Uncertainty. The word is inseparable, almost synonymous, with Solvency II. Uncertainty is often discussed in the context of regulatory compliance; it is less frequently mentioned as a barrier to insurers’ day-to-day operations and business as usual planning.
Doubts about the start date of Solvency II have all but disappeared now. But clarity on the timeline, and more recently on the Delegated Acts, has given way to a new set of uncertainties.
Firms can no longer treat Solvency II as something that will happen ‘sometime in the future’. Concrete decisions have to be taken now. Actual numbers must be filled in forms and budgets allocated. At the same time there are still several requirements, formulas and calibrations that will only be clarified next year, yet others, will be left up to national supervisors. The combination of concrete deadlines and uncertain rules is forcing some firms into a difficult position of having to make long-term future plans based on assumptions and notional principles.
Uncertainty built into the rules
Since the beginning of the year, the prevailing wisdom has been that insurers are lagging in their Pillar III work while Pillar I work is largely manageable. However, for firms that are heavily reliant on the Long Term Guarantees (LTG) measures for their business model, the remaining uncertainties can pose a serious challenge.
Some uncertainty is built into the rules. For example, the rules on the use of the Matching Adjustment, which provides capital relief for a matched portfolio of assets and liabilities, do not fully define a closed list of admissible assets. Instead the Directive only defines certain behavioural features of the entire asset portfolio that make it eligible for the Matching Adjustment.
In the UK, where the measure is favoured, a recent communication from the Prudential Regulatory Authority (PRA) explained that as a result of this definition, “The PRA is not in a position to prescribe a ‘closed list’ of acceptable asset types. Instead, firms must apply their judgement, and consider carefully whether they are compliant with the criteria laid out in the Directive.”
EIOPA has published a list of broad asset classes that will be admissible and inadmissible in the Matching Adjustment, but as the PRA notes, “Asset eligibility is a case-by-case judgement.”
For industry this makes planning more difficult. One senior manager at a UK annuity provider explained that the main impact of the LTG measures is on the firm’s ability to price business as they need to ensure that the assets they hold are compatible with the LTG requirement. “The uncertainty around this is incredibly frustrating as we are having to make investments now that we will hold for a significant long-term on the assumption that these will work under the Matching Adjustment,” the manager said, speaking on condition of anonymity.
“We can’t put our business on hold while we wait for the PRA to decide what works and what doesn’t. So there is a significant risk that the interpretation we have made of what liabilities and what assets are eligible under the Matching Adjustment turns out to be incorrect.”
Uncertainty extends to other LTG measures as well. The final calibrations of the Volatility Adjustment will only be known when the Delegated Acts are finalised (after reaction from the Parliament and Council), but some of its more technical components are still to be defined.
The Volatility Adjustment provides capital relief based on a proportion of the risk-corrected spread between the interest rate that would be earned by a reference portfolio. The makeup of the reference portfolio will be defined by EIOPA. Member States can also decide if the Volatility Adjustment will require pre-approval by the national supervisor, further complicating the firms’ planning.
The lack of clarity for both measures is holding insurers back from some of their investment planning, according to Erik Vynckier, Chief Investment Officer, Insurance (EMEA), at AllianceBernstein. “Insurers are not at this point ‘optimising’ their balance sheet for Solvency II. For one, the fine print is not yet sufficiently clear, and national regulators may follow peculiar interpretations or apply additional Pillar II guidance. A premature optimisation could backfire.”
Solvency II is not the driver, as insurers must remain capitalised under the current Solvency I rules, but is certainly a critical constraint on investment strategy, he added. “What we do see is that insurers look forward and only approve new investment strategies if these strategies seem, from current understanding, to be well received under Solvency II.”
More consultations to come
There are some measures that will require supervisory approval that have not been consulted on yet. Solvency II will allow the use of two transitional measures for business that has been in existence before the implementation date: risk-free interest rates (Articles 308c) and technical provisions (308d). In its recent consultation (CP 16/14) published in August, the PRA said that it would be consulting on any required rule changes at a later date. “At present, there is insufficient evidence to quantify the precise impact of changes to PRA rules,” the document states. According to Oliver Wareham, a partner of Slaughter and May, “It remains unclear in what circumstances the PRA will allow the use of the transitional measures on risk-free interest rate and technical provisions and how in practice those measures will feed into the stress scenarios in the SCR calculations.” Overall, the discretion afforded to national supervisors may compound the challenges for firms, Mr Wareham, said. “Although the Directive is intended to be maximum harmonising, I suspect that there will be many areas where national supervisors continue with divergent approaches, and firms will face uncertainties as to how their national regulators are going to interpret the rules or whether they are going to apply ‘gold-plating’.”Pressure on Internal Model firms
The problems outlined above become more acute for firms that are planning to use an Internal Model, as they must get model approval before the implementation date. What’s more, an application can only be accepted or rejected in its entirety. The tight deadline means there is little room to manoeuvre if firms don’t get it right the first time. National supervisors cannot process applications formally yet, but they have been engaging in active dialogue with firms. The supervisor’s approach to giving feedback and capacity to process the volume of applications will be critical. In Germany there are currently seven insurance entities in pre-application, a number that is likely to grow. A BaFin spokesperson told Solvency II Wire that more insurance companies have announced their intentions to apply after this first wave. In accordance with the Directive, the German regulator does not limit when a reapplication can be submitted. “A firm is allowed to send an application letter at any time. The result of the application depends on when and whether the firm meets the requirements,” the spokesperson, said.
In Ireland, where 18 firms are in pre-application, a spokesperson for the supervisors said, “The Central Bank of Ireland is working closely with all (re)insurance undertakings currently involved in the Internal Model pre-application process and is providing continuous feedback on areas where the Internal Model does not meet the requirements.”
If an insurance undertaking’s formal application is rejected it can re-apply. “Once a (re)insurance undertaking has dealt with the deficiencies identified by the supervisory authority, then it is open to it to re-apply,” the spokesperson, said.
The PRA in the UK would not say how many firms were in pre-application, but sources familiar with its work put the figure at around 40-50 firms. A spokesperson for the PRA said it has been working with a “large number of firms” in pre-application and it expects many of them to submit a formal application next year. “However, some firms have already chosen during the pre-application phase not to pursue model approval at this stage, and others may reach a similar decision between now and next April.”
As in the other Member States, UK firms can reapply at any time, but the PRA warned that the reapplication should take account of the reasons for rejection. “An intention to reapply should be discussed with a firm’s PRA supervisory team,” the spokesperson said.
The PRA has six months to reach a decision on the firm’s model. “Applications resubmitted after the 30 June 2015 may not be reviewed in time for the Solvency II implementation date of 1 January 2016,” the spokesperson, cautioned.
EIOPA explained that the proposed Implementing Technical Standard (ITS) on the Internal Model approval process foresees an on-going communication between the supervisor and the firm during the approval phase. “The ITS also includes the possibility of the NCA requesting adjustments to the Internal Model before the final decision is made,” an EIOPA spokeswoman said. “There may be special cases where the NCA considers that the application could be approved subject to terms and conditions.”
Interaction with national rules
In some cases even when the rules are clear, firms can be caught up in ambiguities between European law and national discretion and initiatives. Insurance firms in run-off or administration may find themselves in limbo depending on the regulator’s approach to what constitutes the best path of policyholder protection.
Solvency II includes a number of exemptions and transitional measures, including two related transitional measures for firms in run-off which last until 2021 (if the firm is also in ‘reorganisation measures’) or 2019 (if it is not). But according to Chris Finney, Partner at Edwards Wildman, these will be of very limited use in practice. “Who gets until 2019, and who gets until 2021, is unclear because Solvency II and the proposed UK law are not fully aligned. It can therefore be difficult to work out whether a firm qualifies for the longer period, or not.”
These issues are more acute for firms that will not be able to meet their MCR under solvency II. “If a firm breaches it MCR, and it cannot recover its position in 3 months, the PRA will have a Solvency II and UK-law obligation to cancel its Part IV Permission before seeking to have it wound up. At the same time, the PRA will have a UK-law discretion to delay cancellation and winding up if it is in policyholders’ interests to do so.”
Another group caught out by conflicting rules are mutual insurers in the UK that have with-profits funds.
The rules on ring-fencing, combined with the UK definition of with-profits are causing uncertainty on their future capital position, according to Martin Shaw, CEO of the Association of Financial Mutuals. “That is encouraging mutuals to be more cautious in outlook. For example in taking up the opportunities presented by the recent Policy Statements by the FCA and PRA on mutual capital,” Mr Shaw, said.
The overall impact of the uncertainty is constraining longer-term decision-making. “Some mutual insurers are having to delay key strategic decisions, or put off further investments. Others are avoiding the full set of activity they should be undertaking now to wait for greater certainty. This will add to further resource pressure later on and increase the costs of compliance.”
Clarity
Ironically, the area where firms appear to be least prepared – reporting – is the one with the most clarity and has potentially the least disruptive impact on insurers’ business as usual operations. According to one reporting expert at a leading UK insurer, currently the firm is not experiencing significant impact on business as usual, this despite extensive Pillar III work. “The proposed changes to business as usual reporting in order to accommodate Solvency II reporting obligations are based on certain principles that are not expected to change significantly,” the expert said. These principles include the reporting deadlines and the accounting principles that are being based mostly on IFRS. Uncertainty is, however, affecting work at a more granular level, both for specific cells of the Quarterly Reporting Templates (QRTs) and in asset definition. In cases where information about specific cells is unclear the firm has drafted internal guidance. More significant questions are put to EIOPA through its Q&A facility. “Whilst awaiting a response, we use some form of internal assumption and hope that the final response does not create significant rework,” the expert added. Where there are various minor points of uncertainty (of which there are many), we develop pragmatic solutions and assumptions.”Asset data classification codes
Solvency II allows firms to classify assets based on the insurer’s risk exposure. In so doing it aims to provide a more risk relevant profile of the portfolio. The Complementary Identification Code (CIC) introduced in Solvency II combines an asset’s characteristics and risk exposure so the classification can change depending on an insurer’s use of the asset in the portfolio.
Clara Yan, Director, UBS Delta, explains the impact on insurer’s reporting workload. “We have seen clients applying different interpretations for the same assets – particularly on Complementary Identification Codes and Nomenclature of Economic Activities (NACE) code where there is no industry standard for classifying assets.”
The impact on the work will have to be taken into account. “Uncertainty is a part of life in Solvency II – we expect we would have to make changes to our QRT reporting as we receive further clarifications from EIOPA leading up to the Solvency II deadline.”
There are, however, a number of areas of uncertainty that are preventing firms from developing a holistic, timely solution, according to the reporting expert. “These include national specific templates, final details of ECB reporting requirements as well as, of course, the unfinalised Level 2 and Level 3 texts.”
There is also speculation that in some Member States’ national supervisors will ask for some form of external audit of the Solvency II technical provisions. In the UK, it is possible that this will be extended to larger firms not applying for an Internal Model as well.
Uncertainty. A reality
The Delegated Acts have now been published, bringing with them the illusion of clarity and certainty. A lot more will be clear now, but not everything. Firms managing regulatory change must manage it as they would the myriad of factors affecting the business. It would be nice to have more certainty on Solvency II; it would be nice, too, to live in a world where everything else was more certain. — To subscribe to the Solvency II Wire mailing list for free click here.
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