When Solvency II becomes Solvency III

COMMENT

Mark PiperIt is commonplace for multiple versions of financial regulation to be enacted. Basel I, II and III, MiFID I and II, and of course Solvency I and II are all examples of this – but what is the tipping point for the existing version to need a “sequel”? And is there a way to determine if the Solvency regime is heading towards a trilogy? Mark Piper, VP UK, Ireland and the Middle East at Wolters Kluwer Financial Services, takes a closer look. 

In the software industry, the development lifecycle follows the basic steps of analysis, design, quality assurance, implementation and maintenance. A similar process can also be applied to the way regulation is formed. With Solvency II, for example, EIOPA is currently in the quality assurance phase or more accurately, the quantitative impact survey (QIS) stage. While there may be rumours of post-QIS5 solvency II framework being put in place, a crucial step for the regulator has to be deciding when to commit to the next phase.

However, an important point to note here is that software developers have recognised ISO standards that they can adhere to in order to judge what constitutes a ‘hot fix’ or the next version. Regulators ultimately have to make the final decision on when and how to issue the regulation themselves – albeit with intensive input from the industry.

One way that a regulator may judge whether or not a change constitutes a ‘hot fix’ or ‘release’ is to consider whether it falls into one of three categories: unresolved issues, missing elements or a major shift in the external environment.

Unresolved issues

Comparisons between Basel III and Solvency II are made frequently and are met with various (mainly negative) reactions. Despite this, unresolved issues can impact the release of final regulation – no matter the industry. For example, a major point which was deemed unresolved in Basel II was the issue of liquidity held by banks, a factor brought into sharp focus by the financial crisis. Because this omission was material, it warranted a ‘release’ rather than a ‘hot-fix’.

Currently an unresolved issue in the latest version of Solvency II is catastrophe risk. QIS5 reported instances for non-European catastrophe risk where the Solvency Capital Requirement (SCR) results were 200% higher for companies applying the standard formula than for those calculating using an internal model. If this is not addressed, it could lead to a gross overstatement of the SCR, leading to an unfair advantage for those implementing a standard formula. This is no doubt an issue at the front of EIOPA’s mind. Using the software analogy again, it could be argued that this goes beyond a mere bug-fix.

Missing elements

The Markets in Financial Instruments Directive (MiFID), the European Union law that provides harmonised regulation for investment services across the European Economic Area, was introduced in 2007 and was followed by plans to introduce a revised version – MiFID II – just three years later.

The change was introduced for a variety of reasons, including the need to incorporate other asset classes outside of equities into the directive, and the inclusion of a unified source of post-trade data to be used by all exchanges and traders – both elements that were not included in the original draft.

In the insurance world, one of the areas that many industry pundits have noted as “missing” in the latest version of Solvency II is around the issue of illiquidity premiums. Currently annuity writers in UK insurance firms can issue these premiums that mature after 30 years, whereas in Europe it is between seven and 20. For the UK insurance industry it is extremely important that this is not missed in the final Solvency II rules because if it does change significantly, it could lead to a considerable rise in the amount of additional capital held. Bug-fix or new release?

External environment

Given that the Solvency I directive was introduced 38 years ago, the external environment has inevitably changed dramatically. While the crux of the directive remains to unify a single EU insurance market and enhance consumer protection, it now has to reflect significantly different risk management practices, in order to define required capital and manage risk – justifying this latest significant overhaul.

Of course, changes in the external environment are the most unpredictable of the three factors that can influence the formation of a regulation. While external events can be monitored in the lead up to the final rules being published, at some point the button needs to pressed and the rules firmed up.

Recent news has suggested that the European Parliament is moving closer towards the implementation phase of Solvency II. Once in place, time will tell how much influence any unresolved issue, missing element or external environment factor may have on the final rules and if a bug-fix or a new version – aka Solvency III – will be next on the horizon.

The author is VP UK, Ireland and the Middle East at Wolters Kluwer Financial Services. The views expressed are the author’s own.

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