Insurance Industry Solvency Issues

The EU Single Market's web site dedicates an entire section to Solvency. When it comes to the banks' "cousins"—insurance firms—the solvency margin is the amount of regulatory capital an insurance undertaking is obliged to hold against unforeseen events. Solvency margin requirements have been in place since the 1970s and have been amended by the Solvency I Directives in 2002. However, Solvency II is a fundamental review of the capital adequacy regime for the European insurance industry that aims to establish a revised set of EU-wide capital requirements. These requirements should help supervisors protect policyholders' interests more effectively by making prudential failure less likely—reducing the probability of consumer loss or market disruption. Namely, while the Solvency I Directives aimed at revising and updating the current EU solvency regime, the Solvency II project has a much wider scope, since it includes a review of the overall financial position of an insurance undertaking—not just limited to the solvency margin requirement.

Its aim is to ensure adequate policyholder protection in all EU member states, and it will take into account current developments in insurance, risk management, finance techniques, international financial reporting and prudential standards, etc. One key objective is that the requirements better reflect the true risks of an insurance undertaking, as there is widespread recognition that this is not the case in the current system. Another important feature of the new system will be the increased focus on the supervisory review process, with the idea to increase the level of harmonization in general, including that of supervisory methods, tools, and powers. As explained in Solvency 2 on the Financial Services Authority's (FSA's) web site, the framework under development consists of three "pillars," whereby pillar 1 sets out the minimum capital requirements firms will be required to meet for insurance, credit, market and operational risk. Pillar 2 will be the supervisory review process $ because of this, supervisors may decide that a firm should hold additional capital against risks not covered in pillar 1. The aim of pillar 3 disclosures is to harness market discipline by requiring firms to publish certain details of their risks, capital and risk management.

The European Insurance and Occupational Pensions Committee (EIOPC) has approved the new Solvency II regime's basic architecture. It is based on the same three pillar approach as it is for insurance (quantitative requirements; supervisory activities; and reporting and disclosure) and the banking sector. If it is of any consolation, Solvency II is still at an early stage. As discussed in FSA's Solvency 2, before it develops the level 1 framework directive, the European Commission is consolidating the existing solvency regulations and getting technical advice. The Commission expects to publish its formal proposal for a Framework Directive by July 2007, and based on this, one should expect Solvency II to be implemented by 2009/10.

Further on banking and financial institutions regulations, and coming back to the IAS framework, IAS 32 and IAS 39 in particular establish rules for the valuation of financial instruments. Again, in tune with the spirit of IFRS and IAS, accounting systems for financial instruments should enable banks to prepare IAS-compliant financial reports and create parallel financial statements based on a central data pool fed by the existing system landscape.

Thus, appropriate enterprise resource planning (ERP) and financial management systems must provide a comprehensive set of financials and analytics capabilities to meet the requirements of the rating process. Namely, transactional financials capabilities should enable banks to accelerate the preparation and processing of financial information, capture and organize relevant financial data more rapidly, and achieve tighter corporate governance and control. Analytics capabilities should allow banks (and related financial institutions) to automate and optimize corporate planning, analyze internal and external risk factors, integrate business strategy and risk management, and improve transparency and trust. With such sound systems in place, financial institutions should have the tools they need to streamline the company-wide planning and budgeting processes; increase transparency (and thereby avoid planned-versus-actual deviations, and mitigate the changes of uncertain events); get the most out of capital allocations (that is, make smarter investment decisions and improve results through risk-based management); comply with laws and regulations; and implement measures for damage prevention.

Just as with banking, insurance, and other financial institutions, the automotive and the food and drug industries are two areas of business where a growing number of government legislations and safety initiatives require organizations to implement industry-oriented ERP systems in order to ensure compliance. The specifics on how these industries address compliance issues will be looked at in the next installment of this series.

Banks and Financial Organizations' Liquidity Issues

However, to further complicate things, many industries have their own inherent regulatory requirements. For instance, banks and financial institutions must comply with a growing array of national and international legislation and recommendations. For example, the Gramm-Leach-Bliley Act (GLBA), signed into law by former US President Clinton, has drastically changed the way financial institutions conduct business. With this law, many responsibilities have been placed upon banks and financial institutions to protect the customers' nonpublic, personal information. The GLBA governs the collection and disclosure of customers' personal financial information by financial institutions. It also applies to companies that receive such information, whether or not they are financial institutions. Namely, the GLBA Safeguards Rule requires all financial institutions to design, implement, and maintain safeguards to protect customer information, and the rule applies not only to financial institutions that collect information from their own customers, but also to financial institutions that receive customer information from other financial institutions, such as credit reporting agencies.

Recently and frequently publicized has been the New Basel Capital Accord, or Basel II, which establishes requirements for banks to manage the risks of issuing loans. As discussed in Checking It Twice, the regulation, whose implementation was completed at the end of 2006, increases both the level of risk management and the required level of disclosure, and consequently requires significant changes in financial institutions' policies, processes, and systems. A recommendation issued by the Basel Committee on Banking Supervision, Basel II is a recommendation to help credit institutions protect themselves against the risk of credit loss and increase the overall transparency of their business in their daily work with market, liquidity, and general risks. To that end, banks must identify potential risks and set aside capital to compensate for potential losses. Furthermore, Basel II calls on the banking supervision authorities to conduct regular inspections of credit institutions to jointly monitor and analyze risks. Finally, the banks are committed to publishing their equity capital structure and their own risk situation.

Accordingly, as noted in Checking It Twice, before granting credit in the future, banks will have to assess the recipient's credit risk using an internal or external rating. As a result, the conditions under which the credit is granted will be tied more closely to the liquidity of the borrowing company, which will in turn affect the duration, interest rate, and the collateral of the credit agreement. To receive a good Basel II rating, reliable financial figures and well-documented planning are essential. A sound financial management system has to provide the necessary transactional data for this purpose, as well as the range of functions for supporting Basel II as part of the extended portfolio of analytical applications that have to be especially developed for carrying out financial and profitability analyses and risk management.
If one thinks about this a bit more, Basel II affects not just banks, but all organizations. In particular, it effectively requires organizations to demonstrate their ability to meet their payment obligations—a process called rating—which typically involves a comparison of planned versus actual financial values covering a multiyear period. Strategic planning, risk management, and internal control processes all have an impact on rating results, which is a key concern especially for small and midsize businesses, many of which lack thorough planning and control processes. Basel II is expected to have a global impact, because members of the Basel Committee include the Group of Ten (G10) countries, most of which intend to transform Basel II regulations into local law. Thus, some well-attuned software applications will be needed to help these companies meet Basel II requirements for risk exposure and capital adequacy, and implement risk-mitigating supervisory review and disclosure processes. See mySAP ERP Financials: Basel II Support for more information.