The Future of the Insurance Sector and the Impact of Solvency II
Interview with Karel Van Hulle (Head of Insurance and Pensions, Internal Markets and Services - European Commission)
Solvency II is an important European project for regulating the insurance industry yet it seems to be delayed. What are the remaining issues and how are the timings?
Van Hulle: Solvency II is indeed the most important regulatory change in insurance since the last 30 years. The introduction of a risk based solvency regime that is based upon a market consistent valuation of assets and liabilities in the middle of a severe financial crisis has not been evident. Although the Framework legislation was introduced in 2009 (the Solvency II project was designed as a three level regime with a Framework Directive to be adopted by Council and European Parliament (level 1), implementing measures to be developed by the Commission (level 2) and further guidance (level 3) to be developed by the supervisors, i.e. by CEIOPS (Commission of European Insurance and Occupational Pensions Supervisors)), we are still struggling to adopt the so-called Omnibus 2 proposal which was introduced in January 2011 and which was supposed to deal mainly with the powers of the new authority created after the financial crisis: EIOPA (European Insurance and Occupational Pensions Authority), which was set up in 2011 to replace CEIOPS. As this proposal is amending the Solvency II Framework Directive adopted in 2009, the Solvency II project is stalled until Omnibus 2 will have been adopted by Council and European Parliament.
In its deliberations of Omnibus 2, the European Parliament's Economic and Monetary Committee decided at the end of March 2012 to introduce some important changes into the Commission's proposal, a proposal which had already been broadly accepted by the Council in September 2011:
- bring some of the provisions which had already been drafted for the implementation of the 2009 Solvency II Framework Directive into the discussions, i.e. move them from level 2 to level 1. These provisions deal with the specific regime for long term guarantees. It has appeared from QIS 5 (the last major quantitative impact study carried out in 2010), that the instability in financial markets created a great deal of volatility in the calculation of the technical provisions (which have to be calculated on a market consistent basis) and therefore also the own funds of the insurance undertakings. This resulted in a Solvency Capital Requirement that was very volatile. Such a situation is particularly problematic for insurers that offer long term guarantees and want more stability in the calculation of their technical provisions. The EP decided to bring the solutions adopted in the context of a working group established by the Commission in 2011 (to discuss possible amendments of the Solvency II regime in order to take account of "artificial" volatility) into the Omnibus 2 proposal. These solutions include a so-called counter-cyclical adjustment, to be decided by EIOPA in the case of extreme situations in financial markets and a matching adjustment for contracts where assets and liabilities are very closely matched;
- expand the transitional regime for the entry into force of Solvency II particularly in the area of public reporting and supervisory reporting;
- change a large part of the implementing powers granted to the Commission into powers to be delegated to EIOPA.
These changes proposed by the EP were not easy to accept for the Council because the EP reduced much of the scope of the long term guarantee package that had been agreed between the Commission, Member States, the supervisors and the industry in 2011. The EP also brought up other issues which were difficult to agree on such as the equivalence of third country solvency regimes with Solvency II and the treatment of sovereign risk.
The main remaining issue on the table is the long term guarantee package. It is hoped that a solution can be found during the course of September. It was agreed in July to test this package before the Commission will draw up the implementing measures (delegated acts). The test will be carried out by EIOPA based upon specifications to be agreed between the Council and the European Parliament. The Commission is expected to present a report based upon the test carried out by EIOPA. This report will be discussed by the Council and by the European Parliament. It will form the basis for the Commission's implementing measures (delegated acts) which will be presented to Council and Parliament once Omnibus 2 will have been agreed and published in the Official Journal. It is the intention to start the new regime from 1 January 2014 onwards.
There is some concern about long-term financing of the European economy, especially with the impact of Basel III on banks. Will Solvency II encourage or restrict the investment in equity or risk capital?
Van Hulle: Solvency II, in its design, promotes long term investment by providing for a low capital charge for long term liabilities that are matched with a portfolio of fixed income securities held to maturity over a long period of time.
Solvency II includes a less favourable regime for investment in equity or real estate because of the uncertainties relating to an investment in those assets. However, through diversification and/ or the use of a partial or full internal model, insurers can reduce the capital charge relating to an investment in equity or real estate.
In its final decision on the calibration of the various risks, which will be taken in 2013, the Commission will take account of the need to provide incentives for growth. The Commission wants insurers to continue to be long term investors in the economy. The right balance will have to be struck here between the protection of the policyholders, which is the main objective of Solvency II, and broader macro-economic priorities.
Will Solvency II contribute to financial integration in the EU through cross-border insurance?
Van Hulle: Today, insurance products and markets in the EU are still very different because of considerations that are linked to tax, legal regime, tradition, culture, etc. It is very difficult to change this and insurers have tried to coop with this by not directly offering their services cross-border but by acquiring local operators and/or establishing subsidiaries in other MS.
Solvency II is likely to bring important changes to that situation. As the new solvency regime is risk based, insurers will have to re-examine the products which they offer today. This will lead to more harmonisation in product design because it will no longer be possible to offer products that do not take account of the risks related to these products. Furthermore, some insurers are likely to transform some of their subsidiaries into branches and that again will have an effect on the marketing of products cross-border.
As Solvency II is a risk based solvency regime, insurers will be incentivised to take account of all risks related to the products which they bring on the market. This will eventually lead to the marketing of products which are more readily comparable, thereby promoting more cross-border business.
It is therefore likely that Solvency II will contribute to a situation whereby more cross-border business will take place.
We are now creating a Banking Union. Can we expect something similar for the insurance sector?
Van Hulle: The question needs to be answered how one should deal with financial conglomerates which include banks and insurance undertakings? It is in that context that the insurance issue is being raised. There is no specific request – at this stage - to also have an insurance union in addition to a banking union. The pressure for the creation of a banking union results from the Eurozone crisis. It is different from the idea of a common rule book which was developed after the financial crisis. For insurance undertakings as well as for banks, it is recognised that there needs to be more commonality in the prudential rules both in theory and in practice.
One of the problems that must be resolved relates to the expertise which is required in supervising insurance undertakings.
The insurance sector is suffering from continued low interest rates. Will Solvency II have an impact on this?
Van Hulle: The low interest rate environment is particularly problematic for the insurance industry. It shows clearly how a measure that is taken by supervisors to assist the banking sector can have negative consequences for the insurance sector. It affects the insurers twice: on the asset side because of the lower return on their investments and on the liabilities side for the calculation of the discount rate.
Solvency II will show this more than Solvency I is doing at present. This is an important reason why some insurers prefer to stay in a Solvency I world which allows them to pretty much ignore market risk. It is also an important reason why from a prudential point of view the introduction of Solvency II is badly and urgently needed to avoid insurers continuing to offer long term guarantees which they can no longer avoid.
Do you think the insurance sector is sufficiently prepared to implement Solvency II or do you still foresee some important problems ahead?
Van Hulle: As Solvency II is the most important change in insurance regulation since the last 30 years, it is obvious that not all insurers are widely enthusiastic about Solvency II. Change is always difficult and there is no doubt that Solvency II is far more complex than Solvency I.
Many insurers have been preparing themselves for Solvency II. They were assisted in that by 5 quantitative impact studies of which the last covered a large majority of the industry (more than 70%) both in terms of large and of small and medium-sized insurers.
There will of course be problems of implementation. This is the reason why there will be a number of transitional measures that should help the industry particularly in the area of public disclosure and supervisory reporting.
Should we consider insurance organisations as SIFI’s (Systemically Important Financial Institutions)? Will there be, much like in banking, a different rule set for large insurance companies?
Van Hulle: Insurers keep repeating that insurance is not banking. The insurance business model does not show the same characteristics as the banking business model: liquidity is not equally important. The risk that the economy as a whole will be affected by the insolvency of an insurance undertaking is rather small.
However, insurers may engage themselves in shadow banking or in non-traditional insurance activities which could turn them into systemically important financial institutions. It is therefore not to be excluded that some insurers will be labelled as SIFI's at least for part of their activities. The solutions will then depend on the reasons why the insurer is considered as systematically important. If the activity is similar to banking it would be logical to adopt the same approach and to impose the same remedy. However, if the activity is traditional insurance, a different solution will have to be found.
The final decision on whether certain insurance undertakings should qualify as SIFI's will be taken by the Financial Stability Board (FSB) upon the advice presented by the International Association of Insurance Supervisors (IAIS).
You are also responsible for the Pension Funds Directive. Will this contribute to more pan-European pension plans?
Van Hulle: The Commission is preparing a review of the Pension Funds Directive which was adopted in 2003. One of the objectives is the introduction of a solvency regime that is equivalent to that introduced for insurance undertakings. This is particularly relevant for those pension funds that offer defined benefit plans. The Commission's proposal to which reference was made in the Green Paper and the White Paper on pensions, will be tabled by mid-2013. In order to prepare this, an impact study will be carried out by EIOPA starting in October 2012 and finishing by February 2013.
The difficulty here is that (occupational) pension funds live in a different world. Little is known about the financial situation of many pension funds in the absence of common rules on accounting, solvency and reporting. Furthermore, the industry is afraid that the introduction of solvency II type of rules will lead to increased capital buffers and will therefore make pension plans more expensive.
A reform in this area is needed to ensure that members of pension funds will also in the future receive a pension that is decent and allows them to live comfortably. This will not be possible unless pension funds also take account of the risks related to the guarantees that they offer. There is not such as thing as a free lunch. Pension funds are struggling with the low interest rate environment and the volatility in financial markets in the same way as insurance undertakings. Some of the remedies introduced for the insurance industry should therefore also be relevant for pension funds.
On the other hand, a pension fund is a vehicle set up between social partners. They will decide who will get which benefit. To the extent that social partners can change the benefits, the solvency regime will have to reflect that. This is the reason why we need a solution which takes account of the specificities of the pension promise.
Whether this reform will lead to more cross-border pension arrangements remains to be seen. Further changes will be necessary: more harmonisation of social and labour law and a tax regime that looks more similar. Portability of pension rights is also an important element.