05 March 2020
Carlos Montalvo Rebuelta reflects on what we should expect from the Solvency II 2020 review based on past amendments of the Directive. So good or bad news?
As a non-native English speaker, one has to be particularly cautious when picking the right words for what one wants to say; and, when asked to write about 'insurance investing and the Solvency II review', I thought the impact of such review should be put into context. Particularly, when we consider that low interest rates are no longer a problem, as the new reality is negative rates, but also that social expectations around sustainability and ESG have become a driving force to many insurers investment strategies. For these reasons, the title of the article slightly differs from the one proposed by the editor, moving from "and" to "in the context of".
What should – but doesn't always – keep investors awake is whether they are getting sufficient value for the risk taken, both in terms of credit risk and liquidity risk.
Indeed, we have seen how quantitative easing policies have led to an excess of liquidity in the market which in turn contracted spreads, thus artificially changing the pricing for credit risk. This is well known, and insurers are generally managing that risk well. What may be less obvious is the fact that liquidity spreads are equally distorted, in this case due to the mismatch between supply and demand of long-term assets, leading to an additional contraction of the spread.
In parallel, what keeps (amongst other issues) the regulator awake are concerns around how insurers are approaching liquidity risk, at a time where they are taking more and more of it, not always at the right price, nor always aware of the risk tolerance they can afford.
This concern was highlighted in last year's Supervisory Statement from the UK Prudential Regulation Authority drawing plans requiring insurers to implement a liquidity risk framework, to hold liquidity buffers and to undertake regular monitoring and stress-testing of liquidity.
At the European level, the European Insurance and Occupational Pensions Authority (Eiopa) has made similar proposal reflected in the ongoing consultation to review Solvency II. The existing requirements for liquidity around the matching adjustment and the volatility adjustment have proved to be insufficient, so expect enhanced supervisory action in this field.
There is a second area of concern for the regulatory community in the era of negative rates, namely how reinvestment risk in the current conditions is leading to more risk taking, and whether this additional risk is taken with proper due diligence to properly understand which risk it makes sense to take and which ones should be avoided.
Due diligence should be a core element of any investment strategy. But in some cases, the lack of it has been triggered by policy makers.
The greatest example of this has been changes to regulatory requirements around infrastructure investments.
A couple of years ago, there was a very strong political message towards institutional investors on what their role should be in funding Europe's infrastructure. Such message was reinforced with regulatory changes to incentivise investing in these assets via capital requirements relaxation in Solvency II. This led in many cases to insurers and pension funds buying some of these assets without a proper understanding of what they were doing.
At a time of enhanced expectations around sustainability, and the role of insurers as investors, two elements become relevant: the level of ambition that we all should target, and how to ensure that proper due diligence surrounds risk taking in an ESG world.
On the latter, "experience is the name we give to our mistakes" Oscar Wilde once said. So, let's learn from what went wrong in the review of Solvency II to incentivise insurers' infrastructure investments via capital discounts.
What happened can be simply summarised as "taking short-cuts", and it didn't work as intended. On the one hand the targeted investment levels were never reached, and on the other many insurers (and pension funds) didn't undertake the right level of due diligence to understand the risks they were taking and their price.
The better projects ended in the hands of those insurers with the capacity to understand and price them... the not so good ones ending in the balance sheets of mid and small insurers. Is this what we want for the sustainability agenda?
With regards to ambition, if we consider that the role of insurance in the ESG agenda is first and foremost as an institutional investor, we are self-limiting and ignoring the ability of insurers to contribute through the liability side of their business models. Via resilience enhancement and building back better, insurers can help reduce both frequency and severity of natural disasters.
Thinking outside the box
As articles like this one are a perfect platform for thinking "outside the box" and sharing thoughts, allow me to propose that the next Solvency II review targets ESG integration but not via capital requirements incentives for specific asset classes, but by considering investments in terms of resilience enhancement as risk mitigation techniques, by allowing its recognition as mitigant for underwriting risk – which would still be consistent with the way Solvency II was originally designed.
Beyond sustainability issues, the next review of Solvency II should insure the regulation is still fit for purpose when it comes to treatment of investments at a time of negative rates.
The main change introduced by Solvency II when the Directive was adopted (2009) and then applied (2016) was the so called Prudent Person Principle, which remains a building block of the system and is not put into question.
This is good news, at a time where new type of assets are taking more and more weight within insurers' portfolios.
The Prudent Person Principle requires the risk to be neutrally reflected through capital requirements (same risk, same charge; different risk, different charge) and ensures proper understanding of the underlying risks associated to the different assets.
Looking at Eiopa's proposed changes for the 2020 review, the approach seems to be more of an evolution than a revolution. In other words, the proposals are more of a refinement than a fundamental change.
On the solvency capital requirement (SCR) treatment, Eiopa proposes to maintain the existing correlation model, with two layers (sub-module and module). Eiopa considers there may be a misrepresentation of the embedded risk in two areas: equity risk and interest rate risk. Both areas are also identified by the European Systemic Risk Board in their latest paper (February 2020) on the macro dimension of Solvency II.
With regards to equity risk, although Eiopa remains sceptical about the calibration of the so-called strategic equity participations, no changes are foreseen, as a political decision to lower the capital charges has already been made.
A different situation surrounds the debate on interest rate risk, as the design of the standard formula was not constructed to reflect negative rates, thus leading to a potential misrepresentation of the risk of downfall. I don't have a crystal ball so I can only anticipate an interesting debate around this topic, and note that the outcome will be linked to whether political or technical reasons prevail. Still without a crystal ball, but having been part of the construction of Solvency II since 2001, allow me to predict another very tense debate around spread risk, regardless of Eiopa not proposing any change.
Regarding the review of the so called LTG (Long Term Guarantees) package, a very interesting proposal from Eiopa can change the way some insurers are investing, as well as their product offering. Indeed, Eiopa sends a message of support around the concept of the matching adjustment (MA), precisely at the juncture where its main advocate, the UK, has decided to leave the EU.
Indeed, at a time of negative rates, Eiopa's suggestion to amend the treatment of the MA should allow its use by other EU countries where insurers design products of long duration, with a certain level of guaranteed return and robust asset-liability management.
By removing the current "ring-fencing" of the MA portfolios and allowing for the recognition of diversification benefits against the rest of the insurer portfolio, the MA becomes more attractive.
By clarifying the treatment of restructured assets, de facto Eiopa proposes to give a green light to investing in such instruments... provided conditions inter alia around proper risk management, are met. The objective of such changes can only be to make it possible, under today's reality, product offering where the policyholder will not bear all the financial risk and that can become a vehicle for EU citizens to invest in their future retirement through insurance products. A win-win if properly implemented.
So, in a nutshell, when it comes to treatment of investments, Eiopa is proposing only small fine tuning as the regime is robustly constructed. The challenges will stem from external reality, rather than from regulation, and this is not necessarily bad news, is it?
Carlos Montalvo Rebuelta is a partner at PwC. Previously he was executive director at Eiopa.