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Institutional Investment - September 23, 2009

Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies

Since the turn of the millennium, a profound shift in the management of insurance companies has been underway. The main catalysts of this shift are the growing complexity of risks, the sophistication of the means of measuring them, and the demands made by investors for greater transparency and for higher-quality management. In this environment, prudential (Solvency II) and accounting (IFRS) requirements must also adapt to create new frameworks offering a better view of the risks borne by companies.

All insurers, regardless of their characteristics (public companies, mutual insurers, provident societies) will be subject to the new prudential rules and will thus have to make heavy investments in the data collection, risk measurement, and simulations required by the supervisor. The objective of this new study is to show how, by having these investments respond to objectives more inherent to the company, these Solvency II constraints can be capitalised on. With a fictitious company, we build a management tool for an insurance company subject to Solvency II constraints. We then highlight the contributions this tool makes to the perfecting of the strategy of the company, in particular for the definition of policy for asset allocation, management of capital, asset/liability management, hedging of risks, and the launch of new products. At the heart of this model is value creation for shareholders or mutual members.

To show how to transform Solvency II constraints into an opportunity to perfect company management, we first survey the changes in the ways of measuring performance. So, keeping in mind the major work done over the last three centuries, we present in the first chapter the genesis of value creation. We show how it is an integral part of the management of an insurance company and responds to the goals of the industry as a whole, including the member-centred mutual insurers. These analyses make it possible to understand the shift from a study of margins to the more complete and relevant market-consistent embedded value and the economic capital models put in place by the leading European insurers.

Chapter II focuses on the differing objectives of regulatory and economic capital, but it also shows the degree to which the Solvency II prudential framework could become an industry benchmark for the creation of economic capital models and thus contribute to the perfecting of insurance company management. This chapter also shows how, by building an economic capital model subject to Solvency II constraints, these constraints can be turned into a management opportunity.

Chapters III and IV present the elaboration of such a management model, and they do so by simulating—based on data from a fictitious insurance company active in six lines of life, property and casualty, and business—the underwriting, market, and counterparty risk modules elaborated by the international supervisor. The construction of this model makes it possible to gauge the complexity required and to determine the feasibility of this construction for all insurers, regardless of their particular features.

Chapter V puts in place an economic capital model subject to Solvency II constraints, a model based on the work done in the preceding chapters. We highlight the contributions made by the model not just to the definition of the strategic objectives of the company but also to the tracking, control, and measure of strategy and management.

This research was carried out with the support of Swiss Re.