Regulatory developments in the European Union and United States present opportunities for large insurers that can use their resources to reduce their capital requirements, while smaller insurers may have to consider strategies such as specializing in particular lines of business to compete, a new report says.

The report by Conning Research & Consulting, “Insurance Solvency Regulation: The Race for a Workable Risk-Based Solution,” analyzes proposed regulatory schemes that have evolved since the financial crisis, such as Solvency II in the EU and — in the U.S. — the National Association of Insurance Commissioners’ Solvency Modernization Initiative. The report also looks at the New York Insurance Department’s expectation that each insurer establish an ERM (Enterprise Risk Management) function, Rating agency Standard & Poor’s review of insurers’ ERM practices, and the Financial Stability Oversight Council’s focus on identifying systemic risks to the financial system, which Conning says “potentially will involve evaluation of the financial stability of large insurers.”

While the report details differences in the approach to solvency regulation initiatives in the the EU and U.S., it notes, “Despite differences in approach and emphasis, the one consistent trend among regulators, rating agencies, and other parties is the need for insurers to articulate clearly their understanding of company risks.”

In this area, Conning sees an opportunity for insurers, particularly larger ones, to gain perspective on their capital and risk-management strategies. “For larger insurers with sufficient resources, more sophisticated ERM systems and processes can provide a benefit in reducing capital requirements under both Solvency II as well as from credit rating agencies such as S&P. Larger insurers can enhance the credibility of their internal models and reap the rewards of diversification benefits. They may also be able to craft their own asset models, not just liability models.”

Insurers of all sizes, Conning adds, should gain from the “better understanding that comes from a robust risk-management process, regardless whether it is required by regulations.”

Smaller insurers, though, have fewer resources, and Conning says they may have to reconsider their strategies to compete in a regulatory regime such as Solvency II.  Conning says smaller insurers could choose to specialize in particular lines of business, “which would allow insurers to build credible economic capital models for those more targeted blocks.”

Conning adds, “Another benefit to specialization is the potential for superior financial performance that makes the return high enough to balance the need for higher capital relative to the large multilines.”

While Conning notes that regulatory changes can lead to better insight into risk and a “structured approach to managing it,” the report also points out potential threats that come with regulatory changes. Conning focuses mainly on Solvency II, since, the firm says, “the NAIC approaches to regulatory change tend to be more gradual and evolutionary in nature….”

Conning says insurers could create problems for themselves if they wait too long to prepare for a regulatory change like Solvency II, or if they do not have sufficient resources to comply with new regulations. “These threats are borne primarily by smaller insurers,” says Conning, “though some larger insurers may also lack resources to comply fully or quickly.”

If some companies cannot remain viable under the new regulatory scheme, Conning says another negative consequence could be a concentration of risk as the industry consolidates. Conning also says companies may hide risks if they feel they are in danger of not complying with new regulations, and also says model-driven regulations, relying on shared models, can carry risks of their own. 

“The financial crisis witnessed these threats, primarily in investment-banking activity,” says the report. “The lessons of other regulatory failure may point the way for insurance regulators to avoid the same fate.”