As the EU's new regulatory regime settles in, Milliman's Oliver Gillespie observes insurers facing greater uncertainty about their actions, confusion among investors and more volatility in their balance sheets
With Solvency II having been implemented at the beginning of this year, already a number of expected and unexpected factors from the massive regulatory regime change have started to hit. Activities such as restructuring, acquisitions or merging funds have in some ways become more difficult to assess.
That was to be expected in part, because it's all new, but with many key elements of the Solvency II balance sheet requiring approval from the regulator, such as the matching adjustment or transitional measures, there are unfamiliar processes for everyone – including the regulators.
Getting approval can involve multiple steps of compiling information for review by the regulator, so when structuring or putting together strategic solutions firms can find themselves with additional uncertainty over whether a particular application will meet with approval in the 'post transaction' scenario. This means that actuaries and other advisors are frequently being asked to provide an opinion on whether or not a regulator will approve the use of an instrument. There are clearly a number of risk management and legal issues here that are not inconsiderable. Companies must take them seriously and advisors must make their clients and the boards, etc., aware of this.
Regulators, for their part, tend to be somewhat less than forthcoming because their statements and actions may be public and therefore have outsize effects on the market. That means that, for the time being, as the industry and regulatory regime take time to become acquainted with one another, many factors have to be considered effectively as unknown. It's simply harder to know if something is a good deal or not.
That makes it important, as we are already seeing, for companies to start factoring Solvency II requirements directly into their corporate strategies. Because for some companies so much capital efficiency and reporting protocols depend on regulatory approval, the sensible action is to engage the regulators very early on. However, this means more work for already resource- and time-constrained regulators. The expediency of a commercial deal may not be high up the priority list of a regulator when they have many concerns in respect of enforcing adherence to the new rules and making sure policyholders are protected.
A related consequence of Solvency II is that we are starting to see a change in the information available to investors and policyholders. Some large companies across Europe have decided, since the beginning of the year, to discontinue reporting on an embedded value (EV) basis and to switch instead to an 'adjusted' Solvency II basis. It's a decision that probably makes business sense, but we are hearing that for analysts, investors and users of accounts this feels like a backward step; as it makes it harder to assess the performance of a firm over a period, or determine with any assurance the values involved in deals.
Solvency II is also having an impact on the risk profiles of companies. For example, the regime introduces a "risk margin" which did not exist under Solvency I and is a calculation that involves projecting and discounting the cost of holding capital against a company's non-hedgeable risks. Given the long term of the projection period for most companies, this risk margin calculation can lead to a material increase in the interest rate exposure and thus a volatile new element on the balance sheet.
There are almost certainly more bumps ahead as Solvency II settles into place, but the hope is that the framework is solid and the improvements quick, steady and prioritised appropriately.
Oliver Gillespie is a Principal at Milliman in London.