Solvency II: is the new regime fit for purpose?

The Solvency II regime, a European Union directive that aims to codify and harmonise EU insurance regulation and echoes Basel II in outlining the minimum levels of capital that insurers must hold, is finally introduced this month. The measures have attracted much controversy, being opposed by many companies in the sector, and have regularly undergone revisions with the launch put back several years.

Certainly, Solvency II has been a long time coming. Its origins can be traced back to 2002 and the first European impact study to test the level of financial prudence in insurers’ technical provisions. The initial step in developing the new regime was undertaken in the autumn of 2005. A generation of actuaries and regulators have grown grey in working on Solvency II’s development. Yet that long process is now complete and the new regime finally came into force from January 1, 2016.

Solvency II is more than just a solvency test. It encapsulates an entire regulatory framework covering risk management, internal controls, reporting requirements as well as the quantitative solvency test itself. For policyholders, regulators and investors it promises a common set of standards for a sector long regarded as opaque. It should offer a better view of an insurer’s economic health than that presented by International Financial Reporting Standards (IFRS) accounting or, for European life companies, the current mix of market consistent and European embedded value.

The principles on which the new regime has been founded have not, however, been without their critics. Tidjane Thiam, in one of his final conference calls as chief executive (CEO) of Prudential plc, highlighted two fundamental areas of concern. The first was around market consistency as a way to assess the value of assets and liabilities across the economic cycle. Thiam argued that the 2008-09 global financial crisis showed that market consistency didn’t really work because of the pro-cyclicality within the Solvency II model.

Valuing insurance liabilities using a risk free curve during a period when monetary policy had driven interest rates to exceptionally low levels threatened the ability of life insurers to continue to provide retirement solutions to Europe’s aging population. Equally a solvency test, which might force insurers to liquidate assets at depressed prices in response to a market crash, risked increasing systemic risk at a time when the long-term nature of insurers’ assets and liabilities should be a source of stability.

Subjects of concern

Much of the delay in the implementation of Solvency II was caused by the long-term guarantee assessment (LTGA), which tried to address some of these concerns. The result was a series of adjustments to the curve used to discount insurance liabilities and the confirmation of an ultimate forward rate for the period beyond which market interest rates are observable, set in most markets at 4.2%. While the volatility adjustment sought to address distortions created by market illiquidity, the matching adjustment recognized that certain assets held to maturity to match equivalent liabilities were not sensitive to changes in market pricing.

The LTGA also extended transitional measures and gave insurers up to 16 years to implement Solvency II capital requirements for specifically identified books of business. This significantly diluted the impact of the legislation and gave insurers more time to adapt to the new regime.

Thiam’s other concern was that the measurement of Value-at-Risk (VaR) and the one year perspective copied from the banking sector and embedded within the Solvency II legislation was inappropriate and inadequate in the case of the long-term liabilities of life insurers. The liabilities of an insurer come due over an extended period and are unlikely to ever crystalize at one moment in time. Denis Duverne, group deputy CEO of France’s Axa recently revealed that the group had originally started building a long-term internal capital model for Solvency II but switched to a short-term economic capital model with a one-year horizon after realizing that this was the approach preferred by regulators.

Under the Solvency II standard formula, the capital requirement is made up of a series of capital charges for different types of risk such – as market risk, reserving risk and counterparty risks. The market risk measures the required capital which could absorb a one-year decline in asset values of a scale that is estimated to take place no more than once every 200 years. It assumes a 12-month liability maturity profile for all insurers – even though a life insurer with liabilities and with maturities of up to 20 years is much less sensitive to illiquidity risk than a property insurer with much shorter maturing liabilities.

This also has implications for the assets in which insurers can invest. Much debate has surrounded the issue of infrastructure investment and whether the new rules should do more to encourage life insurers to use their assets to support infrastructure projects at a time when bank and government resources are constrained. Infrastructure investments are attractive to life insurers because of their long maturity profiles. Yet under the Solvency II rules, very long-term assets still attract higher capital charges compared to sovereign or corporate bonds, even where infrastructure bonds are backed by the European investment bank.

A catalyst for consolidation?

The Solvency II rules generally favour certain asset classes to the detriment of others, since the standard formula imposes lower capital charges on short-term investments and investments with higher credit quality. This tends to discourage investment in more capital intensive classes such as equities, long-term investments and asset backed securities even after credit has been given for diversification.

There is a risk that the regulations, including the way the volatility adjustment is calculated, will drive greater convergence in investment strategy towards an almost uniform allocation. While that might, in theory, reduce risk it also brings systemic dangers. For example, an industry bias towards holding government bonds may not prove so attractive should we enter a period of rising interest rates and increasing inflation.

Many larger insurance groups have sought to overcome the limitations of the standard Solvency II formula by seeking regulatory approval of their own internal models. Internal models allow insurers to better calibrate capital requirements for asset classes and insurance risks based on their own experience. This has the potential to result in lower capital charges compared to the standard formula but gives rise to concerns about transparency.

It also raises a question as to whether this is really a level playing field. Most of the largest multinational insurance groups intend to use internal models starting from January 2016 and others may look to move from a partial internal model to full internal model by the end of 2016. For smaller insurers, which have already expressed concern about the cost and complexity of the new regime, the ability of large insurers to use their resources to develop complex internal models to reduce their capital requirements puts smaller groups at a further competitive disadvantage. This risks driving further industry consolidation, with the biggest groups becoming even larger.

There is, however, some recognition that the focus on risk management and governance is bringing benefits. In a survey by Insurance Europe (formerly the Comité Européen des Assurances), 79% of respondents reported that governance had improved as a result of Solvency II while 74% said that risk monitoring and identification had been enhanced and 63% felt that data quality had been improved. Such advances are important for a European industry which still faces very serious challenges from sustained low interest rates. Whatever the debate over individual aspects of the regulation, it still marks a huge advance over what existed previously. This is reflected in the fact that a number of other regulatory authorities around the world, ranging from Mexico to Singapore are looking at Solvency II as a model for their own regimes.

While the new regime might have its flaws, and many feel it has borrowed too much from bank regulation, most insurers believe they now have a framework they can work with. In reality the Solvency II regime will continue to evolve. The Delegated Acts provide for a review of the methods, assumptions and standard parameters of Solvency II in 2018 based on the experienced gained in the first few years of operation.

Longer term, Solvency II is likely to become part of a much wider global regulatory regime. The Financial Stability Board has already begun the regulation of Global Systemically Important Insurers (G-SIIs) and has a wider objective of applying group-wide global capital standards to internationally active insurance groups from 2020. Aligning European, US and other national capital rules into one regime is likely to present many challenges. If European insurers thought Solvency II marked the end of a period of intense regulatory change they are likely to be disappointed. Let’s hope, however, that the development of a set of global capital standards doesn’t take the 13 years it has taken to get Solvency II launched.

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