Europe's Solvency II delay not seen as big setback
Draft law for insurers won't be ready until next year. But many regulators say need to bolster insurer solvency remains urgent. David Keefe reports
The European Commission, the European Union's executive arm, bowed to the inevitable in early January as Commission sources said the draft framework directive on Solvency II won't appear until towards the end of 2006. This is a year later than the end-2005 date envisaged in the roadmap for the development of Solvency II issued by the Brussels-based Commission in only August last year.
But Alexander Schaub, the Commission's internal market director general, and other officials had from the start described the end-2005 target as challenging. The decision to postpone the issue of the draft framework directive, which will provide the general principles of the project, caused little surprise.
Commission officials don't regard the delay as a setback and say the new timetable is `reasonable and do-able' and generally more manageable than the old one.
The year's delay to drafting the Solvency II law for making Europe's insurance industry safer is a reminder, like the hiccups seen in the Basel II process for banks, of just how big is the task of developing risk-focused financial regulation.
The size of the task of devising a regime that bolsters the solvency of insurers by getting them to align their capital and risk management policies more accurately to the risks they face was known from the beginning, they say.
Many European regulators regard the need to improve insurer solvency as very urgent. They think the industry is seriously undercapitalised and in many cases behind the times in terms of its risk management policies. Some EU countries - the UK and the Netherlands, for instance - are already implementing their own risk-based regimes, not trusting to the current, and simpler, EU Solvency I rules which are seen as a make-shift stop-gap.
Risk management consultants Mercer Oliver Wyman contentiously estimated last year that at the end of 2002 the European life insurance industry, for instance, would have seen a €100 billion ($131 billion) shortfall between available capital and regulatory capital requirements had Solvency II been in force. This number was disputed by some in the industry, but it gives an indication of what is at stake.
More time needed
Commission officials say the delay reflects recognition of the time needed for several aspects of Solvency II, including the quantitative impact studies for assessing the effect on insurers of the planned regime. The still unresolved question of how to value insurance contracts, which form the bulk of insurer liabilities, under the new International Financial Reporting Standards (IFRS) is also a factor.
Industry analysts say it's difficult to see how the amount of capital insurers need to absorb losses from the risks they face can be calculated in the absence of a uniform way of valuing their most important liabilities.
A new roadmap for the project is expected to be issued in March for the next meeting of the Commission's Insurance Committee, which comprises government-level officials from the 25 EU member states. Commission sources say a draft text of some kind is still expected by the end of this year so that firms can start testing the likely impact of the regime on them.
The August roadmap named 2008 as the year for completing the law-making process. Commission officials declined to comment on whether a new date is now envisaged, but the industry assumption is that the completion date must be shunted on by the postponement of the draft directive.
No official implementation date has been set for Solvency II; 2010 has been cited as possible, but later dates are also mentioned. Some officials have said previously that Solvency II could be brought into effect in stages.
And some regulators believe that the Commission should develop its own accounting definitions for Solvency II, and not wait for the International Accounting Standards Board (IASB), the London-based accounting rule-maker that devised IFRS, to agree a method for valuing insurance contracts in accounts. At present, a finalised standard on valuing insurance policies, the contracts that form the bulk of insurer liabilities, won't be ready until at least mid-2008.
Olav Jones, head of insurance risk at banking and insurance group Fortis, says the delay has echoes of the problems encountered in the five-year development of the Basel II upgrade of international rules for bank safety.
Solvency II is modelled on the three-pillar structure of capital requirements (pillar 1), supervisory review (pillar 2) and market discipline (pillar 3) embodied in the complex Basel II capital adequacy rules.
But Basel II, which was designed by the global banking supervisors of the Basel Committee on Banking Supervision, suffered several delays during its development both as a result of the size of the project and because of the political and technical arguments that emerged on the way, Jones notes.
Devil in the detail
Jones, who also chairs the Solvency II steering group of the Paris-based Comité Européen des Assurances (CEA) - the European Federation of National Insurance Associations - says Europe's insurance industry fully supports in principle the Solvency II project and its three pillars. But the devil, as always, will be in the detail.
He says that while adopting the three-pillar structure of Basel II, the designers of Solvency II must recognise the differences between banks and insurance firms.
For example, for banks credit risk tends to be very dominant and explains the focus on this in Basel II. Only credit, trading and operational risks are included in the pillar 1 solvency capital. The capital required for each risk is then simply added to arrive at the capital requirement, so no allowance is made for diversification, Jones says.
For insurance companies, credit risk tends to dominate less, and the risks tend to vary depending on the type of insurance business involved. For traditional life business, asset liability mismatch risk tends to dominate. For non-life insurance, the dominant risk tends to be claims risk. For unit-linked business, it tends to be operational risk. Jones says the general view among the insurance industry is that pillar 1 should include all key risks, but the diversification that exists between risks should be taken into account. He notes that diversification lies at the heart of most insurance business.
However, the designers of Solvency II do have two advantages over their Basel II counterparts, says Jones.
The first is that the negotiation of Solvency II involves fewer countries - 25 - than did Basel II. While Basel II is initially an agreement between the 13 leading economies that are members of the Basel Committee, the international banking pact is designed for adoption by banks all sizes in any country. Just over 100 countries, including the Committee members, plan to adopt Basel II.
As an entirely EU generated project, Solvency II will be the first major test of the so-called Lamfalussy process for making the development EU financial regulation more efficient and speedier. Under this process, framework directives are adopted by `co-decision' of the Commission, the Council of Ministers and the European Parliament. But measures designed to implement detailed requirements are approved through `comitology', the use of specialist, expert committees. The key specialist committee for insurance is the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), which comprises senior insurance supervisors from the 25 EU member states. CEIOPS, whose secretariat is based in Frankfurt-am-Main, Germany, will oversee the implementation of Solvency II.
Basel II, which emanates from an external body, will be applied as law via the Capital Requirements Directive, with a small number of changes from the original Basel II document, to all EU banks and investment firms in two stages in 2007 and 2008.
A second advantage
The second difference is that the Solvency II planners have Basel II as a guide, whereas the Basel regulators had much less to go on by way of experience of risk-focused regulatory regimes, says Jones.
And Jones says there are several lessons to be learned from the Basel II experience. He says the regulators must tackle from the start the problem of measuring risk diversification at consolidated group level, and not be left struggling with it at a late stage as the Basel banking supervisors are having do in respect of the operational risk advanced measurement approaches (AMAs). The problem stems from the fact that risk measured in a group as whole is generally less than the sum of the risk present in each subsidiary or entity making up the group. But regulators in a country hosting a unit of a large international insurance group are likely to want to ensure that the unit is capitalised on a stand-alone basis and not in terms of its relationship with the group as whole.
Jones says the industry wants the internal risk models that will be available under Solvency II to be full models, in the manner of the operational risk AMAs in Basel II, from the start and not partial models awaiting further development. Full credit risk models, tracking credit risk as whole rather than in separate loan categories, aren't available under Basel II; they will feature in the further evolution of the Basel capital adequacy rules.
Harmonisation wanted
Insurers also want Pillar 2 - supervisory review - to ensure the maximum harmonisation of regulation across EU borders and supervisors need to be equipped to do this.
Jones says he welcomes the fact that the diversification issue is recognised in the Commission's latest request to CEIOPS for technical advice, which was issued in late December.
This second call for advice largely centres on pillar 1 capital requirement issues such as technical provisions, solvency capital and quantitative impact study data. The first call, issued in July, revolved around pillar 2 supervisory review questions. The third wave of advice calls from the Commission, expected in February, will focus on pillar 3 - improving the action of market discipline on insurers by getting them to disclose more information about their risk management systems and policies.
Meanwhile, the CEA, which brings together the national industry associations of 32 European countries, expects to produce a report in early 2005 on a pilot project that looks at the issues involved in existing models that could be used for pillar 1 capital requirements under Solvency II.
It's part of a drive, spearheaded by Jones's Solvency II steering group, to enhance the Federation's input into the debate with the Commission and CEIOPS.
The aim of the pilot project is to make a comparative study of the main existing insurance solvency models, such as those used in the UK, the Netherlands and the US as well as the Basel II models and others. A parallel Pillar 2 exercise is also taking place.
Jones says that the Commission and CEIOPS may have to develop their own accounting definitions, where necessary, for Solvency II and see at a later date how they fit with the eventual IFRS rules.
The IASB was due at its January meeting to review progress on a standard for valuing insurance contracts. IFRS will apply in two phases to European insurers listed on EU stock exchanges. Non-listed firms won't have to comply.
In phase I, IFRS applies to insurer assets from January 1, the date that the new accounting rules came into force generally for some 7,000 EU firms of all types. IFRS won't apply to liabilities until phase II comes into force when the IASB produces a standard for valuing insurance contracts.
No liquid market
The task of devising a standard that produces a current, or fair, value for insurance contracts is made difficult by the lack of any liquid secondary market for insurance policies which could provide a fair value pricing guide.
IASB sources said an exposure draft on valuing insurance contracts isn't expected until mid-2007 and typically it would be another year - to mid-2008 - before a final rule standard appeared, and another two years before it came into effect.
Separately, meanwhile, CEIOPS has issued a consultation paper on its suggestions for so-called prudential filters to prevent the IFRS rules leading to unintended increases or decreases in the capital needed to support solvency requirements (see page 7)
