Blog Commissie ERM: Why do we need regulations? - by drs. Servaas Houben AAG FIA CFA FRM (member of the AG ERM committee)
Solvency II has been a major transition in the insurance landscape. Where in previous regulations the focus was more on business as usual scenario analysis, with Solvency II the focus is on the impact of extreme events, more awareness for risk management and mitigation, and better understanding of the interaction of risks. All these changes have resulted in a better understanding of the insurance business. Therefore the following table came as a big surprise to me:
|Number of undertakings|
|Standard formula||Partial internal model||Full internal model||Total|
Undertakings pursuing both life and non-life activity
Table 1: Souce EIOPA1
Apparently 94.5% of insurance companies apply the standard formula. So despite the increased necessity for a better understanding of risks, this has not resulted in many insurance companies using the partial or full internal model options, which should not only give them more insight and control over their business, but should also provide them capital benefits from a regulatory perspective. It is unclear if this preference for using the standard formula is based on a lower capital requirement, lack of experience with risk based regulations or following the overall market choice for the standard model.
Of course one can argue that Solvency II does not just focus on the first Pillar (the pure calculations), but that risk management and disclosure are important components as well: these components will force insurance companies to think through their current processes and governance better, which will help them to prepare for extreme scenarios. However, insurance undertakings are unique in a sense that some risks like expenses and lapse behavior maybe should not be simply copied based on average industry standards. Furthermore, by simply applying the standard formula approach, the many benefits a (partial) internal model provides are lost. Are dividends in- or excluded when determining an equity stress? What historical data period is still relevant for our current business? Are we including future trends in our analysis and when doing so, how do we support these assumptions? Applying the (partial) internal model is not a goal in itself, instead it is the entire thinking process which will result in improved understanding of risks, which is the real benefit not gained when applying the standard formula.
Compared to Solvency II, IFRS17 seems to adopt a more principle based approach which allows more flexibility for insurance companies to implement the standard according to their specific interpretation (the clause “without undue cost or effort” is mentioned multiple times throughout the text). This allows insurance companies to make a cost-benefit-analysis for each step in the process so that they can focus on risk drivers which are most material for their business. IFRS17 can therefore be an excellent stepping stone for insurance companies to improve their models, processes, data and systems after which a transition to a (partial) internal Solvency II model might be easier to complete.
At the end of the day, the use of regulations is to improve understanding of the business and create awareness for risks, and there are better ways than simply applying the standard formula to accomplish this.
Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of het Koninklijk Actuarieel Genootschap (AG), any company or professional body.
1 Source: EIOPA Report on long-term guarantees measures and measures on equity risk 2016