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Global Scale by Coletta Kemper Ditching Old Habits

The European Commission understands that the complexity and sophistication of risk management in the insurance sector has outgrown the current scheme for regulating. This alone is a quantum leap in thinking.

By  Coletta Kemper

Nearly four years after the launch of the European Union single market initiative, the Berlin Wall came tumbling down, and the EU has been kicking down walls ever since. Its vision is to create a single market for the 21st century by eliminating country and regulatory barriers that slow down trade among the EU members.  

Part of its mission is to transform its financial services sector into a modern, nimble industry able to compete globally. To accomplish this task, the EU has embraced the idea that regulation should boost competitiveness, not stifle it.

The latest in a series of bold initiatives is Solvency II. After years of study, last summer the European Commission adopted a comprehensive and far-reaching reform package that will remove obstacles to an efficiently functioning insurance and reinsurance market, while improving supervision. The benefit, the EC says, will accrue to consumers, industry, the EU economy and overall financial stability.

The Commission acknowledges that the complexity and sophistication of risk management in the insurance sector has outgrown the current scheme for regulating. This alone is a quantum leap in thinking. The result is a big gap between how insurers manage risk and how they are regulated.

Charles McGreevy, European Commissioner for internal markets and services, says they learned from the old system “that capital is not enough in ensuring the soundness of insurers. What is needed is greater focus on the management of insurers and the management of risks.”

To compound the regulatory challenge, member states often add country-specific rules to the minimum standards that the EU sets out. The lack of uniformity from country to country distorts the single market and hinders competition. The result is higher costs for insurers and consumers, which in turn hampers growth.

Solvency II introduces economic risk-based solvency requirements across all EU member states. The total balance-sheet approach takes into consideration both asset-side risks and liability-side risks. The proposal expands the definition of risk to include market risk (fall in investments), credit risk (default on debt) and operational risk (product liability or business interruption) in addition, of course, to insurance risks. Insurers will be required to hold capital against all these risks. They also will be required to actively manage their risks by identifying and measuring the potential for future exposures whether from a new business plan or a catastrophic event.

There’s a competitive upshot to all this. The better a company manages its risks and the more diversified it is, the less capital it may have to ante up. Some predict the new rules will drive consolidation as insurers strive for more diversification of risks.

A new supervisory review process will allow regulators to evaluate an insurer’s overall risk profile to determine capital requirements and if it has adequate risk management and governance systems in place for handling the “nature, scale and complexity” of its business.

To streamline supervision of insurance groups operating in more than one country, the plan calls for group supervision from the home country. The home supervisor will coordinate oversight with regulators in other jurisdictions. The approach is to ensure that risks outside a supervisor’s jurisdiction are not overlooked and that policyholders are protected.

Of course, one important key to all this is good data. Insurers will be required to disclose publicly far more information than in the past.

The EU wants to create a solvency model for the world. Few would question the need for global oversight of multinational insurance entities. But the regulatory mindset has to change.  Jorgen Holmquist, the Commission’s director general for internal market and financial services, brings home the point: “We must ditch old habits.”

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