The Solvency II Experts News

By Richard Camp – International Underwriting Association of London: Secretary of the IUA Accounts Taxation and Solvency Committee.

The consultation period for the first wave of CEIOPS’ 2009 consultation papers has now passed, with the second wave expected imminently. Although the consultation papers amounted to over 300 pages, across 12 consultation papers, it is probably fair to say that there were no ‘show-stoppers’ arising from the consultations. That is not to say that there were not any important issues arising from the consultations – there have been many comments made by various stakeholders identifying issues which will need to be addressed and considered – but it does demonstrate how an open and co-operative discussions between regulators and industry can help to develop a sensible, workable and more secure supervisory regime.

The remainder of 2009 is likely to be taken up with the remaining Second and Third consultation waves, currently expected to span July-September and November-December. However whilst the remaining consultation papers are awaited, it might be worth reflecting on some of the more salient issues arising from the first wave of consultations, at least from a General Insurance perspective.
The following issues are those that we have identified as some of the concern to our members who are general insurance companies operating in the London commercial insurance market.

CP 27 – Technical Provisions: Segmentation

The segmentation proposed in this consultation was the same segmentation proposed at least since QIS 3, with concerns surrounding the inherent limitations of the proposed segmentation, particularly for non-proportional non-life reinsurance. It was suggested by our members that greater granularity might be necessary in order to recognise the different characteristics between classes of business.
For example, the treatment of “non-proportional casualty reinsurance” as a single class of business was considered inappropriate, given the wide ranging classes of business which could be encompassed in this class. Casualty reinsurance may encompass anything from motor to financial lines reinsurance, and environmental to public liability reinsurance. Similarly it was felt that Marine, Aviation and Transport business differs sufficiently to be treated as separate classes of business. Each of these classes have very distinct features and characteristics, and the treatment of each as a single class will generally result in a loss of the diversification benefits exhibited by that business.

It is important to strike a balance between sufficient levels of granularity between lines of business, and ensuring that the approach advocated is not overly burdensome. However, from the feedback we received the diversification in the underlying characteristics between these lines of business was considered sufficient to call for this extra detail.

CP 28 – Counterparty Default Risk

A common issue raised in response to a number of these consultation papers was an emphasis on the need to maintain proportionality. In the context of this paper, our members considered it particularly important that the counterparty default risk should not be overly burdensome to calculate, particularly where a number of counterparties exist, such as on reinsurance programmes where there are a number of layers, each with a number of different subscribers on each layer.

It was also queried whether it is reasonable for the draft advice to suggest that all OECD and EEA countries should automatically be considered risk free given that there are some jurisdictions with a credit rating of less than a BBB+ rating, and one with a rating less than BBB- (based upon S&P ratings). Concern about the “credit-rating-cliff” exists for sovereign states just as much as businesses (i.e. downgrades result in reduced demand for sovereign debt, which in turn makes debt more costly to service, which in turn could lead to further downgrades), particularly where the regulatory system incentivises towards higher ratings, and thereby introducing a degree of procyclicality. Nevertheless, our members considered it worthwhile to at least to ask the question whether the holding of, for example, BBB rated sovereign debt should necessarily be treated as less risky than securities from A rated financial institutions.

The point was also made that under the Insurance Mediation Directive, those intermediaries based in states which have introduced strictly segregated client accounts, might present a rather lower credit risk than other Type 2 exposures. Furthermore, it was also highlighted by our members that some Type 1 counterparties may not always be rated, and similarly, Type 2 counterparties might have credit ratings, blurring the two types of counterparty outlined in the consulation.

CP 29 – Supervisory Approval of Ancillary Own Funds

Ancillary own funds are funds which can be called upon to meet losses, such as unpaid share capital, letters of credit, and other legally binding commitments. Such funds need supervisory approval to account towards own funds which can form part of the SCR capital requirement.
One issue arising from the draft advice of concern to our members related to the need for continuous monitoring of ancillary own funds. Although the need for this was recognised, it was also considered important to emphasise that that monitoring should fall on undertakings rather than supervisors, with supervisors only reviewing the arrangements at the initial submission and at periodic intervals with the undertaking. Reservations were also held about the need for the renewal of supervisory approval every 12 months.

Our members suggested instead, that a presumption of renewal at 12 months intervals would be preferable, except where material changes to the security of the ancillary own funds, or a material change in the composition of the firm’s capital base exist; in either case the firms’ continuing monitoring and reporting obligations should highlight where such a material change occurs. Such an approach should provide firms with some certainty with regards to the continued eligibility of its ancillary own funds.

Based upon feedback we have received, it was also considered that timely communications with supervisors, particularly in cases where supervisors decline the approval of supervisory own funds, or an approval for less funds than was requested, would be important so that the undertaking can take any necessary action. Additionally, it was felt that the supervisor should be obliged to provide an explanation of why the any request for approval was rejected. It was also queried whether in light of such an explanation, if a revised request for approval could be made after consideration of the supervisors’ rationale behind its initial decision.

CP 31 – Allowance for Financial Mitigation Techniques

This paper considered the effects of financial mitigation techniques in the assessment of the SCR. The paper outlined five general principles, which our members were generally supportive of, although they also hold the view that the principles should not be applied in such a way that they stifle innovative or sophisticated risk management techniques.

Some concern was also raised in response to the consultation paper’s proposed requirement for only those instruments that perfectly match the exposures of the undertaking, to be automatically allowed for in the calculation of the SCR. Where the instruments do not perfectly match the exposures of the undertaking, the draft advice suggested that the risk mitigation benefit can only be allowed, if it can be demonstrated that the “basis risk” of those instruments is not material to the mitigation effect. It was considered that, depending on how it is defined, instruments which are not “perfectly matched” might encompass many financial mitigation instruments, and therefore the need to demonstrate the basis risk to mitigation effect could become quite onerous. It was also questioned whether diversification of basis risk through the holding of many different types of instrument might also be recognised.

CP 32 – Assumptions About Future Management Actions

This paper considered the circumstances where future management actions are accounted for in the calculation of technical provisions. In light of this our members felt that care had to be taken not to unduly stifle management activity, and innovative management actions, through the adoption of rigid requirements.

We also queried how far into the future such management actions would need to be considered. As time goes on, the certainty of future actions is likely to diminish and could change in response to events. At least for general insurance business, considering all conceivable future actions, whilst looking a long time into the future could be quite onerous. This is especially true given that some future actions might be dependent on other future actions taken before it; the further one looks into the future, the greater the number of permutations of future actions there could be – and therefore the greater the burden on firms.

Some of our members also sought clarity on the principle of “internal consistency” raised in the draft advice, and in particular if the principle related to a single entity, or extended to wider group operations. For example, some group subsidiaries might be run as independent entities, or acquisitions might result in different management practices. In those circumstances, we suggested that it might not necessarily be appropriate to apply the “internal consistency” principle.

CP33 – Governance

The governance paper was the longest of the consultation papers in the first wave, and contained a significant amount of information towards requiring sound systems of governance and emphasised the importance of firms putting in place effective control and risk mitigation measures under Solvency II.
In the introduction, CEIOPS noted that they took into account lessons learnt from the financial crisis. However in response we felt it important to highlight that the financial crisis has not generally uncovered fundamental failings in the insurance sector. Whilst insurers have not been entirely immune to the effects of the current financial crisis, clearly insurance was not the source of the problems and that generally, core insurance business has performed well. Whilst we recognise lessons do have to be taken on board, care has to be taken not to automatically assume the insurance sector has significant governance failings and become regulated accordingly.

A recurring issue in response to various issues raised throughout the paper was that while the need for strong governance procedures is recognised, the need for proportionality and ensuring that any governance requirements are both realistic and not overly burdensome on firms would also be important.

The dangers of potential conflicts of interest regarding remuneration are well known, and remuneration has been of particular interest following recent events. The consultation paper, aside from raising more general points relating to remuneration, specifically mentioned the remuneration of the internal audit function. In response it was noted that generally most internal auditors in the insurance industry do not have bonuses as a multiple of salary, and therefore the magnitude of danger from adverse incentives was significantly reduced. It was also highlighted that it would be difficult for businesses to give any kind of bonus that does not bear some relation to the overall performance of the company. Instead, it was considered that it might be more appropriate to require “the function [to be] mostly compensated according to its own objectives”, thereby also bringing materiality and proportionally into the consideration.

Another key issue in the draft advice related to the actuarial function and the standards applied. Three options were provided. Option 1, would require CEIOPS to develop a set of technical standards the actuarial function should adopt. Option 2, would rely on technical standards widely accepted in the industry and profession and Option 3 requires the formulation and agreement of a full set of technical standards at a European level. We considered that Option 3 could be difficult to achieve and would likely be a longer term approach given the Solvency II implementation timeframe, and in any case would probably require an interim measure. Option 2, would however also require a degree of supervisory flexibility in assessing the actuarial standards in different EU States. On balance, given the options available, we felt that Option 2 would probably be the favoured option.

CP34 – Transparency and Accountability

This paper dealt with supervisory transparency and accountability in order to foster and deliver a harmonised regime. We consider the principle of supervisory disclosure to be a sound one, and the harmonisation that results will be a key benefit from the Solvency II regime, and will be necessary to prevent regulatory arbitrage.

In addition to supporting the minimum information requirements set out in the paper that supervisors will need to disclosed, as well as the availability of supervisory disclosures in a common language, our members also considered that supervisors’ criteria and method for applying remedial measures, such as applying capital add-ons, should also be disclosed.

Furthermore, the paper set out the possibility for supervisory discretion over whether to keep historical information available beyond one year; we felt this might hinder transparency and comparability across member states. It was therefore suggested that the availability of aggregate historical data from previous years would be a useful addition, over and above the previous year. Once data has been posted on websites, it was considered that it would be of little extra burden to require that information to remain available for forthcoming years.

CP36 – Special Purpose Vehicles

A number of issues were identified from this consultation paper. The first was the need for further clarity on the treatment of Non-EEA Special Purpose Vehicles (SPVs) given the Consultation Paper’s focus upon EEA SPVs.

Our members also sought further clarity in respect of the “fully-funded principle” which requires SPVs to be fully-funded at all times in the interests of ensuring security to the ceding parties and minimising prudential risk to policyholders. A number of questions however remain. For example, whilst “underfunding” (where the value of assets falls below the value of potential reinsurance recoveries and aggregate liabilities) should not occur, in the event it did, would the SPV supervisor have options other than withdrawal of authorisation available to them, for example, by requiring an injection of capital from investors, subject to approval from the supervisor, so that it can retain its status as a full-funded entity? Or would the breach of the principle result in the automatic withdrawal of authorisation? Such further clarity would also be useful, to ensure a harmonised and proportionate application of the principle across all supervisors.

The draft advice also stated the need for appropriate “risk modelling and understanding” under the fit and proper requirements; we therefore questioned whether in practice this might require an SPV to have and make use of an internal model.

The consultation paper also noted that the only circumstances where repayments to investors are permitted, are where such repayments are agreed at authorisation. Given that there may be a significant period of time before all of the SPV’s further reinsurance liabilities have expired, the question was asked whether there might be any exceptions to this in the event a SPV could be demonstrated to be significantly overfunded, providing the SPV adheres to the fully-funded principle. This might occur, for example, where shorter term liabilities extinguish at a level below what was allowed for when the SPV was initially funded.

CP37 – Approval Procedure for an Internal Model

The draft advice outlined further detail relating to the approval process for a full or partial internal model. A 6-month approval timeframe was set out in the Level 1 text, however, we suggested that in the event a supervisor identifies any missing information as a result of a mistake or oversight, they should inform the undertaking in a timely manner, with the 6-month period suspended until such a time that the further information is provided. This would avoid a situation where undertakings might have to wait six months before they find out their application was rejected due to omitted information.

An item in the draft advice of more concern, was the suggestion that internal model rejections might also be publically disclosed. The draft advice acknowledged that this information is potentially commercially sensitive but CEIOPS also believed that this information was of interest to the wider audience. We therefore suggested that in order to strike a balance between these interests, an annual report released by supervisors detailing common issues and reasons why models were rejected would serve the requirement to inform the wider audience as well as protect the commercial interests of undertakings.

Conclusion

In summary, the consultation papers provided useful further detail on some of the key areas of Solvency II. A recurring theme throughout was to emphasise the need for a principles based approach that is proportionate to the size, nature and complexity of undertakings’ activities. Further guidance is probably also needed in a number of areas, although any extra guidance or further detail provided should not be inflexible or overly prescriptive.

The further consultations due shortly will be a further step towards shaping the framework, and will therefore be particularly important for all industry stakeholders to be on the lookout for potential issues. Although there is likely to be a lot of information forthcoming which needs to be considered throughout a challenging timetable, the participation and involvement from stakeholders will be especially important, primarily to identify any necessary issues which might need to be addressed. However, it will also be a useful opportunity to continue developing a familiarity with the eventual details of the framework that will need to be complied with in preparation for implementation.