The 2020 Review of Solvency II

Author: Francisco Carrasco Bahamonde

“All difficult things have their origin in that which is easy, and great things in that which is small”

Solvency II is made up of an extensive regulatory package of which the key components are Directive 2009/138/EC, the Level 1 standard, and the Delegated Acts based on the above, which are given definitive form in the Delegated Regulation (EU) 2015/35, the Level 2 standard. These two texts are accompanied by Regulatory technical standards and Implementing technical standards, both directly applicable, and also by the Guidelines issued by EIOPA, which require supervisors either to comply or to explain themselves should they fail to do so. Finally (although this list is not exhaustive), we find other softer measures which, while their objective is essentially to harmonize, have, in practical terms, a remarkable influence on ensuring that things are done so that they can be understood in line with the SII requirements.

Taking into account that the Level 1 standard had already been amended before it even came into force, through Directive 2014/51/EC (a comprehensive text that involved the inclusion of such transcendental concepts as volatility adjustment and matching adjustment), it should be no surprise to learn that it prescribes a date to launch the process of its own review.

Likewise, the Delegated Acts, by virtue of their status as their “founding standard,” were also amended before their entry into force (through the Delegated Regulation (EU) 2016/467) so as to provide for their future readjustment, to be conducted independently and prior to that of the directive. This was presented very recently, in June 2019, restricting itself to the calculation of the solvency capital requirement (SCR) through the standard formula. Although this may seem like a relatively straightforward undertaking, it consists of 70 pages, together with a further 80 pages of amendments to the annexes. These address items of such importance to the standard formula as deferred tax assets, recalibrations of insurance risks (with disaster risk being particularly spotlighted in the Spanish case), debt without credit rating, capital investment for non-listed companies, clarifications and specific details for long-term investments in shares.

Before the publication of this innovation, work was already under way, and still continues today, on the so-called 2020 Review of Solvency II. The Directive in fact requires that by January 1, 2021 the European Commission propose to the co-legislators, i.e. the Council and the European Parliament, an analysis of the operation of various aspects of the Directive, providing, where appropriate, recommendations for its improvement. To this end, the Commission has issued a request for advice to the European Insurance and Occupational Pensions Authority (EIOPA) in which it sets out, in 19 points, the matters on which it requires its opinion. It is a major project, not only because of the large number of sections it contains, but because this is further compounded by the great weight and scope of some of them. By way of example, one section alone examines every aspect of matters as far-ranging and complex as the matching adjustment and the volatility adjustment.

To respond to this request, national supervisors, through EIOPA, have spent months analyzing the subtleties of each of the various disciplines, collecting data and assessing different alternatives and their impacts. A crucial part of this process is transparency and participation, seeking to gather the opinions of different stakeholders in order to make well-founded decisions. This is achieved through different mechanisms, the most prominent being the Consultation Papers, in which EIOPA sets out its provisional position for comments. To this end, the “Consultation Paper on the Opinion on the 2020 Review of Solvency II” was published on the EIOPA website on October 15, and can be commented on by those who wish to do so until January 15, 2020.

The report consists of almost 900 pages, providing the vision of supervisors to meet the Commission’s request for advice. It should be stressed, however, that some issues are the subject of a specific document, and that there are others in which the opinion, intentionally, goes somewhat farther than what was requested.

This process of renewal, which is mandatory in part, has been used by the European Commission to assess the effectiveness of a number of additional aspects of Solvency II and to incorporate some ingredients that were not initially considered (or were envisaged only to a very limited extent) into the framework.

Among the existing elements that are reviewed are long-term guarantees, the improvement of which was already foreseen and which have been the subject of an annual study ever since the entry into force of Solvency II. This heading reflects on such essential issues as matching adjustment, volatility adjustment (especially its calculation), and what should be the last degree of liquidity of the euro for extrapolation of the risk-free interest rate curve.

While the standard formula was refined in June 2019 as mentioned, it is now addressed once again, with particular emphasis on the capital burden of the interest rate submodule. EIOPA has already pointed out, when it examined the standard formula, the deficiencies detected in relation to this stress, related to low and negative interest rates, which derive, in all logic, from a capital requirement designed in an economic situation and an interest rate context that were far removed from the current situation. Other factors, such as the calibration of real estate risk, which could be enriched by additional data sources, or correlation matrices, which were not addressed in the recent review, are also worthy of consideration. In addition to the SCR, the behavior of the MCR during this period is analyzed including, as a horizontal factor, all aspects relating to reporting.

One of the most novel approaches introduced by Solvency II was the organization of groups. This regulation has had a certain amount of success in attracting supervisors’ attention to groups of insurance companies, since until then surveillance focused almost exclusively on individual companies. The time has come to review how this new paradigm has operated, trying to overcome weaknesses that are quite comprehensible in such an ambitious and complex initiative. This, therefore, constitutes one of the areas to which the Consultation Paper devotes greatest attention.

The experience acquired during the years that the system of free provision of services and the right of establishment has been in use makes it advisable to make some adjustments that maintain and refine the existing system of control by the home Member State, with the triple purpose of avoiding regulatory arbitration, addressing systemic weaknesses in cross-border supervision, and ensuring an adequate level of protection for insured persons and beneficiaries, regardless of the location of the company’s headquarters. With a view to achieving all of the above, a number of adjustments to some of the articles of the Directive are suggested.

As a transversal and structural axis of Solvency II, the principle of proportionality, is subjected to intense scrutiny. While it must be clear that it is operational even if it is not expressly cited, past experience leads us to think that it is an opportune moment to make some corrections that will allow us to further analyze its implementation.

In this way, the study proposes raising the limits for some of the exclusion criteria in the scope of the directive, so that more companies would be positioned outside it. In addition, a thorough study is carried out, for each of the three pillars, of particular facets that could benefit from the application of this principle. It examines their potential benefits in the field of calculating technical and SCR provisions, reporting, key functions, risk and solvency self-assessment (ORSA), or written policies, among others.

As noted above, the Consultation Document also proposes the introduction of a number of highly novel subjects into the context of Solvency II.

In this regard, the section on the macroprudential dimension should be highlighted. It is remarkable that the European Commission asked for guidance in relation to possible improvements to a well-defined and very specific list of items: ORSA; the preparation of a systemic risk management plan; a liquidity risk management plan and liquidity reporting; and the “prudent person” principle. However, EIOPA has expanded its response to these and many other macroprudential policy elements, judging that there are not enough tools in the current regime and that, according to scientific doctrine, it is crucial to have multiple instruments to address this risk. In this way it could be attacked from different angles, reducing the possibilities of evasion and increasing efficiency.

Increasing attention is being paid to this subject at a global level, and in fact EIOPA has already published three dossiers in this respect. In Spain, the Macroprudential Authority Financial Stability Board (AMCESFI) has recently been established by Royal Decree 102/2019 of March 1, 2019, which not only establishes the Macroprudential Authority Financial Stability Board, but also establishes its legal regime and develops certain elements related to macroprudential tools. Chaired by the Minister for the Economy and Enterprise, it brings together representatives of the three financial supervisors (the Central Bank of Spain, the National Securities Market Commission and the General Directorate of Insurance and Pension Funds), together with the Ministry of Economy and Enterprise itself.

This section of the report contains ample explanations to underpin the position adopted by EIOPA. The potential systemic risks in the insurance sector and its transmission channels are discussed, as are the various measures to achieve operational objectives that will enable the achievement of intermediate objectives. Two are discussed here: how to mitigate the likelihood of a systemic crisis and how to mitigate its impact, which in turn determine achievement of the ultimate objective: financial stability.

It is important to note that the study recognizes that features already exist in the current system that can have an impact on stability:

– in general, discouraging attitudes of excessive risk through:

  • a capital requirement against specific risks (equity, interest rate, concentration, etc.);
  • consideration of the absorption capacity of deferred losses and taxes;
  • the constitution of reserves;
  • proactive risk management

– on an indirect basis, with:

  • the “prudent person” principle;
  • ORSA;
  • capital additions under certain circumstances

– with direct impacts such as:

  • matching adjustment;
  • volatility adjustment;
  • symmetrical adjustment of share-related risk;
  • extension of the recovery period;
  • transitional measures for technical provisions

This being the case, the text postulates the introduction of a set of tools that include the following:

– capital charges for systemic risk under certain circumstances;
– “soft” concentration limits;
– the extension of the use of ORSA for these purposes;
– the broadening of the “prudent person” principle;
– the formulation of preventive recovery and resolution plans;
– the possibility of requiring systemic risk management plans;
– liquidity risk management policies;
– a new supervisory capacity to suspend or temporarily limit rescue rights to all or part of the market;
– strengthening reporting

The desirability of defining a counter-cyclical buffer is discussed, although it is considered that this approach would not be in line with the foundations of Solvency II.

Another of the main developments outlined is the aspiration to a minimum harmonized framework for guarantee funds. In this respect, EIOPA began its consultation on July 12, 2019, and concluded it on October 18, so we will not examine this subject in detail at this time.

As a final new feature, it is important to outline the introduction of a more uniform “playing-field” in relation to recovery and resolution. The Commission’s request for technical advice already anticipated a significant interest in this subject, and proposed an open scenario in the different environments to be explored. The resolution objectives would be, in addition to protecting the insured parties and maintaining financial stability, to strengthen the continuity of the functions of companies whose interruption of activity could damage financial stability or the real economy and thus to safeguard public funds. Briefly, and in order not to extend this article further, action is recommended to provide supervisors with a range of powers for early intervention, accompanied by the appointment of a resolution authority that would also enjoy a wide range of powers.

As can be deduced from this document, Solvency II is very much in the forefront of activity at the present time. Far from being considered perfect and complete, it is still open to a wide spectrum of changes that will allow for its improvement in terms of providing protection to policyholders, beneficiaries and insured parties in general, and contributing to the stability of the financial system as a whole.

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