3 March 2014Analysis

Solvency II: a Sisyphean task

The Lamfalussy process, an approach to the development of financial services regulation employed by the EU, is evidently not the most appropriate way to design and implement regulation for a sizable insurance market, particularly one with a broad variety of historical specialities in each country. Back-slapping within political circles and the European administration should not mislead the industry that this is a tailored solution for the insurance industry or its customers.

“When captive owners consider their insurance activity they should not fear Solvency II’s requirements, as captives and local supervisors will almost always find a PoP-based common denominator.”

The basic idea to improve the rationale of supervision and develop risk sensitive insurance regulation was needed, as Solvency I proved a rather counterproductive exercise. The move was not however triggered by the financial crisis (which did expose the dependence of life insurers on the global financial market), but was needed from a professional perspective and for the benefit of the insurance industry. However, the issue is that the EU fundamentally overreached in its project, attempting to cover all potential scenarios, particularly when you drill into the specifics of the Solvency II guidelines.

Formulated as a principles-based directive, Solvency II has all the features of a forward-looking, flexible and successful strategy. Drilling down into the details however, the change from a principles based approach at Level 1 has been sacrificed on the altar of regulatory and political fears to the application of a rules-based approach to Levels 2 and 3.

Technical discussions will not be held until July 2015, when we can expect the publication of part two of the guidelines. Then local authorities have to transform the European Commission pages into local laws and regulation. The clock will be ticking, but still insurers cannot study final regulatory requirements. After the issuance of guidelines in all official EU languages, national supervisors will have two months to report to the European Insurance and Occupational Pensions Authority (EIOPA) their compliance or intention to comply, ie, by September 2015.

Fortunately, most insurers have started with preparatory work, some very intensively, others less ambitiously. In parallel, local supervisors have started to roll out frameworks similar to Solvency II and are collecting information regarding the actual and gradual implementation of these rules by individual insurers.

All supervisors will initially follow the ‘comply or explain’ approach. Later, I expect discussions between National Supervisory Authorities (NSA) and EIOPA when opinions on certain requirements are irreconcilable. The question is whether politics will calm such situations?

Looking ahead

There are already transitional options for insurers to implement the requirements with increasing detail over time. Nevertheless, some smaller or medium sized insurance carriers—captive insurers in particular—will apply the principle of proportionality (PoP), which is incorporated in the EU Lisbon Treaty under Article 3b:

Under the principle of proportionality, the content and form of Union action shall not exceed what is necessary to achieve the objectives of the Treaties. The institutions of the Union shall apply the principle of proportionality as laid down in the Protocol on the application of the principle of subsidiarity and proportionality.”

And in the Protocol on the Application of the Principle of Subsidiarity and Proportionality, Article 5, which states:
Draft legislative acts shall be justified with regard to the principles of subsidiarity and proportionality. Any draft legislative act should contain a detailed statement making it possible to appraise compliance with the principles of subsidiarity and proportionality. This statement should contain some assessment of the proposal’s financial impact and, in the case of a directive, of its implications for the rules to be put in place by Member States, including, where necessary, the regional legislation. The reasons for concluding that a Union objective can be better achieved at Union level shall be substantiated by qualitative and, wherever possible, quantitative indicators. Draft legislative acts shall take account of the need for any burden, whether financial or administrative, falling upon the Union, national governments, regional or local authorities, economic operators and citizens, to be minimised and commensurate with the objective to be achieved.”

The PoP is a fundamental component of the Solvency II directive which is deemed to be:

  • A principles-based risk sensitive quantification approach under Pillar 1;
  • A principles-based risk sensitive request under Pillar 2 to self-assess and manage prudently in a pre-described manner the operations and processes of the insurance undertaking; and
  • A principles-based requirement to disclose financial information to increase transparency and market discipline.

When captive owners consider their insurance activity they should not fear Solvency II’s requirements, as captives and local supervisors will almost always find a PoP-based common denominator.

Captive owners should instead focus their attention on exaggerated service volume and costs suggested by certain outsourced functions. One future quality criterion of captive managers, actuaries and consultants will be an appropriate approach to achieving Solvency II targets by applying the economic principle, which is more or less identical with the PoP. Certainly, comparisons and benchmarks might be necessary; quality standards should be the same or improved in such studies, but never reduced due to cost considerations.

Another consideration for captive owners is likely to be the gold plating requirements of some local supervisors, such as the request to appoint a specific quota of independent board members.

Based on the result of the QIS 5 questionnaire, which has been conducted by some major captive managers in cooperation with ECIROA, compliance with Pillar 1 capital requirements should not be a big issue; in some cases strategy adjustments are necessary (such as on investments) and in a smaller number of captives capital increases may be required.

There is however sufficient insurance management intelligence available in the market to master the respective requirements. And now, before we can start in the real world of Solvency II, we will have the opportunity to again study and comment upon draft papers from EIOPA and the EC. Sisyphus is calling.

Guenter Droese is chairman of ECIROA. He can be contacted at: guenter@droese-partners.com