Solvency II: Approaching the first hurdle

As Solvency II approaches its first major milestone, with the publication of the draft framework directive for consideration by the European Parliament, the ABI looks at how well it has so far delivered on its key objectives

In 2000, the European Commission initiated a fundamental and wide-ranging review of the overall financial position of insurers, the Solvency II project. The Commission has now almost reached the first key milestone of the project: On 10 July 2007, it will publish its draft of the Solvency II framework directive for consideration by the European Parliament.

The Commission described the objectives of the Solvency II project as: "To establish a solvency system that is better matched to the true risks of an insurance company. A future solvency system in the EU should also not be overly prescriptive, avoid undue complexity, reflect market developments (such as derivatives and alternative risk transfer) and, where possible, be based on common accounting principles."

The ABI agrees with these objectives. We believe Solvency II must meet five key challenges if it is to deliver a globally competitive insurance industry providing high quality, good value protection and investment products. These are:

- Market-based methods for the valuation of assets and liabilities.

- Appropriate capital requirements.

- A reform of the current system for group supervision.

- Appropriate incentives for effective risk management.

- A principles-based approach.

With little more than three months left before the first key milestone, this article looks at whether the project so far has delivered against these objectives.

Market-based valuation of assets and liabilities

Solvency II should see a decisive move toward market-based valuation of assets and liabilities. Under existing European rules, volatility and uncertainty in the estimated value of liabilities is addressed in a way that often does not reflect the underlying risk. Insurers are obliged to include additional, undefined prudence in their valuation of liabilities, coupled with simplistic capital requirements.

Instead, we need a more sophisticated framework using market-based methodologies, including the cost-of-capital approach for 'non-hedgeable' liabilities (those liabilities for which a market value cannot be identified). This should enable firms and supervisors to better understand the risks insurers are taking and the degree to which these have been mitigated.

The advice in CEIOPS' Consultation Paper 20 on Pillar I, published in November 2006, stated that for non-hedgeable risks, the cost of capital methodology is suitable to determine the market value margin for the technical provisions. We strongly support this advice. The next challenge will be to find an appropriate definition for hedgeable risks for which the market value alone can be used when calculating technical provisions (without a risk margin). CEIOPS' current wording, "Risks are non-hedgeable whenever they cannot be hedged in deep liquid and transparent markets," would seem to limit hedgeable risks inappropriately.

Appropriate capital requirements

Under Solvency II, supervisors will monitor two important capital thresholds. The solvency capital requirement (SCR) will be the normal target level of capital for an insurer. Firms may derive this either through their own capital model or through a prescribed standard formula. The minimum capital requirement (MCR) represents the regulatory minimum level of capital needed by an insurer. MCR should be set at an appropriately low level to reflect its role as a trigger for the most severe regulatory action, for example a suspension of new business or a winding up of the business (if the firm cannot present a credible recovery plan).

Between SCR and MCR there will be a 'ladder of intervention' where regulatory action will escalate according to the severity of the firm's capital position, including its proximity to the MCR, and the timeframe needed to restore capital to the SCR level.

It is important that Solvency II provides an incentive for firms to use their own internal models to calculate the SCR. The MCR must therefore be set low enough (in relation to the standard formula SCR) for it not to interfere with the SCR as derived from the firm's internal model (likely, in many cases, to be somewhat lower than the standard formula SCR). Equally, if MCR is too close to SCR, a 'ladder of intervention' will not work appropriately.

Currently, the supplement to CEIOPS CP 20 suggests a modular approach to the MCR: the MCR should address the main risk modules of the SCR in a simplified way so as to ensure auditability and robustness. However, the ABI and the Comite Europeen des Assurances (CEA) have long argued for a so-called compact approach to the MCR. This would see the MCR calibrated as a percentage, for example 30%, of the last approved SCR (whether calculated on the basis of an internal model or the standard formula). We continue to believe that the compact approach is the right method for calculating the MCR.

The modular approach is unsuitable because it can lead to distorted results where the MCR is too close to or even exceeds the SCR. This was one of the key problems identified in the results of the second quantitative impact study (QIS2). The reason for this is the design difference between the SCR (particularly where internal models are used) and the MCR. Inevitably, where the SCR includes all risks and the MCR only the key risks, there is a greater likelihood of distorted outcomes.

The compact approach, on the contrary, fulfils CEIOPS' own aim for the MCR - that it should be "optimised for simplicity". As the compact approach is based on the last approved SCR, it is risk-sensitive because it allows for diversification and risk mitigation. It also allows for the risk-absorbing nature of certain insurance liabilities. And it automatically ensures a sufficient difference between the SCR and the MCR. Finally, where insurers use internal models, supervisors can ensure through the model validation process that they are comfortable with the internal model, before its results can be used to calculate the MCR.

The indications are that the third quantitative impact study (QIS3) will test both the modular and the compact approach. We hope the QIS3 results will once more demonstrate that the compact approach to the MCR is more suitable than the modular approach. Accordingly, we hope that the framework directive will allow for the adoption of the compact approach.

A reform of the current system for group supervision

Solvency II presents an opportunity to develop a new approach to supervision for large cross-border groups. The current legal requirements are based at the individual legal entity level. For groups operating across Europe this can result in a significant degree of duplication in the regulatory process. It also constrains the efficient use of capital across the group.

Solvency II should recognise the economic reality of large, cross-border groups by introducing a single lead supervisor. The lead supervisor would assess the entire group using a consistent approach to capital assessment and supervision. It is also imperative that Solvency II takes diversification effects properly into account, provided the group can demonstrate it has the freedom to move capital around according to need between different legal entities.

CEIOPS' final advice on sub-group supervision retains the current concept of solo supervision as the cornerstone of insurance supervision, although it also helpfully points to a somewhat more progressive approach to group supervision than set out in the currently applicable Insurance Groups Directive.

The joint HM Treasury / FSA discussion paper, Supervising insurance groups under Solvency II, presents a fresh approach to group supervision which the ABI supports. The paper argues that groups should be required to hold capital locally to match the technical provisions and the MCR, but not to hold capital to match the SCR in all their subsidiaries. Instead, the group would be free to hold the capital where it is most appropriate for its business. At the group level, the SCR would be calculated by a standard formula or by an internal group model, in each case taking into account group diversification benefits so that the group SCR would be less than the sum of the individual group members' SCRs.

The group would satisfy its capital adequacy test if it has sufficient assets available for transfer across the group (without any legal or other impediments) to cover the difference between its MCR (calculated as the sum of the individual company MCRs) and the group SCR. An intra-group transfer of assets would only be required if a group member had insufficient assets to cover its MCR.

The paper also proposes a new approach to group supervision. A lead supervisor should be appointed to undertake one coherent assessment of the group. Local supervisors would participate in the group supervision process by monitoring the MCR position of solo companies within their jurisdiction and assessing the adequacy of governance and risk management systems. This approach would eliminate much of the current duplication of regulatory requirements.

We believe this is the right way forward for group supervision. But we also recognise that this represents a tremendous cultural change for European supervisors and will require much closer cooperation and considerable trust between them. It is key that the framework directive provides comfort to the solo supervisors so that, in return for losing some control over the subsidiaries in their jurisdiction, they will obtain more information about the group as a whole and, crucially, that they can be certain that the group will transfer funds to the subsidiary if its capital were to fall below its MCR.

Appropriate incentives for effective risk management

Solvency II should incentivise insurers to use modern risk management practices, including reinsurance, derivative contracts or securitisations, to transfer risk. We therefore support CEIOPS' advice (in CP 20) that, "Insurance undertakings should be permitted to fully recognise the effect of risk mitigation techniques in their actuarial model," (as long as risks arising from the use of the risk mitigation technique are properly captured in the actuarial model).

We also believe Solvency II should see a much greater role for insurers' internal capital modelling, helping insurers to manage their business and also providing a significant input into the supervisor's assessment of the firm. The considerable challenges of internal models and their validation in the Solvency II context have been set out in detail in the last issue of Life & Pensions. We believe the Solvency II directive must not impose arbitrary criteria or unduly burdensome tests for insurers to satisfy before their model can be validated.

Principles-based approach

Solvency II should mark a significant shift away from detailed, prescriptive rules and instead adopt principles based on market-consistency and economic and market realities. This principles-based approach should not only apply to the framework directive, but also to the more detailed implementing measures at level two. We believe regulation should complement and not undermine the ability of insurers to manage their own business. It should also ensure that senior management own and understand the approaches used to assess and manage the risks in their business.

Once the framework directive is published, we will be able to assess to what extent it delivers a principles-based approach. If the document published on 10 July 2007 meets the challenges set out here, it will have cleared the first hurdle on the way to delivering a world class regulatory regime - a regime that will help the European insurance industry to better meet the needs of consumers across the Single Market and to compete globally.

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