Financial Services. Solvency II. Briefing note

Transcription

1 Financial Services Solvency II Briefing note

2 The recent publication of draft technical specifications for the fifth quantitative impact study (QIS 5) by the European Commission and the previous CEIOPS advice for Solvency II implementing measures have exposed a number of fundamental outstanding issues around the calibration of Solvency II, which are far from resolved. It has also become clear that there is a significant disagreement on the target level for the industries capital requirements and own funds between the regulators (as represented by CEIOPS) and the European Commission as the decision maker. While there is relief in the insurance industry that QIS 5 and hence the expected Solvency II calibration is not as onerous as CEIOPS advice suggested, there are also voices by other stakeholders suggesting that the QIS 5 calibration may be too soft. The final word on the calibration of Solvency II capital requirements has not been spoken. We are likely to see some adjustment of the QIS 5 technical specifications by the end of the corresponding consultation process in July and more adjustments following the results of QIS 5 towards the end of this year and before Solvency II implementing measures can be formally adopted by the European Commission in Time is running out to resolve these issues, for which the stakes are extremely high. If we can expect anything, it is that the lively debate around the detail of Solvency II regulations will inevitably continue. Given the uncertainty in exact requirements, smart and flexible Solvency programme management is essential. Companies need to have a clear, big-picture view of what their business will look like under Solvency II. Definition of your Solvency II ambition must include how you will manage business impact, and this ambition will need to be updated as requirements evolve to inform and steer the actual implementation work. 2 Copyright 2010 Oliver Wyman

3 Key issues of debate In the remainder of this briefing, we will first discuss the key issues that are still being debated and explain why they are important. We will then provide an overview of what this means for your Solvency II preparations. Market-consistent valuation of technical provisions There are three main discussion items surrounding the marketconsistent valuation of technical provisions: First, what market rates to base liability discount rates on; second, whether or not to allow for a liquidity premium in the liability discount rate; and third, how to determine long-term interest rates. While QIS 4 and CEIPOS advice on implementing measures suggested that AAA-rated government bond rates should be used in determining technical reserves, the European Commission s technical specifications for QIS5 allow swap rates as preferred by the industry. In addition, QIS5 will allow a liquidity premium for all insurance contracts with a term of more than one year, increasing the liability discount rate. Finally, QIS5 technical specifications set out that in the absence of a liquid market long-term interest rates should be extrapolated using macroeconomic assumptions. These issues may appear very technical, but ultimately this is about defining the cost of manufacture for insurers. Using swap rates rather than AAA-rated government bond rates and allowing for a liquidity premium increases the discount rate and decreases the value of technical provisions. Allowing the extrapolation towards a macroeconomic equilibrium at the long end of the yield curve reduces the volatility in technical provisions for long-dated liabilities. In aggregate, the answers to the three questions surrounding the liability discount rate can change the total resource requirements of European insurers by hundreds of billions of Euros. Calibration of stress factors for the standard formula approach In the wake of the global financial crisis, it is not entirely surprising that CEIOPS, in its advice on level 2 implementing measures, has increased the stresses to be applied in the standard formula approach for calculating the Solvency Capital Requirement. However, there was some surprise about the size of the increase in the CEIPOS final advice relative to the QIS 4 calibration. The increase in stresses has only been partially taken back by QIS 5 draft technical specifications. Examples of increases in stress factors include: Credit spread risk: The shocks to be applied to credit spreads have roughly doubled. Copyright 2010 Oliver Wyman 3

4 Under QIS 4, the spread increase was 103bps for an A-rated bond in the shocked scenario, whereas the European Commission now proposed a change to 260bps in its QIS 5 draft technical specifications. In other words, insurers would need to hold 26% of market value as spread capital alone for an A-rated bond with a 10-year duration. Even after diversification benefits, this number would only fall to about 17-18%. Clearly, these increases in capital requirements will materially change the relative attractiveness of corporate bonds as an investment class. Non-life underwriting risk: In QIS 5 draft technical specifications, the factors for premium and reserve risk in the standard formula for non-life underwriting risk have increased by an average of 15%, increasing the Solvency Capital Requirement for these risks by the same proportion relative to QIS 4. Here, QIS 5 draft technical specifications take back a more extreme suggestion by CEIOPS in its advice that would have increased capital requirements for non-life underwriting risk by approximately 50% relative to QIS 4. Another important factor for the size of the Solvency Capital Requirement is the degree to which diversification is allowed and the specific diversification assumptions. Here, we have first seen a significant increase in correlations between QIS 4 and CEIOPS final advice, which has now been taken back by the CEIOPS draft specifications. The ongoing debate around the calibration of stresses and correlation assumptions for the standard formula makes QIS 5 an extremely important exercise: This is CEIOPS last chance to assess the impact of the suggested calibration before the standard formula stress factors are finalised. Recognition of own funds Until recently, the Solvency II debate was almost exclusively focused on the valuation of liabilities and calculating the Solvency Capital Requirement. However, the rules around available financial resources are just as important. CEIOPS advice on own funds implied that there would have been stricter rules around the form of hybrid funding that counts towards tier 1 and tier 2 capital. This would have had significant impact on insurers funding strategies. However, QIS 5 draft technical specifications have diluted the requirements for hybrid capital; this is now less of an issue. Another important change between CEIOPS advice and QIS 5 technical specifications is the allowance of expected future profits (value of the in-force of VIF ) in Tier 1 capital. CEIOPS advice was to only qualify expected future profits as tier 3 capital. This would have fundamentally undermined the economics of some products such as unit-linked products, which have so far been self-funding. QIS 5 technical specifications allow 4 Copyright 2010 Oliver Wyman

5 expected future profits as tier 1 capital this eliminates the concerns around unit-linked products but raises new questions around the lossabsorbing capacity of expected future profits. Group supervision and third-country equivalence While the guidelines for Group supervision and colleges of supervisors have been laid out, this does not seem to be working in practice yet. For example, there are huge discrepancies across Europe in the internal model approval process. In some countries, regulators have already been on-site while in others discussions around internal models have not even started. For large insurers in particular it seems to be difficult to agree on requirements or even a process for internal model approval and ongoing supervision due to the large number of national supervisors involved. Finally, one major outstanding question is that of third country equivalence. While the indicators for third country equivalence have been laid out in CEIOPS consultation paper, it is not yet clear whether the US in particular will receive third country equivalence. The answer to this question can have significant impact on many groups Solvency II programmes. In summary, there are major issues outstanding that require thorough discussion by industry participants, regulators and EU bodies. Given that Solvency II has been in development for many years now, it is somewhat worrying that there are still so many questions outstanding that each have the potential to change the total financial resource requirements by hundreds of billions of Euros. Getting ready for Solvency II As a consequence of these uncertainties, it is more challenging for the industry to prepare for Solvency II than ever. Insurers are having to participate in and shape the regulatory debate, while they are simultaneously preparing themselves to implement the ever changing new regulations. This makes it even more important that insurers are well organised in their Solvency II preparation and that their readiness programmes are up to the challenge. To achieve this, there are a few principles that we consider key for running a successful Solvency II programme in this challenging environment: Executive steering of Solvency II efforts: As illustrated above, Solvency II will significantly change the economics of some parts of your business. Dealing with this fundamental change requires Executive focus and steer. The fact that requirements are still unclear is no excuse. On the contrary, uncertainty typically brings along strategic opportunities. Defining your Solvency II ambition at the Executive level is key to gauging these. Copyright 2010 Oliver Wyman 5

6 Early focus on risk organisation and business impact: It is immensely important that your Pillar 2 capabilities are developed early on. Risk organisation and governance and risk management capabilities are important factors in succeeding in the new regulatory world but also in dealing with the uncertainty around requirements. The level of capital requirements may still be unclear but there is no doubt that they will need to be taken into consideration in core business decisions such as ALM, product design, capital allocation and risk portfolio optimisation. Building the necessary tools and the risk management structures to do this now will also enable you to effectively react to changing requirements and to deal with the volatility in your solvency position that will be introduced. An integrated approach to Solvency II development: Your Solvency II programme should be integrated across pillars. It is important to have a central team that monitors developments and feeds them into the Solvency II programme across pillars and across workstreams. Likewise this central team or design authority should also sign off all content development, ensuring that the individual pieces fit together and to overcome silo thinking in each of the pillars. Appropriate resourcing of your Solvency II programme: Your Solvency II programme requires skilled staff that are content experts but also up to the task of managing your Solvency II programme towards unclear and changing requirements. Resource availability is getting tight, if your Solvency II programme is not fully staffed yet it is important to move now. For more information on these principles, please read our full report: The Strategic Impact of Solvency II. 6 Copyright 2010 Oliver Wyman

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