News & Articles > EIOPA Consultation Paper (CP17/004) on first set of advice to European Commission on specific items in the Solvency II Delegated Regulation

Overview

In 2016, EIOPA started a review of the Commission Delegated Regulation (EU) 2015/35 (“the Delegated Regulation”), in particular the Solvency Capital Requirement (“SCR”) standard formula, issuing a discussion paper in December 2016. The main aims of this review are to ensure the supervisory regime is proportionate and technically consistent and to ensure proportionate application of the requirements, including the use of simplifications. The responses received to that discussion paper have been analysed and used to help formulate policy proposals from EIOPA.

The first set of these proposals is set out in CP17/004, published on 4 July 2017. These cover seven specific issues, which are discussed in this newsletter. The consultation period has now closed, and EIOPA expects to finalise its advice on the seven items in October 2017. Although the final advice will almost certainly be different to the proposals, and the European Commission will not necessarily act on EIOPA’s advice, this does provide us with clues about likely future changes under Solvency II.

A second set of proposals is expected during 2017 covering other technical issues, including risk margin, premium and reserve risks, catastrophe risks, mortality and longevity risks, counterparty default risk, currency risk for groups, interest rate risks, own funds, unrated bonds and loans, unlisted equity and strategic participations.

Simplified calculations

Assessment of proportionality

In order to use a simplification, an insurer needs to assess the error due to the simplification. The paper makes clear that, if a qualitative assessment shows that the error is immaterial, a quantitative assessment is not necessary. This should reduce the workload for those who had interpreted the regulations differently.

Lapse risk

EIOPA proposes a simplification allowing the calculations under the lapse stress by homogenous risk groups rather than individual policy calculations. However, use of this simplification would only be possible if the insurer could demonstrate that there is no material offsetting of the best estimate liability between policies in the lapse stress. This method would reduce run times.

Mortality risk

EIOPA proposes improving the mortality risk simplification formula to allow capital at risk to vary over time. It also proposes correcting an error in the original formula.

External credit ratings

Under Solvency II (and in other areas), insurers are generally very reliant on credit ratings from External Credit Assessment Institutions (“ECAIs”). In this paper, EIOPA considers possible alternative credit assessments within the standard formula.

Nomination of ECAIs

The consultation paper implies the standard formula requires a credit rating for all assets within a debt portfolio. In order to cover all assets an undertaking will normally need to nominate multiple ECAIs. Some insurers have taken the approach that a reasonable interpretation of the rules is to only cover most of the assets, as to do otherwise would require several ECAI licenses, which would lead to disproportionately high costs. This approach would be taken with the view that they are capturing sufficient risk sensitivity with the coverage provided by the chosen number of ECAIs. Whilst we believe this is a reasonable approach, it is a simplification which is not specifically defined in the Delegated Regulation.

The consultation paper does propose a simplified calculation for spread and credit risk, where only one nominated ECAI would be required and all investments not covered by that ECAI would be assumed to be of credit quality step 3. However, the proposed conditions are:

(1) The nominated ECAI covers most of the portfolio (although “most” is not defined).

(2) The only assets not covered are bonds or similar investments.

(3) The insurer does not provide participating or unit-linked business.

(4) The insurer does not use a matching adjustment.

The simplified calculation would fall under Article 88 of the Delegated Regulation. Therefore, any undertaking making use of the simplification would need to demonstrate that the simplified calculation is proportionate to the nature, scale and complexity of the risks.

Condition (3) means that the simplification could not be used by mutuals or most other life insurers. The reason given for this condition is that EIOPA believes a detailed assessment of investment credit quality is necessary to protect policyholders. We believe this unfairly penalises small mutuals in particular, where the cost of additional ECAIs may outweigh the benefit of knowing the credit quality of all assets rather than, say, 95% of them.

Internal credit assessments

The Delegated Regulation states that all insurers should aim to conduct internal credit assessments for all exposures, but requires it only for larger or more complex exposures. Many insurers with well-diversified vanilla investments have interpreted this as not requiring internal credit assessments. We believe this is the right approach for those insurers where the cost of an internal credit assessment would be disproportionately high, particularly where there is no relevant expertise internally.

EIOPA is aiming to provide guidance on how to develop internal credit assessments, which should help those insurers who do not currently have the expertise to conduct such assessments.

Market-implied ratings and accountancy-based measures

EIOPA has considered the use of market-implied ratings and accountancy-based measures of credit risk, but concluded that these would not generally be appropriate under the standard formula. However, it intends to consider whether such measures might be appropriate for certain asset classes.

Treatment of guarantees

EIOPA particularly considered whether the different treatment of exposures to regional governments and local authorities (“RGLAs”) in the banking and insurance regulations was justified.

• The two frameworks have different lists of RGLAs and EIOPA proposes harmonisation of the lists.

• EIOPA proposes introducing an intermediate treatment of RGLAs equivalent to that under banking regulations, allowing RGLAs not meeting current criteria to be treated as equivalent to non-EEA central government loans of credit quality step 2.

• RGLAs are currently treated differently under the market and counterparty default risk modules - for counterparty default risk, they are assumed to be equivalent to central government exposures. EIOPA proposes the same treatment for market risk. In general, we would expect this to lead to the calculated market risk for RGLAs to be reduced. • EIOPA proposes that RGLA mortgage loans that meet certain criteria should also be recognised as having central government guarantees.

• EIOPA proposes that the counterparty default risk module should recognise unconditional partial guarantees, but that this should not be extended to spread or concentration risk.

Risk-mitigation techniques

The paper considers whether the regulations appropriately define “risk-mitigation techniques” and allow for newer risk mitigation techniques. EIOPA proposes an exposure adjustment to allow for exposure changes due to weekly hedging, allowing some hedges to be recognised in the standard formula SCR.

Various suggestions had been made by stakeholders on changes in relation to longevity risk transfers finite reinsurance, and adverse development covers, but EIOPA did not propose any changes - although later in the year it will consider the issue of the risk margin allowing for reinsurance but not longevity derivatives and other financial instruments.

In order to take account of the use of reinsurance with a reinsurer that has breached its SCR, Article 211(3) of the Delegated Regulations requires insurers to determine if the reinsurer has in place a realistic recovery plan. However, it is difficult for an insurer to know whether its reinsurer has a realistic recovery plan in place. EIOPA proposes allowing recognition of the reinsurance, reduced by the prescribed factors, for up to six months following the breach, although no recognition should be made if it becomes clear that the reinsurer has not submitted a realistic recovery plan or will not rectify the breach within six months.

Look-through approach

EIOPA is planning to consider look-through as a whole in a later consultation paper. This paper considers whether look-through could or should be extended to include holdings in investment related undertakings. One issue is the definition of an investment related undertaking, and EIOPA proposes to define it as a related undertaking (as defined in Article 212(1)(b) of the Directive) that meets the following criteria:

• Its purpose is holding assets on behalf of the (parent) insurance undertaking.

• It supports the operations of the insurance undertaking related to investment activities, following a defined (precise) investment mandate.

• It does not run any other business than investing for the purpose of the parent undertaking (ie pure investment entity).

EIOPA then proposes that using a look-through approach for an investment-related undertaking should be mandatory. This is only likely to affect large insurers who have their own investment subsidiary.

Undertaking specific parameters

EIOPA considered a number of suggestions made by stakeholders in relation to undertaking specific parameters (“USPs”). It rejected most suggestions, but proposed a new method to calculate the adjustment factor for stop loss reinsurance.

Loss-absorbing capacity of deferred taxes

EIOPA reports on the range of methods used to calculate the loss-absorbing capacity of deferred taxes (“LACDT”) and their likely impacts, and summarises the factors that affect the LACDT, but does not propose any changes. However, EIOPA states that such advice may be included in a later consultation paper if deemed appropriate.

EIOPA does provide some comparisons of LACDT relative to SCR and the split of LACDT between that attributable to a current deferred tax liability and other sources, which may be of interest in benchmarking.

Summary

• Final advice on the proposals should be published in October 2017.

• Assuming the advice is as set out in the proposals, then we suggest that firms:

o consider whether any simplifications that it had previously rejected through the amount of evidence it considered to be necessary, would now be worth using, in light of EIOPA’s confirmation that quantitative assessment is not always necessary, and

o consider whether any of EIOPA’s proposed changes would or could apply to them and if so whether they could lead to significant changes in results, processes or timelines.

• Firms may also want to consider whether their current assessment of credit ratings (and in particular use of ECAIs which only a cover a % of the debt portfolio) meets the current regulations.

• A second consultation paper covering other technical advice is due during 2017.