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Regulator updates insurers on the development of Solvency II "early warnings"

Insurers must develop "simple" early warning indicators which, if breached, will trigger "an immediate supervisory response" as part of their preparations for new Europe-wide risk management and solvency standards, the Financial Services Authority (FSA) has said.09 Oct 2012

In a letter (2-page / 54KB PDF) to those firms that plan to adopt an internal 'model', or compliance system, the regulator's insurance head Julian Adams encouraged insurers to provide their usual supervisory contact with feedback on the proposals by the end of the month. In the meantime, he said, the regulator would use data from firms to "inform the development and calibration of early warning indicators".

"Our underlying concern is that, if not adequately monitored and updated, the solvency standard delivered by internal models can deteriorate over time," the letter said. "The implementation of internal models inherently rests on a great number of judgements and assumptions, both explicit and implicit. Our experience suggests that, over time, if models are not appropriately updated, these assumptions and judgements can become less appropriate, leading to an overall reduction in solvency standards."

In May, Adams outlined some "general weaknesses" the FSA had observed from submissions to its internal model approval process (IMAP) in a letter to firms. Weaknesses identified by the regulator included the methodology and assumptions used and the inclusion of inadequate supporting documents. Companies will be permitted to develop individual models in order to calculate their liabilities under the new regime, known as Solvency II, or will be able to use a 'standard' model which will likely mean higher capital charges.

Omnibus II (155-page / 3.7MB PDF) is a draft EU Directive which sets out stronger risk management requirements for insurers and dictates how much capital firms must hold in relation to their liabilities. The regime, which was originally expected to come into force later this year, has been subject to numerous delays.

At a recent meeting between the EU Commission, Council and Parliament Commissioner Michel Barnier appeared to suggest that there would be a further delay to the Directive, which would see it transposed into national law by July 2014 and implemented from 1 January 2015. The FSA, however, has said that will continue to work towards a 1 January 2014 implementation date until a new timetable is officially confirmed.

In his latest letter, Adams said that the use of early warning indicators would form part of the supervisory process for firms using their own compliance models. Indicators will supplement information collected from firms during the supervisory preview process, and would be set up in such a way as to identify any "significant deviations" in the firm's risk profile from the assumptions used to calculate that firm's particular solvency capital requirement (SCR).

To be effective, he went on to say, it was important that firms based their early warning indicators on metrics independent of the SCR. The indicators should be "simple in their construction, calibration and application" and trigger an "immediate supervisory response" if breached. An immediate capital injection would likely be the most effective way to restore compliance in most cases, he said.

Last month the FSA published  interim findings (20-page / 166KB PDF) from its review of the quality of data used by firms in their internal models. Its report suggested that firms were continuing to struggle with the data requirements imposed by Solvency II and identified 10 areas where insurers' current processes were inadequate. Most common among those were deficiencies with data control, confusion over data ownership and difficulties in building bespoke data directories.