Articles - In Conversation: Paul Brenchley and Curt Burmeister

 By Paul Brenchley, a Director in KPMG’s Insurance Risk team, and Curt Burmeister, Vice President of Risk Solutions at Algorithmics

 In an extract from Algorithmics in house magazine THINK Paul Brenchley, a Director in KPMG’s Insurance Risk team, and Curt Burmeister, Vice President of Risk Solutions at Algorithmics, discuss the macro and micro challenges facing insurers as they prepare for life under Solvency II.
  

 THINK: Solvency II represents a move from rules-based regulation to one based on principles. What does this switch mean for insurers?

 PAUL: A rules-based system has the advantage of providing greater certainty for firms but at the detriment of being prescriptive, as rules set rigid boundaries within which firms are required to operate. The aim of principles is to give greater flexibility in implementation but they come with an element of the unknown as well. When principles are supervised, as under Solvency II, there will be an element of judgment involved from both sides. There’s a benefit however to those firms who can interpret the principles in the best way that they see fit, as long as these firms can justify their approach as being most appropriate for their business and operations to supervisors.

 CURT: Whenever you change paradigms and move from a well-understood framework to something new, there’s uncertainty. It takes time to work through the issues and details to find the appropriate solutions. We’re in a stage now where those who have gone first have figured out how to solve a majority of their specific problems. We’re entering a phase where the firms that started a bit later are facing the biggest challenges.

 PAUL: Firms that started first have an advantage in terms of their thinking and working through scenarios of how to apply the principles best for their business. A lot of firms, especially in UK, have taken the regulators with them on that interpretation journey, and have not necessarily waited until the regime is in place to showcase what they’ve done. I think with a move from rules to principles that’s actually an important aspect to consider; you don’t want to go knocking on the regulator’s door on Day One and hope that everything you’ve done will be accepted. It is trying to get some buy-in and steer in that process so that firms can ensure they’re on the right track in the regulator’s eyes.

 CURT: I would also make the point that what we’re seeing with Solvency II, Basel II and some other regimes is a convergence in the way regulatory capital is calculated. This trend across the financial industry should be an interesting factor that impacts the way firms are going to manage and think about risk.

 THINK: A recent industry poll of insurers found that 30% are still undecided between internal models and the standard formula. Does this result surprise you?

 PAUL: I had heard that statistic and was surprised by the results actually. I would have thought – and hoped – that insurers would have made their mind up by now as to which SCR (Solvency Capital Requirement) route they were going down. The QIS 5 (Quantitative Impact Study) results from late 2010 should have given firms a pretty good idea about the capital requirements under the standard formula and assisted in informing this decision. Some of the uncertainty might be in relation to the fact that some smaller and medium sized firms may be waiting for the final specification before deciding on their preferred SCR approach as QIS5 tested proposals not the final specifications. However the QIS5 results should have given firms a decent view of the fit between the standard formula and the risk profile of their organization.

 As Curt will well know, developing an internal model does take time and resources so there is a cost/benefit analysis to be done in deciding to invest to get a model approved vis-à-vis living with a standard formula if you are able to.

 CURT: The deadline to begin implementing an internal model is rapidly approaching. It’s pretty clear that if you haven’t already started on your internal model, it will be very challenging to finish the model and get regulatory approval by the 1st of January 2013. In general the larger and more complex firms have gravitated towards the internal model earlier, because they get the bigger capital benefits. And because the implementation process for a larger firm takes longer, most have already started. If someone is still in the decision making process, for practical purposes you really have to start with the standard formula and look to migrate to an internal model over time.

 THINK: For those who didn’t make this deadline or chose the standard formula, are they now married to this path or are other options available?

 CURT: The idea of migration is something we’ve built into our Solvency II solution. We have three editions of Solvency II Solution: Reporting and Compliance, Standard, and Enterprise. The Reporting and Compliance edition focuses on Standard Formula while the Standard and Enterprise editions focus on internal models. However, we’ve consciously built-in an evolutionary path with the solution so that if clients start with the Standard Formula they can grow to a partial internal model and/or full internal model at any future date.

 Assuming you have aspirations to go beyond the standard model and want to keep the doors open, we’ve built that into our product strategy. We’ve spoken with a lot of firms that are actually saying they want to do internal models but are going to start with standard formula. That’s not an uncommon position for people to be taking now.

 PAUL: Entering the FSA’s IMAP means that you have the greatest chance of getting your model approved from Day One of Solvency II. There is nothing preventing firms applying for internal model approval after the start of the regime but they will have to live with the SCR derived from other means in the interim. Solvency II does provide options to tailor the standard formula, which we’ve seen a number of firms intending to do as well. I know a number of our clients, post the QIS 5 exercise, have been looking to try and tailor the standard formula to fit their risk profile better than the standard formula does on its own using undertaking specific parameters if they have decided not to go for an internal model. The FSA have stated that they are open to receive undertaking specific parameters applications for approval at the same time they are open to receive internal model applications as of March 30, 2012.

 THINK: As firms choose an approach and seek to optimize it for their risk profile, are they looking to leverage business benefits from Solvency II or are they viewing their efforts as primarily a compliance exercise?

 CURT: The Use Test is a fundamental part of Solvency II, which simply states you need to be using the outputs of your system in the managing of your day-to-day business. And that’s one of the big differences between Basel II and Solvency II. The Use Test obligates you to incorporate risk into the operations of the company, which leads to both direct and indirect benefits, so by its nature, Solvency II is more than just a compliance exercise.

 THINK: Do you share that perspective Paul?

 PAUL: I do. Fundamentally Solvency II is a regulation but looking at it purely through those eyes, you risk overlooking some of the obvious business benefits and given the budgets being spent here the business benefits should be explored. KPMG has been helping a number of clients who have ambitions for a minimum level of compliance with Solvency II if you like, but also helping those whose ambition is higher, who are looking to extract a number of business benefits from compliance. These firms are considering areas such as their future strategy and future business models now and preparing for changes that they may have to make. We’ve also been working with KPMG clients to improve many different aspects of their business model from systems and data assistance, simplifying company structures, and embedding new governance arrangements. As Curt alluded to, there’s the possibility of enhanced risk-based capital decision-making as part of Solvency II as well, that if well understood will drive a greater optimization of capital resources. The Use Test is one of the fundamental concepts there, along with the ORSA (Own Risk and Solvency Assessment), which is bringing together the risk and capital processes of the regime.

 THINK: Is there a correlation between size and how forward thinking an organization is about these strategies?
 A lot of firms, especially in the UK, have taken the regulators with them on that interpretation journey...you don’t want to go knocking on the regulator’s door on Day One and hope that everything you’ve done will be accepted.
 Paul Brenchley, KPMG

 PAUL: KPMG published on its website a benchmarking survey that we recently undertook where we asked our clients and others to rate themselves against a set of criteria looking at their current preparedness for Solvency II. The results are split across large companies and smaller companies. In almost all of the categories, the larger companies viewed that they are further ahead than the smaller companies including their thinking around their strategy in a Solvency II environment. We have found that the greater implementation challenges exist in large firms whereas smaller firms are able to make any changes in a shorter timeframe so these findings are not necessarily a concern at this stage.

 CURT: In terms of size, forward thinking can mean two different things. It could mean thought leadership but it could also mean that you mean you are part of a bigger and more complex entity and have already started working on many of the implementation challenges. In the latter case, you might not be any closer to completion than a smaller firm who is just starting out now and is planning to take the standard formula approach, but the size of the firm dictated that the process had to start earlier.

 THINK: There are substantial resources required to ensure compliance with any new regime. What challenges are firms facing in regards to technology acquisitions and upgrades?
 We’ve spoken with a lot of firms that are actually saying they want to do internal models but are going to start with standard formula. That’s not an uncommon position for people to be taking now.
 Curt Burmeister, Algorithmics

 CURT: As a software vendor, we’re part of that technology stack. One of the things we see is how budgets become a factor in planning. Some firms choose to prioritize their problems, and focus first on where their biggest technology challenges lie. This might be in the area of data warehousing for some, and for others it could be Pillar I calculations. Sometimes it depends on what the starting point is for the organization and where their relative strengths and weaknesses are from a technology point of view. We’ve certainly seen situations where people come to us and say, ‘we like your software but we think we have something more pressing to deal with so we’ll come and talk to you after we’ve dealt with that problem’.

 PAUL: We tend to find that in the UK a lot of insurers have legacy systems, therefore if you’re going to implement a change program it’s not quite as easy as flicking a switch and then all the data you need is magically there for you in the right format at the right time. We see a lot of activity around data warehouses, as Curt said. Other common areas we have been supporting our clients on are around data governance frameworks, building data dictionaries, and also data quality tools. Systems and data has become a real area of focus particularly when some of the reporting deadlines for Solvency II are very tight. There’s a lot of automation and trust in automation required.

 We’ve also been engaging with a number of external data providers, not only companies like Algorithmics but also asset managers and 3rd party administrators. It’s important for firms to consider that where they rely on a 3rd party that they are having discussions with that partner to make sure that the data is coming across in the right format in the right timeframe.

 THINK: Are there elements of Solvency II that are more challenging than insurers may anticipate?

 PAUL: There are challenges in all aspects of the regime. If you look across the three Pillars; Pillar I contains a new methodology of calculating technical provisions and there are some new tests that require a lot of effort in terms of getting an internal model up to an approval standard; in Pillar II there are some tough governance requirements, including expectations around risk management and the ORSA, which is a new concept that Solvency II brings in; Pillar III has new requirements for all insurers across Europe with new reporting and disclosure templates. On top of this, there is the group aspect to the regime, which requires consistent implementation across groups for the three Pillars. The group requirements are going to provide significant challenges for the large multinational groups in particular. I don’t think we can really match one set of issues with one client to the exact same set of issues in another. It does depend where the gaps are given their existing practices and where improvements should be made. We’ve been working with our clients on the evolution of their existing processes and operations in many areas to a Solvency II standard.

 THINK: Curt, what are people not anticipating from an implementation perspective?

 CURT: The one thing that people generally underestimate is the complexity associated with the workflow and audit functions of Solvency II from a software perspective. A complete solution must offer multiple users the ability to work on a single data set to ensure that the data inputs are valid, correct, and approved. The solution must also provide controls that prevent inconsistencies. This is where the analytics interact with operational, workflow, and audit-related functions and these interaction points don’t really get teased out until you start to implement the solution. Often it’s as complex and challenging for our larger clients to address these aspects as it is for the actual calculations themselves.

 THINK: Paul, having worked both at the FSA and with KPMG you have a unique perspective on concerns about Solvency II. What adjustment could make this process more painless for all the stakeholders?

 PAUL: It’s an interesting question. If there’s any one element that would benefit all parties, I think it would be more time. An extended implementation schedule would give firms a bigger window to think through the implementation of Solvency II, to consider the wider business benefits, and ultimately drive a better solution from their side.

 Additional time would also help address regulatory uncertainty. Policymakers would gain more space to consider some of the key proposals that are still on the table with the industry in greater detail. Organizations like EIOPA (European Insurance and Occupational Pensions Authority) are under a lot of pressure to deliver in a relatively short space of time to the European Commission. I think that would help the regime to come to a better place in a few years. The timeline would be the first thing I would adjust if I held the pe