Economic ructions in Europe and delays to Solvency II are threatening to derail a grand European exercise. Carlos Montalvo, executive director of EIOPA defends current progress of the wide-ranging regime.
How concerned are you about the economic situation in Europe and globally? Does the downturn raise the spectre of systemic risk for the captive sector?
Current global economic uncertainty is certainly a major challenge for the European insurance market. This is particularly the case considering that the likelihood of a prolonged period of low policy interest rates is increasing. Current low interest rates are even more challenging for life insurers, due to the high proportion of products with investment guarantees. Depending on their business model, investment strategies and reliance on investment incomes, captives may also be vulnerable in such an environment, but this exposure would not be systemic in nature.
Overall, coordinated political initiatives such as the banking union proposal and actions by the European Central Bank (ECB) have helped to ease the pressure in the financial markets, but we consider that risks to financial stability within the insurance sector remain high.
How worried are you about the potential for systemic risks created by Solvency II, such as obligations to invest in particular capital instruments or conform to particular risk models? What can be done to address such concerns?
Solvency II applies the so-called ‘prudent person principle’, meaning that there are no limits or restrictions artificially set by regulatory rules; rather there is a focus on sound risk management and capital charges that mirror the underlying risk profile of assets held. There is also no obligation, other than to understand the product you are investing in, and its potential implications.
Capital charges can be determined with the help of internal models—total or partial—as well as through standard formulae. Even for the latter, the loss-absorbing capacity of certain investments as well as those risk mitigation techniques applied are considered when determining solvency requirements.
No concerns about systemic risks should be created by Solvency II. However, this will be checked by successive qualitative and quantitative impact assessments that are due to be undertaken. On the other hand, continuous monitoring of the undesired effects of prudential regulation on systemic risk is intrinsic to Solvency II and is sought in European System of Financial Supervisors and EIOPA regulation. In addition, mid-term impact assessments, with special emphasis on potential systemic risks created by Solvency II, are also foreseen in the latest drafts of the Omnibus II Directive.
EIOPA has been running a number of stress tests of the insurance sector. How resilient is the insurance sector to the prospects of a prolonged period of low interest?
As part of our stress test exercise, a satellite scenario was devised to explore the resilience of the insurance industry to a prolonged period of low interest rates.
Two types of interest rate scenarios were investigated:
1. A downward movement in the level of interest rates in accordance with an unconditional forward rate of 4.2 percent, and a pronounced U-shaped flattening of the curve in the shorter part of the maturity spectrum.
2. A downward movement in the yield curve to a level and shape similar to the lowest level of the euro curve observed in recent years, namely August 2010.
The results showed that between 5 and 10 percent of those companies surveyed would face severe problems in the sense that their minimum capital requirements (MCR) solvency ratio would fall below 100 percent in the two scenarios. In addition, several other companies would observe a deteriorating capital position with solvency rates falling only slightly above the 100 percent mark, whereby they potentially would become vulnerable to other external shocks.
No ad hoc analysis was made on captives, but I would like to take this opportunity to invite captives to take part in the 2013 exercise.
The ‘solvency deficit’, ie, the capital needed to restore a 100 percent MCR coverage amounted to approximately 7.8 billion and 3.7 billion for scenarios 1 and 2, respectively.
Is it your view that the shifting deadline of Solvency II will encourage those that opted out of equivalence in the captive space to believe that they have taken the right step, or do you think that the delay will give jurisdictions and captives more time to accept and prepare for compliance?
The delay that has occurred can both trigger a relaxation of efforts and provide a window of opportunity for re/insurers to use this extra time to prepare better. EIOPA strongly believes in the latter, and is taking action to channel this extra time as an opportunity to further advance Solvency II.
The captive industry has sought to gain a greater voice for itself over Solvency II. How successful has it been in doing so?
Solvency II is a strong regulatory framework and as such acknowledges all the businesses it supervises, including captives. A risk-based framework will always make sense for captives, with the understanding of their specificities achieved through proportionality. Already the standard approach for solvency capital requirement calculations considers specific simplifications for captives.
But other areas also need to be addressed, such as the issue of ratings, and here solutions should differentiate between equivalent and non-equivalent jurisdictions.
Can a captive-friendly Solvency II emerge?
Solvency II is a risk-based framework that encourages sound risk management, and we cannot forget the fact that captives are a relevant risk management tool kit for the economy, so the starting point is the right one.
Solvency II acknowledges the specific circumstances of captives without putting at risk the level playing field and ensuring the politically accepted and fixed level of policyholder protection.
Does the political will remain to rein in offshore domiciles in Europe and should such jurisdictions be concerned about potential overtures from Brussels?
Allow me to disagree with you. Equivalence is an exercise of supervisory trust based on the understanding of third country regimes. This is a precondition to better cooperation but, equally importantly, will help to reduce duplication of regulatory requirements and any unnecessary burden. In order to go in such a direction however, supervisors need to be confident that there is an equivalent level of policyholder protection. There is no will to rein in offshore domiciles, only to reduce the regulatory burden and foster greater international cooperation.
EIOPA, regulation, Solvency II, Carlos Montalvo