AEGON N.V./Transamerica comments on Comparing Certain Aspects of the Insurance Supervisory and Regulatory Regimes in the European Union and the United States October 27, 2012 AEGON appreciates the opportunity to provide comments on the Technical Committee Reports Comparing Certain Aspects of the Insurance Supervisory and Regulatory Regimes in the European Union and the United States. AEGON has operations in Europe, Asia and also in North America where we operate under the Transamerica brand. We are active in the life insurance, pension, and asset management businesses. AEGON is based in the Netherlands, and has significant operations across Europe. The majority of AEGON s operations, however, are in the United States. We believe that this geographical profile uniquely qualifies us to provide perspective in this extremely important dialogue. We anticipate that this process will create a path to a solution which preserves the ability of global insurers such as AEGON to compete in local markets on both sides of the ocean while ensuring adequate protection of policyholders and effective supervision of groups such as ours. First, we will make some general comments that we believe need to be considered in taking this dialogue forward. Second, we provide some specific comments on group supervision and on solvency and capital requirements. Finally, while we believe that neither the US system nor the EU system is currently positioned to be a global model, we suggest areas where additional convergence is both possible and desirable. A. General comments The dialogue paper is built on seven separate technical committee reports, each addressing one specific topic. However, the report would be strengthened if, in the introduction, it were to address overarching themes, including the following: 1. Both regimes are designed to achieve the same ultimate objectives. The ultimate objective of both regimes is primarily protection of policyholders but also facilitating an effective and efficient marketplace and ensuring financial stability. However, this objective is achieved in different ways because of different underlying philosophies. The US system is based on the notion that policyholder protection and financial stability are best achieved by using a conservative, long term, and stable approach to valuation. As a result, the US system employs cost accounting, incorporates various smoothing mechanisms, and includes multiple elements of prudence. In comparison, the EU system is based on the notion that policyholder protection and financial stability are best achieved by maximizing transparency and by creating risk management incentives. As a result, the EU system employs market value accounting and calibrated capital requirements. 1
Other differences between the systems can be linked to different underlying philosophies. One philosophical difference relates to the use of capital requirements. The US system is based on a minimum capital concept that is used primarily for purposes of regulatory intervention, while the EU system is based on an economic capital concept that is intended to serve as a management benchmark. Another difference relates to the Own Risk and Solvency Assessment (ORSA). The EU ORSA, as presently conceived, is a required standardized tool for internal company risk and capital management. The US ORSA, as presently conceived, is a report to the regulator of the company s approach to risk and capital management. These differences, in our view, are not evidence that one system is more advanced than the other, but rather evidence of different philosophies as to how insurance should be regulated. We believe that policyholder protection, efficient marketplaces, and financial stability can be achieved in more than one way. 2. Individual elements frequently work together to achieve broader regulatory objectives. For example, the EU system places all of the prudence in capital requirements as opposed to the technical provisions. In the US, on the other hand, minimum capital was designed as a supplement to reserves, which include a significant element of prudence. As a consequence, an isolated comparison of either capital requirements or reserves/technical provisions is likely to produce misleading conclusions. 3. The regimes have taken different approaches to regulatory reform. The EU approach and the US approach to regulatory reform have differed. The EU policy was to opt for a new approach with Solvency II, while the state based system in the US has used an evolutionary approach to update the existing system. The EU Solvency II regime is being built as a single, integrated regime, designed to replace Solvency I existing regimes in member states. This new regime is a holistic approach to legal entity and group level supervision and a unified framework for qualitative and quantitative requirements based on a three pillar approach. Pillar 1 consists of the quantitative requirements, pillar 2 sets out requirements for the governance and risk management of insurers as well for the effective supervision of insurers and pillar 3 focuses on disclosures and transparency requirements. It is an ambitious project with a decade already invested in its development. Solvency II has been developed with the intention of producing an entire supervisory framework in a single act of reform. The US regime, in contrast, is not a new framework, but a framework undergoing constant, incremental reform. The policy decision has been to add on the existing system rather than to replace it, often in an effort to rectify perceived deficiencies. At present, the NAIC s Solvency Modernization Initiative and the consequences of Dodd Frank prudential regulatory standards are important evolutionary developments. 4. The regimes are tailored to suit their respective local environments, including their legal systems. In the US, insurance is, by law, regulated by the states at the legal entity level. US state regulators face limitations as to their authority over non insurance entities and insurance entities that are domiciled in other states. In contrast, insurance in the EU has historically been regulated on the national level, and the Solvency II system is designed to regulate the industry consistently across the EU. These legal and environmental differences are important to understand in the context of group supervision. Solvency II is intended to place equal emphasis on the group and the solo entity level, while the US system focuses on legal entities. In the EU, solvency requirements under Solvency II exist at both the legal entity and group level, while in the US, formal state based solvency requirements exist at only 2
the legal entity level (although federal group capital requirements will soon apply to some insurers as a result of Dodd Frank reforms). In addition, in the US, material intra group transactions must be preapproved by the regulator in the interest of protecting the legal entity, while in the EU, such transactions are generally reported after the fact, reflecting more of a group perspective. We view these differences as a product of different local environments and legal systems, not as an indication of deficiency in one system or the other. B. Specific comments In addition to the preceding general comments, we have specific comments about two important sections within the report. 1. Group supervision We believe that the report should more fully describe current enhancements to the concept of group supervision within the US system. The report notes that group supervision in the US currently involves the windows and walls approach, whereby the primary interest of regulators is the impact that activities within the group may have on the regulated insurance company, while attempting to wall off such exposures. However, more robust and coordinated supervision of US insurance groups is emerging. Financial examinations of all of a group s legal entities are coordinated across states and legal entities. Supervisory colleges are currently being formed as the result of revisions to the Insurance Holding Company Model Act. In addition, the new ORSA will provide group level risk and capital information to regulators. While the report makes mention of many of these developments, we believe that identifying them in one location is helpful in countering a possible misperception that group activities in the US are lightly regulated. 2. Solvency and capital requirements As mentioned previously, the different roles that capital requirements play in both systems needs to be recognized and understood. In addition, both capital requirements and technical provisions (reserves) are interrelated. Therefore, the capital requirements of the EU and US systems should not be compared in isolation as is currently the case in the draft report. Specifically, in the US, reserves (or technical provisions) within the balance sheet valuation are both historically and currently the primary source of prudence within the solvency framework. The draft report omits the fact that the risk based capital regime was originally added on top of the statutory reserve system, and no element of the reserve system was amended when RBC was introduced. This historical development explains why US regulators typically place more emphasis on reserves and less emphasis on capital requirements than supervisors in other jurisdictions. We have found that this is sometimes not well understood outside the US. In contrast, Solvency II has been structured in a way that places all of the prudence within the capital requirements. The risk margin within the Solvency II technical provisions is not intended to provide prudence but rather is an inherent element of an economic valuation, as it reflects the compensation over and above the best estimate that risk averse market participants require for accepting the 3
uncertainty in insurance obligations. We have found that this is sometimes not well understood in the US. In addition, we are concerned about the overly simplified conclusion that the discount rate used within the EU reserving basis is lower than that used within the US basis. Because the discount rate has a very significant impact on the valuation of long term life insurance liabilities, this part of the report is very important. And the reality is complex. A fundamental difference is that the EU valuation basis is a variation of market value accounting, while the US employs cost accounting, subject to a liability adequacy test. An inherent characteristic of cost accounting is that the relative prudence may increase or decrease (to a point) over time. Other important issues adding to the complexity of the discount rate discussion include the following: Ongoing discussions about counter cyclical measures will impact the discounting approach within Solvency II. In the US, the report notes that Moody s bond index rates are used to determine valuation (discount) rates. However, the report omits mention of formulaic adjustments, required by law, that reduce these rates. In general, these downward adjustments are greater when product guarantees are longer and when interest rates are higher. In some historical environments, maximum valuation (discount) rates for US life insurance products have been well below riskfree (US Treasury) rates. In addition, we believe that the report understates the role of asset adequacy testing within the US framework, relegating it to a single sentence. Asset adequacy testing is the liability adequacy test that supplements the cost accounting based reserve framework, evaluating whether reserves need to be increased. It assesses whether the company s assets are sufficient to mature its liabilities under multiple stress scenarios. The work is documented in company produced reports that run hundreds of pages. In order to provide a high level perspective on the differences between the frameworks, we have produced the following chart, which compares the major quantitative elements of the two systems. Comparison of Major Quantitative Elements of US and EU Frameworks Solvency II in the EU State based regime in the US Source of quantitative Capital requirements Primarily in reserves (technical prudence provisions); secondarily in capital requirements Accounting basis Market value with counter cyclical adjustments Primarily cost, supplemented by liability adequacy test Solvency modeling One year mark to market (used for Lifetime runoff (used for liability approach capital requirements) adequacy test) Supervisory emphasis Stresses used in capital calculations Assumptions used in reserve calculations In summary, it would be very misleading to limit the focus of comparison to capital requirements and ladders of intervention. The total picture must include technical provisions, and even then, a comparison would be a function of the type of product, when it was sold, emerging experience, permissible capital resources, and other factors. 4
C. Proposed enhancements While we do not believe that complete convergence of the EU and US supervisory frameworks is achievable at this time for reasons described in the General Comments section of this letter, we believe that the overarching aims of supervisors would be furthered by certain targeted enhancements within each regime. These enhancements would have the benefit of bringing the regimes closer together. 1. Group supervision The report observes that Solvency II in the EU has been designed to apply at both the group and legal entity levels, and that the group supervisor has significant authority over the legal entities of the group. In contrast, the US regime is focused on the legal entity, and, while regulators share information about the legal entities of the group, no single regulator has authority over all of the legal entities of the group if such entities are domiciled in different states. It is our observation that group supervision exists in the US, although it is at a somewhat informal and early stage of development. For instance, the new ORSA requirement is applied at a group level, and new holding company requirements both facilitate supervisory colleges and require potentially extensive disclosures about the risk exposures of the group. It is also our observation that a lead state concept frequently exists in an informal sense. We would support the development of a more formal overlay of group supervision within the US. This would involve the following: (a) continued development of supervisory colleges, (b) formal identification of a lead supervisor with responsibility for understanding and providing insight to other supervisors and the Federal Insurance Office about the group s structure, strategy, financial position, risks, and risk management, (c) development of a basic set of information to be supplied to regulators (d) a mechanism for coordination of supplementary information requests about the group, and (e) mandatory participation by lead state regulator in the group supervision regime. This proposed overlay of group supervision would not be intended to detract from the existing focus on legal entities. It would, however, address a perceived gap in the US framework and streamline the regulation of the group. It would also bring the state based system in the US closer to certain parameter of Solvency II in the EU. 2. Counter cyclical measures The primary concern of many insurers about Solvency II is the significant volatility in own funds that may result from changes in market credit spreads. This volatility may encourage procyclical behavior and appears to require insurers to maintain a significant buffer above the solvency capital requirement (SCR) to avoid regulatory concerns. We have been encouraged by the recognition of this issue and the development of, first, the liquidity premium, and, more recently, the matching and countercyclical adjustments. We are concerned, however, that these measures might apply to only a limited scope of products, except in times of market turmoil. In particular, they would have a limited effect on many important long term insurance products that meet important social needs within our various local insurance markets. We believe that a sound argument can be made either for a broader application of the matching premium or for a reintroduction of a separate liquidity premium. The core insurance business model is based on the predictability of cash outflows resulting from the law of large numbers. Insurers may not know which policyholders will file a claim, but they often can reliably estimate the number. This same 5
principle applies, in general, to lapse or surrender of policies. As a consequence of the predictability of cash outflows, insurers can often prudently invest in relatively illiquid assets and harvest the investment premiums. This predictability, therefore, has real economic value for an insurer, and an economic solvency framework such as Solvency II should reflect it. We are encouraged that a QIS exercise on the counter cyclical measures is underway, and we believe that the results of the exercise will show that these measures can be designed in a way to achieve a sound and robust prudential framework while respecting the long term nature of the insurance business. We believe an adequate application of such measures would significantly reduce volatility and bring Solvency II in the EU closer to the concepts underlying the state based framework in the US. 3. Reinsurance and collateral requirements As our US business is a large purchaser of reinsurance, we would welcome the potential for increased competition within the US market. Historically, such competition has been limited by requirements that non US reinsurers must hold 100% collateral. The 2011 amendments to the NAIC s Credit for Reinsurance Model Law introduced reforms that allow strong reinsurers to hold less than 100% collateral under certain circumstances. The dialogue report notes, however, that significant differences nonetheless exist between the US approach to non US insurers in qualified jurisdictions and the EU approach to non EU insurers in equivalent jurisdictions. We would support additional reforms to the NAIC model that would bring it closer to the EU approach. In general, we do not believe that collateral should be required from highly rated, well capitalized, and well regulated reinsurers. To that end, we suggest: (1) collateral reduction/elimination should be possible for in force business, not just new risks, and (2) the sliding scale of collateral, which is a function of rating agency ratings, should be eliminated. In addition, the NAIC model should be an accreditation standard, thus making national uniformity significantly more likely. These changes would both benefit US direct writers and bring the state based system in the US closer to Solvency II in the EU. D. Concluding remarks In summary, the state based system in the US and Solvency II in the EU have the same ultimate objectives. The methods used to achieve these objectives have been informed by philosophical differences, legal frameworks, and historical practices. However, the existence of such differences should not imply that one system or the other is not equivalent for protecting policyholders, facilitating an effective and efficient marketplace, and ensuring financial stability. To be clear, convergence of supervisory and regulatory practices is desirable and in our view may be an achievable objective over time. An exercise of ongoing convergence is facilitated by bilateral regulatory dialogue between the EU and the US. As this dialogue progresses, it will need to include not only factual comparisons of individual elements, but an understanding how those elements work together. Therefore, this dialogue needs to continue and evolve. In the meantime, complete convergence is not a pre requisite for mutual recognition of different solvency and supervisory systems. The insurance markets in both the US and EU are best served by a regulatory environment that allows non domestic insurers to compete on a level playing field. We advocate policy decisions that achieve this outcome. 6