Matthew Elderfield: Solvency II - the impact in Europe and Bermuda
Address by Mr Matthew Elderfield, Deputy Governor of the Central Bank of Ireland, at the
Insurance Day Summit, Hamilton, 12 June 2012.
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Thank you to Insurance Day for the kind invitation to join you at this event. It's a great
pleasure to be back in Bermuda to have this opportunity to speak and also to spend a bit of
time meeting the Bermuda firms and my former colleagues at the Bermuda Monetary
Authority. In addition to my obvious personal interest in Bermuda, there are clearly close ties
between Bermuda and the Irish insurance market. A number of Bermuda insurance
companies have a significant presence in Ireland which they use as their base for pan
European activity. And more broadly, wearing my hat as a member of the European
Insurance Regulators or EIOPA Management Board, there are very close ties between
Bermuda and the EU. Bermuda is an important source of risk capital and insurance services
into the European Union, and as such it is an important source of diversification of risk and
provides benefits to wholesale and ultimately retail consumers across the European Union.
For example, 37% of EMEA property cat risk was placed with Bermuda companies according
to the most recent Aon Benfield data. France, Germany, Spain and Benelux each place
between 18-25% of their total premiums with Bermuda companies.
It is therefore encouraging to see that in spite of difficult operating conditions last year the
Bermuda Insurance market is continuing to play an important role internationally and that the
Bermuda Monetary Authority is continuing to make good progress in its drive to enhance its
regulatory regime.
What I propose to do today is to start with a brief update on Solvency II implementation.
Secondly, I want to choose 3 particular aspects of Solvency II to consider in a bit of detail.
And, finally, I would like to take an opportunity to say a word about the equivalence process
and what it means for Bermuda.
By this time almost everyone in the Insurance Industry from chairmen to secretaries,
underwriters to loss adjusters and indeed not just in Europe but in Bermuda, the US and
elsewhere, will have heard about Solvency II. It is the new regulatory framework for setting
risk based solvency requirements for insurance and reinsurance companies operating within
the European Union. It is organised around three pillars: a first pillar setting quantitative
solvency requirements covering all aspects of insurance business, including asset risks and
prescribing eligible forms of capital. The second pillar is aimed at qualitative requirements
concerning risk management and governance standards. And a third pillar is designed to
encourage market discipline by requiring a high level of transparency and disclosure from
regulated firms. This framework is a clear improvement on the current European Solvency I
rule book. Unlike Solvency I, it is risk based, covers the asset side of the balance sheet and
provides an incentive for investment in risk management, including the use of internal
models. Importantly, it is founded on a balance sheet based on market consistent economic
value.
Solvency II is not a single piece of legislation but rather an interconnected group of laws and
European rules. The Solvency II directive itself has been adopted but a supplemental piece
of legislation known as Omnibus II is concluding the process of approval in Europe and
makes important amendments to the core Solvency II law. In addition the directive framework
will be supplemented by a significant raft of so called level 2 regulations and EIOPA, the
European Insurance Authority, will promulgate a wide range of binding technical standards,
guidance and other materials to flesh out the detail of this regulatory framework, often known
as level 3 measures.
This all adds up to what will certainly be a highly complex corpus of rules. While Solvency II
has many benefits and is a distinct improvement on the current European Framework, that
complexity is certainly a source of concern. Regulators, large firms and certainly small firms
will each struggle to some degree to assimilate and implement this significant scale of
change. This complexity is indeed impacting the implementation timetable of the directive.
The process of finalising Omnibus II has unfortunately been delayed in the Brussels process,
which has the knock on effect of squeezing the time available for consulting on, issuing and
then implementing the range of secondary rules. The current target is that member state
governments will domestically implement the European framework by 30th June 2013 and
then the directive will come into force for insurance firms themselves at the start of 2014.
While this timeline is certainly challenging even if it does slip a little, it is certain that Solvency
II is getting very close and will have significant implications for the insurance industry not just
in Europe but globally.
There are a lot of dimensions of Solvency II which could be discussed and which will impact
on the industry, but I would like to take an opportunity to focus on just three in the brief time
available.
First, a word on the impact of Solvency II on the life industry, as this is the biggest open issue
that remains in the final negotiations on the directive and its related rules. At question here is
the impact of the market consistent economic valuation principle on the life industry business
model, particularly with respect to the provision of long term guarantees. Industry has
expressed concern that by prescribing a fixed common discount rate while at the same time
requiring mark-to-market changes in asset values, then long term guarantee products in
particular could be exposed to spikes in solvency requirements in times of short term market
volatility. Similar but related concerns exist regarding the impact of mark-to-market
requirements on assets more generally and in light of recent experiences on sovereign debt
in particular. Again: short-term the concern is that volatility that drives mark-to-market
changes in the fixed income portfolios of insurance companies could lead to volatility in
solvency buffers. This has caused concern among some observers on a number of fronts.
First there is the worry that this framework will discourage the provision of long term
guarantee products, which provide a useful source of savings and investment for retail
consumers. Second there is a worry that the framework may be inherently pro-cyclical by
exacerbating pressure to dispose of assets in times of increased market volatility.
These are real and reasonable concerns and are being tackled in the final negotiations on
the directive. Discussions are underway to adapt the framework by allowing adjustments to
applicable discount rates for certain matched assets and liabilities. Also, a so called counter
cyclical premium is being developed - again to allow an adjustment to discount rates to
offset excess short-term volatility in certain aspects of the fixed income portfolio. There are a
number of different technical approaches to achieve this end and as ever the devil is in the
detail, but the desired outcome is a framework that seeks to square the circle of providing a
more risk sensitive solvency framework, while at the same time permitting the continued
provision of guaranteed products and avoiding dangerous pro-cyclical effects. While this is a
highly technical debate about the detail of discounting and valuation requirements on
particular portfolios of assets backing certain insurance products, I think it is important to
highlight it as one of the key outstanding issues because of the significant impact it will have
on the development of long-term savings products and its relevance to the current turbulence
in the euro sovereign debt markets.
The second subject I would like to mention briefly is that of internal models. Solvency II
permits insurance companies to propose the use of their own internal model as an alternate
to the directive's standardised formula for calculating solvency requirements. The framework
is calibrated to provide an incentive for firms to invest and develop more sophisticated risk
management. This is to be welcomed and encouraged. But there are risks to manage as
well. Solvency II's use of internal models is broadly similar to that of the Basel Framework
but in fact provides even greater scope to firms in their modelling, as Basel set certain
minimum correlation assumptions for models but Solvency II does not. There is clearly a
strong incentive for insurance companies to optimise their use of capital under the directive
and to do so through the adoption of models. This is perhaps stronger in the general
insurance market than in the life market due to the anticipated relative strengthening of
solvency standards. Internal models are, however, subject to supervisory approval, and of
course approval by the insurance company's own board. To my mind it is important that the
approval process doesn't get bogged down in detail such as endless documentation reviews
but stays focussed on the key drivers of the overall solvency calculation arising from the use
of a model.
Regulators and industry spend a lot of time arguing about the detailed calibration of very
specific risk factors under the Solvency II Framework. But it is when the solvency
requirements for different lines of business and different aspects of risk are combined that
the overall solvency requirement can swing significantly as a result of the judgements that
are made regarding correlation and diversification. If this is where the big swings in numbers
can occur, it should be at the forefront of the regulatory approval process and above all in the
challenge from insurance companies' boards.
Diversification is of course an inherent part of the insurance business model but as you are
aware, the risk is that diversification in times of stress is more apparent than it is real. The
assessment of correlation and the level of diversification that is recognised is not a matter for
a black box or a theoretical formula. It is inherently a matter of expert judgement for an
insurance company's senior management and boards, not just its quants and risk team. It is
right and proper that boards should be expected to challenge vigorously the amount of
diversification benefit being claimed in internal models even if they don't know the internal
plumbing of copulas or correlation matrices. Regulators should expect them to take a prudent
and conservative approach and to ask challenging questions about how the models will hold
up in times of stress.
The third dimension of Solvency II I would like to mention briefly is the impact of the directive
on business models or, more narrowly, corporate structures. As I have mentioned, capital
optimisation will inevitably be a key theme for the management of companies impacted by
the directive. In addition to the use of models, revisions to corporate structures are to my
mind likely to be a further avenue of exploration. In particular, in Ireland we see considerable
interest in the so called Hub and Spokes Model. This involves choosing a single European
jurisdiction as the location for the Hub operating company and conducting pan European
insurance business on a branch basis throughout various EU countries. As necessary,
existing subsidiaries outside of the hub country are therefore transferred into branches. This
has the dual advantage of consolidating operations, thereby reducing costs through
economies of scale, and also crucially of optimising capital, as capital is no longer
fragmented in each individual subsidiary.
There are some prominent examples of the Hub and Spokes structure in Europe involving
Ireland as the choice of Hub. We will have to see whether this trend continues or not,
although as I say there appears to be a compelling logic behind it. A challenge for the
supervisor is the effective supervision of such structures. For our part, our starting
proposition that the Hub must have substance and be able to deploy effective controls over
the operations of its branches. Then, as a supplement, as a supervisor we too will assess
branch operations directly or through the use of skilled persons such as auditors and
consultants. Finally there is a significant challenge of coordination between both home and
host supervisors to ensure that all interested stakeholders are kept well informed. At the
Central Bank of Ireland we are very committed to ensuring that the appropriate regulatory
framework is in place for Hub and Spoke operations and that our supervisory resources are
adequate to the task of overseeing such operations. It will be interesting to see whether this
model will grow as Solvency II gets closer to implementation.
I have by now given you a sense of where Solvency II stands in the implementation process
and a few of the key issues that are currently being debated or considered. Let me conclude
with a few words about the equivalence process and where Bermuda stands. Solvency II
requires that insurers from third country jurisdictions must be subject to a regulatory
framework that is broadly equivalent to that within Europe itself. Absence of such an
equivalence finding provides the prospect of a more punitive solvency treatment for firms
from such jurisdictions.
Bermuda, along with Switzerland and Japan, is in the first wave of countries being assessed
for equivalence and is making extremely good progress. The first assessment of Bermuda by
EIOPA was largely very positive, albeit with some further work to do in some areas. The
protracted process of Solvency II implementation in Europe has in fact given more time for
Bermuda and other countries to adapt their framework in order to be ready.
Following a further assessment by EIOPA the ultimate decision will rest with the European
Commission, in consultation with other EU institutions. My view is that Bermuda is very well
placed for this assessment process and is to be commended for the work that Jeremy Cox
and his team have undertaken to drive forward enhancements to the Bermuda regulatory
framework. These are by no means insignificant and have included the development of a risk
based solvency framework and introduction of group solvency requirements. This is a
significant accomplishment, although clearly more remains to be done.
It may seem odd that recently Europe has proposed a transitional equivalence regime which
will allow the benefits of the directive to be enjoyed on an interim basis, allowing other
jurisdictions to take a longer route to reforming their regulatory frameworks to broadly match
that in Europe. I wouldn't be distracted by those developments. By being in the first wave of
the equivalence assessment process and by hopefully winning a favourable outcome,
Bermuda will be in the enviable position of having definitively cleared the EU process before
many other competitor jurisdictions are able to do likewise. That provides absolute certainty
to the Bermuda Market as to the treatment it will receive under the EU rule book and unlike
other countries means that the risk of adverse regulatory developments will not be hanging in
the background. Moreover, full equivalence recognition will cement Bermuda's reputation as
a financial centre that is committed to high standards of regulation.
There will, however, be continuing challenges in implementing the new framework on the
ground. A regulatory framework is only effective as the supervision system that implements
it. In Bermuda, the three issues that I have flagged earlier will have local ramifications that
need to be worked through. The Bermuda solvency framework for life companies' remains to
be finalised and the implications of a market consistent economic valuation approach on
balance sheets still needs to be fully developed. The internal model approval process will, as
in Ireland and Europe, be a big challenge for Bermuda and will require some tough
supervisory calls. And the new complex group structures of the post Solvency II world will
require adequately resourced and high quality supervisors. Let me reinforce that last point in
the Bermudian context, given the likely significant number of groups for which the BMA will
be responsible. Group supervision is a major task and requires high quality dedicated
supervisors who understand the business models of the firms they supervise, are able to
periodically test governance and control frameworks, have a good understanding of complex
intercompany transactions, can oversee the assessment of group solvency requirements,
closely monitor the performance of internal models and ensure effective coordination and
information flow between all relevant supervisors with an interest in the group. It is important
that the Bermuda Market continues to provide support to the BMA as it builds up its capacity
to undertake effective group supervision in practice, as the various tasks come on line and
need to be executed. The Central Bank of Ireland is committed to working closely with the
BMA to ensure effective cooperation in the supervision of those Bermuda groups with a
presence in Ireland and across Europe. There is also a good working relationship between
EIOPA and the BMA on questions of Solvency II cooperation and implementation.
Solvency II - while its implementation is not yet directly upon us - will have profound
implications for the shape of the insurance market in Europe and beyond. The new
regulatory standards will have implications both subtle and profound for insurance pricing,
investment strategy and risk taking. It will encourage investments in risk management
capability and ever more sophisticated modelling. It may provide incentives for fundamental
reshaping of corporate structures. These are big challenges for regulated firms and for
supervisors too. It is essential then that Ireland and Bermuda, and indeed Europe and
Bermuda, work closely together through this process. It is encouraging to see the progress
that has been made so far and I am confident that it will continue in the future.