Autorité de Contrôle Prudentiel et de Résolution, First Deputy Secretary General
Italian Insurance Supervisory Authority , Member of the Board of Directors
Federal Financial Supervisory Authority, Germany, Chief Executive Director of Insurance and Pension Funds Supervision
International Association of Insurance Supervisors, Secretary General
European Insurance and Occupational Pensions Authority, Head of EIOPA Risks and Financial Stability Department
Allianz SE, Head of Group Regulatory Affairs and Public Policy
Joseph L. Engelhard
MetLife, Senior Vice President, Head of Global Regulatory Policy Group, Global Government Relations
CNP Assurances, Deputy General Manager
1. Challenges faced by insurance regulation
1.1. The review of Solvency II should address the complexity and volatility of the framework
The first challenge, from the perspective of an EU supervisor, would be the improvement of Solvency II. Regulators are working with EIOPA and the European Commission in reviewing the system. In that context, addressing complexity and volatility without hampering the other advantages of Solvency II are the two objectives. Rather than focusing excessively on the reduction of the complexity, the aim should be to maintain risk sensitivity while reducing the volatility of supervisor’s reaction to the signal sent by Solvency II.
An industry representative also stated that the volatility has to be removed from Solvency II. Such volatility stems from the fact that the framework overstates liabilities and understates capital. However, the risk based framework is a good system overall and should be maintained. The industry also needs to avoid the insurance capital standard impeding insurers who wish to invest long term in illiquid assets. If it is reviewed appropriately, this will be the key for investment and growth, especially since investments desirable from a political perspective can only be made once the volatility is taken out. That is a mistake in Solvency II, which should not be made in the ICS. Waiting up to three years longer is therefore not the best solution: Solvency II should be reviewed earlier than 2020.
1.2. The current EU framework already encompasses tools to addresses excessive volatility
However, a representative of a public authority noted that there are elements currently embedded in the system that aim at addressing the volatility. Another important element in how volatility and a macro view is already included in Solvency II. Examples here include the ‘volatility adjustment’ and the ‘symmetric’ adjustment to the equity risk model, the latter being essentially a functionality that builds on capital during good times and releases capital during bad times. That is not far from saying that a countercyclical tool is already embedded in the system.
Another useful tool, which has thankfully not yet been used, is the extension of the recovery period. When EIOPA declares the existence of an exceptional adverse situation upon request by one or more National Competent Authorities, it is possible to extend the recovery period of an institution or group of institutions up to seven years; that is already in the framework. This is important, because it may prevent fire sales or any actions in the market that may make any situation that is subverting the market and create an even worse situation, because institutions need to de risk for any reason.
Furthermore, EIOPA but also in IAIS, are currently looking at what they could have in place, on the recovery and resolution frameworks for insurance. That is very important. It is a tool that helps in many forms. The resolution plans help the supervisors to see what actions there are, to see if an insurance undertaking is resolvable, and whether it is possible to ensure some structural process when things go wrong. Having in place a recovery and resolution framework with pre emptive recovery plans at the level of each institution, also helps the institution to consider possible sources of risk at an early stage. This was seen in the CMG (Crisis Management Group), which brings together home and key host authorities of all Global Systemically Important Financial Institutions (G-SIFIs).
1.3. Anticipating the risks for policy holders of the dramatic development of digital in the insurance sector is important
A public authority representative stated that, in the current context of dramatic development of IT techniques, there should also be attempts as far as possible, to anticipate the risks for policy holders in the design, pricing and distribution of products, and what is peculiar for insurance in the execution of the contract. Indeed, regulation is, by its nature, reactive, and insurance goes beyond the simple delivery of the financial service. Another public authority representative highlighted that there are interesting issues in this respect around fintech and the proactivity of regulators.
2. A harmonised global capital standard for insurance companies for measuring and aggregating exposures at sectoral and inter sectoral levels
A representative of a public authority stated that work should also continue towards a harmonised global standard for capital. If there are common metrics for measuring exposure, the industry can better aggregate and assess the exposure at sectoral and inter sectoral levels, notably in order to better detect systemic threats. Additionally, on an entity specific basis, having an ICS like or stress based method to calculate the exposure of the companies would improve the way in which the systemic character of the companies is reflected in the methodology for designating the companies as systemically important. An ICS is an objective to continue to pursue.
Another public authority representative stated that the IAIS’s press release in February makes clear their two focuses: one is on Insurance Capital Standards (ICS); the other is an activity based approach or a systemic risk discussion in general. That had some change, or reinforcement of change, in February. ICS is the centre of the IAIS’s activities in the context of ComFrame. The first version will be produced in June, with version 2 to follow in 2019. Version 1 is the extended supervisory report or field testing, and version 2 is the regulatory consequence, and as such has a direct impact on internationally active insurance companies. The IAIS are very much committed.
New activity based policy measures will be issued in 2019. In addition, the revised entity based approach methodology will be issued in 2019. The discussion upon a new identification methodology of systemic companies, will be achieved in in 2020. Each will apply in 2022. Those are the two key work streams and the time schedule. A key message there is that there is interaction between the two. The integration of the issues on systemic risk into the policy measures is included in the 2019 timeline, since the combination between the activity-based and the capital framework is now clear.
Based on new ICP, ICS will be developed and applied in 2022. The key message is that ICS is the centre. Both the ICS and activity based activities will be concluded in 2019, with implementation beginning subsequently.
2.1. Harmonisation of a global regulation for insurance is also necessary for achieving a level playing field in the global context
An industry representative stated that they are in favour of global regulation. However, the global regulation should not focus only on the financial stability problem, though it may be a problem for regulators and the financial sector as a whole. It is only part of the problem for insurers. Their institution would welcome harmonisation of a global regulation of the insurance business. Solvency II will later go back on some aspects, but it exists and has been implemented in the EU, and has given a risk sensitivity that is appreciated. However, in other parts of the world the rules are observably much laxer. It can create problems for a level playing field to some extent.
2.2. The ICS must be risk based to appropriately reflect business models – notably long-term ones – for management and risk mitigation purposes
A representative of the industry stated that, in order to be improved, the ICS must properly reflect the business model. It should be a risk based system. The specificities of the long term investment possibilities of insurers should be taken into account. Indeed, though the spread risk is normally for insurers, insurers are typically buy and hold investors and do not want to trade things. To buy and hold investors, the spread risk is not decisive, but it is just default risk in the end, whether or not they get their money back from the investment; this point is particularly important. The speaker also thinks the ICS should go toward internal models. Internal models have to be proven very well, and they are now implemented in a lot of companies with a lot of effort. Internal models are a great chance to accurately mirror the business, both for business steering purposes and to looking at where the risks effectively are.
Indeed, another industry representative commented, regarding Solvency II that from their institution’s perspective, the current main weakness may be how Solvency II does not specifically address the very long term products available in the savings or pension markets, which allow liabilities to be matched with very long term investments. In that regard, it does not have the same volatility if it is kept for 10, 15 or 20 years in an intra year cycle. That should be taken into account in providing good products and returns for clients, and to better finance the European economy.
Lastly, the speaker asked whether there would not be too much restriction around collective ambition as regulators. The worst outcome would be to focus only on the ancillary impact of market volatility and to solve it with only capital add ons. That would only multiply the anti competitive factors impacting the industry in the EU, which would not necessarily maintain financial stability of the market.
3. A challenge ahead is also the definition of a potential macro prudential framework for insurance, which takes into account insurance sector specificities and complements Solvency II
The first topic in this respect is the activity based macro approach since the current (entity based) approach has room for improvement, and where to go is an important issues. The second is the current capital framework and where to go with capital, by taking into account the macro or systemic issue.
A private sector representative stated, regarding systemic risks, that everybody agrees that designating just nine G SIIs does not make the market any more secure. The solution is not adequate for the problems. To give an example, the derivative volume of the nine G-SIIs is only 28% of the overall derivatives volume in the insurance sector. The derivatives volume of the insurance sector compared to the global volume of derivatives is just 1%. Finally, these designations only capture 0.28% of the whole derivatives volume.
Transparency is also needed on the designation process. The industry needs a proper comparison to other industries, which may include industries beyond banking and asset management, that are systemically important. Overall, the industry has to see that it is a level playing field. That leads to an activity based approach based which addresses transmission channels for systemic risk. Capital may not be the solution. If there is a macroeconomic or systemic crisis it does not matter if an organisation holds 100% more capital resources; it must have adequate measures afterwards.
An industry representative added that in the area of insurance, capital add-ons cannot be the right solution to every problem of systems. Insurers would call upon a specific and pragmatic analysis of the kind of risk related to interpenetration and interrelation, before defining international standards, which the speaker’s institution supports in principle.
3.1. Some insurance activities may have financial stability implications
A public authority representative acknowledged that one challenge ahead is how to address the definition of a macro prudential framework in insurance. This is due notably to the fact that the topic of systemic importance in macro-prudential frameworks, has almost exclusively concerned banks. Recently that approach has changed, partly due to the realisation that risk in the sector may affect the sector as a whole, as illustrated by the current low interest rate environment in Europe. There is also the increase of interconnectedness between sectors. Finally, there are empirical studies that indicated an increased systemic importance of the sector, but that was mainly based on market observations and market price movements.
Yet for good reasons, the discussion so far has mainly concerned the banking sector. The banking sector engages in liquidity transformation, making it very prone to liquidity and domino effect risks in the context of increasing interconnectedness, notably through money markets and the financing of growth and money creation. Though there is a whole set of activities that banks engage in that are not at all similar to insurance, however, this may be a ‘false friend’. If one only relies on the fact that insurance activities are different to banking ones, then one can miss that what one may be doing in the insurance sector has financial stability implications. In addition, there are cases where insurance activities also include maturity transformation, and activities that may look more like banking than insurance. In those cases, there must be the potential for hurtful behaviours.
Some individuals will argue that insurance is more of an amplifier than a source of systemic risk; however, the speaker suggested that rather than engaging in the debate of whether or not it is systemic, there should be a common understanding that insurance can have financial stability implications under certain circumstances. That should be a guiding principle. Then the discussion can focus on the appropriate toolkit and macro prudential framework that might be needed to address insurance specificities.
The supervisory community needs to ‘do its homework’. They need to set an objective and define intermediary objectives that will assist towards that goal. An appropriate toolbox should also be implemented to such a case. However, before engaging in new tools and policies, one has to first look at what is already in place. In this case, there is Solvency II. Another thing, of equal or greater importance, is to try to ensure consistency between macro and micro supervision. The two frameworks must be complementary and consistent. There is currently a good opportunity to bring the discussion within the Solvency II review to ensure that consistency to the best possible extent.
4. A cross-sectoral activity-based approach is required for improving the individual designation process, favouring tailored macro prudential solutions, and taking into account both management practices and micro prudential rules that have a macro prudential impact
An industry representative stated that they wanted to focus on the decision of the IAIS to develop an activity based approach. It is a very good development. In many ways, it represents a natural evolution of the debate on how to properly assess systemic risk and designate systemically important Insurance groups.
The speaker’s institution has a number of concerns about both the domestic and international individual designation process. The central concern has always been how to properly identify and measure potential threats to financial stability. An activity based approach is a better alternative, because this institution’s vision for how an activity based approach would work is that it starts from the analysis of any activities in the insurance sector which they consider limited and indirect in a minor set of ways, but would potentially be systemically relevant. The key is also to start from the current consensus of the three systemic risk transmission channels which are interconnectedness, asset liquidity and substitutability. He remarked that for the insurance sector, it is generally about the first two.
The representative’s institution is encouraged that the IAS is looking into an activity based approach because it allows them to begin from fundamental starting points. It consequently allows for a number of improvements over the individual designation process. First of all, it accounts for both the tsunami and domino theories. An activity based approach is the best way to address both those risks. Another key benefit is that it allows for tailored solutions. When starting from a macro prudential or systemic risk transmission channel lens, once potential threats are identified, any policy measures should directly address those transmission channels. By contrast the traditional approach and the individual designation process would only add capital requirements, which, for liquidity, is not really a solution.
The activity based approach also better takes into account either internal risk management practices or micro prudential rules that would have a macro prudential impact, which is another good recent development. The IAIS is integrating the development of ICS with an activity based approach, but both need to be looked at. It is very encouraging. The two things that are particularly appreciated about an activity based approach are that it more efficiently allocates supervisory resources, and that it creates a level playing field. It should be cross sectoral. If one focuses on what is going on in Europe, there is a small handful of activities. To the extent that they are potentially systemically relevant, they should be addressed in the same way in all the sectors involved in these activities. This is happening in the asset management industry, and the direction of the IAIS is encouraging.
5. A conceptual framework that describes what could create or transmit systemic vulnerabilities that have potential impacts on the whole market, is needed before hand at the global level
5.1. Identifying what activities could create exposures and vulnerabilities that have the potential to impact the market is a priority
A public authority representative stated that, firstly, it is important to have a clear picture of the objectives. The first step is to have a common understanding of ‘macro’, ‘micro’, ‘entity’ and ‘activity based’. Their institution is trying to include the activity based approach in a coherent policy framework.
It is clear that micro supervision is there to protect policy holders in the failure of single companies, and it has focused mainly on reducing the probability of failure of single companies. When discussing macro supervision, one should first look at those tonalities, at what goes beyond the company and could impact the system. That could be seen also at the entity specific level in the sense of what is the impact of the failure of a single company. Many have highlighted that and taken into account the sector as a whole, or more companies, whose behaviour in situations could impact the market as well.
The next goal should be a conceptual framework that describes what activities could create exposures and vulnerabilities that have the potential to impact the market through certain transmission channels. That is not easy to describe.
An industry representative noted that there is also the question of what replacement is and what the ultimate goal is, but the whole framework needs to be developed first. Two things cannot be compared until they have been defined. Ultimately, the speaker is comfortable that when one looks at the relative few areas where there may be threats to financial stability. Until that process is complete, a decision cannot be made.
5.2. Setting the appropriate balance between the activity-based and the entity based approaches, is essential
Following these two phases required to sort out ‘macro’ and ‘micro’ issues and ‘entity’ and ‘activity based’ ones, one would be in a better position to judge which policy measures are necessary for mitigating the systemic risk arising from the activity, which is the third step.
This step requires conducting a gap analysis to check whether there are policy measures there for micro purposes that could also play a role in achieving macro objectives. It should also be identified whether there are policy measures there for micro purposes that could also be counterproductive from a macro perspective.
That gap analysis will be the core of the work. In that context, there were two possible approaches. First is an assessment using a total balance sheet approach referring to activities and exposures, rather than the products and labels given to different activities. In that context, it will be important to have tools for measuring the exposure in a coherent way. In that regard, it returns to the ICS. Second, the gap analysis should be done as far as possible, taking into account cross sectoral aspects, as has been done in the banking and asset management sectors.
Finally, after having designated which policies are relevant in an activity based approach, is questioning what it means for the entity based approach. One objective is to check whether the risks that are supposed to be mitigated in an entity based approach are perhaps better mitigated in an activity based approach.
The starting working assumption is that the two approaches look at the same thing from different angles so that they complement each other. A key issue to address the next two years is that, since capital is not a measure to address systemic risk and Assuming that capital is used as a policy measure for the entity based approach, they would question how the activity based approach can balance this policy, assuming that ICS has a systemic risk element. That may be the most difficult part of the task. At their current stage, we welcome input from all stakeholders, including large groups and small companies that could play a role in the context.
5.3. A level playing field requires cross sectoral activity-based approaches
An industry representative stated that if the industry takes the route of activity based regulation, there are a number of activities where other sectors than the insurance sector intervene. The insurance sector must be set in a level playing field with pension funds, asset managers and all the participants that provide collective, professional or individual pension plans. Europe is working on the concept of a personal European pension plan. It will be more difficult to regulate that kind of level playing field at the global stage, but that must be taken into account when considering the pension plan’s features.
Another industry representative added that the process of determining externalities is a challenge, noting that ultimately very few activities meet the systemic risk transmission channel criteria. The assessment of those will probably lead to the conclusion that there are just a few limited ways in which there is systemic relevance in the insurance sector.
5.4. The definition of the appropriate systemic risk mitigation tools is the last challenge to face at the global level
5.4.1. Regulators are working at the global level to avoid possible fragmented regulatory approaches
The US Securities Commissioners recently mentioned that, whatever the geopolitical answer, everybody loses if they take the fragmented approach in the context of global insurance and a global sectorial approach. They are working together. The IAIS are committed to keeping version 1 of the enhanced field test approach and version 2. The IAIS appreciate the regulators, stakeholders, industries and all others working to create a level playing field, a better world, and consistent regulation.
5.4.2. Solvency II already signals macro prudential threats and proposes some mitigation tools but supervisors are not familiar with macro prudential issues
A public authority representative acknowledged that that the panel made clear what the main challenges are, and there are a lot of issues. The main challenge for this speaker is to have a clear picture of what they are really discussing regarding macro prudential challenges. Indeed, as a supervisor, they are very familiar with the micro world and know the tools; however, the macro world is still unclear. Solvency II provided the first signals of macro risks in the EU, which are currently being analysed by supervisors.. They are analysing them to understand how they can implement the tools proposed by Solvency II and understand whether it is the right tool itself.
In this context, the supervisors are working well at the IAIS, but still struggling to define what the ultimate goal is. There is therefore a lot of work and progress, but deciding how that will continue and where it will lead to is the main challenge. Once there is a clear understanding, the industry will perhaps have the courage to say that there is no real macro issue, and that they should focus on the micro issue.