Solvency II: what it means for investment management systems
Solvency II requirements and their practical implementation pose a number of issues for investment management organisations – currently and in the near term up to 2013. This article outlines how and in what ways investment management companies will need to prepare their software system infrastructures and investment management systems for Solvency II.
By Dr. Thomas Varain, Partner and Swiss Insurance Head, KPMG, Switzerland;
Dr. Peter Ott, Partner, KPMG, Germany
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Solvency II brings a fundamental change to the regulation of insurance companies in the EU. The requirements of the new principles-based regime, which are proving to be a hot topic for debate and discussion, can be broadly divided into three pillars. The first pillar sets the requirements for the capital adequacy models. Companies can choose whether to use a standard model or to develop a full or partial internal model.
The second pillar defines risk management requirements for insurance companies, including risk management for investments. Pillar 3 covers in detail the reporting and disclosure requirements regarding risk to the regulator and the public. Insurance companies need to demonstrate to the regulator and to their clients that they have a comprehensive and appropriate risk management system in place that is integrated in their decision-making processes and strategy.
IMPLICATIONS FOR INVESTMENT MANAGEMENT
From an investment management perspective, all three pillars are relevant for insurance companies:
• the first pillar covers standard and internal models to measure investment risk;
• the second pillar covers risk management of investments;
• the third pillar sets out the disclosure requirements for investment allocation and investment risk.
The fifth Solvency II Quantitative Impact Study (QIS 5) raised the awareness of the fundamental revolution in the regulatory requirements. The broad spectrum of possible consequences of the regulatory changes, in areas such as products, investment management and the structure of the insurance market, is beginning to become clear. One of the most obvious consequences is the effect on asset allocation.
Solvency II replaces the current investment categories and limits; in particular, it replaces national investment regulations with investment categories, limits and solvency requirements defined by the EU Commission. In contrast to the old system, the new guidance is sensitive to the structure of the investment portfolio.
The proposal of the EU Commission in Omnibus II Circular in January 2011 is not very clear on the actual effective date of Solvency II. Omnibus II specifies the harmonisation of supervision in Europe; in particular the new European insurance regulator founded on 1 January 2011, the European Insurance and Occupational Pensions Authority EIOPA. Also, the binding effective date for Solvency II is fixed as 1 January 2013, which should end discussions on a further delay.
However, the EU Commission’s circular allows maximum transition periods for core areas of the directive. For example, the suggested transition periods for topics such as regulatory reporting, governance system requirements and the valuation of assets, technical reserves and solvency capital range between three and 10 years.
Standard model
For pillar 1, insurers can use the standard model to determine their Solvency Capital Requirement (SCR). In any EU countries, the majority of insurance companies will use the standard model, because smaller and mid-sized insurers lack the capability to develop a full or a partial internal model. However, within its overall structure, the standard model takes only limited account of the actual investment risk profile of the company.
In addition to the risk module for insurance risk, the QIS 5 standard model contains modules for market risk, default risk, risk from intangible assets and operational risk. The market risk module is one of the most important modules in the standard model. The key elements are interest-yield curves and stresses there on and market risk for equities.
The interest risk is based on two predefined yield curves to which a steep increase or decrease in interest rates is applied. Insurance companies have to consider both: investments that are sensitive to interest-rate changes and technical reserves that are valued based on yield curves. The market risk for equities is based on percentage declines in market value and takes account of correlations.
Investments in real estate require capital of 25% of the market value derived from the IPD Total Return Index for the UK. Listed shares in the EU or in an OECD country require capital between 39% and 49% of the market value, depending on the historic development of the MSCI World for the valuation date.
The Berlaymont building hosts the EU Commission's headquarters in Brussels
ASSET MANAGEMENT CHALLENGES
Basically, all three pillars are relevant for the investments of an insurance company and Solvency II therefore sets demands on asset management companies. Initially, the implications of Solvency II for asset management were not entirely clear. Therefore, it is all the more important for the industry to adjust to the coming developments and be able to make the necessary changes.
Insurance companies will generally aim for low investment risk, as higher risk requires higher solvency capital. This will change the asset allocation strategy and will also have an impact on the investment management industry. Also in the short and medium term, the data management and data quality requirements resulting from Solvency II will be a huge challenge for insurance companies and their asset management.
The complexity of models in the insurance industry has increased significantly. Whereas in the past, the models focused on insurance risk and actuarial reserves, today, assets are becoming more and more important. Insurance companies are forced to develop their own models for investments if the standard model does not adequately reflect their risk profile.
The calculation of the SCR requires large amounts of input and data that of course have to be available for investments as well. Here the asset management companies are challenged because they have to provide most of the data. Due to the importance of data, software systems and technology in Solvency II requirements, it is important that they are considered from the beginning, even though the implementation of the market and credit risk models is not yet fully completed.
The asset management industry should not neglect this important factor and should not rely on the insurers needing a certain time until the models are fully implemented. In addition, the requirement for data is not limited to companies that develop an internal model. The standard market risk model under Solvency II requires certain information which asset management is often not yet able to provide.
Biggest challenge
The biggest challenge for asset management is that companies have to be able to manage and provide all the data that feeds into the calculation of solvency requirements as well as financial and regulatory reporting. This includes, in particular, the data quality requirements and data being up to date.
Solvency II requires that the data used is complete, appropriate and accurate and emphasises how important the quality of data is for the effective implementation of Solvency II. This goes for both internal and external data. Solvency II expects companies to develop guidelines and standards for data quality, as well as for the updating and validation of data. Regulators will check compliance with the directive in the course of their approval of the internal models.
Data quality
Data quality will also be of high importance in areas looked at by the regulator, such as the input and output data for the Own Risk and Solvency Assessment (ORSA), the Use-Test and the data that is required for disclosures, e.g. Solvency and Financial Condition Report (SFCR), Report to Supervisor (RTS) and Quantitative Reporting Templates (QRT). I t is unavoidable that data used is validated and subject to a quality assurance process and that all data and its sources are documented and archived.
As insurance companies must demonstrate their compliance with Solvency II, they will also have to obtain confirmation of compliance from their asset managers, as they may have to show this to the regulator. Insurers will also probably want to perform their own checks on asset managers to ensure that the Solvency II requirements have been met.
High complexity
The complexity of asset management for insurance companies is high due to the differences in the individual investment portfolios of insurance companies and the resulting different levels of granularity of the requirements. Examples of data required include: quoted market prices and yields of bonds and equities; detailed information on derivatives; geographical data on the individual assets; and information on guarantees.
As a result of Solvency II and the new disclosure guidance, it is also possible that insurance companies will require certain data more often than has been the case until now.
IMPLEMENTING THE REQUIREMENTS
The administration of investment data will be more complex for companies under Solvency II compared to the previous regulatory regimes. This includes, for example, the comprehensive documentation of data flows. Data management will also have to be adapted to reflect the new environment. We expect that the importance and use of data-repositories and data warehousing systems will increase significantly. Smaller and mid-sized asset managers will probably not be able to meet the new requirements without a comprehensive data management system.
Solvency II has multiple implications for the systems, processes and controls within the infrastructure of asset management. Because of the wide-ranging changes required, companies should start to address the challenges soon. Companies need to be aware that higher costs and resource requirements may result from the necessary changes. Apart from Solvency II, asset managers will face additional legal and regulatory requirements, which increase the importance of an early response. A n efficient, timely and structured approach can save costs and resources. This topic also affects the asset services sector. Companies in this area should also assess on a timely basis where changes are required to meet the demands of Solvency II.
INTEGRATED SOLUTION
Prior to the start of a large and expensive project to implement the changes required, companies in the asset and investment management industry need to clearly understand their position with regard to the governance, definition, quality and reporting of data and what is expected of them in the future.
This relates to the requirements from Solvency II and also to the needs of clients, i.e. what kind of data and reports insurance companies will require. In the future, it will be unavoidable for companies to maintain a comprehensive and consistent data management system, including appropriate governance. Investment managers should check in which areas adaptations and enhancements are required, including relevant processes, controls and governance guidelines.
In addition, appropriate data quality and validation, as well as documentation and governance guidelines, should not only be in place because they are a regulatory requirement. Data and investment management systems are key building blocks of the asset management business, and companies should place a high value on being able to build on an appropriate and solid foundation.
Last but not least, investment management companies should be made aware that they also stand to benefit from the situation. Insurance companies will prefer asset managers who have demonstrated that they are well equipped to meet the Solvency II requirements.
Dr. Thomas Varain is a Partner and Swiss Insurance Head, Audit Financial Services, KPMG, Zurich, Switzerland. He is in charge of the KPMG insurance audit practice and co-ordinates KPMG’s service offering towards insurers. With 14 years of experience providing audit and advisory service to international insurance companies, he started his career with KPMG Cologne. Thomas Varain has extensive experience in the audit of international insurance companies and is specialised in accounting and regulatory issues, as well as in insurance asset management. A Certified Accountant (D), he holds a business administration degree from the University of Passau, Germany, and a Ph.D. from the University of Goettingen, Germany.
Dr. Peter Ott is a Partner at KPMG in Munich, Germany. Specialising in Solvency II and risk management for insurance, he has been a Partner in Financial Services at KPMG in Munich since 2005, where he has headed KPMG’s Solvency II projects and initiatives since 2006. With 15 years of experience providing audit and advisory services to insurance companies, he started his career with KPMG Munich. Peter Ott has extensive experience in the audit of insurance companies and is specialised in accounting and actuarial issues, as well as in insurance asset management. A Certified Accountant (D) and an actuary he holds a Ph.D. in business administration and a Master’s degree in business research (MBR) from the University of Munich, Germany.
