Andrew Rich /
30 May 2017Insurance

The perils of pillars: one actuary’s tirade on the counterproductive ‘monster’ that Solvency II became

The 22nd May was the deadline for the first full set of Solvency II reports. Large parts of the reporting are public, but media, stock markets and even the European Insurance and Occupational Pensions Authority (EIOPA) reacted to the news with a yawn. To those of us having worked with little else for the past four-month run-up, it is also tempting to forget Solvency II reporting the next months; but the recent experience should call for reflection.

The original idea of Solvency II was a principle based regime around three pillars: capital requirements, governance and disclosure. These pillars are independent barriers to insurance failure: if one or two pillars fail, there is still hope that the remaining pillar or pillars will support the company and its policyholders from insolvency.

If all pillars follow a minimum standard, an insurance failure is unlikely.

As Solvency II developed, these ideas were forgotten. Pillars and sub-pillars were developed in silos as if no other safety-net existed. The pillars grew into towers of Babel (or Basel) with the original principles buried in details. Actuaries, analysts, risk management and local regulators were reduced to interpreters and messengers serving EIOPA in the impossible task of micromanaging thousands of European companies through xbrl protocols and Lamfalussy processes.

Pillar 1 describes capital requirements (=April 1 to scrabble and risk-modelling enthusiasts).

Modelling extremes was acknowledged to be a challenging task in the early phase and simplifications were made. A one-in-200 event is still the formal basis of the capital requirements, but important parts of the modelling share characteristics of Bismarck’s sausages. Cutting corners is unavoidable when measuring the immeasurable, but the understanding of this fact seems unevenly spread among the architects of the regulation.
The sentiment “better roughly right than precisely wrong”, was soon replaced by “better consistent, complete and auditable than roughly right”.

Pillar 2 concerns governance and is seemingly a sensible pillar. Once again the devils (bureaucrats and forward-looking consultants) have revelled on the details and produced policy and reporting requirements of biblical proportions. Today the easiest way to comply is to stop thinking and start transcribing articles into internal policies, opinions and reports. This way auditors and regulators can check boxes and no-one needs to understand the meaning of what they are reading or writing.

Pillar 3 describes disclosure requirements and is by far the worst pillar. The pillar involves a multitude of data, the interesting parts of which are only disclosed to regulators. The public part is disclosed in a Solvency and Financial Conditions Report by 20 weeks after the end of the year (also known as 22nd May). This is a 50-150-page document, the greater part of which could be auto-generated based on Solvency II definitions and requirements. The details reported to regulators are more interesting, but it remains to be seen if regulators or (more likely) hackers develop this information to actionable intelligence rather than further consistency checking.

The Solvency II regulation might be appropriate for the largest “too big to fail insurers”. When in the business of buying and selling insurance companies rather than insurance, capital models and common standards might even add value. For the smaller insurers Solvency II is not only a nuisance, but also a risk. When actuaries and analysts spend time on filling in spreadsheets to EIOPA and writing policies and reports there is less time to analyse claims and profitability.

Companies that get the expected values wrong (in terms of technical premium or provisions) represent a greater risk to investors and policyholders than companies with limited understanding of the extremes of the extremes. The shift of attention can also affect the boards of the companies that must approve policies and reports rather than focusing on profitability, growth and innovation.

The early years of Solvency II preparations were helpful in raising standards in risk assessment and awareness. The monster that grew out of the process is however counterproductive in the very task it was designed to achieve. Ancient civilizations were fond of pillars to an extent that pillars with nothing to support is the archetypical ruin.

In the age of globalized insurtech disruption it remains to be seen if the pillars of Solvency II will have the same fate.

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