Europe’s approach to international insurance regulation

32px-Flag_of_FranceFrom an ‘also ran’ position in the global financial order, insurance has been elevated to new heights in the international financial arena; no longer playing second fiddle to the mighty banking and derivatives industries. Following the financial crisis and the catastrophic, almost cataclysmic, failure of AIG and mono-line insurers (remember those?), international regulatory bodies such as the Financial Stability Board and the International Association of Insurance Supervisors, a sister-like body to the Basel Committee on Banking, have taken an active interest in the regulation of the insurance industry at an international level. Some might say an overactive interest.

Europe’s insurers managed the crisis relatively well, but not without some help from the taxpayer or serious intervention from the regulator, as was the case in the Netherlands, Switzerland and Italy.

Many financial institutions bounced back from the lows of the crisis, but at what cost? Near zero per cent interest rates and stagnant growth. What is the opportunity cost of the financial crisis?

Europe’s response to the global financial crisis included the creation of a regulatory pyramid. On top of the existing base of national regulatory authorities were placed a set of pan-European regulatory authorities. These are the three ESAs: EBA for banking, ESMA for securities and EIOPA for insurance. At the top of the pyramid (somewhat next to but a little to the side of the ECB) Europe established the European Systemic Risk Board (ESRB), which it tasked with “macro-prudential oversight of the financial system within the Union in order to contribute to the prevention or mitigation of systemic risks to financial stability.”

Now, for the first time, and exclusively to Solvency II Wire, the head of the ESRB’s Insurance Experts Group (IEG), Stanislav Georgiev, shares his own views about the ESRB’s work on and approach to the regulation of the European insurance industry and international regulatory efforts.

“Insurance topics have been on the ESRB agenda recurrently since its very beginning,” Mr Georgiev told Solvency II Wire in a written exchange. “However, it was considered that the importance of the insurance market for the EU economy implies a more focused and thorough assessment, especially in light of the international developments in this field.”

The International Association of Insurance Supervisors (IAIS) was set an ambitious timetable by the Financial Stability Board (itself directly accountable to the G20) to design and implement a global insurance standard. The entire process appears to be premised on the systemic importance of insurance. “The ESRB as an institution has not yet made up its mind on the systemic risk posed by the insurance sector and on the initiatives of the IAIS. It has recently analysed and discussed the macro-prudential aspects of Solvency II and the systemic risk of a possible ‘double hit’  – a combination of low asset price and low interest rates,” Mr Georgiev said.

Europe’s approach to international insurance regulation 3Based on this analysis, the ESRB was one of voices calling for an impact assessment of the LTG package by EIOPA in 2013. The ESRB analysis also helped to inform the adverse scenarios in the EIOPA stress test in 2014, Mr Georgiev explained. It was also the catalyst for creating the IEG, which he now leads.

The ESRB IEG was mandated to analyse a broad range of topics. “The analysis started in a rather general manner with the role of insurance in the EU economy. We then looked into the possible contagion channels between insurance and other sectors of the economy as well as within the insurance sector.”

After mapping out the exposures and contagion channels, the group began looking for possible triggers of systemic risk within the insurance sector. “Here we are investigating a plethora of different topics ranging from specific business models, like reinsurance or financial conglomerates, to the incentives and disincentives of prudential regulation.”

The IEG has also been mandated to propose policies and instruments to mitigate any risks it may find.

IAIS proposals on G-SIIs

Two of the more contentious aspects of the work of the IAIS are, first, the designation of nine Global Systemically Important Insurers (G-SIIs) and, second, distinguishing between so-called traditional and non-traditional insurance business.

But Mr Georgiev stressed that the IEG is taking a slightly different approach: “The systemic risk debate is fairly complex and requires multiple layers of analysis, the very least global and regional. I am therefore happy that the IAIS has taken an active role in addressing systemic risks on a global scale.”

“However, it should also be recognized that the thinking on systemic risk is constantly evolving and that currently more and more voices in the discussion are asking whether the designation of a limited list of companies puts a full stop to the topic of systemic risk,” Mr Georgiev added. “In the ESRB working group, we have therefore taken a broader stance in the ‘hunt’ for insurance systemic risk. I guess you can put it like this: we go out with nets and not so much with a big rifle.”

The interest in insurance extends beyond the negative impacts of the financial crisis. In many regions insurers continue to hold centre stage as they are seen as important investors in the economy. In Europe, where the insurance sector is the largest institutional investor, they appear to attain an almost saviour-like status. With their long-dated liabilities and their long-term investment horizons they are viewed as ideal investors in infrastructure projects, for example, and therefore a vital player in restoring economic growth.

Europe’s approach to international insurance regulation 1Elsewhere, insurance is seen as the ideal mechanism for privately funding protection against natural catastrophe. According to a 2012 report from the Bank for International Settlements only about a quarter of losses are currently insured. This leaves a market of about 300 billion US dollars unprotected. The potential for profit and social benefit is enormous.

Investing in insurance, and particularly reinsurance, is starting to look ‘cool’ – trendy almost. The past few years have seen increasingly large capital flows, often from alternative sources, into the sector, in part because it is one of the few assets that offers an attractive risk/reward profile.

All these factors are filtering into the debate about systemic importance of the insurance industry in an international context.

Creating a global insurance regulatory standard will require setting a global capital standard. Much like Solvency II, the IAIS framework is based on three pillars (capital, governance and disclosure). And in a surreal and disturbing way some of the difficulties encountered in Europe are being amplified onto the international stage. Readers familiar with the complexity and political intrigues of the Solvency II LTG debate will immediately recognize the traps of trying to standardise this diverse sector.

In some sense the problem of designing the global capital standard is a product of the nature of insurance business. While banking is naturally international in nature with relatively simple liabilities – money – insurance liabilities tend to be very specific to regions and counties: designed for the needs of local communities and national markets. Trying to impose a global capital standard on what is effectively a local industry at heart is problematic.

IAIS proposal for the BCR and ICS

To overcome these differences the IAIS is proposing a three-step plan. The ultimate goal is to create an Insurance Capital Standard (ICS) by 2019, which will apply to all Internationally Active Insurance Groups (the ICS is part of ComFrame: the Common Framework for the Supervision of Internationally Active Insurance Groups). To achieve the ICS it has already defined a Backstop Capital Requirement (BCR) in 2014, which is essentially a measure of comparability aimed at addressing the differences outlined above and will serve as the basis for designing a Higher Loss Absorption (HLA), a capital add-on for G-SIIs only. It is expected that this process will then inform the final design of the ICS.

Mr Georgiev believes that this was a necessary step, given the expectation of the FSB to ensure higher loss absorbency for G-SIIs. Any other solution, based on national frameworks, would have aggravated the already existing un-level playing field.

“One of the key lessons learned from the crisis was that shortcomings in group supervision could lead to the building up of pockets of systemic risk just outside of the supervisor’s sight and intervention range. Of course, one can always impose a capital add-on, but I believe that in insurance we have much more specific and precise measures to target systemic risks on the micro-prudential level. Therefore, plugging the holes on the micro-prudential level, before we impose macro-prudential measures, is probably a sensible approach.

“However, it’s good to keep in mind that in Europe – thanks to the long, but fruitful discussions on Solvency II – we are one step ahead. Therefore, this is a discussion that we in Europe fortunately don’t need to have anymore.”

The discussion about international regulation is closely linked to Solvency II, given that Europe chose to surge ahead with Solvency II and lead the way in creating a risk-based regime focused on the stability of individual firms.

“With Solvency II we have a fairly advanced risk-based system in place in Europe,” Mr Georgiev said. “That makes the work of macro-supervisors easier, since the capital requirement already captures a broad range of current and prospective risks. In particular, the Pillar II requirements, like the ORSA, can give us a lot of information on what is going on beyond the 99.5 % quintile.

“I am aware that there are voices in the international discussion, which advocate a different view and attribute precisely the risk-sensitivity of Solvency II to the rise of macro-prudential risks like pro-cyclicality. However, I think that this is an illusion, since the alternative – book value accounting – may not induce pro-cyclicality, but it leaves supervisors ‘tapping around in the darkness’, lacking any information at all about what is actually going on in the insurer in terms of risks.”

Europe’s approach to international insurance regulation 4Mr Georgiev admits that Solvency II is not perfect, as would be the case with any other regulatory framework. “I am sure that as the global thinking about systemic risks evolves and as more experience is gained in this field, better solutions will come up to tackle the remaining unintended consequences of pure market consistency, such as pro-cyclicality, for example.”

But he expressed doubt whether the idea of systemically risky activities, such non-traditional non-insurance (NTNI) activities as defined in the current IAIS drafts, could be directly applied to the European insurance market. For example, the current list adopted by the IAIS contains many products that are of limited relevance to the Europe.

“I believe that every jurisdiction has taken the approach which is most suitable for its own market,” Mr Georgiev added. “For example, the Financial Stability Oversight Council (FSOC) in the USA relies on a balance between quantitative and qualitative assessment in order to account for the heterogeneity of the companies that are examined.

“Furthermore, the ESRB is asking different questions to begin with. We are not identifying any systemically risky companies. Our goal is to understand exactly what is going on in the insurance market in terms of systemic risk and then think about appropriate measures. For this we rely on a rather analytical and quantitative approach.”

Solvency II and global regulatory standard

Much of the current international debate is dominated by the question of which regulatory system is most appropriate for designing the international framework.

“As stated I believe that a sound micro-prudential regulation is key for the effectiveness of macro-prudential measures. It is therefore important to ensure that we have such a sound foundation on a global level. To my mind, the ICS is a key element of that. In this context, I think there are two things which should be emphasized from the European perspective. First, the ICS will not and cannot be a mere copy of Solvency II. Second, Solvency II must, as a matter of principle, be viewed as a practical implementation of the ICS requirements.

“That being said, I believe that the more aspects of Solvency II find their way into the global capital standards, the easier it will be to impose effective global measures for insurance firms on top of these standards.

“It’s good to keep in mind that with Solvency II, Europe set the bar quite high in the international context. We shouldn’t end up with a situation where a lot is required from European undertakings, but this only shifts the systemic risks to other, less regulated parts of the world. After all, ring-fencing the entire market is not a realistic macro-prudential tool.”

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