Comment: A good compromise is one where no one is happy

Channels: Regulation, Risk, SAA/ALM

Companies: PwC, EIOPA, European Commission

People: Carlos Montalvo Rebuelta

Carlos Montalvo Rebuelta analyses the European Commission's proposals for the Solvency II review, in particular those changes that have been flying under the radar of public debates.

Carlos Montalvo Rebuelta

I came into 2021 with an agenda full of New Year´s intentions, including one of writing more about insurance, sharing views and ideas around it, with a focus on the regulatory agenda. And indeed, I published, already in January - here, in Insurance Asset Risk - an article about the Solvency II 2020 review, and the opinion issued by EIOPA. Since then, little if any has come out from my side. So, what a better occasion to address this than the Commission Proposal regarding Solvency II review? It seems a natural follow up, Doesn´t it?


Preface: A balanced outcome?

I started my previous article on the Solvency II review with a clear message: "no need to panic", as EIOPA proposal was only the beginning of the journey, and a reflection of regulatory concerns and views. Whilst my former colleagues always run sound technical assessments, there are other actors in the process, as well as additional goals, that need to be factored in. So, allow me to start this article with another clear message: as lawyers like saying, "a good compromise is one where nobody is happy with", and under the Commission´s proposal all parties are getting (or keeping) key elements of their agenda, yet nobody is getting it all. For example, the proposal keeps macro tools for supervisors... or proposes a reduction on the Cost of Capital from 6% to 5%, with an estimated impact, combined with the other changes in the risk margin, of €50bn.

The communication line chosen, both by EIOPA and the Commission, was one of "balanced outcome", that would not increase capital charges. The latest message conveyed by the Commission is that €90bn assets will be made available for insurers to invest in. Could this still be defined as balanced? The response can be a yes, where additional tools are granted to supervisors to do their job... and this is the case in the proposal from Commission. Having said so, if such tools -including Macro- would be removed, then so would vanish the balance.


The process

What goes next, in terms of process, remains as relevant as it was back in January; perhaps even more, as the Commission is shedding some light around how to progress. The package presented by the Commission includes a proposal for changes on the Solvency II Directive, a proposal for a Directive on Recovery and Resolution for insurers, but also a communication regarding the review, which is where the main changes that will be channeled via a Delegated regulation are presented; it also contains an Impact assessment, as well as a Study on Insurance Guarantee Schemes.

Whilst the focus of many will be on the changes to the Directive (the so-called Level 1), which will be discussed by the Council and the European Parliament, please beware that such changes will only materialize and become applicable in 2024 or 2025. However, a less heralded piece, yet even more relevant, of the package that Commission has presented is the Communication document that is part of it, as it details the areas and even content of those changes that can be undertaken via Level 2 (Delegated regulations). Furthermore, it is worth reminding that the Delegated regulations must be endorsed or rejected (binomial decision, Y/N) by the co-legislators, with no room to change. Being politically incorrect, it can be foreseen that the fact that many relevant issues to different countries will be part of the Level 2 proposal, ensures both that it will be adopted, and that the Commission will make good use out of it.

Process wise, the million-euro question, which I already raised in my prior piece, remains: When will the Commission come out with their proposal of Delegated regulation? If they wait until the agreement of the Level 1 text, the alignment will not be challenged... but this will come at a cost in terms of time. Perhaps the response to the question will be that discussions will take place in parallel, but adoption can only follow that of Level 1. Time will tell.

Also, from a process viewpoint, some will have wondered why a separate Directive to deal with Recovery and Resolution. There are good reasons, ranging from legislative (consistency with the Banking and CCPs frameworks) to operational (don´t let Recovery become an obstacle to an already complex negotiation) to tactical (it is harder to fully kill an ad hoc proposal, so splitting ensures survival).


The proposals

I won't cover here each and every proposal, but only those that have been the center of interest, or those that I found worth exploring even if they have been flying "under the radar".

Technical provisions: Long Term guarantees

This is perhaps the proposal that has received the most interest and has been the most debated. Not part of the original Level 1 text, LTG measures have -for good reasons, as they address valuation of liabilities, the elephant in the room- become a cornerstone of the framework, and a reminder of why perfection is enemy of good. Indeed, whilst from an academic viewpoint a pure risk-free rate to discount is the "right and true" approach, a practical application to EU insurers of a theoretical approach had led us into disaster. Yet, they can be improved.

If we start with extrapolation, EIOPA proposal was setting the obvious. Pretending a Last Liquid Point of 20 years is a political rather than technical assumption. As the situation evolves, moving from political assumptions to evidence-based ones is the right way forward. At the same time, the impact of the change cannot be underestimated, especially in certain markets. What the Commission is proposing, namely to change the methodology but embed a phasing-in until 2032, seems to be a balanced compromise. What is still to be seen, is how this will be finalized when the Commission issues Delegated acts specifying the new methodology... an interesting change, considering that the previous methodology was developed by EIOPA.

Regarding the Matching Adjustment (MA), the proposal is aligned with EIOPA´s suggestions. Removing the current ring-fencing is good news for the users of the MA, and should increase the interest for insurers outside Spain (or UK) in this mechanism, not so much for their existing portfolio of products, but regarding new products, with guarantees embedded, where not all the investment risk is to be taken by policyholders. Please be reminded that, for a large number of supervisors, the underlying rationale of the MA is sounder than that of the Volatility Adjustment (VA), even if not used in their markets.

Talking about the VA, whilst the methodology for calculation will change, the obvious point of attention has been the increase of the percentage of spread that can be used moving forward (from 65% to 85%), as it will have a relevant impact for those insurers using it. A less obvious one is the change in the wording, by which the Reference portfolio will be composed by investment in debt instruments, instead of the prior reference to assets; for example, currently, under article 49 of the Delegated regulation, the portfolio of assets includes equity and property, so it is not clear if the aforementioned change will have an effect on the calculation. Not surprisingly, as the methodology is changing, such change will cover the former "Country VA", to ensure a smooth application that better addresses the so called "cliff effect" embedded in the prior design. It is, in my view, a good step towards convergence that the approval of use is no longer an option. Similarly, responding to the issue of overshooting (which we saw emerging during COVID-19, unduly leading to better solvency ratios by certain insurers at a time of severe market distress) will reinforce supervisory reliance on the measure. To sum up, the VA levels will increase moving forward, perhaps not as much as insurers had liked, probably more than what EIOPA had supported, but that is another story.

Not of lesser relevance could be the floor that the Commission is proposing, for those entities and groups using the so-called Dynamic VA through internal models. The Commission is embracing the proposed approach by EIOPA of a so called "DVA prudence principle", to address over-shooting effects. At the same time, the debate seems to be closing up regarding the (non) use of the DVA by standard formula insurers.


Technical provisions: Risk Margin

If we look back in time, it is worth noting that the decision to follow a calculation for liabilities based on a best estimate combined with a risk margin was not the preferred one for the regulatory community, more inclined toward a percentile approach; however, the Insurance industry successfully managed to introduce the current approach, and the rest is Solvency II history. At the same time, it is fair to say that the current methodology is flawed, in particular regarding the high-level of embedded volatility, therefore changing it is the right way forward. On this basis, EIOPA proposed changes to address this issue by improving the calculation methodology (including also a floor). The proposed approach by the Commission goes way further, as it will reduce the amount of the RM by €50bn... and will not be welcomed by EIOPA, as not only it removes the proposed floor, but most importantly it reduces the current 6% factor applied to the so-called Cost of Capital to 5%.

Considering the relevance of technical provisions for insurers, let me share some thoughts around this: firstly, over provisioning is wrong... but so is under provisioning; let´s hope that these changes, that take us out of the first one, do not lead to the second; secondly, if the purpose is -as part of Capital Markets Union agenda- to free up extra capital from insurers to invest in EU economy, beware that, by amending technical provisions calculation, instead of SCR, tax implications will have to be factored in by insurers moving forward as the value of liabilities go down and so does the corresponding tax deduction.


Long-term Equities

The most political of the technical changes currently under discussion. No surprises here, yet some uncertainty remains. How can this be possible? In a nutshell, because the Commission has made clear that the proposed changes by EIOPA to facilitate the use of the so-called LTE (Long-term equities) to insurers, are seen as insufficient; in other words, the Commission will go beyond EIOPA´s advice in this field, which does not come as a surprise -also considering the political dimension, and role, of the Commission´s proposals vs. the technical and prudential one of supervisors-, and EIOPA will dislike it -not surprisingly, either-. However, as the final changes from the Commission will come in the Level 2, it is still to be seen the exact way in which the current conditions will be either replaced or simply removed.


SCR changes

In line with the direction of change for LTE, the approach taken regarding SCR falls within the boundaries of what could be expected: on the one hand, the intention of EIOPA to amend the way interest rate risk is currently calculated -if only because of intellectual coherence, as the current approach does not respond to a reality of negative rates- is taken on-board by the Commission, combined with a phased-in approach to smooth it (and, who knows, if also to buy us all time so we get out of the current negative rate environment?). In addition to that, I already hinted in my prior article that changes may be expected regarding spread risk... and changes have come, although in a different way as many had expected: indeed, the correlation between spread risk and interest rate risk will be amended, thus increasing diversification benefits and reducing the effective capital charge.

As diversification benefits, and their effects, have been put on the table, allow me to be, again, politically incorrect: Why is it the case that, when debating e.g. whether 22% is the right charge or not for LTEs, we ignore the effect of applying the correlation factor, and how the effective charge would go down, to say 13%, depending on how diversified the portfolio of assets is? After 20 years of work in Solvency II, I still haven't seen a debate on this, as the current focus on notional charges is hiding the reality of the measures and their effects.


Proportionality

I like the idea underlying the new category of low risk profile undertakings, for which more simplifications and areas where explicit proportionality measures can be brought in are introduced. Solvency II remains overly complex, and this is a step in the right direction. However, I am not sure if the name chosen is the most appropriate one: indeed, from a financial stability perspective, it goes without saying; however, experience tells us that several entities that would qualify as "low risk" would at individual micro level entail higher risk than most.

I also welcome the fact that the Slovenian Presidency has decided to focus their efforts during the Council negotiations on this particular topic, since -let´s be honest- Solvency II entails such a level of complexity that an ambition to make the life of many insurers less complicated can only be praised... yet history tells us that nobody has really pushed for this in the 20 years of Solvency II discussions. The Presidency will need the support of all stakeholders, please stand ready to push for progress here.


Macro tools

Should a prudential framework designed to address micro supervision be expanded to also cover the macro dimension? Both EIOPA and the Commission agree that this should be the case. Starting with the why, macro reality (as well as monetary policy) is affecting Insurance business model and its viability; regarding the what, Solvency II currently has a blind spot in terms of providing supervisors with the right toolkit to respond to systemic risk related challenges, so filling such gap seems the logical step; on how to do it, I got the impression that EIOPA proposal was, consciously, over ambitious, incorporating some bargaining chips such as add-ons that would drop, to ensure that key tools and requirements would remain... and it has worked out well.

Amongst the aforementioned tools, putting the focus on liquidity risk and requiring fully fledged contingency plans seems to be the logical counterbalance to changes in both LTG and LTE measures... but also to the current approach from insurers to their investment policies, where they are searching for yield and increasing holdings in alternative assets, trying to earn a spread in the illiquidity part of the premium, rather than the credit one.

The Commission´s idea to split pre-emptive recovery and resolution (RRP) and channel it in a separate text is an excellent one... firstly, it avoids contaminating an already complicated negotiation on Solvency II; and secondly, it ensures that there will be at the end a dedicated framework for RRP, with a clear focus -rightly so- on the recovery part of it.

Putting Insurance Guarantee Schemes (IGS) "in the fridge" is also a smart way to avoid a debate for which there is not at this stage a sufficient supporting majority. But, as some regulators say: let´s work on all the elements that will help us avoiding liquidation, and by so doing we will reduce the need of IGS moving forward. A pragmatic approach, and probably a realistic one, based on experience (I started working on IGS as CEIOPS Secretary General back in 2008, and the issue came back during my EIOPA days as well, but it was clear that we were lacking the level of support required, and this has not changed, not yet) as well as on the fact that Solvency II design, rightly so because the alternative would be un-economic, allows for insurers to go down.


The "under the radar" changes

There are two changes proposed by the Commission, both in the Level 1 Directive, that I thought worth raising, even if they have not been part of the most heated debates.

The first one, changing art. 112.7 of the Directive, will make compulsory to insurers using internal models to disclose to their supervisors an estimate of the SCR under standard formula. As a strong supporter of the role of models, and contrary to what may be the first reading of this proposal, I strongly believe that in the medium term this will help internal model users, by being able to better demonstrate to their supervisors -supervisory dialogue- the origin of the divergences between the model and the standard approach, and the underlying rationale, thus avoiding that regulators see such models as black-boxes, and reinforcing the case for their use moving forward, come rain or come shine.

The second one, in line with what has been more and more the approach followed by regulators, is the new art. 214.3 that the Commission is proposing: in a nutshell, it removes the current uncertainty around how supervisors will respond to group structures with multiple layers: if removing layers and not reaching the ultimate parent company level implies material effects in terms of level of own funds (e.g. because of intra group financing, or issuance of hybrid debt that would not meet tiering levels), then all supervisors will have to extend supervision to that ultimate level. In my work as a consultant I have seen more and more of these situations emerging, and shedding light regarding the treatment moving forward, whilst bad for my personal business, is good for the credibility of the framework.


Epilogue: Is time on our side?

I concluded my previous article on the review, back in January, with the following sentence: "Good advice may render ineffective if implemented too late, and in this particular case, there is an option to accelerate certain changes via Level 2, so why not embracing it?". When I see how the challenges around the Green Deal ambition are addressed in the proposal, including a request to EIOPA to monitor and report... in 2023! I get the impression, again, that we do not always walk our talk when it comes to urgency, particularly in the field of Green agenda. Let´s look at alternatives, let´s be creative and ambitious... but let´s do so today, rather than tomorrow, as we cannot afford differently.

Were you aware that the EU Treaty introduced the idea of Sustainability back in 1998? Indeed, a new Article 3c was incorporated, stating that "Environmental protection requirements must be integrated into the definition and implementation of the Community policies and activities referred to in Article 3, in particular with a view to promoting sustainable development." How different would things be if we had started acting then, Wouldn´t it?

 

Carlos Montalvo Rebuelta is a partner at PwC. Previously he was executive director at Eiopa.