Solvency II Gets Real

EIOPA: Pre Stress SCR Ratios

The last few days have seen an avalanche of documents from the European regulator EIOPA.  Solvency II, for so long a dream or nightmare, is due to go live in just over 12 months.  It’s getting pretty real.

Stress Test Stress

Amongst the avalanche of output from Frankfurt was a press release released on Sunday 30th November announcing the result of the recent stress tests.  The results  were a surprise.  Despite the normal positive spin about the health of the market, the “failure” rate was higher, much higher, than pundits had predicted (mea culpa).  14% of companies surveyed reported solvency capital ratios of under 100%.

This is a similar failure rate to meet solvency capital requirement (SCR)  to that seen in the last Quantitative Impact Study, QIS 5.  But QIS 5 was carried out in the aftermath of the global financial crisis; insurers were weaker and the factors used in QIS5 were often harsher than those applying now.  Firms should be stronger, the test is easier and so far fewer should be failing.

More startling was that 8% of the sample failed to meet the minimum capital requirement (MCR), broadly the level for closure to new business,  in QIS 5 the MCR failure rate was less than 5%.

The Big, the Bad and the Ugly

EIOPA reported that only 1 of the 30 largest groups failed to meet their SCR target, implying that the bulk of the problem was smaller firms.  Now QIS5 was a broad sample of the European insurance industry: 95% by gross technical reserves, 85% by gross premium.  The recent stress test, whilst substantial, had a lower take up: EIOPA reporting 55% of total gross premium in one section, 60% by gross reserves in another.  The biggest gap is likely to be smaller firms – the true proportion  of failure across the entire market by number of firms would almost certainly be significantly higher.

No Quiz in QIS5

Why are results so bad?  Some commentators (mea again culpa) did speculate that the QIS5 failure rate was artificially low as the returns were not checked by national regulators, a number of inadvertent, and perhaps a few “advertent,” mistakes were made.  The new stress test results were checked thoroughly by national regulators and EIOPA; that, coupled by greater understanding of the standard formula, could well be the reason for the higher than expected result.

No Level Playing Field

You’ll notice on the country summary results graph above (source EIOPA) that the usual suspects come up worst: Greece, Portugal, Ireland and Spain. Interestingly Great Britain appears to be fifth worst.

The stress test calculated SCR using the standard formula only, not undertaking specific parameters or internal models.  London Market business is almost certainly bringing the British score down; it doesn’t fit the standard formula well, particularly non-European inwards catastrophe excess of loss business; the reason why it is essential that Lloyd’s gets internal model approval.   I  suspect same may be true to a degree for Ireland where there will be a disproportionately high percentage of inwards reinsurance business due to firms domiciled there for tax reasons.

To Internal Model or Not to Internal Model?

Of course the better performing 30 large firms will all have, or at least be building, internal capital models.   It will be interesting to see of the insanely complicated and long-winded internal model approval process means that  some do not bother putting their models up for approval if they show a decent performance under the standard formula (as would be expected given maximum utilisation of the 7+ levels of diversification credit available within Solvency II). IOPA notes that 25% of companies have Solvency Capital Ratios of over 200% – which will include many of the big boys.

Reinsurance

Reinsurance under the stress test was performed under QIS5 rules not the new rules for non-life reinsurance outlined in June 2014 in a draft guidance paper.  The new reinsurance rules derive their own blog, indeed series of blogs, to be unveiled in the New Year after the close of the renewal season   It would be interesting to know whether the imposition of these new rules would have made a difference.  The great news about the new guidelines is that they do explicitly make clear that multi-peril, multi-country, annual aggregate, umbrella, clash and even stop loss covers can get credit under the non-life catastrophe element of the standard formula (due in now small part to Willis Re’s efforts on the EIOPA committee).  The bad news is that the European Commission’s requirement for standardisation has resulted in a document of stunning complexity and opacity.

Another part of the recent  EIOPA paper mountain has been the results of the consultation on the guidelines.   Some commentators (yes me again) found them impenetrable and very poorly explained.  I’m pleased that others clearly had similar issues, EIOPA reporting that:

Most of the comments proposed drafting suggestions to the guidelines to make the meaning clearer … A common voice from stakeholders is to include more examples within the guidelines and/or to move explanatory text to the guidelines which may be difficult to interpret separately.”

Despite these comments the guidelines are largely unchanged with the wonderfully Solvency II –esque comment that

“Whilst it is considered that worked examples were useful, these cannot be included as part of the guidelines due to the legal nature of the EIOPA guidelines.

More on that in January….

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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