The International Soap Opera That Won’t End
The European Union’s new Solvency II regulatory regime has dragged on longer than a Russian novel—and accomplished far less. It exposes rifts between state, federal and EU regulators.
A monumental upheaval is under way in the European insurance regulatory landscape, and it’s sending shockwaves around the insurance world.
New rules for capital adequacy and reporting went into force January 1 for all risk carriers in the 28 states of the European Union. The rules are now resounding in other important insurance jurisdictions, including Bermuda, Switzerland and the United States, which has just seen the Obama administration intervene.
The comprehensive program is known as Solvency II, echoing earlier Basel Accords for bank solvency. It is more than just a tweaking of the rules. Its three pillars fundamentally change the way insurers and reinsurers allocate capital to risk and tell regulators about their financial health. The rules have been a long time coming.
Solvency II goes beyond capital requirements.
Solvency II goes beyond capital requirements. It replaces a mass of European Union regulation—mirrored in the statutes of each member state—to cover almost all aspects of European insurance supervision.
It details how insurers are regulated and governed, how they manage and reserve for risk, and what and how they must report to national supervisors and the wider public. It is divided into three components, known as the “Three Pillars.”
Pillar 1 covers financial requirements. It sets two solvency thresholds: the Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (MCR).
The SCR is a risk-based capital allocation, which can be determined based on either a prescribed, standard formula or on an internal model. If the latter, the model must be approved by the regulator.
The MCR is a portion of the SCR. It must be at least 25%, but not more than 45%, of each company’s SCR. Assets that comprise an insurer’s capital, and the liabilities that offset them, in part are valued according to a “harmonized” standard. That is EU-speak for a methodology common to all member states.
Pillar 2 covers governance and supervision. It requires insurers to adopt an effective risk management system, including a regular “Own Risk & Solvency Assessment” (ORSA). Pillar 2 also sets out details for the conduct of supervisory reviews and interventions.
Pillar 3 covers reporting and disclosure. Companies are required to make public the details of the risks they hold, their capital adequacy, and the risk-management measures they have adopted, with the goal of allowing the market to improve the industry’s discipline. More detailed reports must be issued to regulators to ensure companies the SCR is in line with the risks on its books.
They are complex and demanding. And not everyone is prepared.
With January’s deadline fading into the distance, the press (including daily newspapers, which rarely give insurance issues any space at all) is crammed with dire warnings about unclear guidelines, unapproved capital models, impossible targets, and the unsustainability of a Hydra-like regulatory burden. Only a few voices are now beginning to proclaim better regulation and improved solvency as a competitive advantage.
The simple goal of Solvency II is to ensure “supervisory convergence” in all 28 EU-member states. Under the EU’s common market rules, an insurer headquartered in any European Union country can sell insurance to buyers in any other EU country—from the United Kingdom to Bulgaria—under so-called “home state” supervision. That’s the main driver for common regulatory standards. Further, the desire for other jurisdictions to match the European standards is broad, primarily for countries where European risk carriers do a lot of business.
“Equivalence” is the Holy Grail. It allows EU insurers to report on subsidiary operations in equivalence-approved countries under local rules. It also exempts those companies from some of the new EU rules for their European operations. A nation granted equivalence is one whose requirements for insurer and reinsurer capital and regulatory supervision provide the same level of policyholder protection as EU nations. The purpose is to provide for free trade between the EU and nations granted equivalence.
And what does this all mean for brokers? The ramifications are tough to isolate. The new regime could affect the valuation of foreign-owned carriers and also could put pressure on them to withdraw from various markets. That said, ratings companies have warned brokers not to use Solvency II as a guide to determine a carrier’s financial strength. Rating agency Moody’s stated, for example, that “Solvency II ratios may underestimate or overestimate insurers’ actual economic capitalization, because of the challenges in calibrating all risks on a pure economic basis at a 99.5% confidence level, and the impact of the transitional measures agreed to smooth Solvency II implementation.”
In June, the European Commission (EC), the EU’s executive branch of government, approved full and permanent equivalence for Switzerland and partial, temporary equivalence for the capital-adequacy regimes of the United States, Australia, Bermuda (excluding captives), Brazil, Canada and Mexico. The latter six countries’ supervisory regimes were deemed to meet European Union levels in terms of solvency calculations and have been granted equivalence in this area for 10 years.
However, local rules governing supervision by the authorities of insurance conglomerates and reinsurance contracts are not yet deemed equivalent in four of the six nations. In late November, only Bermuda and Japan were granted full equivalence.
The American Exception
Negotiations are under way between the EC, the European Insurance and Occupational Pensions Authority (EIOPA) and, in the United States, the National Association of Insurance Commissioners (NAIC) and the Federal Insurance Office (FIO). They are intended to lead to equivalence approvals in the remaining areas. Much is at stake: between them, supervisors in the U.S. and the EU oversee more than 70% of the world’s premium. A 2012 memorandum of understanding between the EU and the U.S. set a goal for full equivalence in 2017.
Despite the first-glance allure of a unified regime, U.S. equivalence came as a surprise, since it was not actively sought by the American insurance industry or U.S. regulators. Some actually opposed it, likely because they see the advantage it would give to foreign competitors as greater than the benefits accruing to themselves.
No one is a winner in Europe yet, and some companies have been distinctive losers. Aegon, the Dutch owner of TransAmerica, took a share-price hit of almost a quarter in August when it revealed its Solvency II capital surplus would be lower than anticipated—dropping to $600 million from $1 billion. The decline represents a solvency surplus deterioration at 40% to 70% above the minimum, down from a level 50% to 100%.
Dutch rival Delta Lloyd saw a 43% share-price slide over “worries about the company’s position under the new Solvency II rules,” reported Reuters. The company is to raise €1 billion ($1.06 billion) through a rights issue to meet the demands of the solvency regime.
In general, any capital surplus below about 60% could lead to greater regulatory scrutiny and to cash calls to investors. At the very least, any imminent return of capital to shareholders during these times of bounty for insurers seems extremely unlikely under Solvency II.
Stephen Mullan, a divisional director at Willis Re, says the failure to establish equivalence could create “substantial headaches” for EU companies with foreign parents or subsidiaries, since they might have “to separately establish compliance with both regimes.” Lack of equivalence could also severely hamper the market for reinsurance transactions between EU insurers and foreign reinsurers.
“The U.S. has been a particular concern because its risk-based solvency standard—while long established—differs fundamentally in approach from Solvency II,” Mullan says.
An EU-U.S. Pathway
Discussions between the European Union and the United States are following a plan set out in a December 2012 document published by the NAIC titled “The EU-U.S. Dialogue Project: The Way Forward.” The project arose after U.S. regulators rejected a unilateral process, in part because not all EU countries treat U.S. reinsurers the same. This follows provisions for bilateral deals outlined in the Dodd-Frank Act.
The “Way Forward” established clear standards for developing mutually recognized supervisory regimes. The goal is “enhancing understanding and cooperation for the benefit of insurance consumers, business opportunity and effective supervision.” The document identified seven objectives:
- Professional Secrecy/Confidentiality: Information exchange between EU and U.S. supervisors is to be held closely.
- Group Supervision: This establishes a “robust regime” to supervise multinational insurance groups, with a “single group/lead supervisor” for each. It also seeks to avoid double-counting regulatory capital and monitoring of risk concentrations.
- Solvency and Capital Requirements: The negotiating parties hope to reach agreement on methods for assets and liabilities valuation, which are risk-based, flexible and transparent.
- Reinsurance and Collateral Requirements: Negotiators have pledged to “examine the further reduction and possible removal of collateral requirements in both jurisdictions” on the thorny issue of credit for reinsurance. The U.S. will “outline what possibilities exist for revising the current model laws on credit for reinsurance.” State regulators in particular object to this objective.
- Supervisory Reporting, Data Collection and Analysis: Through a compare-and-contrast exercise probing supervisory reporting systems, the group hopes to achieve greater coordination in solvency supervision. A particular call for the EU to follow the NAIC’s centralized data collection process is mirrored by a call for the U.S. to learn from EU group reporting and analysis techniques. They will consider a shared data platform.
- Peer Reviews: In effect, the supervisors are to monitor each other.
- Independent Third-Party Review and Supervisory On-Site Examinations: This provision attempts to ensure supervision consistency and effectiveness.
Under the U.S. state-based, risk-based capital regime, corrective action is triggered when a company’s capital falls below a specified level. “That amount of regulatory capital is likely to be lower than the EU Solvency Capital Requirement,” according to a Technical Committee report. This suggests European standards for solvency are more stringent.
The U.S. and the EU
Also, “Own Risk and Solvency Assessments” are required under Solvency II as well as U.S. rules adopted in 2012. This was part of the NAIC’s solvency modernization initiative following the AIG debacle. They were first implemented this year for companies writing more than $500 million of premium.
Solvency II judges a company’s solvency as an ongoing concern, while in the United States solvency is considered on a winding-up basis, meaning a company has enough capital to cover its liabilities if it were to stop underwriting but not enough to accept new risks.
Solvency II allows the U.S. more management discretion as to the use of methodologies.
The work of the “EU-U.S. Insurance Project” continues, but the pace is slow. From July 2014 to September 2015, little to no progress was reported. However, participants reaffirmed the project’s intention to continue work through 2017. Delays are attributed in part to differences between the FIO and Deputy U.S. Trade Representative Robert Holleyman.
Following the partial equivalence bequeathed to the U.S. by the European Commission last June, more wrinkles developed. Reinsurance has been a sticking point. The NAIC opposes reinsurance equivalence.
Former NAIC CEO Ben Nelson reportedly told a New York conference in early November it would be “unnecessary and irresponsible” for the Federal Insurance Office to agree to a deal with the EU on concessions to reinsurance collateralization to garner full equivalence.
European and especially London reinsurance organizations, which lodge huge caches of capital in the U.S. to back reinsurance obligations, have been seeking to reduce it for decades. A 2012 NAIC model law, adopted by at least 32 states, reduced collateralization requirements for seven countries, but this flies in the face of the EU’s single-market approach.
Nelson called for the EU to declare full equivalency, continuing the turf war between the state-focused NAIC and the new Federal Insurance Office. “Federal action is unwarranted,” Nelson has said.
Olivier Guersent, the European Commission’s director general for financial stability, financial services and capital markets union, speaking to the European supervisors in late November, said he was “disappointed” that formal discussions on a reinsurance agreement between the EU and the U.S. had not gotten under way.
Treasury tried to flex its muscles to remove the barrier. The FIO, which is part of Treasury, has written to several congressional committees, stating its intention to negotiate—through the USTR—a deal with the EU. In its letter, the FIO told Congress it will “seek to ensure that U.S. insurers and reinsurers will be permitted to operate in the EU on the same regulatory terms as insurers and reinsurers domiciled in the EU or in jurisdictions deemed equivalent under Solvency II.”
FIO noted the “integrated state and federal insurance regulatory and oversight system in the United States” is bound to rankle state supervisors. But they appear to have been trumped in the ongoing saga of equivalence by the Obama administration’s power to negotiate international agreements. In response, the NAIC published a new set of draft, conflicting model laws on credit for reinsurance. It seems the state regulators are having difficulty determining their own preference, which wouldn’t be the first time. It may also explain why federal authorities have chosen to leave the state regulators out of the process.
A Never-Ending Story?
The development and enactment of Solvency II has dragged on longer than a Russian novel, and implementation on January 1 marked nothing more than a milestone. Local regulators have approved only a handful of European reinsurers’ internal risk models, and some insurers (especially in the life sector) have been given 16 years to comply with some aspects of the new rules.
Similarly, questions about equivalence and the mutual recognition of foreign supervision regimes seem equally unlikely to be resolved with alacrity—and certainly not by the January deadline.
In November, the European Commission admitted it would not make progress in the assessment of more than a dozen countries that had applied for equivalency status.
No one is quite sure if equivalence will be of most benefit to the Europeans, the local companies, or indeed to the ultimate insurance consumers anywhere. Federal assertiveness in the U.S. may now have drowned out various supervisors’ disagreements about what they want from a harmonized regulatory regime. Meanwhile, in Brussels, Washington and supervisory centers around the world, the bureaucrats continue to fine-tune their prescriptions for a patient who, by most accounts, is healthier than ever, after enjoying more than a decade of outsized profits.