Pigs Fly: Solvency II Agreement Reached

Pigs Fly

There is a special form of the Theory of Relativity that applies to insurance. As Solvency II’s planned implementation date approaches, time slows down and then grinds to a halt—Solvency II must always be three years away. The theory has held true since 2005 (2008 implementation) to 2013 (2016).

But it looks like the theory no longer holds. We are now just a couple months away from 2014 but it looks likely that Solvency II’s planned implementation date will remain 2016—flying pigs are spotted in the sky over Brussels and Frankfurt.

The Trialogue, the wonderfully named coming together of the European Commission, the European Parliament and the European Council of Ministers, has finally reached agreement on the two issues that have been delaying implementation: long term guarantees (LTGs) for life business and equivalence.

Coming to a Compromise

In what sounds like a typical piece of political theatre; the parties were locked in a room (which would have been smoked-filled prior to recent smoking bans) until agreement was reached. Squaring up over the LTG issues were the British, French and German camps, each with their own preferred solution to the LTG problem.

Details of the agreement are still sketchy, but initial reports seem to indicate that the politicians have put their differences to one side to amend the proposals of the European regulator, EIOPA, across the board. When details emerge we will find out if all parties really have got what they want and their insurance industries need.

The Brits have seen a cap on the benefit of their preferred asset/liability matching mechanism, the matching adjustment, significantly eased. But, as always, the devil lies in the detail.

The French have similarly seen the calibration of their preferred mechanism, the volatility balancer, improved.

The Germans have got their wish for an extended period of transition, up to 16 years, before elements of the new regime will be fully enforced.

What About Outside Europe?

The other hot potato was equivalence. If a country’s regulatory regime is not declared equivalent to Solvency II then European insurers operating in that country must apply Solvency II rather than local capital rules. For some classes and countries, e.g. U.S. life, many thought that this would mean they could no longer compete with locally based rivals, subject to significantly lower capital requirements.

The U.S. was a particular issue as its state-based insurance regulation was not compatible with Europe’s requirement to deal with a national regulator. In any case the U.S. felt, justifiably perhaps, that the EU was in no position to be judge and jury on what is good insurance regulation is and what isn’t—no regulation without representation.

It seems that the equivalence ball has been kicked firmly into the long grass. Sharon Bowles, chair of the European Parliament’s economic and monetary affairs committee said “where there is a set of conditions, a risk-based system that is capable of being broadly equivalent, then we can have provisional equivalence that can last for 10 years and can be reviewed and extended for another 10 years. It can be perpetual if we never get a satisfactory solution”.

This probably means that if a local regulator has a risk-based based regime consistent with the International Association of Insurance Supervisors (IAIS) core principles, then they are OK and will get provisional equivalence far into the future.

If the ball is ever found deep in the hay, it looks likely that it will be swiftly passed to the  IAIS to sort out the mutual recognition issue via enforced international regulatory standards.

A Light at the End of the Tunnel

So what does this all mean? It looks like Solvency II will be implemented in 2016 at last, but then again, I have been wrong before – every time. Likely lower risk factors and long transition periods mean that Solvency II may not have a significant capital impact for most European insurers, certainly not for the short to medium term.

There is still much to agree, still political and practical minefields to clear. There remains the tension between the European Commission’s desire for a set of simple, universally applied rules against EIOPA’s desire for a “correct” calibrated set of rules that reflect, more or less, differences in insurer size and type and spread of business written.

As I have noted before, what we have now is neither fish nor fowl. Unfortunately the desire for a common European standard, a level playing field, may not allow for regulators to apply judgement around a more pragmatic rule set.

There remains the risk, for example, that some of the most effective forms of reinsurance to manage capital may not be allowed under the standard capital formula as they do not fit neatly into the simplified gross risk capital calculation.

A Perspective on Proportionality

Let us hope that the much abused and overlooked concept, proportionality, is embraced and reflected fully in the guidance and technical specifications that will finally emerge after the revised Solvency II directive, Omnibus II, is passed in March 2014. Let us also hope for a new pragmatism.

For example, firms should be encouraged to build internal models of their risk and/or develop undertaking specific parameters (USPs). Rather than viewing these as attempts to get around the standard formula, and so stifled by over onerous approval processes, they should be seen to be an attempt to fully understand and quantify the risks the company faces.

Both internal models and USPs do potentially also allow the value of reinsurance to be properly calculated, removing the temptation to buy reinsurance to game the standard formula rather than better protect the company and its policyholders.

Am I optimistic? To be honest no. But then the pigs are currently flying – perhaps EIOPA can catch a couple and bring home the bacon.

The views expressed in this article are those of the author and not Willis Group.

About David Simmons

David is a Managing Director in the Willis Re Analytics team in London. He focuses on Enterprise Risk Management, i…
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