Look-through Symposium: regulator’s response


Carlos Montalvo

Carlos Montalvo, Executive Director, EIOPA

EIOPA has followed a fully transparent approach towards stakeholders in the Solvency II project, particularly with regards to reporting. We are fully aware of the concerns that the industry and relevant stakeholders have raised, in this area in general and the look-through approach in particular. We have aimed first to understand, then address the concerns raised both in formal and informal consultations (the final report stemming from this two-year process was published in July) and as part of the ongoing dialogue with national supervisory authorities. In what follows, I will address some of the specific points raised by the participants in the symposium.

Conflicting requirements

Solvency II, as a risk based framework, sets capital requirements based on the risk profile of insurers and the way these risks are managed. If we look at the asset side and compare with Solvency I, the difference is relevant: on the one hand asset risks are considered and dealt with via capital requirements, while on the other, existing artificial investment limits are removed and replaced by the so called prudent person principle.

From a prudential point of view insurers should take appropriate account of investment risk in their overall solvency needs, encouraging them to invest in assets and instruments whose risks they fully understand through properly identifying, measuring, managing, monitoring and reporting such investments and their embedded risks.

A look-through perspective is required first and foremost for the SCR calculation. As a consequence, the contractual provisions regarding funds may need to adapt to the new Solvency II regime, taking into account all three pillars.

EIOPA has understood that there has to be a balance in terms of avoiding unnecessary burden for undertakings in their reporting. With this in mind – for reporting purposes – information on look-through of funds will only be required quarterly when funds make up more than 30% of the portfolio (this has increased from 20% in the July 2012 Report, accommodating a valid concern from stakeholders). This information is however important and thus requested annually for all undertakings.

As for concerns about potential breach of confidentiality for fund-of-funds, supervisors, and therefore supervisory reporting, are bound by strict confidentiality rules. In terms of the relationship between funds managers and insurers, there are ways to address such confidentiality issues via contractual provisions. It should be noted that there is no requirement to disclose such information publicly.

Altering investment strategy

Asset managers expressed concerns that the reporting requirements will alter the investment strategy of some (especially smaller) insurers in order to avoid the associated complexity and costs, with a potential reduction in terms of returns on investments.

Solvency II, as a risk based framework, provides incentives towards sound risk management. As a consequence, EIOPA acknowledges that the Solvency II regime may lead to some changes in the investment strategy of undertakings, driven either by a better understanding of underlying risks or by a strategy to maximise the aforementioned incentives, e.g. via diversification of assets. We do not expect that insurers will change investment policies because of reporting requirements. In the medium term, such a risk-based approach will be beneficial to the undertaking as well as to the consumer.

The crisis has shown that higher returns may, in many cases be driven by higher than expected risks. Better risk management will allow insurers to understand the underlying risk, guide their investment decisions and maximise return for policyholders in accordance with their risk appetite. If insurance undertakings are not able to fully understand and manage the risk of an investment, they should not invest in it.

Distinction of own and externally managed funds

It was argued that there should be a distinction between the reporting on own funds and the reporting on externally managed funds due to different costs implied. This issue has been considered during our ongoing discussions with stakeholders.

Although when facing the demands of risk based frameworks such as Solvency II, financial institutions may view the new regulatory standards as onerous, but supervisors are convinced that this only reflects good risk management practice that should already be in place. Such good practice should not only apply to own managed funds as the underlying principles also extend to those investments that are externally managed; where insurers also need to understand the underlying risks taken.

In order to develop a proactive strategy for the management of risk and capital of their assets, insurers will need high-quality and timely information about all assets, including those held in investment funds.

An alternative to detailed information about holdings and risk exposures would be uniform, ‘risk blind’, capital charges on all fund investments, which could potentially create wrong incentives. An appropriate level of risk look-through can help realign capital requirements with economic risk and insurance companies should actively seek to optimise capital-adjusted return while improving risk awareness.

Unit-linked funds

The argument has been made that unit-linked funds should not be part of the look-through reporting because the insurer does not carry the financial risk. EIOPA understands that this is the case, but at the same time would like to note that excluding investment funds of unit-linked business from the reporting requirements would undermine a comprehensive view of the undertaking’s overall risk profile. In particular, contagion risk or reputational risk would be left out. The crisis has shown how relevant this has been to certain products and undertakings.

Reporting timeframe to be used

On the specific question of what timeframe should be used for reporting (prospectus information or current value), a risk and economic based framework such as Solvency II needs to consider current information. Therefore reporting should be done using current value at the reporting date. However, it should be noted that in order to take on board concerns from stakeholders, reporting will not consider a full look through approach, but only requires a partial one – by type of assets, currency and geographical area (EEA/OECD/rest of the world).

Passing costs on to consumers

A further concern expressed by the industry is that the complexity of the Solvency II reporting requirements will lead to increased costs that are likely to be passed on to consumers. As regulators we acknowledge that there will be an initial cost for undertakings when implementing the processes to comply with the new rules, although this will not be incurred on an ongoing basis. These costs have to be accepted and shared as a consequence of improved financial resilience and better informed decision making both by undertakings and supervisory authorities.

At EIOPA we think that the cost argument partially misses the point. The need to properly manage the risks of assets under Solvency II implies that undertakings should have access to this information for decision making purposes. EIOPA reporting requirements are based on the premise that all information requested for supervisory purposes is information that insurance companies should already have for their own management purposes. Better information leads to better decision making, thus compensating for the initial cost incurred.

Using data for supervisory purposes

A key question that has been raised not only in this symposium but elsewhere is: how will EIOPA and other regulatory bodies use the data for supervisory purposes? At an organisational level the data will be used for regulatory tasks of the National Supervisory Authorities and EIOPA, both for micro prudential supervisory purposes as well as for assessing market trends, analysing vulnerabilities regarding financial stability and for developing a Risk Dashboard with a common set of quantitative and qualitative indicators that will be shared with the ESRB.

As EIOPA is aware of the potential implications that this dual purpose may have, in particular regarding unnecessary costs, the information to be used for financial stability purposes will only be required for those groups/undertakings with more than €12 billion in assets, provided 50% national market share is covered. This doubles the previous threshold and thus significantly reduces the scope of undertakings subject to such requirements.

Aggregated reporting alternative

Stakeholders asked if EIOPA would consider some form of aggregated reporting for assets instead of line by line. As we have said previously, and following thorough internal discussions, we still deem line by line reporting as the most appropriate solution as this level of reporting should not be created by the insurance companies specifically to meet supervisory requests. They should already have this information to properly understand and manage their own risks.

Moreover, from a cost perspective, line by line reporting (which is already a current practice in many Member States) will be less costly than reporting of aggregated information. Reporting of aggregated information may increase exponentially both ad-hoc reporting and onsite inspections by the supervisors, which ultimately would be more costly to all stakeholders (supervisors, industry and consumers).

The overall benefits of look-through reporting

In summary I would like to highlight some of the reasons for asking for information on a look-through basis and point out some of the benefits to undertakings.

A look-through approach will improve risk management and capital efficiency for an insurance company’s investment in a pooled fund. Adequate information is critical to monitor and manage the risks associated with pooled fund investments, from money markets to hedge funds.

This requirements stem directly from the need to calculate the SCR on a risk based framework. Beyond the regulatory requirement, there are economic benefits embedded, as insurers should employ fund look-through to better manage regulatory capital and maximise the incentives provided by Solvency II.

The financial crisis highlighted the need for accurate and timely risk information across the whole balance sheet. Any subscription to a pooled vehicle should not rely on the stated investment policy or external ratings alone. Examples of unexpected risk exposures revealed by the crisis abound. What looked like ‘money market’ funds took on risky or insufficiently liquid positions, while the Madoff case highlighted the potential dangers associated with the lack of transparency of certain funds and investment processes.

Information about the risk positions assumed by a hedge fund should allow an insurer to identify and measure emerging risks, such as yield curve basis risks, currency correlation risks or differential behaviours of equity indexes across markets.

Lastly, reporting should not be viewed in isolation but in conjunction with other important risk management tools that include scenario analysis and stress tests to complement Pillar I.

Link to Symposium index page.

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