The final part of an extensive interview Carlos Montalvo, Executive Director of EIOPA, in which he talks about the challenges of reporting, look-through and contemplates the future of Solvency II.
Mr Montalvo is a proud Madrileño. When we chatted before the interview he seemed genuinely interested in my experience in the city and was keen both to hear where I had been and offer some recommendations. As I am no stranger to Madrid he proffered some suggestions off the beaten tourist tracks of Gran Via, Puerta del Sol and Prado: a selection of restaurants to the east of Retiro, and the Museo Lázaro Galdiano home of the 19th century collector, which my wife and I visited the following day. Four floors representing a lifetime of collecting things grouped in the simplest of taxonomies: coins, fabrics, gold statuettes of women holding baskets, etc.
Mr Montalvo often refers to his Spanish heritage when speaking at events. In the three years following Solvency II I have heard quite a few stories and analogies about football and his beloved Real Madrid. Three years ago, at the first EIOPA conference he began a presentation with a slide of Goya’s Mujer Desnuda, a painting of a nude woman reclining on a sofa. His message: firms should stand naked in front of the regulator. Transparent.
Transparency has become a cause celebre in the post-crisis regulatory environment; in Solvency II it is built into the DNA. But Pillar III (reporting and disclosure) has been treated as last and indeed least by many; the forgotten pillar, often addressed as an afterthought to the capital model and governance of the first two. Now the Long-Term Guarantees (LTG) measures have added another dimension to it as a new battlefront opens up over reporting the impact of the measures on the balance sheets.
The EIOPA LTG proposal called for the impact of the measures to be recorded separately as a “special” Own Funds item. This was later changed in the Omnibus II agreement to be incorporated in the calculation of the best estimate liability values, although firms are required to publicly disclose the impact of any measures they use.
The industry is sending strong signals that it opposes any reporting of the impact of the measures separately. That tension surfaced in a somewhat edgy and highly entertaining exchange between Mr Montalvo and Pierre-Olivier Bouée, Group Chief Risk Officer, Prudential plc, at the last EIOPA conference. While discussing transparency Mr Bouée suggested there are “many ways to define it”.
I asked Mr Montalvo how he defines transparency.
“There is a good way to define transparency,” he says. “It is ensuring there are no relevant people – investors, analysts, supervisors – thinking that there is something hidden in the closet or under the cupboard. That is transparency.”
He continues. “When you have nothing to hide you are being and you want to be transparent. Now why wouldn’t you want to be transparent? If you have a good story to tell, go on and tell it. The market will reward you for that. If you don’t have a good story to tell it’s a completely different story.”
I can’t tell if he is talking in general terms or if he is being specific, and if so, when did he switch? But what is clear is that for him it is an open and shut case. Transparency is transparency – you can see what is inside and nothing is hidden.
He maintains the same calm and directed manner. A sort of tranquillity with a purpose, which is not easily defined but rather sensed. Some combination of the razor sharp logic of a lawyer delivered with the tranquilidad of Madrid perhaps. If you didn’t see my notebook and faithful audio recorder you could have easily mistaken us for two guests in the hotel, enjoying a cup of coffee and the glow of the Madrid winter sun bursting through the glass walls of the café.
Talk of transparency segues neatly, and naturally, to discussion on reporting of asset holdings and look-through, a topic that I have maintained all along is one of Solvency II’s as yet unrealised big stories, simmering quietly under the cover of delay and uncertainty – waiting to erupt.
The look-through in Solvency II will require firms to identify, and account for, the underlying assets in collective investments. Like market-consistency, it has become one of those parts of the Directive that touches the very core of established conventions, albeit practical ones.
What work has been done on look-through has laid bare the fact that what appeared to be a reasonable requirement (that insurers understand the full exposure of their investment portfolio) is turning out to be extremely challenging to deliver.
To a large extend this is because of the technical difficulty in obtaining the data, which seems to have caught everybody by surprise. The industry makes a convincing case that at times this will require a large amount of effort and resources to obtain information that may be inconsequential to the firm’s exposure. You could credibly argue that a three per cent holding in a fund that is held by a fund of funds (itself representing less than one per cent of the insurer’s entire portfolio) is unlikely to have a material impact on the balance sheet if it defaults or loses half its value overnight. Still the fact that firms can’t easily identify their full exposure across the board has raised some questions.
“When I was a local supervisor in Spain, in 2005 and 2006 I have seen some structured products owned by insurers and when you would scratch [the surface] you would get surprises. And companies didn’t know what was underlying because they didn’t do this look-through opening box type of exercise.”
Look-through, according to Mr Montalvo, makes sense regardless of the Directive. “In terms of risk management leave aside Solvency II, leave aside regulation or supervision. Is that a sound exercise for companies to undertake? To try to understand what is underlying?” It’s a rhetorical question to which the answer “yes” hangs in the air. Propped up by the background chatter in the vast café.
“One of the mantra questions out of the crisis in terms of lessons learned is: don’t buy something you don’t understand… Also don’t sell something you don’t understand.”
“Do the look-through requirements help you understand what you’re buying or what you’re selling or not? And I think that depending on the response you’re giving, you have the response for the whole debate. If it helps you in your business in terms of understanding the assets that you’re acquiring or if you need that information, then forget about Solvency II. You should have had it indeed a number of years ago when perhaps you haven’t got into some problems or difficulties.”
The whole debate is further complicated by the question of cost. Who should pay for providing this data, the insurer or the asset manager? Some argue it is an additional service, while others say it is a basic part of the service that should be provided. Mr Montalvo certainly has his view. “Now, the whole debate in terms of companies, asset managers and so on. I want a service, I want to understand what I am buying. If you don’t give me sufficient description of what I am buying, probably I would look for another provider or another product. But that should be embedded in the way that companies are run and managed. It shouldn’t be something that has to come from the regulator.”
Like the debate on market consistency, the debate on look-through and transparency is gnawing at the essence of the workings of a part of the financial system. In trying to provide a safer risk-based approach to insurance regulation, Solvency II is uncovering what appear to be some deeply ingrained practices within the insurance industry and other parts of the financial system. Regardless of the final shape of the rules and the timeline these may prove some of the Directive’s more lasting legacies.
The legacy of Solvency II
Solvency II will have a profound impact not only on industry but also on the supervisory community by introducing a more qualitative and forward-looking approach to supervision. This, again, dovetails with the post-crisis supervisory environment where judgement and intervention are preferred to the laissez fairesque approach supervisors took before the crisis (in many ways encouraged by their political masters).
True, Solvency II drew much of its design from Basel II, but the emphasis has always been on the governance piece in Pillar II and the ORSA (Own Risk and Solvency Assessment) that requires much more discretion from the supervisor. Mr Montalvo, however, wished to clarify this point.
“I wouldn’t call it supervisory discretion,” he says, “I would call it supervisory judgement, which is different.”
“You’re going towards a more qualitative driven type of regulatory framework. And not everything is automatic in the way you calculate your requirements and so on. So you need judgement.”
This evaluation will be required both of supervisors and firms in their risk management. “And judgement is not just supervisory dialogue with the company, it is one step further than that. It is supervisors challenging also the plans of the company of understanding what the reality of the business is and so on, but it is not supervisors running insurers’ business.”
The move towards a more judgement-based approach, as Mr Montalvo describes it, raises questions about consistency in the application of the rules across the individual Member States. Given the different sizes and levels of sophistication in respective industries there is a real concern in the variance of interpretations by supervisors and he sees ensuring the convergence of supervisory practices as one of EIOPA’s key roles. “One size doesn’t fit all, yes, but under similar type of circumstances there will be similar responses. That is where we will stand ready to have an active role.”
Our hour in the glow of the Madrid winter sun draws to an end, although it shines as brightly and persistently as when we started. Such a major reform will inevitably require some adjustments as markets and regulators begin to comprehend the consequences of the rules. Given the scale of change it is unlikely everything will work on day one and there is likely to be a process of adjustment over time. The Omnibus II LTG package, for example, recognises this by monitoring the impact of the rules on an annual basis and including reviewing the measures after five years.
Such iterativeness in applying the rules is as essential to the process as the dialogue between industry and rule makers is for designing effective regulation; especially in an environment that chooses free markets and innovation over more control and central planning. It is virtually impossible to get it right on paper and consider all the likely outcomes and side effects. Sir John Gieve, a former Deputy Governor of the Bank of England, once said to me that regulation is a bit like law: the rules are written by the legislature but tested in the courts and what ultimately affects the real world are the precedents they set. The process of challenge and adaption is what finally establishes the rules on the ground.
Legislation can’t be perfect on day one Mr Montalvo explains, making the point that for a regulation that is more than ten years in the making it is unlikely every aspect will be right from the start. “Most of the things have been tested, some of the things have not been tested sufficiently and some of the things will need to be changed or improved. Some of those will simply not have to be improved because they will, from day one, make full sense.”
“Now we will stand ready to change those things that need to be changed. Definitely. Definitely. Does it mean that everything will have to be changed? Definitely not.”
One advantage, as Mr Montalvo sees it, is that the interim period and the Guidelines will be an opportunity to test out some of these rules. “Because everybody – and definitely supervisors as much as anyone else – needs to learn this new framework and this new way to do things. This applies to insurers, supervisors and markets. Lets not wait until 2016. Let’s start now.”
The curled up biscuit is exactly where it landed, just over an hour ago when the waiter served the two con leches. I for my part couldn’t find an opportune moment to remove it. Finally when the bill was settled the waiter collected away the delicate fallen specimen into the basket. Alas, Solvency II’s antinomies can’t be as easily swept away.
My last question is about the relevance of Solvency II. It has been such a long and tormented journey with so many ‘final’ deadlines that attitudes have changes significantly. In the past year we have seen a kind of Solvency II “switch off” to varying degrees across Europe. The Directive suffers a serious credibility problem. While preparing for the interview I reread an article I wrote about the then FSA Conference in 2011. One of the subheadings reads “You must, you must, you must … be ready by 2013” – that was January 2013.
Many have been asking why this time should be different. The remaining uncertainty surrounding the drafting of the Level 2 text does nothing to mollify concerns. Meanwhile the IAIS plans to develop a global Insurance Capital Standard by the end of 2016, which will apply to internationally active insurance groups from 2019. It also plans to finalise a Basic Capital Requirements for Global Systemically Important Insurers by the end of 2014.
One trend which charactarised last year as the Directive hovered in existential limbo was that firms got rid of most of the external consultants and contractors, and Solvency II work was re-evaluated on a business case basis. Solvency II labels were stripped off and if no other justification remained, firms either shelved projects or dropped them.
What will be the relevance of Solvency II in the years to come?
“I think that we need to split between two elements: how much money you have spent and how much money you have invested. If you’ve spent money just for the sake of fulfilling with the regulation and you don’t see any business benefits then probably we are all doing something wrong. When you were spending money on enhancing your reporting lines, on improving your risk management capacities, your understanding of your business, that is not spending – that is investing, because you get a return.”
“So when you are starting to see now how can I make money again, I think it’s a legitimate question. This is a business and insurance companies are here to make money. Now, should Solvency II be an obstacle for you to make money? I would love someone to explain to me how Solvency II can be an obstacle to you making money or running a business? Because what you’re trying to bring is risk-based regulation to a very risk driven business.”
The core of insurance business is making money out of risk, in a good sense, and he believes that its regulation should reflect that. “So a regulation that acknowledges risk, that allows for diversification and so on, that tries to bring judgement to the right level rather than optimisation, should benefit companies and should provide – in particular when you’re thinking on a global level with a company – advantage.”
Again he poses a characteristic rhetorical question and answer. “Have we come with the framework in which you are only investing and not spending? No. But that doesn’t exist, let’s be honest. Have we come with a framework in which you are investing more than spending, or unnecessarily spending? I would say yes.”
His tone becomes slightly more emphatic as he drives the point home. “How many of the things that have been put on the table in terms of Solvency II do make sense – leave aside regulation, in a regulatory free world – for running the company? Try to understand your risks. Try to manage them. Try to mitigate them. Make decisions on that basis, try to anticipate, try to pre-empt. All this is Solvency II. But also all this is sound risk management.”
This last statement has a particular energy to it. Rising as he lists his points and then ebbing as he delivers the inevitable conclusion, “All this is Solvency II ….”
I put it to him that companies, especially the larger ones, believe that their systems are already adequate, that they have advanced risk management systems in place and that Solvency II is about spending a lot of money unnecessarily.
“Isn’t that the very same type of message that we were listening to bankers in 2006, 2007, 2008 with the Basel [rules on banking] debate? Or that we are listening to banks today with regards to Basel III and so on?”
“I think there is probably an ‘in between’. To say ‘changing doesn’t make sense – we are well as we are full stop’ – maybe it’s a little bit too much. To say ‘we need to change the world and let’s deny anything that was coming from the past’ is also too much. You were saying before in terms of regulation we need a balance between industry and supervision. Here we also need a balance between what has worked well (and let’s keep it), and what hasn’t worked well. And, whilst a number of things have worked, there are also some things in insurance that haven’t worked well, let’s be honest.”
At the end of the interview we walk together a short distance up the steep Calle de Don Ramón Cruz into the barrio of Salamanca behind the hotel. Such interviews are as much about the subject as they are about the dynamic with the interviewee. I didn’t feel I fully connected with Mr Carlos Montalvo Rebuelta but I certainly understood him. In the process I got a better idea of the aims of the organisation he manages and of Solvency II itself: to shed light on the insurance industry making it more transparent and safer so as to better serve policyholders and the economy. We say our goodbyes on the corner of Calle de Serrano and wander off in the bitter cold under the ever-present Madrid winter sun.
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