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How do you view benefits of Solvency II from rating agency perspective?

We view it as a huge benefit. A lot of the tenets of Solvency II touch upon the rating process—issues such as a risk-AA capital approach— and whether a company uses its own Solvency II-led models or those that AM Best employs, the strengthened overview of risk and capital adequacy associated with Solvency II is a beneficial development for the sector.

The only risk in implementing Solvency II is that when you get into Pillar 2 and Pillar 3, some of what is required from a risk management and reporting perspective is not applicable to smaller organisations. Formalised processes and documentation is sometimes not necessary for smaller captives.

Applying proportionality to the process makes a lot of sense. If you are not applying a risk-based approach these days you really are positioning yourself behind the eight-ball.

Minimum capital requirements essentially say nothing about financial strength because they don’t incorporate the risk that the company is bearing and that’s what a risk-based capital model such as Solvency II will do.

With Pillar 2, a lot of the risk management is already present in well-run and rated captives. It is in the formalisation of this risk management process where a smaller captive would differ, but if proportionality is applied under Solvency II, then smaller entities will still find it possible to conform to the European regulatory regime. You would want to see all the right things are being done and all of the controls over the claims and underwriting process and loss control are in place, but it’s the formality of the process that could be lightened.

For Pillar 3, there is a lot of talk about reporting requirements and how companies measure up from a compliance perspective. This adds a layer of additional resources dedicated to tracking a company’s performance. I don’t think that anyone would argue that this is a prudent approach, but the formalisation of the process has costs that for a smaller organisation may or may not make sense.

AM Best is a strong proponent of Solvency II implementation with proportionality and we believe that international insurance regulatorsare going to have to respond to Solvency II in some way, shape or form. Latin American regulators are already discussing how they will respond and I suspect that it will become the gold standard for insurance regimes globally.

Assuming Europe approves a captive carve-out, do you think others will follow the same approach?

The carve-out is really the only answer that makes any sense from a cost:benefit perspective. Logical thought processes will prevail. The discussion regarding whether such an approach is appropriate is a good thing, but in the end the regulatory cost will be money well spent. We view the issue as something everyone will have to respond to. If there’s a carve-out in Europe, then the other domiciles that have looked at whether they’re going to seek equivalent status with Solvency II are likely to adopt the same approach or something similar.

You mentioned Latin America. What about the US response to Solvency II?

Now is an interesting time for global financial services regulation. We can start with the convergence of US generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS). Included in the initial phases of convergence is a re-look at insurance contracts. There’s going to be significant and substantial changes made to the way insurance companies report results such as earnings and profit and loss, and that’s happening concurrently with changing global insurance regulation.

Solvency II has a chance of beating by a year or two accounting standard convergence, because it’s more of a myopic project. Every domicile that has any significant insurance presence will have to respond in some way to Solvency II. First, there will be global competition for quality regulatory environments and second, it just makes logical sense. While there will be an initial discussion over all the extra costs that a regime like Solvency II ushers in, no-one can say that it doesn’t make good sense.

The big trick in the US is in getting the National Association of Insurance Commissioners (NAIC) to start thinking about how they’re going to respond. They may take their time, because I think they believe their regulatory environment is robust and that while Solvency II may have some particular strengths over the current regime here in the US, it would be marginal.

"There is no issue that bermuda is going to seek equivalence, adopt it and do well at it, but where do you draw the line?"

Nevertheless, Solvency II will raise the bar and there will have to be a response similar to the one we saw with US GAAP and IFRS convergence. The financial accounting standards board in the US didn’t want to merge and adopt the principles-based view of the world that IFRS brings, as it’s not simply a changing regulatory environment, but a complete change of mindset. In the US, we have much more of a rules-based regulatory environment, whereas under Solvency II there is more leeway as regards establishing a risk perspective. Essentially, Solvency II is moving towards a principles-based system and there are repercussions to that. You can’t simply stay with the old model, it will lose its relevance, and the competitiveness of those domiciles that continue with a rules-based infrastructure, will inevitably suffer.

Is there a concern that this kind of regulation will make captives less attractive?

It will have an effect—and it could be material—on interest in captives that are run for simple economic reasons. If it is just a tax-saving vehicle or a way to access the reinsurance market, then you’re going to have to secure more capital. Cost:benefit analysis might lead some to say, what are we running this captive for? However, if the captive was a vital part of risk management at the parent company level, then those captives are already well capitalised, well run, implementing sophisticated enterprise risk management, loss control and engineering to prevent claims. Global corporations that run robust captives could not do without them from a risk management perspective. Going to the commercial market rather than bearing the risk themselves, they would not have the same tools they have in well run captives available to prevent and mitigate losses.

The change does represent an opportunity for the protected cell sector. Vermont recently added protected cell legislation to its books in an effort to provide tools for those marginally run captives as the domicile moves closer to global insurance standards. As cells buy products andservices together, some of the frictional cost will be economised under an evolving global standard.

Do you think Bermuda will be ready for equivalence before Europe?

There’s definitely a feeling in the marketplace that because Bermuda is one domicile and they have a very clear vision of what they’re doing, they could be equivalent to something that hasn’t yet been implemented. In Europe it’s different—you have different environments and while everyone is pointing in the same direction, a lot of the details need to be worked out. Bermuda-based firms can act more concisely because they only have to worry about their own environment. Certainly Switzerland and Bermuda have a clear vision of what they want to do and a strong buy-in from the commercial sector.

Any thoughts on proportionality?

By far the biggest question relates to proportionality. There is no issue that Bermuda is going to seek equivalence, adopt it and do well at it, but where do you draw the line? What regulation makes sense and what doesn’t? What size and scope of companies get the light treatment? You can’t just draw a line, and say ‘every company under $20 million doesn’t have to do x and y’, because there can be complexity in a small company. It is much more a case of the regulators sitting with a particular company and saying ‘this is how we’re going to implement equivalence for you. You have to have this and this, and these other features will be optional, because we know how you operate and they don’t necessarily make sense for you’.

You can’t be dictatorial in your approach to capital models, or just come up with grand statements and they become the rules, because regulation is not a ‘one size fits all’ approach.

You have to implement it on a customised basis. It means Bermuda is going to have to spend some time looking at companies that will struggle with full implementation and decide how they’re going to actually implement Solvency II-light. This is where there should be a detailed discussion and plan. Clearly what doesn’t work is a broad, rules-based approach. It needs to be more of an incisive, customised, reasonable, cost:benefit approach that takes into account each company’s complexity and operating history.

Steven Chirico is assistant vice president at AM Best. He can be contacted at: steven.chirico@ambest.com