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Battle lines drawn up over Solvency II review

Posted May 2, 2017

By David Worsfold

After over a decade of preparation, meticulous debate and not a few false starts, Solvency II was finally enacted 15 months ago, ready to be transformed into a broader rolling agenda around financial stability.

There are, however, a handful of key issues, including the treatment of infrastructure investments and securitisation, still unresolved and the debates around the 2018 review of Solvency II are already starting in earnest. Any thoughts that we might be entering a period of calm and stability around prudential regulation are misplaced.

In particular, Insurance Europe, which represent Europe’s major insurers, has responded to a European Insurance and Occupational Pensions Authority (EIOPA) discussion paper on the upcoming review of Solvency II with some very clear declarations of where its members’ interests might be threatened by what it sees as EIOPA’s impatience in some key areas

The EIOPA discussion paper was prompted by the European Commission initiating the promised review of Solvency II for next year but Insurance Europe argues that the regulator has overstepped the mark in some areas:

“One particular area raised in the discussion paper, namely the interest rate risk sub-module, which does not form part of the EC call for advice, should not be looked at as part of the 2018 review but rather as part of the 2020 review, as this is closely linked not only to the overall political agreement of the Solvency II framework of 2013, but also because technically the issue is closely linked to the long-term guarantees package, which is itself under the scope of the 2020 review”, declares Insurance Europe.

Beyond that, Insurance Europe has taken the opportunity to highlight several areas where it believes the review should focus its attention:

  • Loss absorbing capacity of deferred taxes – Insurance Europe does not support a default approach whereby the loss absorbing capacity of deferred tax would be capped at the level of net deferred tax pre-shock. This would go against the economic approach underpinning Solvency II and contradict the framework directive.
  • Risk margin – Insurance Europe believes that the current method and assumptions for the risk margin are not appropriate as they lead to excessive levels of risk margin and volatility, particularly for long-term insurance business.

Look-through approach – Insurance Europe supports the extension of the application of the look through approach to investment-related undertakings used as investment vehicles by insurers. This would ensure a more tailored capital requirement for these vehicles ensuring better alignment with underlying risks it argues.

  • Treatment of guarantees, exposures guaranteed by a third party and exposures to regional governments and local authorities – Insurance Europe strongly supports a better recognition of the risk-mitigating effect of guarantees in Solvency II. This is consistent with the risk-based nature of the framework and will improve the reflection of economic reality for insurers‘ risk exposures.

While insurers focus on this new agenda, they won’t be losing sight of some of the other outstanding issues around Solvency II, said Olav Jones, deputy director of Insurance Europe, in advance of the publication of the EIOPA paper.

Top of the list for some time has been getting better recognition for high quality infrastructure investment: “The European Commission have committed to meeting our concerns about infrastructure being unnecessarily penalised under Solvency II. EIOPA has confirmed that the recovery rates make it a high quality, less risky asset. It will be important that corporate finance infrastructure projects like Heathrow are attractive to insurers because, if not, there could be an impact on the real economy. There will be a corrosive effect over a few years if nothing is done about this”.

Hopes are high that this will be resolved soon as the relevant Delegated Acts are currently making their way through the European Parliament and are expected to be approved before the summer.

Less progress is being made with similar proposals to improve the treatment of some securitised assets, says Jones.

Overall the focus for the 2018 review, must be on reducing the risk of unnecessary volatility, says Jones: “Solvency II artificially exaggerates the market risk within insurers’ portfolios. The way to address that is to improve the measurement of volatility so it is less pro-cyclical. Part of the problem is that Solvency II still contains an underlying assumption that insurance companies are traders. We’ve always believed that is a flawed assumption and will be challenging it again in the 2018 review”.

This is a consistent theme for Insurance Europe, especially in the current low interest rate environment, and will be one of the key battlegrounds for the Solvency II review.

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