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

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

While the report details differences in the approach to solvencyregulation initiatives in the the EU and U.S., it notes, "Despitedifferences in approach and emphasis, the one consistent trendamong regulators, rating agencies, and other parties is the needfor insurers to articulate clearly their understanding of companyrisks."

In this area, Conning sees an opportunity for insurers,particularly larger ones, to gain perspective on their capital andrisk-management strategies. "For larger insurers with sufficientresources, more sophisticated ERM systems and processes can providea benefit in reducing capital requirements under both Solvency IIas well as from credit rating agencies such as S&P. Largerinsurers can enhance the credibility of their internal models andreap the rewards of diversification benefits. They may also be ableto 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-managementprocess, regardless whether it is required by regulations."

Smaller insurers, though, have fewer resources, and Conning saysthey may have to reconsider their strategies to compete in aregulatory regime such as Solvency II.  Conning sayssmaller insurers could choose to specialize in particular lines ofbusiness, "which would allow insurers to build credible economiccapital models for those more targeted blocks."

Conning adds, "Another benefit to specialization is thepotential for superior financial performance that makes the returnhigh enough to balance the need for higher capital relative to thelarge multilines."

While Conning notes that regulatory changes can lead to betterinsight into risk and a "structured approach to managing it," thereport also points out potential threats that come with regulatorychanges. Conning focuses mainly on Solvency II, since, the firmsays, "the NAIC approaches to regulatory change tend to be moregradual and evolutionary in nature…."

Conning says insurers could create problems for themselves ifthey wait too long to prepare for a regulatory change like SolvencyII, or if they do not have sufficient resources to comply with newregulations. "These threats are borne primarily by smallerinsurers," says Conning, "though some larger insurers may also lackresources to comply fully or quickly."

If some companies cannot remain viable under the new regulatoryscheme, Conning says another negative consequence could be aconcentration of risk as the industry consolidates. Conning alsosays companies may hide risks if they feel they are in danger ofnot complying with new regulations, and also says model-drivenregulations, relying on shared models, can carry risks of theirown. 

"The financial crisis witnessed these threats, primarily ininvestment-banking activity," says the report. "The lessons ofother regulatory failure may point the way for insurance regulatorsto avoid the same fate."