Solvency II - Benefits of Strategic Implementation

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1 International In-house Counsel Journal Vol. 8, No. 32, Summer 2015, 1 Solvency II - Benefits of Strategic Implementation MAEVE VERDON Associate General Counsel, AIG Asset Management (Europe) Limited, Ireland Introduction Asset management is the professional management and trading of securities and other types of assets to achieve a specific investment goal. Asset managers specialise in managing discretionary mandates and investment funds through providing cost-efficient portfolio management solutions to meet particular investment goals and constraints. It is an agency activity performed on behalf of end investors. It is, therefore, not surprising that institutional investors constitute the majority of the client base. Across Europe, total assets under management (AuM) increased 9% in 2013 and 15% in 2014, to reach an estimated EUR 19 trillion at end This growth came on the back of strong performances on financial markets around the globe. Insurers play a significant role in the market for institutional investments: at the end of 2014, institutional investors dominated the European asset management market constituting 76% of total AuM in Europe, with retail investors accounting for the remaining quarter. Of this total, investments by insurance firms, accounted for 39% of total institutional AuM last year. 1 While this represents a drop of 3% from 2013, the relative importance of individual client groups has not changed markedly over the past decade. Up to now, investments by insurers in the European Union (EU) were governed by the Solvency I Directive 2, along with legislative guidelines at national level. The Solvency II Directive (2009/138/EC) (Solvency II) is a EU Directive that codifies and harmonizes 14 existing EU life, non-life and reinsurance regulations/directives. While the Solvency I Directive was aimed at revising and updating the current EU Solvency regime, whereby capital requirements are determined based on profit and loss account measures (premiums and claims), by contrast, Solvency II introduced a risk-based, total balance sheet solvency regime to assess capital requirements for insurance undertakings operating in the EU and has a much wider scope impacting key requirements relating to product development and sales, internal models, risk calculation and measurement. The Solvency II rules brought into effect for the Solvency II Framework Directive 2009 during 2014/2015 bring about fundamental changes in the regulatory landscape. Primarily, this aims to ensure that EU insurance companies are adequately capitalized with risk-based capital. The essence of the Directive is to require insurers to provide transparency over their risk and the levels of capital held to cover that risk. Solvency II is the most comprehensive regulation ever imposed on the insurance industry across Europe and represents an important challenge for the European asset management industry. The accompanying qualitative and quantitative guidelines for investment and reporting raises the bar on better enterprise risk management practices, governance and transparency in reporting to better define and describe required capital and manage risk in the financial 1 EFAMA, Asset Management in Europe, Facts and figures, April First Council Directive 73/239/EEC of 24 July 1973 on the coordination of laws, regulations and administrative provisions relating to the taking-up and pursuit of the business of direct insurance other than life assurance, as amended and recast by a series of further Directives. International In-house Counsel Journal ISSN print/issn online

2 2 Maeve Verdon markets and will significantly impact the institutional client business of asset managers. In the first place, insurers are already demanding comprehensive investment reporting in accordance with the new rules from their asset managers, to ensure proper coverage of investment portfolios in reporting, and especially to reduce capital adequacy requirements through compliance with transparency guidelines. Asset managers who are unable to satisfy these demands are at risk of losing clients. Secondly, the rules for calculating insurers Solvency Capital Requirement (SCR) will result in additional considerations for investments, and the benefits of strategic implementation will be uncovered in the topics discussed below. Success factors in the implementation of Solvency II for asset managers include consistency of methods, uniform reporting and comprehensive expertise in portfolios eligible assets. Challenges may include investment data management, contribution of eligible assets to solvency capital requirements and overall portfolio performance, standardized reporting for internal monitoring and control of the investment process, as well as more granular challenges posed by Solvency II regulatory and financial reporting requirements. Supervisory competence is in the hands of the European Insurance and Occupational Pensions Authority (EIOPA) alongside the national-level regulatory bodies. Following an EU Parliament vote on the Omnibus II Directive on 11 March , Solvency II is scheduled to come into effect on 1 January Solvency II Solvency II, conceptually based on the Basel II structure for the banking sector, is similarly built on three pillars: quantitative requirements, qualitative requirements and reporting requirements (see figure 1). The central regulatory metric, and starting point for the adequacy of the quantitative requirements under Solvency II, is the solvency capital requirement in pillar 1. The pillar 1 framework sets out quantitative and qualitative requirements for calculation of SCR and technical provisions for outstanding claims and premiums. Solvency II represents a total balance sheet approach, and the technical provisions (valuation to be equivalent to the amount another insurer would be expected to pay in order to takeover and meet the insurer s obligations to policy holders) are the most important liability on the balance sheet of non-life insurance companies. The total balance sheet approach determines that all capital elements on the liability side of balance sheet which are not liabilities from solvency/policyholder perspective, are treated as part of the available capital. This would include subordinated debt, surplus funds and existing equalisation reserves. This is very different from the current Solvency I approach, which aims to apply eligibility limits on certain elements of the balance sheet (e.g. 50% of certain types of subordinated debt) and does not value the liabilities using marketconsistent techniques, a core aim of Solvency II. In addition, insurers must have available resources sufficient to cover both a SCR and a Minimum Capital Requirement (MCR). While the SCR remains the target capital requirement under normal market conditions, the MCR is also included. SCR represents a minimum amount of capital required to conduct insurance business. It covers all of the insurer s quantifiable risks, and corresponds to the value-at-risk (VaR) of the own funds in the fair market value balance sheet of an insurer at a confidence level of 99.5% over a one-year horizon 4. The MCR represents the threshold below which the national regulator would intervene. The MCR is 3 The Solvency II Framework Directive (2009) on the financial position of insurance undertakings had to be adapted in response to (i) new architecture for its implementing measures introduced in the Lisbon Treaty (2009) and (ii) new financial supervision measures introduced in Regulation 1094/2010 establishing the European Insurance and Occupational Pensions Authority. These changes were implemented via the Omnibus II Directive. 4 Article 104(3) of Directive (2009/138/EC) of the European Parliament and of the Council, of 25 November 2009, on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II) (recast).

3 Solvency II 3 intended to correspond to an 85% probability of adequacy over a one-year horizon, and is bound to a corridor of 25% to 45% of the SCR. The MCR must be calculated simply for ease of audit 5. For supervisory purposes, the SCR and MCR can be regarded as "soft" and "hard" floors, respectively. That is, a regulatory ladder of intervention applies once the capital holding of the insurance undertaking falls below the SCR, with the intervention becoming progressively more intense as the capital holding approaches the MCR. These requirements (SCR, MCR and technical provisions) must be covered by eligible capital (termed Own Funds) under Solvency II. Determination of Own Funds starts with the excess of assets over liabilities with any qualifying subordinated debt added back in and the combined amount is known as basic own funds. Some forms of off-balance sheet finance (e.g. unpaid share capital, letters of credit and guarantees) may receive regulatory approval to qualify as additional components of Own Funds, known as ancillary own funds. The whole amount is classified into tiers of Own Funds depending on prescribed criteria and the SCR and MCR both have rules restricting the extent to which the tiers of Own Funds can be used to meet the capital requirements 6. For calculation of the SCR, the insurer may decide to apply the standard formula (a deterministic model provided by the regulator) i.e. apply a set of instantaneous shocks, calculate the net impact on balance sheet at valuation date and then apply appropriate correlations to the results of individual shocks to aggregate total capital. Alternatively, the insurer can make use of an internal (or partial internal) model based on its own methods. 7 Even if an internal model is applied, insurers are also required to calculate the SCR according to the standard model and report the results to the regulator at least once a year 8. The SCR should cover at least the following risks: life/non-life underwriting risk, health underwriting risk, market risk, credit risk and operational risk (including legal risks, but excluding reputational risk and risks arising from strategic decisions). The SCR consists of a series of stresses against the key risks affecting all balance sheet components (assets, as well as insurance liabilities), together with a charge in respect of operational risk. In terms of earned premiums and technical provisions, operational risk capital charge cannot exceed 30% of the sum of basic SCR. With respect to life insurance contracts where the investment risk is borne by the policyholders, the calculation of the capital requirement for operational risk must take account of the amount of annual expenses incurred in respect of policies 9. The calculation of technical provisions will be based on their current exit value. Technical provisions can be valued directly (i.e. for hedgeable risks) if a market instrument exists that replicates the cash flows under the policy 10, however, they are far more likely to be valued as a combination of two components: the best estimate of the liabilities (i.e. the central actuarial estimate) plus a risk margin. Best estimate represents the probability-weighted average of future cash flows, and, when discounted for the expected present value of future cash-flows, uses a risk-free interest rate term structure (the basic risk free interest rates are normally derived on the basis of interest rate swap rates for interest rates of each currency, adjusted for credit risk 11 ). Adding back in a risk 5 Article 129 of Directive (2009/138/EC) (Solvency II). 6 Title I, Chapter IV, Sections 3, 4 and 5 of Directive (2009/138/EC) (Solvency II); Guidelines on ancillary own funds EIOPA-BoS-14/167 EN. 7 Articles of Directive (2009/138/EC) (Solvency II). 8 Articles 101(3), 102 of Directive (2009/138/EC) (Solvency II). 9 Article 107 of Directive (2009/138/EC) (Solvency II). 10 Article 77(4) of Directive (2009/138/EC) (Solvency II). 11 On 10 October 2014 the Commission adopted a Delegated Act containing implementing rules for Solvency II. Following approval of the European Parliament and Council, this was published in in the Official Journal on 17 January 2015, as Commission Delegated Regulation 2015/35, and entered into force the following day.

4 4 Maeve Verdon margin increases the overall value of the technical provisions from the discounted best estimate to an amount equivalent to a theoretical level needed to transfer the obligations to another insurance undertaking. In the context of technical provisions, the main impact on the balance sheet is to assume contracts run to their maturity and a proportion of expected future costs (i.e. general overheads) will be supported by future business. For non-life business, Solvency II requires that valuations of the best estimate and risk margin provision for claims outstanding and for premium be calculated separately. Solvency II considers the best-estimate outstanding claims provision to relate to expected future paid losses and claims handling expenses for claims that have occurred as of the valuation date. Solvency II considers the best-estimate premium provision as a replacement for the current provisions for unearned premium and potential unexpired risk reserve resulting from a liability adequacy test, under Solvency I valuation principles. The Solvency II calculation of the best estimate of the premium provision relates to all future claims payments arising from future events that are insured under existing in-force policies, corresponding future administrative expenses and all expected future premium. Risk margin will be calculated using a cost of capital approach (i.e. for non-hedgeable risks). The cost of capital approach requires the risk margin to be calculated by determining the cost of providing the capital necessary, equal to the SCR, to support the current obligations over their lifetime. 12 In this regard, the cost of capital rate used is the same for all insurers (e.g. fixed percentage) and corresponds to the spread above the riskfree interest rate that a BBB-rated insurance firm would be charged to raise eligible Own Funds. Given best estimate discounting for the expected present value of future cashflows and adding back in a risk margin, is a significant shift in valuation approach, the expectation is that risk margins will be calculated, to some extent, using suitable simplifications. Like for solo insurance firms, an adequate valuation method to determine the risk-free interest rate term structure is of vital importance for group solvency under Solvency II 13. The consolidation method is the default method for groups under Solvency II. With the consolidation approach undertakings will be able to recognise group diversification. However, in some cases, undertakings may face difficulties in producing full consolidated accounts due to the absence of data, issues with the timeliness of information or other practical reasons. The deduction and aggregation method often provides considerable more conservative results, but is easier to apply for many groups. Accordingly, in some cases due to the relatively small size of related undertakings and the resources needed to produce consolidated accounts, in line with the principle of proportionality, groups should be able to opt for the deduction and aggregation approach 14. The latest comprehensive, detailed guidelines of the (final) Set 2 of Implementing Technical Standards (ITS) and Guidelines (technical specifications) 15 were submitted by EIOPA to the EC by 30 June With this second set of ITS and Guidelines, expected to be published during the third quarter 2015, EIOPA will release the final major outstanding piece of the Solvency II framework. 12 Articles 77, 81 of Directive (2009/138/EC) (Solvency II). 13 Title III, Chapters I-III of Directive (2009/138/EC) (Solvency II) April 2015 onwards Phasing-in of Solvency II for supervisory approval processes and decisions related to group supervision (Article 308a of Directive (2009/138/EC) (Solvency II). 15 Current - Technical Specifications for the Preparatory Phase (Part I), EIOPA-14/209, Annexes to the Technical Specifications for the Preparatory Phase (Part I), EIOPA-14/211, and Technical Specifications for the Preparatory Phase (Part II), EIOPA-14/210, dated 30 April 2014.

5 Solvency II 5 Pillar 2 encompasses internal risk assessments by the insurer, as well as the setup of an efficient and appropriate operational system of risk management 16. At the organisational level, there will be various requirements. A key issue at this level will be the requirement for core functions and processes to be established to support a sound risk management system i.e. risk management, actuarial, finance and internal audit functions and internal control processes 17, with the board having the ultimate responsibility for compliance over all three pillars. Internal audit will be a key area of development arising out of Solvency II since all risk-related processes will be subject to the activities of internal audit, to ensure they are operating as intended. This pillar also requires regulators to challenge firms on risk management issues and look at the qualitative aspects of a firm s risk management and internal control systems. Under pillar 2, it will not be sufficient for insurance companies to simply execute their core competency i.e. manage their retained risk: risk strategy and control (both quantitative and qualitative) must be integrated into the business strategy. There will be qualitative requirements for risk management systems in insurance companies to clearly set out the requirement for an independent risk management function. The qualitative requirements necessitate strategic implementation based on three main areas (i) overall responsibility of leadership for risk management, (ii) a clearly defined risk strategy which is linked to the business strategy and (iii) ongoing management and control of the company s risk-bearing capacity. Risk management is the area where pillar 1 and pillar 2 integrate, linking the qualitative issue aspects of pillar 2 to the quantitative issues from pillar 1. The basis of pillar 2 is that insurance firms are required to have an effective risk management system (which will cover at a minimum asset-liability matching, underwriting and reserving, operational risk management, liquidity and concentration risk management, investment commitments and reinsurance and other risk mitigations techniques) and to calculate the appropriate capital against these risks and to report these accordingly. The risk management system must cover the risks included in the calculation of the firm s SCR under Article 101(4) of Solvency II, as well as other risks which are not fully included in that calculation. If an internal (or partial) model is used to calculate the SCR, then the insurer will need to demonstrate that the internal model is embedded in the risk management system. The risk management system in relation to the internal model will need to cover (i) design and implementation, (ii) design and validation, (iii) documentation of the internal mode and any subsequent changes to it, (iii) analysis and reporting on its performance and (iv) model improvement and enhancement. To adequately meet these requirements, insurers may consider an Enterprise Risk Management framework (ERM) which takes a risk based approach to managing the undertaking and integrates concepts of internal control and strategic planning and which addresses the needs of various stakeholders who want to understand the broad spectrum of risks facing the insurer to ensure they are appropriately managed. In addition the insurer may look at appointing a chief risk officer (CRO) or the establishment of an executive level risk committee, or both. The principle of proportionality can be taken into consideration when determining whether a full time CRO is necessary for the risk management function, but the insurer must be able to demonstrate that the function is objective and independent. Additionally, pillar 2 requires the insurer to undertake its own forward assessment of its risks, corresponding capital requirements and adequacy of capital resources. As part of their risk management system, all insurance undertakings must have a regular practice of assessing their overall solvency needs with a view to their specific risk profile, known as Own Risk and Solvency Assessment (ORSA). The main aim of the ORSA is to identify 16 Article 45 of Directive (2009/138/EC) (Solvency II). 17 Title III, Chapter II, Section 3, Chapter IV, Section 2 of Directive (2009/138/EC) (Solvency II).

6 6 Maeve Verdon whether the particular risk profile of an insurance firm deviates from the assumptions underlying the regulatory capital calculation (i.e. standard formula). The ORSA has a twofold nature. It is an internal assessment process within the insurance firm and is therefore fundamental to the strategic decisions of the insurance firm. It is also a supervisory tool for supervisory authorities, which must be informed about the results of the insurance firm s ORSA. The ORSA does not create a third solvency capital requirement. A deviation between the ORSA and the SCR calculation does not lead to an automatic increase of capital 18. The supervisory authorities have a range of supervisory tools if they deem it necessary to react. A capital increase is just one possibility. The ORSA is very specific to the insurance firm s risk profile. It therefore is not required to be too burdensome for small or less complex firms. As part of pillar 2, a Supervisory Review Process (SRP) to be carried out by the regulator, the aim of which is to ensure compliance with the requirements of solvency II and to identify insurers that have potential financial or organisational weaknesses that could increase risks to policyholders. The SRP will also be undertaken at group level. In an effort to enhance the SRP, Solvency II offers incentives to supervised institutions to better measure and manage their risk situation 19. The three required elements of the supervisory review process, which should be applied consistently (subject to the proportionality principle and supervisory discretion dependent on the perceived risks) are as follows, and there should be effective communication, both with the authorised firm or head of the insurance group: Risk assessment framework: This should be risk-based and forward-looking and consider both the current and future risks faced and assess the firm/group s ability to manage and report those risks. This will then influence the frequency of reporting by the firm, supervisory priorities and creation of a supervisory plan, taking account of both its risk and impact assessment. Detailed review: This includes both on-site and off-site work, depending on the supervisory plan, focusing on the areas of risk identified in the risk assessment framework. Firms should be given sufficient time to respond to findings and requests for additional information. Supervisory measures: This should be based on the findings from the detailed review stage and aim to address perceived weaknesses and actual or potential areas of noncompliance. Actions proposed should depend on the significance of the area of concern and must be notified to the firm in writing along with the actions required and timeframe for compliance. The regulator must also then monitor whether these have been effected properly and update the supervisory plan accordingly. Pillar 3 (reporting and disclosure) introduces numerous reporting obligations vis-à-vis the public and regulatory authorities aiming to achieve greater levels of transparency to supervisors and investors so that insurers are more disciplined in their actions. This pillar focuses on disclosure requirements to ensure the transparency of the Solvency II regime and that regulators have the necessary information to ensure compliance with Solvency II. There is a private annual regular supervisory report and a public solvency and financial condition report that increase the level of disclosure required by firms. This includes an annual Solvency and Financial Condition Report (SFCR) that will contain key quantitative information. From a practice perspective, the scope of tasks under the pillar 3 umbrella ranges from defining and updating company disclosure policy and technical requirements, to completing documentation of Solvency II procedures and the 18 Article 45 of Directive (2009/138/EC) (Solvency II). 19 Title III, Chapter II, Section 3 of Directive (2009/138/EC) (Solvency II).

7 Solvency II 7 implemented reporting cycle-run. The rules are contained in a set of guidelines 20 published by EIOPA on 31 October 2013, comprising 62 Quantitative Reporting Templates (QRTs) for mandatory use by insurance firms (48 annual QRTs for each individual subsidiary and 34 at group level, 31 quarterly QRTs for individual subsidiaries and 20 for insurance groups). During the transitional period, a reduced number of reports for 2014 are to be submitted by insurance firms to their national regulators: during the first week of June 2015 annual reports to 31 December 2014 (mid-july 2015 for groups) and last week of November 2015 quarterly reports to 30 September 2015 (first week of January 2016 for groups). Requirements relating to pillar 3 form a major component of the second set of ITS and Guidelines, and insurers now have increased clarity on the disclosure requirements that will apply from In particular, the second set provides a full updated set of QRTs. This will allow insurers to put their preparations for Solvency II pillar 3 into the final phase as 2016 approaches 21. Figure 1 Solvency II Pillar 1 Pillar 2 Pillar 3 Quantitative Requirements Qualitative Requirements Reporting Requirements Market-consistent valuation of assets and liabilities Calculation of Solvency Capital Requirement (SCR) Calculation of Minimum Capital Requirement (MCR) Own funds Calculation of insurance-specific stress tests Consistently risk-based systems Risk Strategies Organisational Structure Internal control Actuarial and Auditing Supervisory Review Process (SRP) Own Risk and Solvency Assessment (ORSA) Objectives Improved risk management processes Reporting to investor and regulator Transparency Corporate strategy, risk management and model Solvency and Financial Condition Report (SFCR) - annual - quantitative and qualitative Regulatory reporting - QRTs - quarterly and yearly Harmonisation Key Indicators of Solvency II at Portfolio Level Under Solvency II, there are no prohibitions on classes of assets. The detailed rules requiring investment of assets in a list of specified admissible assets and the counterparty and asset limits contained in the current regime for EU insurers will be 20 The ITS and Guidelines supplement requirements for narrative reporting that were previously published by the European Commission in its final version of the Delegated Acts, released in October Mid-April 2016 first prudential reporting by insurance firms under Solvency II, with reference to the first day of application (for firms with financial year end on 31 December).

8 8 Maeve Verdon replaced by the 'Prudent Person Investment Principle' 22. This approach ensures transparency on risks of investment portfolios in that, an insurer is free to invest in any assets it chooses, provided that it fully understands the risks involved, makes proper provision for these and that investment decisions are made in the interest of the policyholders. The insurer s regulatory capital (via the SCR) should then reflect its asset position resulting in a need to match assets to liabilities as closely as possible. The contributions to the SCR from the market risk module are the control parameters. Asset valuation: Solvency II imposes market-consistent valuation of assets and liabilities, as well as for capital requirements. This is because Solvency II considers that the capital requirements are impacted by risks related to investment policies. Risk diversification is taken into account whereby Solvency II sets out a range of capital charges for each asset class which is likely to influence strategic asset allocation to ensure optimal use of the insurer s capital while continuing to address its asset-liability matching requirements. Asset allocation: While Solvency II generally encourages investments in incomegenerating instruments like bonds, overall Solvency II does encourage asset diversification within the market risk module through the use of correlation factors between different asset classes. Under Solvency I, there is no explicit capital requirement related to market risk. This means that insurers do not have to hold capital against the risk of holding equity investments, or any other volatile or risky financial asset. The management of investment risk is dealt with in a more simplistic and non-risk sensitive way by splitting investments into two categories: (i) assets covering technical provisions, which back obligations relating to policy holders and are subject to a number of quantitative restrictions (e.g. asset eligibility criteria and quantitative limits); and (ii) free assets i.e. any other assets which are not subject to quantitative restrictions. Under Solvency II, this distinction will cease to exist. Instead all assets, including equity, will be subject to a capital requirement commensurate with the level of risk of that asset. This means that the more volatile a particular asset category tends to be over the one-year regulatory time horizon, the higher the capital charge. In terms of looking at the treatment of individual asset classes: although equity has the highest capital charges (at least 39% under QIS5 23 ), due to the diversification benefits, the marginal capital cost of adding equities to a portfolio is much lower and, with higher expected returns, this asset class would remain attractive for those insures who are not capital constrained. That said, Solvency II also includes dampener mechanisms to ensure it does not amplify cycles in equity markets. In order to avoid firms being unduly forced to raise additional capital or sell their investments as a result of unsustained adverse movements in financial markets, the market risk module of the standard formula for the SCR should include a symmetric adjustment mechanism with respect to changes in the level of equity prices. This is to avoid pro-cyclical effects where a slump in values requires firms to make fire sales of their assets, depressing values further. Generally the treatment of high credit quality government bonds is favourable in that it does not foresee any capital charge for European sovereign debt holdings by insurers, which makes investment grade emerging market government bonds with high interest rates, quite capital efficient. However, the inconsistent treatment of EU governments versus similarly rated non-eu governments continues to raise concern, due to the fact that, unlike non-eu government bonds, EU government bonds are exempt to spread and concentration risk charges within the Solvency II market risk module. 22 Article 132 of Directive (2009/138/EC) (Solvency II). 23 EIOPA Report on the fifth Quantitative Impact Study (QIS5) for Solvency II, March 2011.

9 Solvency II 9 Under the proposed standard formula approach the capital requirement for corporate bonds is driven by the credit quality and duration of the bonds. Long-dated corporate bonds may become less attractive as they attract higher duration-based capital charges, as Solvency II encourages shorter-dated, higher rated credit to minimise capital requirements. Although the capital efficiency of these assets will depend on the shape of credit curves, and how these evolve over time. Assets which can be used as part of the matching premium requirements for annuity funds will also be in greater demand. Long term guarantees are part of products such as annuities. These pay fixed amounts over a defined period of time in the future. When calculating the best estimate (technical provisions), insurance obligations in principle are discounted using the relevant risk-free interest rate term structure. The basic risk-free interest rates are derived from on the basis of interest rate swap rates for interest rates of each currency, adjusted for credit risk 24. The Delegated Act describes the high level principles for extrapolation of the risk-free interest rate term structure for maturities where the markets for the relevant financial instruments or for bonds are no longer deep, liquid and transparent. However, insurers have argued that they should be allowed to use a higher discount rate (i.e. add a premium to the risk-free rate). The reasoning is that they can match the long-term guarantees with assets that have long maturity dates. Ad they aim to hold these assets to maturity, they do not run any risks with respect to these assets other than ultimate default. It is expected that an interest rate curve to discount cash flows which covers all future periods where liability cash flows occur will be set out in the second set of ITS and Guidelines to be published by EIOPA (end Q3 2015). This is because credible market data does not exist for all future projection periods and therefore it is necessary to extrapolate from the last point where credible data is available from the swap curve to a long term expected discount rate. Therefore, the part of the spread on that asset that does not correspond with the fundamental spread (default risk) should be added to the risk-free interest rate term structure. This is what the matching adjustment 25 does it adjusts the discount rate for certain products where the liability cash flows can be reliably closely matched and the assets are typically held to maturity, thereby mitigating the impact of short term spread movements - although it also includes the risk of a downgrade in the fundamental spread. If an insurer were not allowed to make this adjustment, there would be artificial volatility in its Own Funds. This would be the result of the value of its assets (e.g. bonds) going down if the spread, other than the fundamental spread, for those bonds goes up while the value of its technical provisions (the largest part of the liabilities of an insurer) would not be reduced. This results in lower Own Funds (basically, assets minus liabilities) while the reduced value of the assets will not be realised. A buffer measure is the volatility adjustment, which allows the insurer to increase the relevant risk-free interest rate term structure for the calculation of the best estimate by 65% of the portion of the spread of a portfolio that is not attributed to a realistic assessment of expected losses or unexpected credit or other risk of the assets. The volatility adjustment applies only to the risk-free interest rates of the term structure that are not derived by means of extrapolation and the extrapolation of the term structure must be applied on those risk-free interest rates including the volatility adjustment. The volatility adjustment cannot be combined with the matching adjustment. Investment portfolios may consist of bonds, securitisations, loans, equity and property and the assets must be representative of the investments made by insurers to cover the best estimate Delegated Act 2015 (Commission Delegated Regulation 2015/35). 25 Omnibus II Directive. 26 Delegated Act 2015 (Commission Delegated Regulation 2015/35).

10 10 Maeve Verdon Given the insurance business rests primarily on two pillars: distribution (the liability side of an insurer s balance sheet) and investment management (the insurer s ability to maximise returns by managing its assets relative to what the liabilities and the regulators demand), and with both sides of European insurers balance sheets currently under considerable pressure, as the European yield curve flattens and Solvency II approaches. Given the secular nature of these changes insurers are tending to look at new products aimed at limited regulatory capital charges, in particular investments in real estate and infrastructure, which although not particularly well treated under Solvency II, the income and inflation-hedging attributes of real estate and infrastructure are likely to continue to appeal to insurance companies as substitutes for bonds (given the current low yield environment and decline in credit quality in Europe). The secular outlook is inflationary and at current levels of nominal bond yields, real estate, infrastructure and project financing with embedded inflation hedges may be warranted. EIOPA, recognising that insurers could be an important source of funds for infrastructure investments as the predictable long-term nature of their liabilities may mean that such investments are suitable for their risk profile, is currently preparing technical advice to the European Commission (EC) on the identification and calibration of infrastructure of investment risk categories under Solvency II. Asset allocation should play an increasingly important role in the insurer s overall strategy and capital management. One of the reasons why it is necessary to also consider market risk, or risk associated with investments, is that experience has shown that inappropriate investment strategies or adverse movements in the value of the investments can threaten the financial soundness of an insurer and its ability to meet its commitments. Requiring insurers to hold capital against such adverse scenarios arising out of their investments not only mitigates against insurance failures, but also incentivises insurers to consider the appropriateness of their investment portfolio and the risk associated with it. Future Investor and Regulatory Reporting Invested asset data: Solvency II has created new requirements for the provision of asset data in the form of new data fields, new data coding conventions, greater granularity of data and increased frequency of reporting. Insurers have yet to define the totality of the data set required for all three pillars of Solvency II in order to determine the level of look-through (additional information on a security position so as to enable a fuller assessment of the risks associated with holding the security position) required by Solvency II 27. The need to provide data for each asset held on a security-by-security basis will represent a significant challenge for asset managers. Even on standard asset types, there is a significant array of data elements required under the pillar 3 QRTs, including but not limited to security identification code and type; duration; assets pledged as collateral; issuer name, sector, group and country; complementary identification code (CIC) (a four position code, the first two of which are used to classify the asset by country of listing using ISO country code of XL/XT for assets not listed and assets not traded, the third position is used to categorise the assets into invested asset types e.g. government/corporate bonds, equities etc. and the fourth is used to further categorise the assets into sub-risks for each of the types detailed in position three). Add to this information required on more complex asset types such as loss given default for structured products or maximum loss under unwinding for certain derivatives and the extent of the data challenge becomes apparent. Whilst some of the asset QRTs present positional information as at the date of the report, others require transaction information 27 3rd quarter Release of the XBRL taxonomy based on Set 2 of the Implementing Technical Standards (ITS); Update of the XBRL Tool for firms for the application of the "full Solvency II taxonomy;

11 Solvency II 11 to enable the regulator to assess the insurer s risk exposure during the reporting period. This particularly applies to derivatives, securities lending and repurchase agreement activities. For fixed income, the data is available via ISINs and vendor relationships but there are challenges for smaller firms. For over-the-counter (OTC) traded assets, the investment manager is the only source of look-through information. Insurers will typically have no more than six weeks from each quarter end to complete their solvency calculations and QRTs and will usually be running some comparable form of their Solvency II process at each month end. There will be very short operational windows for asset managers to quality assure and deliver data to support these report cycles. Given the high degree of standardisation, shared services centres providing high performance IT platforms and specialising in reporting and analysis offer advantages over outsourcing for asset managers to focus on the very detailed level of operational investment reporting needed in the context of Solvency II. Conclusion Although Solvency II programmes having been running in insurers (and their in-house asset management divisions) for the past two years, and in many cases have begun migration into business as usual, engagement between asset managers and insurers will need to strengthen. Furthermore, the lack of certainty around key issues such as the finalisation of the QRT content and the degree of look-through that will be required and achievable continues to add further complexity to the challenge of strategic implementation of Solvency II as asset managers need to set up substantial new reporting infrastructure comprising data fields not currently included in investor reporting. The detailed data requirements, together with the very short data delivery timescales require greater interaction between asset managers and their insurance clients than ever before. Accordingly, relationships between asset managers and insurers will need to be significantly strengthened to meet this challenge and ensure that the asset manager does not jeopardise an insurer s ability to comply with Solvency II. Additionally, the interplay between Solvency II and local Generally Accepted Accounting Principles (GAAP) rules may lead to conflicting views on the measurement of risk and return. Differences with accounting rules may also lead to conflicting key performance indicators (KPIs), making optimal asset allocation less straightforward, as certain trade-offs may need to be made to ensure compliance. It is hoped the International Financial Reporting Standards (IFRS) 4 Phase 2 will go some way to increase convergence between Solvency II and industry accounting standards since it is generally regarded to be more market consistent 28. The industry will need to determine processes for the overall scope and format of reporting and there is a need for continued consultation at industry association level. Given the regulatory reporting requirements, insurers will require reports to be available on a quarterly basis. However, the ORSA requirement under pillar 2 involves an assessment of continual compliance with regulatory requirements, which may call for more frequent calculation of actual SCRs (monthly), along with modelling of the related capital implications of fund investments so that the regulatory reporting requirements can be optimally implemented. *** Maeve Verdon is lead counsel for the Irish branch of AIG Asset Management (Europe) Limited. Ms. Verdon is responsible for the legal and regulatory affairs of the Irish segment of the European investment management operations of AIG. 28 CRO Forum, Elaborated Principles for an IFRS Phase II Insurance Accounting Model.

12 12 Maeve Verdon Ms. Verdon joined AIG in 2009 as Legal and Compliance Manager for AIG Investments and the Asset Management segment in Ireland. She has more than 15 years of legal investments experience and has served in various management capacities including at Goldman Sachs and HSBC. Additionally, Ms. Verdon has held legal roles at A&L Goodbody, Zurich Capital Markets and AIB, where she started her career. Ms. Verdon holds a Master s Degree in Social Sciences from University College Dublin, a Barrister-at-Law degree from the Honorable Society of King s Inns, and a diploma in Financial Services from the Institute of Bankers in Ireland. AIG Asset Management (Europe) Limited currently has two branches: London and Dublin. Business carried out in the London office is focused on advising and assisting clients (primarily insurance companies affiliated with AIG) with the management of investment assets and structuring or arranging investment transactions as agent. The Dublin office is responsible for the provision of global investment operational back office activities and EMEA Treasury Operations.