typically introduced in the standard formula documentation as a visually elaborate equation with extensive notation, followed by definitions of the notation. There is normally little, at best, preamble setting out what the equation does and the reasoning behind it. Root mean square calculations, correlation matrices and even more elaborate notation are common features of the specifications. The material reads, in truth, like a financial mathematics textbook. Regulators must also contemplate supervising internal models, which can be hard to understand and normally involve, for example, stochastic simulation exercises driven by an economic scenario generator. Does Solvency II need to be quite so complicated and should simplification eventually become an objective? This article discusses a selection of issues around Solvency II, for which complexity is a common theme. We have to live with complexity An advantage of detail in specifications is greater consistency of application, and a more uniform regulatory framework across territories certainly is one of the hoped-for advantages of Solvency II. Accuracy is, in principle, another advantage of complexity, though there are no guarantees in this respect. Hidden assumptions, insufficient challenge and over -engineering for a system that ultimately requires judgement as well to work properly, are among the issues that require management. As regards complex documentation, it is a fact of life that legal documents, such as the Delegated Acts and Implementing Technical Standards (ITSs), often are difficult to understand, but few would contest the principle “ the simpler, the better ”. Multiplicity of interested regulators will persist It was initially hoped that Solvency II would simplify the management of large insurance companies through a reduction in the number of regulatory conversations for Europea n insurers. Complexity was, in large part, seen as the price for an overarching system that would function across territories. However the outcome probably will disappoint by this measure. New supervisory mechanisms are emerging that will function alongsi de the Solvency II process. The International Association of Insurance Supervisors (IAIS) has proposed a “ basic capital requirement,” which will be simple and factor based, will be applied to global systemically important insurers and will use factors at a level to achieve an appropriate outcome without the various diversification calculations that feature in the Solvency II standard formula. The IAIS released the calculation of the Basic Capital Requirement in October 2014. Initial industry reaction has been fairly muted. The IAIS also is looking to implement a capital regulation project to apply to a more extensive list of internationally active insurers (IAIs). In addition, although Solvency II will apply within the EU and at group level, other territories will still regulate local subsidiaries as they see fit. Even within the EU, the role of national regulators has been enhanced by the recovery and resolution programme being pursued by the IAIS. On this issue, the IAIS is responding to a Financial Stability Board (FSB) initiative. Each + Senior Analyst at A.M. Best in London, where he has been focusi ng on the credit rating of U.K.- based insurers and on sector-wide issues.