Imprudent insurance practices, unchecked, could cause a catastrophic collapse of insurers in the UK.
In part, that’s why the UK signed up to the Solvency II directive in 2016, along with other members of the European Union.
The Solvency II directive now governs many aspects of insurance buying. It’s in your interest, therefore, to know how it can be used to help you. In this article, you’ll learn what Solvency II is, and details of the many advantages that it provides to Insurance Buyers.
Solvency II Explained
In short, Solvency II prescribes regulatory requirements for insurance and reinsurance companies in the EU. It applies to all but the smallest insurers in the UK.
It came into force in the UK in January of 2016. Post Brexit, the rules still apply and are likely to remain, to ensure comparability and competitiveness with EU insurers.
The key takeaway is that Solvency II is a risk-based system. That means it focuses on exposing the risks that the insurance company faces and attempts to allocate capital accurately (and charge premium) in accordance with those risks.
The Three Pillars of Solvency II
With such a functional definition, we can’t move into what Solvency II can do for you. To do that, it’s best to start by describing the three foundational pillars of the system.
- Pillar I: Valuation of liabilities, assets and capital requirements: how an insurer is required to demonstrate that it can meet its liabilities. Put simply, it makes sure insurers have enough money to pay claims as they arise, in all but the most extreme circumstances.
- Pillar II: Rules of governance and risk management for insurers: how insurers should monitor and manage the risks they’re exposed to. Because insurance is ultimately about risk transfer, insurers need to maintain a high standard of risk mitigation.
- Pillar III: Transparency and disclosure requirements for insurers. It establishes all the information insurers are required to disclose publicly.
What Does Solvency II Do for You?
If you examine Solvency II, you’ll come to a vitally important piece of information: insurance premiums are set by looking at future events, not past ones.
Why is this important for you? It gives you a roadmap for presenting your risks in the most favourable way to reduce premiums. Understanding risk in this way allows you to better negotiate your insurance.
When negotiating, here are the factors you should focus on:
Cover Limits, or How Much Cover You’re Buying
The more coverage you purchase, the bigger your premium will be. Therefore, you must understand precisely what you’re paying for.
Say, like some Local Authorities these days, you purchase EL coverage with £100m of coverage per occurrence. In effect, you’re paying for £100m worth of coverage on the potential of the event happening every day throughout the policy year, no matter how impossibly remote that scenario is; but you’ve bought the cover, so you must expect the impossible to happen, otherwise you wouldn’t buy it. That’s over £3 bn of potential claims that the insurer may have to payout over the policy year. That’s what a £100m per occurrence wording means.
That’s enough to bankrupt most insurers who need to charge a premium commensurate with that risk for their shareholders. How much would you charge for taking over someone’s risk that could bankrupt you?
The upshot is that you should always decompose the cover you ask for into:
- Per claim: cover for each and every claim/claimant
- Per event: cover for all claimants from a single event (occurrence)
- Per year: cover for all events in a single year
When presented like this, the amounts involved can be eye-opening.
For example, in the Local Authority example above, the £100m per occurrence wording actually means:
- Per claim: £100m
- Per event: £100m
- Per year: no limit
Instead, buy cover for what you could expect a reasonable worst case to be over the insured period, plus a safety margin to cover the unexpected. For example, how many claimants at £25m each, £10m each, £1m each etc. For a typical local authority, even a single EL claimant for just £1m is very rare.
A typical local authority has 2-3 EL claims per year per 1000 headcount, so even the total number of claims is usually small. The largest local authorities, with perhaps 30,000 employees, typically have 50-100 EL claims per year, averaging £10,000 each; the total cost of all of their EL claims in a single year rarely reaches £1m, let alone £1m per claimant.
What Exactly Is Covered
If you want to make endorsements or extensions to your coverage, be prepared to treat them the same way as the rest of the policy. An endorsement to a policy is essentially an amendment that extends or restricts cover or clarifies some part of the policy.
You must understand what you’re asking for when creating an endorsement. In a perfect world, your policy would cover the broadest possible spectrum of events for the lowest price. But that’s not realistic. Every endorsement that’s made presents a new risk for the insurer. Therefore, it will carry an added premium adjustment that corresponds to that risk, not the original policy’s risk.
Furthermore, even simple extensions to a policy can carry a significant amount of risk. In the Local Authority example overleaf, extending cover to say School Governors, adds another layer of potential bankruptcy to the insurer.
It helps if you consider what the endorsement or extensions change in terms of future events, not what has happened in the past. Many insurance buyers are shocked when they realise how much seemingly innocuous changes to coverage affect their premium.
The Policy Excess (Deductible)
A larger deductible indeed makes an impact on the premium, but most clients are surprised at how small the impact is. The mismatch comes from a fundamental misunderstanding of how insurers calculate risk (and hence premium).
Returning to the example above, say your organisation’s EL cover is £100m per occurrence, but with a £100,000 deductible (per claim). An insurance company sees this as a potential pay out per claim of £99.9m, for every single claim.
If you increase your deductible to £500,000, the insurer will still be liable for a every potential claim up to £99.5m. So, you can see how this does precious little to affect the premium.
To make a real difference in the eyes of the insurer, with cover of £100m per occurrence, you’d have to increase your deductible by several million pounds.
Therefore, the practical way to impact your premium effectively is via a split limit policy, such as £5m per claim/£100m per event. However, this type of policy is usually only available through specialist brokers and insurance actuaries.
In Summary, Focus on the Future, not the Past, When Crafting Your Policy
By now, you should have a better understanding of how Solvency II should impact your insurance buying process.
The critical paradigm shift of Solvency II is in how risk is calculated. Insurers have little benefit from looking at past events when calculating premiums, so neither should you.
Instead, focus on how you can present your organisation as a better risk for the future.
For help crafting a policy that covers all your needs at the smallest cost to you, contact InsuranceInspect Services. We provide a structured and vendor-neutral approach to designing an insurance policy that’s optimal for your bespoke situation.
