Movements toward the Globalization of Insurance …Globalization of Insurance Regulation Although the business of insurance has a long history, the regulation of insurance is a relatively

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A directive for Europe—Solvency II

The path to Solvency II has been at best uneven. What started out as a widely agreed change to Solvency rules with a focus on capital adequacy and risk management has turned out to be a highly difficult exercise. Whereas Solvency I provided for minimum harmonisation, which allowed differences to emerge in the way insurance was regulated across Europe, Solvency II is a maximum harmonisation directive. The directive aims to increase policyholder protection and consumer confidence in insurance products by introducing greater transparency and disclosure requirements. Solvency II also aims to introduce a more rigorous risk management framework to allow for better strategic and operational decision-making by insurers. With Solvency II, the regulators intend to achieve a consistent approach across Europe in relation to:

• Market consistent balance sheets• Risk-based capital• Own Risk and Solvency Assessment

(ORSA)• Senior management accountability• Supervisory assessment

I N V E S T O R S E R V I C E S

“Today, this complex business is faced with a raft of regulatory change adding to a challenging economic environment.”

Movements toward the Globalization of Insurance Regulation

Although the business of insurance has a long history, the regulation of insurance is a relatively modern phenomenon with self-regulation being overtaken by statutory rules, increasing transparency obligations and tighter supervision.

It was only eight years ago that the now-defunct Financial Services Authority (FSA) in the UK took over responsibility for the regulation of insurance from the General Insurance Standards Council (as of April, the Financial Conduct Authority now has overall responsibility). Whilst national regulation remains at the heart of day-to-day business and will continue to play an important role, in Europe change is being framed regionally. Today, this complex business is faced with a raft of regulatory change adding to a challenging economic environment. Alongside, there is growing momentum for a risk-based approach to insurance supervision worldwide with both China and the U.S. evaluating and updating their regulatory requirements, although it is unlikely that there will be fully consistent global standards agreed anytime soon. To this end, the EU–U.S. Insurance Dialogue Project announced a five-year programme of initiatives in December 2012 to harmonize the supervision of insurers—an important milestone given the global reach of the insurance business.

The scope and nature of the changes that lie ahead are foreshadowed by the convergence of a number of developments including the International Association of Insurance Supervisors (IAIS) issuing updated guidelines, “Insurance Core Principles,”1 and several countries around the world moving toward equivalence with Solvency II.

Amongst the many issues to which insurers must pay careful attention, two stand out: Solvency II, and changes to accounting standards—each of which has potential costs attached.

Sheenagh Gordon-Hart Industry and Client Research Executive

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Shifting implementation dates

Following the agreement and publication of the Solvency II Framework (Level I) Directive in April 2009, draft Level II advice was issued to the European Commission in July 2009 by CEIOPS.2 The Directive was originally intended to come into effect on 1 November 2012. However, in January 2011 the Commission tabled Omnibus II—a Directive amending Solvency II and including, inter alia, a shift of implementation date from November 2012 to January 2013. Further slippage on the implementation date was experienced as negotiation continued on the detail of Omnibus II, which required the Commission to table a short, revised Directive on 16 May 2012 amending the date for firms to implement the new rules to January 2014. Member States would be required to transpose the Directive by June 2013. In February 2013, the European Parliament moved the date for its vote on Omnibus II from June 2013 to October. More recently the Commission instructed EIOPA to conduct a further quantitative impact study on measures to deal with long-term guarantees, a critical issue for many European life insurers and providers of annuities. EIOPA was originally due to report back on the results of this study by 31 March 2013 but was delayed to 14 June. The report reflects the complexity of the exercise and industry is assessing the likely impact. The industry trade associations for both Germany and France have voiced concerns that EIOPA’s proposals did not address a number of their concerns and may mean insurers will have to curtail their product offerings and may deter them from investing in higher yielding assets, which could be negative for the economy.

Given that Omnibus II is still not agreed and a consensus is unlikely to be reached before Q3 2013, it is likely that the dates will slip again. Indeed, Commissioner Barnier is reported to have commented on the possibility of a delay of one year, i.e., transposition in July 2014 and implementation from 1 January 2015; it may be however, that the start date will need to move out further to 2016. Commissioner Barnier has also asked that EIOPA should focus “on a speedy

implementation of some of the qualitative (Pillar II) aspects of the Solvency II framework, such as effective system of governance and risk-management system” and “continue in its work of developing common reporting formats and templates.”3

Data management and capital requirements, a critical focus

Whatever its final shape, Solvency II will impose exacting standards, particularly in the area of data management where most firms have had to overcome their legacy silos. The Directive requires data—actuarial, risk and financial—to be accurate, timely and appropriate for all stakeholders. This has meant a significant focus on improving data quality, granularity and accessibility. Further challenges surround the necessary integration of actuarial models to calculate capital requirements so that balance sheets—and regulatory capital—accurately capture all the risk taken across the business at product, subsidiary and corporate levels. Ancillary to this come more onerous reporting requirements to meet the transparency obligations of Solvency II; not only will many more reports be required but turnaround times are being tightened.

The solvency position of insurers will be gauged by two key measures, the Solvency Capital Requirement and the Minimum Capital Requirement based either on a standard model or their own internally developed and approved model. While insurers are well-practiced in analyzing

and understanding the risk of their liability profiles, Solvency II requires a much deeper analysis of assets, and accurate data is vital to an efficient use of capital. Whilst Solvency I focused on admissible assets, Solvency II allows investment in all asset types, with different asset types attracting different capital charges. The chart below shows the capital charges applied to debt instruments; listed and ‘other’ (unlisted and non-OECD listed) equities attract a capital charge of 39 percent and 49 percent respectively; real estate attracts a capital charge of 25 percent.

Naturally, insurers will need to ensure that they optimize their portfolio holdings and where, for example, corporate debt is held in a collective investment scheme, sufficient look-through is available so that such holdings are not deemed to be ‘other equity’ and subject to the higher capital charge that would attract.

Firms are also required to develop an Own Risk and Solvency Assessment (ORSA) that must be calculated and managed consistently. Risks identified by ORSA should be included in a firm’s Solvency II model, and resultant capital requirements will directly affect financial planning. From a compliance perspective, insurers are required to demonstrate how they have developed their compliance processes and that its implementation is valid, consistent and fully embedded into working processes. After implementation, supervisors will conduct regular assessments through the Supervisory Review Process to gauge compliance.

Market risk capital charges applied to debt instruments

Rating Duration Factor

Capital Charge by Duration

1 3 5 10

AAA 0.9% 0.9% 2.7% 4.5% 9.0%

AA 1.1% 1.1% 3.3% 5.5% 11.0%

A 1.4% 1.4% 4.2% 7.0% 14.0%

BBB 2.5% 2.5% 7.5% 12.5% 25.0%

BB 4.5% 4.5% 13.5% 22.5% 45.0%

B or lower 7.5% 7.5% 22.5% 37.5% 60.0%

Unrated 3.0% 3.0% 9.0% 15.0% 30.0%

Source: Aon Benfield4

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A parallel challenge from IFRS

Alongside Solvency II, insurers are also grappling with the long discussed and debated International Financial Reporting Standards (IFRS) accounting changes. For many insurance companies operating on a global stage, consistency in accounting standards is vital to the efficacy of management information. For the marketplace too, consistency would be a welcome development. However, the two projects running concurrently to slightly different timetables with several significant differences pose an immense challenge, not least in reconciling what may be very different datasets emerging from each initiative.

As the management of data becomes more complex and the associated costs of complying with the new regulations escalate, a greater focus on outsourcing is emerging.

1 “Insurance Core Principles, Standards, Guidance and Assessment Methodology, October 2011 (revised October 2012),” 26 October 2012, www.iaisweb.org.2 The Committee of European Insurance and Occupational Pensions Supervisors, now superseded by EIOPA, the European Insurance and Occupational Pensions Authority.3 Letter from Commissioner Barnier to Gabriel Bernardino, Chairman of EIOPA, 8 November 2012, ec.europa.eu.4 Aon Benfield, “Solvency II Revealed,” page 11, October 2011, www.aonbenfield.com.

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J.P. Morgan’s Solvency II solution

J.P. Morgan has a team dedicated to addressing the Solvency II requirements of insurers. As illustrated below, the service incorporates a flexible and adaptable data aggregation system to provide attribute level asset data including issuer information, credit ratings, detailed derivative information and collateral data. The system also is designed to ensure clients can access the data they need at the required level of detail to enable them to carry out their capital requirement calculations and meet their regulatory reporting obligations.

Accounting Data

Compliance / Exposure Data

Derivative Data

Collateral Data

Security Lending Data

Custody Data

Reference Data

Initial Data Store

Valuation

Positions

Trans History

Ref Data

Prices

FXs

Counter-parties

SII Data Store

SII Tables

Reporting

QRT Templates

Data Extracts

Customised Reports

Scheduling

File / Report Delivery

Solvency II Engine

Exception Processing

Data Mapping

Data Enrichment

Source: J.P. Morgan, June 2013