Carlos Montalvo Rebuelta picks 24 issues to consider from the 2020 Solvency II review
Christmas brought us the agreement reached by the EU co-legislators on the review of the Solvency II Directive.
Following my two previous articles looking at the main changes proposed to the Solvency II framework, the risk for a third piece on the topic being redundant is high. Therefore, this time I have opted for a different approach, one that puts the focus on some issues that, in my view, can be of interest – or at least curiosity- to both the newcomer to the regime, as well as to the seasoned expert. Below you will find as many pills as years (24) I have spent working on Solvency II::
1. If it ain't broke, don't fix it: Solvency II has worked well, and served its purpose during a particularly challenging period of time, conditioned by low rates for long, and then a sharp increase of those rates, precisely the type of stressed scenario (we called it "double hit" when EIOPA tested it, back in 2011) most feared by insurers and regulators alike. Whilst all the aforementioned is true, the review can and should further improve the framework, and also evolve in such a way that it can tackle those challenges that will drive insurance as a business, from AI to protection gaps.
2. Serving two masters: A significant change embedded in the review, and one that is seldom discussed, stems from the fact that, contrary to the original approach with the main objective to be a (neutral) risk based regulatory and supervisory framework aimed at protecting policyholders – and financial stability as a secondary objective, per recital (16) of the Directive-, its goals now combine those of prudential nature with more political ones (such as competitiveness of EU insurers, or steering the role of insurers as institutional investors). As an example, the Commission aims "to increase insurers' contribution to the long-term and sustainable financing of the economy"; hopefully this can be done without impinging the interests of policyholders or shareholders... and also without forgetting that insurers should only invest in assets that they understand (prudent person principle), and that yield the right return for the risk taken -including not only market risk, but also liquidity risk-. Whilst sometimes political goals come in the form of "softer" regulatory treatment, beware of this, because not meeting political expectations -as we saw with regards to infrastructure investments- always comes at a cost.
"Whilst sometimes political goals come in the form of "softer" regulatory treatment, beware of this, because not meeting political expectations -as we saw with regards to infrastructure investments- always comes at a cost."
3. Trapped in numbers: no, we are not limiting Solvency II only to actuaries; and yes, we still call it 2020 review, and a deal was only reached last December; yet, the process that the text must follow, including review by jurist-linguists, publication in the Official Journal and transposition period will drive us, easily, to the second half of 2026 (so how about naming this the 2026 review?).
4. Follow the tracks... if you want to better understand the underlying rationale of change. Indeed, by knowing where a given amendment comes from (e.g. a Member of the EU Parliament of country X), you will be able to grasp what is behind the proposed change -and beyond?-. It can be a funny exercise.
5. Changes preceding Change: indeed, the aforementioned process, bringing us deep into 2026, will apply to the Level 1 directive, but what about the changes into the Level 2 regulation? They may be applied earlier, as regulations are directly applicable without the need to transpose them... and considering some of the changes that we will find there, I am convinced that this will be the case, and that some Level 2 changes will be introduced already for 2025.
6. Game of thrones: speaking of Level 1 and 2, a key difference regarding its content is that the co-legislators (EU Parliament and Council) can amend any part of a directive, but only vote yes/no to the full text of a regulation, therefore granting much more power to the Commission. Needless to say, this is a controversial issue, as it was already the case during my times as EIOPA´s Executive Director.
7. Devil is in the detail: and the detail is still pending, as a number of issues will have to be covered through changes in the so-called level 2, i.e. Delegated Regulations. Therefore, whoever pretends, as of today, to have the full picture of the Review, is clearly missing the point. Let´s see what surprises may follow -or not- at the Level 2.
8. Keeping the Devil under control? An interesting feature of this Review, and the aforementioned political process around it, relates to the fact that a number of technical issues, yet politically sensitive, have ended up in the Level 1 Directive, so that the EU Parliament and Council can have a say. To put this in terms of example, if we consider, e.g. the capital charges for, say, equity risk, they all were originally placed in the Regulation, rather than the Directive; please, compare that approach with the following sentence that we will find within the amended article 77a on extrapolation: "For maturities of at least 40 years past the first smoothing point the weight of the UFR shall be at least 77,5%". What a change of approach, isn´t it?
"As a reminder, because insurers are not central bankers and don´t own a "money issuing machine", every billion that will be further invested in equities, after the regulatory change, will come from disinvesting on other assets, e.g. corporate or sovereign bonds. Who will buy those?"
9. Speaking of the Devil: and what belongs to the Directive or to the Delegated Regulation, I invite you, dear reader, to take a look at the new article 105a, on long-term equity investments... as the level of detail it provides, including the fixing of the concrete capital charge, is unique within the Directive, and should belong to the Level 2, if only for consistency reasons. If, as I suggest in this article, I follow the track, I see how this article comes from a proposal by the EU Parliament -supported by the Council, where some EU countries have long been sponsoring this idea-, aiming at ensuring that conditions for applicability cannot be decided by the Commission, and incentives are set for insurers to further invest in EU equities. As a reminder, because insurers are not central bankers and don´t own a "money issuing machine", every billion that will be further invested in equities, after the regulatory change, will come from disinvesting on other assets, e.g. corporate or sovereign bonds. Who will buy those?
10. Ignore Lampedusa: this Review does not change it all, so as all remains the same. Many areas remain untouched, ensuring continuity within the framework. Evolution, rather than revolution.
11. "Follow" the money: when making their original proposal, the EU Commission quantified a capital relief in the vicinity of €90bn that EU insurers may inject into the real economy. Leaving aside that this quantitative impact was done in a low-rate scenario and that additional amendments have been made afterwards, leading to a higher number, the fact is that each and every euro that insurers hold in the asset side of their balance-sheet is already contributing to growth, no matters whether it buys equities, corporates, infrastructure or sovereign debt.
12. "Pay me my money down": indeed, we are talking about dividends, which is nothing more than rewarding the capital invested in insurance -capital that, if not properly rewarded, will migrate to more profitable businesses-. In my first article about the 2020 review (https://www.insuranceassetrisk.com/content/analysis/comment-a-good-compromise-is-one-where-no-one-is-happy.html), I was already anticipating that restricting dividend payments will be more difficult to supervisors, and that a sectoral ban on dividends, similar to what the ECB did during COVID-19 will not be possible. Indeed, such approach has ended up in the final text (new article 144c). Funny enough, whilst this should be good news to insurers, as it brings certainty in terms of when and how such limitation may take place (and let´s not underestimate the importance of regulatory certainty), it has taken the form, in the text, of a "new power" to supervisors, to be used only "during periods of exceptional sector-wide shocks" and only for undertakings "with a particularly vulnerable risk profile". More is less?
13. "Cash, cash, cash": At the same time, liquidity risk importance is growing, and this is evident through the content of the review where, in addition to new requirements such as a liquidity risk management plan to be prepared by insurers, it also opens the door to regulators being able to limit dividends not only due to solvency considerations, but also to liquidity ones. Yes, insurance is not banking; and yes, insurance, just like banking, can be exposed to liquidity risk. Shall we move from denial into acceptance phase?
14. Prophets of doom? Speaking of dividend restrictions, there is another case recently introduced in the Directive, one where such limitation will be triggered automatically, namely where regulators decide, as a last resort measure, to suspend redemption rights of life insurance policyholders as a last resort measure. Without tracking the origin of this new power, one may reach the -wrong- conclusion that this measure was a response to what IVASS did in 2023 regarding a life insurer, but reality shows that the Commission´s original proposal was already foreseeing this. Prophets, indeed. And well done, Commission, as regulation does not always manage to anticipate reality.
"Yes, insurance is not banking; and yes, insurance, just like banking, can be exposed to liquidity risk. Shall we move from denial into acceptance phase?"
15. "Experience is the name we give to our mistakes" (an Oscar Wilde quote). If we have just shown that regulation can anticipate reality, in most cases it is reality that molds and drives regulatory change. An excellent example of this can be found in the area of group supervision, where different provisions have been incorporated to ensure that supervisors can take action -including by asking insurers to change organizational structures- to bring in, as part of the scope of a group, either horizontal groups or those groups where there are subsidiaries in third countries that are not captured, or even groups where supervision does not go all the way up in the structure, allowing for leveraged constructions.
16. Mission impossible? A new category of small and non-complex undertakings will be created through the review, one that aims at reducing complexity and burden to those insurers that have certain volume -and activity-. The measures are well intended, and not only based on size, yet I am not convinced that they will manage to reduce complexity of the framework, nor regulatory burden, in particular if we consider that many of the waivers or reductions shall apply to areas that are either new (such as liquidity risk management plans) or where changes have taken place: for example, today insurers can concentrate key functions (all but internal audit) in a single person; as per an amendment to article 41 of the Directive, this will no longer be possible in order to avoid conflict of interest...except for small and non-complex insurers, that will be allowed to concentrate all but internal audit functions in one person... if certain conditions are met
17. About Apples and Pears. Another change in the directive relates to the obligation imposed to insurers using internal models to calculate, on top of their own internal model, their SCR requirements under the standard formula... or at least that was the original intention of both EIOPA and the Commission, as in the final text some sort of compromise has been reached, allowing entities to provide with an estimation of their SCR where simplifications, to "avoid excessive burden". Being provocative, this approach seems to be far from reality, and the debate around excessive burden artificial, because in practice insurers that decide to run a model will incur in high development and maintenance costs, and the best benchmark against which they are currently measuring whether such investment is worth is precisely by showing how much they save in terms of capital requirements against the standard formula... for which they already need to calculate it! Can reality be burdensome
18. More on Apples and Pears. At the risk of repeating myself, I remain convinced that one of the issues that the review should have addressed -and has ignored- relates to the fact that all stakeholders have put their focus on a number, the solvency ratio of insurers, rather than on how you reach that number -and differences can be shocking if you do the exercise. To illustrate this, when the 2020 review proposal included a draft provision that would not let insurers apply for the transitional on technical provisions, we saw how insurers that decided back in 2016 not to apply it, asked for it just in case they would not be allowed later. They did not apply for it at inception because they didn't need it, had a more robust solvency position than their peers and expected this to be a strength point in terms of analysts and investors assessments of their soundness; they asked for it, perhaps frustrated, because the focus was only on a number -and if you take the data provided by EIOPA in the different reports on impact of the measures included in the Long Term Guarantees (LTG) package, we would be talking about more than 30 points in terms of SCR ratio-, and they were being penalized for doing the right thing
19. Match(ing) time: No, we are not talking about football or dating, but about whether the changes that have been adopted around the use of the Matching Adjustment (MA) will help EU insurers consider its use. At inception, the MA was seen as a British -and Spanish- fit, but one that would not be applicable to existing products in other EU markets (markets with significant duration mismatches). By removing the existing limitation to extend diversification benefits to those assets used for matching purposes (ring-fencing), the MA will become more attractive, makes me wonder if insurers will, rather than thinking that the MA is not suitable for their existing products, start exploring its use in new products, with guarantees, now that monetary policy allows for it. Allow me to share a strong view that I have heard many relevant players say, if insurers put all market risk on policyholders as they have recently done through unit-linked products, can we really say that this is an insurance activity? Citizens want guarantees to their investments, and the MA is the best vehicle within Solvency II to build products that can meet such demand
"...makes me wonder if insurers will, rather than thinking that the MA is not suitable for their existing products, start exploring its use in new products, with guarantees, now that monetary policy allows for it"
20. Be my guest. "The supervision of insurance and reinsurance undertakings operating under the freedom to provide services and the freedom of establishment should be further improved without undermining the objective of further integrating the single market for insurance to ensure consistent consumer protection and safeguarding fair competition across the single market". This message, extracted from the new recital (5b) of the Directive, reflects the most relevant elements around cross-border insurance activity: on the one hand it is positive for policyholders in terms of competition, innovation or product offering, and on that basis it is a cornerstone of the EU Single Market; on the other, supervision must be improved... as there have been issues in the past, and these have affected both host-countries policyholders, as well as the trust amongst supervisors. Keeping -enhancing?- the positives of it may well require giving response to those issues already identified. On this basis, a full range of new measures have been set up in the Directive in order to reinforce supervision, granting host supervisors, if not more powers, at least more and better information, and new tools such as the possibility to request joint inspections or the setting up of collaboration platforms. Working together will help addressing (lack of) trust, and enhancing supervisory convergence, in particular through the role of EIOPA, will only make responses more consistent, therefore benefitting all EU policyholders. But a question remains, and it has to do with the role of EIOPA (moderator, facilitator, decision maker?).
21. Less can be more. Indeed, we have already indicated how the changes embedded in the review will reduce capital requirements for EU insurers. Whilst in principle one could conclude that the outcome of these changes may negatively affect the robustness of EU insurers, my take is different: the review will help addressing blind spots such as liquidity, and this will only reinforce the model. So put me on the side of those that are bullish on the package... if indeed we all focus on a proper implementation of the new requirements, one that cannot be done at the cost of ignoring existing ones. Furthermore, we cannot forget the fact that these changes have to be completed with those stemming from the new Directive on Recovery and Resolution of insurers, one that will tackle another blind spot.
22. The secret of happy couples: or at least one of the secrets, is to focus on the day to day of the relationship, and put all the efforts in making the best out of it, including reflecting on potential hurdles and how best to overcome these obstacles -where not always the same response will work, thus alternatives will have to be provided considering what is going on and what is coming-, rather than putting all efforts on getting the best conditions in case of divorce, as this will distract the couple from what really matters. Why I am bringing this is self-explanatory when we look at Recovery and Resolution: focus on pre-empting failure, and put your efforts there (Recovery) rather than on failure itself (Resolution), and you will increase the chances to avoid it. Yes, as much as I find Recovery a key element of any sound supervisory framework, I think that Resolution is, and should remain, within the remits of supervisors, not interfering with the running of insurers.
23. The last dance? Will there be another review before I retire? In one word, yes, as two good reasons combine: firstly, that Solvency II is not carved on stone, and will need to adapt to the ever changing reality of insurance business (yes, this is a business); secondly, on personal grounds, being a father of five means that retirement will more realistically take place in my 70s than in my 60s. So looking forward to that next piece, still many years ahead.
24. A crystal ball: if we are already anticipating that there will be more reviews, what topics will be covered? Allow me to share my own list, opinion rather than information, and therefore subject to error. I expect upcoming changes to cover, at least, the following topics: pillar 1 capital charges around sustainability -yes, they will come; so prepare for them-; ad hoc capital charges for crypto assets (even if here I am cheating and not guessing, as I am just reading the power granted in the review to the Commission to develop this); enhanced focus around operational resilience is a given, particularly on the digital front, potentially impacting operational risk treatment, including capital requirements; in parallel to pillar 1 changes, we will soon see the adaptation of an ad hoc liquidity ratio, maybe importing the one already developed by the IAIS, to be used for determining appetite and tolerances in this front; on pillar 2, and staying with the ORSA (the Own Risk Solvency and Capital Assessment that insurers must run to check on the risks they are exposed to), I anticipate clear instructions and expectations around, e.g. including conduct risk as a quantifiable risk, one that merits having its own appetite and tolerances -please note that this expectation has already been manifested by IVASS, the Italian regulator, to Italian insurers, in a recent Consultation paper (8/2023) around product oversight and Governance-. We will also see more efforts to simplify the regime, but like before they will not work as intended and complexity will remain as an issue. Last but not least, regarding more powers to EIOPA... they will come and, shall a crisis hit insurers, this will be accelerated.
I have shared 24 pills in this article, yet there may be many others that, for different reasons, may have the same or more relevance to you, dear reader. I just tried to avoid an overdose.
Carlos Montalvo Rebuelta is a partner at PwC, and its current Global Insurance Regulatory leader. Previously he was the first executive director at EIOPA.