Financial Services Ireland

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Solvency II: Something’s got to give

By James Maher, Insurance, Sector Leader

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Solvency II and the European insurance environment

The European Insurance ambition for the Solvency II review is set in a context of significant challenges not foreseen in its establishment. The issues that have emerged point to the need to evolve and revolutionise Solvency II. Against a backdrop of widening protection gaps, a need to stimulate recovery and an ambition to build a sustainable society, what can we do to ensure a better long-term future within a mark to market regime?

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Introduction

There is a clear ambition to resolve the societal and environmental challenges we face through the effective application of insurance techniques and in directing the considerable financial resources of the sector. However, this can only be realised within the current and planned regulatory architecture. A revision to Solvency II needs to balance consideration of real-world problems including:

  • Protection gaps – there are a broad range of protection gaps around pensions, health and cyber risks, together with natural catastrophes, that are all likely to expand and extend as we move forward.
  • Climate change – the challenges in moving to a more sustainable planet, best summarised in a Net Zero strategy, point to a significant shift in trade flows between asset classes and risks.
  • Macro prudential considerations – there is an appetite to contain private sector obligations within the ambit of capital resources in order to avoid contagion that may ultimately fall back on the wider public.

As we move into the final stages for consideration of the proposed revisions of Solvency II by the Commission, it is worth considering the tradeoffs and challenges that await those charged with determining our future regulatory regime.

There is still considerable work to do in the context of the current advice by EIOPA on the proposed SII revisions. There is likely significant change to that advice expected from the review by DG FISMA.

Without preempting or anticipating those challenges and potential changes to the recommendations, the conversation raises some questions around the challenges and tradeoffs that lie ahead.  The three questions that need our consideration are:

  • Is the complexity rewarded in terms of more efficient capital allocation and better risk matching?
  • Can we really meet long term goals through a short-term capital regime?
  • What is proportionate and can we ever get the balance right?

There is still considerable work to do in the context of the current advice by EIOPA on the proposed SII revisions

Question 1 – Capital or complexity?

The insurance sector in Europe is not suffering from a lack of capital. It is, however, suffering from a lack of profits and profitability. I am not aware of any company that is not undergoing significant transformation, and we see three strategic priorities manifesting within the sector:

  • Redefining purpose and strategic direction
  • Transforming the business to be more agile, digital and customer centric
  • Optimising the business through cost management and capital allocation

We see a sector with a clear wish to serve its customers and modernise its estate.  There is a need to negotiate the investment for that change agenda so that businesses can achieve an appropriate and sustainable return for all stakeholders. Insurance is in the middle of significant change, with the focus on re-organisation and re-platforming, moving from non-life business into the life sector.

To fund those investments and realise operating capacity, we see significant re-organisation of groups, externalisation of long term guarantees through reinsurance and in the limit disposal. Much of that new money, whether for reinsurance or for acquisition, is not coming from within the EU but from the outside. It is  solely predicated on the ability to shift the capital frictions outside of the EU.  The global market price for such risks are being set outside of Europe, and sometimes significantly lower than Solvency II assumes.

As such, there is a market signal that we have not got the right balance currently and that the appetite for incumbents is more likely to de-risk portfolios seeking better matching of market to market regulatory capital than “risk on” projects where the short term mismatches are held. The resolution of that tension for those seeking to hold those longer term positions are often associated with a transfer of risk out of the EU regulatory context.

The hierarchy of issues and considerations has been well articulated and for posterity if not completeness I can share a personal reflection and view based on client and wider industry insights with specific focus on the Technical Provisions;

  • First on the European hit list is the Risk Margin; In this the reforms make a move but it is also worth noting there is a trend away from the Cost of Capital model for risk margin globally; The arguments over its construction are well made with a specific attention on the level of the cost of capital; For sure there is something of an inconsistency where we are reducing productivity gains in the future but not adjusting for costs of capital; But the particular perspective to share is a move to abandon the cost of capital model for valuation purposes and bring back PADs based on percentile. More by note than advocacy it is instructive to note a significant shift of non-European companies to look at a percentile approach for IFRS17 risk adjustments and to note the application of such an approach under the ICS basis.
  • Next most favoured topic appears to be the volatility adjustment and this is perhaps a specific area of enhanced complexity with an attendant program of controls that moves the current VA towards a better matching position. This basis is starting to shift in the direction of a matching adjustment and that in turn brings with its considerations of cost benefit and of application and oversight. The feedback that is coming back up the way is that the cost of making it very bespoke will only add to the supervisory burden for the same for larger organisations it is not clear where that balance of benefit will end up in particular for the smaller organisations.

Stepping back from the technical matters, there is also the risk of ending up where the surgery has been a success but the patient had died. In medicine, the reference is iatrogenic, in regulation we reference cost benefit analysis and impact analysis. This is no simple act and is fraught with tradeoffs within and between the actors.

EIOPA has applied diligence in the pursuit of its mandate to provide advice but there is an attendant need for the users of the advice to test and challenge the accompanying cost benefit analysis. From my own review, it appears the costs and impacts underappreciate their effect, and there is the risk of unintended consequences.

There is a market signal that we have not got the right balance currently

Question 2 – Can we meet really meet long-term goals through a short-term capital regime?

Regarding the ambition to increase protection for policyholders, increase the flow of money towards equities to restart the economy and increase the flow of funding for green initiatives, all in the face of potential macro-economic threats, I am reminded of the pre-financial crisis view that variable annuity guarantees could offer outperformance of returns at no additional cost.

This alchemy did not and cannot exist and in the limit the cost of guarantees exceeded the value that customers placed on them while at the same time being underpriced for those selling them. The competing needs to be risk neutral and realise an equity premium could not co-exist.

Are we now entering a phase where we are looking to enter the same trade of getting more utility for risk allocation while strengthening the protection of policyholders?

This enhanced protection is being put in place both ex post and ex ante in the form of more capital, more disclosure and in new institutions to address the macro prudential agenda.

Ultimately the cost of these protections will fall to shareholders, policyholders and taxpayers; The sequence of this will be the flight of shareholders, followed by the flight of policyholders and the obligation landing back on taxpayers and society more generally.

In the limit the insurance industry is a risk transformer, balancing the cost of risk between shareholders and over time, the higher the cost of capital and the higher the cost of manufacturing the higher the price to the end consumer;

It would appear that where the balance of pressure at this point in time is towards reducing protection gaps, facilitating recovery and transition then there needs to be a shift in balance to consider how the system can hold and absorb uncertainty over time horizons and in particular establishing a hyper vigilance against pro cyclicality. Using another analogy, insurance sector is familiar with the concept of a death spiral in pricing, thus an ever-increasing price, even if for honourable reasons, will be highly detrimental to the functioning of the insurance sector.

Ultimately the cost of these protections will fall to shareholders, policyholders and taxpayers

Question 3 – What is proportionate and can we ever get the balance right?

The enhanced program has identified a range of tools and institutions to support the functioning of the cross border markets and the resilience of the same; This begs the question of whether or not we can have too much of a good thing; It seems to make sense to recognise the risk posed by systemic institutions and to have in place preemptive plans for recovery and resolution for the most significant institutions ones where there is likely a disproportionate impacts at a national level; It would appear that we are dancing around the idea of distinct and centralised supervision of systemically important insurers at an EU level or some vehicle that takes the supervision of such institutions above the national level; That is a topic for another day;

Where I think the challenge, lies is in the squeezed middle, those companies that are neither systemically important nor likely to fall into the remit of the Lower Risk Undertakings.

Which brings us to the related topic of group supervisions, intra group flows and intra group remittances together with external capital transactions; We know when companies are scanning the horizon for choice of establishment that clear consistent rule of law are key requirements as well as consistent regulation and application of the same.

It is clear to say that the experience of the pandemic has rocked investors in insurance as regards to remittances and distributions and this for sure points to the need to fully interrogate the remit of the ladder of intervention and in particular where the same is pushing effective control and solvency further and further up the capital slope.

Something’s got to give

In short, there is no easy decision and there is ultimately a political decision to be made over the balance and tradeoffs between risk, complexity and the desire for funding and protection. There is a need to avoid a spiral where costs escalate, policyholders or investors turn away from the sector, and reduce the sectoral flows. There is a need to enable a move towards a cycle of growth and sustainability. For that to happen, there needs to be a joint enterprise and recognition of the role of each party in forming a view and contract based on principles of long-term mutual gain and benefit.

 

This article was first featured in the July-August issue of Finance Dublin.