The insurance industry and regulators should use the current global financial crisis to drive a constructive evolution of regulatory guidance, according to Ernst & Young’s Global Insurance Centre.

Although the insurance industry faces fewer urgent liquidity challenges compared with banks, the valuation of assets has been severely affected by the crisis, and capital reserves in many insurance companies have been signif icantly depleted.

“This is a clear sign that the inter connected web of the global financial markets has far greater implications than the industry could have predicted,” said Ernst & Young Solvency II Task force leader Philipp Keller.

“The significant impact of the finan cial crisis highlights the need for enhanced risk management. It is our view that a principles-based, economic and risk-sensitive approach such as Solvency II, grounded in solid gover nance and supervisory principles, is the right response at this time. This will produce timely, consistent and trans parent messages to the public.

“Principles-based regulation places responsibility for risk management with the management and board of the regu lated companies,” Keller said. “It drives risk management standards appropriate to the complexity of the business. This will foster understanding and account ability for the risks taken, but will also produce a major challenge for manage ment teams and boards.”

However, according to Keller, it is important to recognise that a regulatory framework such as Solvency II in its currently anticipated form, while a sig nificant improvement on current pru dential supervision, will never be able to provide all the answers and can be only one element of sound risk and cap ital management.

Given this, he said, industry and reg ulators should make use of events such as the current financial crisis to drive a con structive evolution of regulatory guid ance. This, he maintained, should complement the Solvency II regime with short-term liquidity testing and cash flow analysis to allow a more holistic approach to anticipating the impact of adverse events, and place more empha sis on the articulation and testing of com pany-specific threat scenarios, in addition to the standard quantitative requirements.

Keller also noted, however, that Insurers often focus their attention on traditional areas of financial risk. While this is not surprising or unusual, he warned that Solvency II will require the global insurance industry to pay closer attention to an often “forgotten” area – operational risk.