Solvency ii News January 2013


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Solvency ii News January 2013

  1. 1. Solvency ii Association1200 G Street NW Suite 800 Washington, DC 20005-6705 USATel: 202-449-9750 www.solvency-ii-association.comDear member,We are pleased to announce our new:1.Certified Solvency ii Professional (CSiiP)Distance Learning and Online CSiiP_Distance_Learning_Online_Certification_Program.htm2.Certified Solvencyii EquivalenceProfessional (CSiiEP) DistanceLearningand OnlineCertification CSiiEP_Distance_Learning_Online_Certification_Program.htmSolvencyII and legal challenges…EIOPA wantsnational supervisorstoensure that insurancefirms haveinplaceSolvencyII basedriskmanagement, corporategovernance andOwnRisk and SolvencyAssessment (ORSA), well beforethe SolvencyIIdeadline. The interestinglegal challenge:DoesEIOPAhavetheauthorityand thelegal powerto implement earlya regime that hasyet tocome intoeffect, and is not final yet?Theseweekswehave the debateabout how muchcapital insurersshould hold to meet life insurancepolicyguarantees. The EuropeanParliament plenaryvote on Omnibus2 waspushedback toaccommodatethis study and is currentlyscheduledfor June 10.Solvency ii
  2. 2. Sebastian von Dahlen and Goetz von PeterNatural catastrophesand globalreinsurance – exploring the linkagesNatural disasters resulting in significant losseshave become more frequent in recentdecades, with 2011 being the costliest year inhistory.This feature exploreshow riskis transferredwithin and beyond the global insurancesectorand assessesthe financial linkagesthat ariseinthe process.In particular, retrocessionand securitisation allowfor risk-sharingwithother financial institutionsand the broader financial market.While the fact that most risk is retained within the global insurancemarket makestheselinkagesappear small, theywarrant attention due totheir potential ramificationsand thedependencies they introduce.Theviewsexpressedin this article are thoseof the authorsand do notnecessarilyreflect thoseof the BIS, the IAIS or anyaffiliatedinstitution.We wouldlike to thank Anamaria Illesfor excellent researchassistance,and Claudio Borio, Stephen Cecchetti, EmmaClaggett, Daniel Hofmann, Anastasia Kartasheva,Andrew Stolfi andChristianUpper for helpful commentsThephysical destruction caused by severe natural catastrophestriggersaseriesof adverseeffects.Damagedproduction facilities,shatteredtransportation infrastructureandbusinessinterruptionproduceboth direct lossesand indirectmacroeconomiccostsin the form of foregoneoutput (von Peter et al(2012)).Solvency ii
  3. 3. Beyond theseeconomiccostsare enormoushuman sufferingand a hostof longerterm socioeconomicconsequences, documented bythe WorldBank and United Nations(2010).By examining catastrophe-related losses over the past three decades, thisspecial feature explores the linkagesthat arise in the transfer of risk frompolicyholders all thewaytothe ultimatebearer of risk.It describesthe contracts and premiumsexchangedfor protection, andthewayreinsurersdiversify and retain riskson their balancesheets.In sodoing, the feature traceshow lossescascadethrough thesystemwhenlargenatural disastersoccur.Lossesfrom insuredpropertyand infrastructure first affect primaryinsurers,whoin turn rely on reinsurersto absorb peak risks– low-probability, high-impact events.Reinsurers,in turn, usetheir balancesheetsand, to a lesserextent, retrocessionand securitization arrangements,tomanagepeak risksacrosstime and space.[Retrocession takesplacewhen a reinsurerbuysinsuranceprotectionfrom another entity.Securitisation refers tothetransfer of insurance-relatedrisks(liabilities)tofinancial markets.]This global risk transfercreateslinkageswithin the insuranceindustryandbetweeninsurersand financial markets.While securitisation tofinancial marketsremainsrelativelysmall, linkagesbetweenfinancial institutionsproduced throughretrocessionhavenot been fullyassessedasdetaileddata are lacking.Further linkagescan arise whenreinsurersgobeyond their traditionalinsurancebusinesstoengagein financial market activitiessuch asSolvency ii
  4. 4. investment bankingor CDSwriting;the implicationsof thoseactivitiesare beyond the scope of thisfeature.Comprehensive informationis needed tomonitor the entire risk transfercascadeand assessitswiderrepercussionsin financial markets.Physical damage and financial lossesNatural catastrophesresulting in significant financial losseshavebecome more frequent over the past threedecades(Kunreuther andMichel-Kerjan(2009), Cumminsand Mahul (2009)).Theyear 2011witnessedthe greatest natural catastrophe-relatedlossesinhistory, reaching $386billion (Graph 1, top panel).Thetrend in lossdevelopmentscan be attributed in large measuretoweather-relatedevents(Graph 1, bottom right-hand panel).And losseshave been compounded by risingwealthand increasedpopulationconcentration in exposed areassuch ascoastal regionsandearthquake-pronecities.Thesefactorstranslateintogreater insured losseswhereinsurancepenetration is high.At $110billion, insured lossesin 2011came closeto the2005record of$116billion (in constant 2011dollars).Thereinsurancesector absorbed more than half of insuredcatastrophelossesin 2011.This considerableburden on reinsurersreflectedthe materialisationofvariouspeak risks, notablyin Japan, New Zealand, Thailandand theUnitedStates.Thelevel of insuredlossesalsodependson catastrophes‘geography andSolvency ii
  5. 5. physical type.Thebottom panelsof Graph 1show that lossesdue toearthquakes(geophysical events) havebeen lessinsuredon averagethan thosefromstorms(meteorological events).The highest economic losses caused by geophysical events occurred in2011 in the wake of the Great East Japan earthquake and tsunami ($210billion), for which private insurance coverage was relatively low at 17%(lefthandpanel).Droughtscan be even more difficult to quantify and insure.By contrast, the right-hand panel of Graph 1showsthat meteorologicaleventsproduced record lossesin 2005, whenHurricanesKatrina, RitaandWilma devastateda region of the USGulf Coasthaving50% or morein insurancecoverage.Thevolume of insured lossesdifferssubstantiallyacrosscontinents,dependingon theavailability of and demand forinsurance.While overall a slight upward trend can be discerned over the past 10years, the widedispersion in insurancedensity indicatesthat the stage ofa region‘seconomicdevelopment playsan important role(Graph 2, left-hand panel).Residentsof NorthAmerica, Oceania and Europe spend significantamountson non-life (propertyand casualty) insurance, whereasmanypopulouscountriesin LatinAmerica, Asia andAfrica hostunderdeveloped insurancemarkets.Poor countries typically lack thefinancial and technical capacitytoprovideaffordableinsurancecoverage.For example, lessthan 1% of the staggeringeconomiclossesdue toHaiti‘s2010earthquakewereinsured.Solvency ii
  6. 6. Thepattern of insuredlossesthusonlypartly reflectsthe geography ofnatural catastrophes.Sources: Centre for Research on the Epidemiology of Disasters EM-DAT database; MunichRe NatCatSERVICE; authors’ calculations.Solvency ii
  7. 7. NorthAmerica accountsfor thelargest insured lossesassociatedwithnatural disasters(Graph 2, right-hand panel).In 23of the 32years since1980, more than half of global insured lossesoriginatedin the region, though part of this volume wasredistributedthrough global reinsurancecompanies.Asia, Oceania and, toa lesser extent, Latin America sawincreasesincatastrophe-relatedlosseson theback of risinginsurancedensityoverthepast 10years.Correspondingly, thesethree regionsaccount for a rising shareofinsuredlosses.Risk transferNatural catastrophe-relatedlossesare largeand unpredictable.Solvency ii
  8. 8. Theinsured lossesshownin Graphs1and 2reflect recent experience.This section describesthe sequenceof paymentsbased on contractualobligationsthat is triggeredwhenan insured event materialises.One can think of theinsurance market asorganisingrisk transferin ahierarchical way.Lossescascadedown from insuredpolicyholders to the ultimatebearers of risk (Graph 3).When catastrophestrikes, the extent of physical damage determinestotal economiclosses,a largeshare of whichis typically uninsured.Theinsured losses,however,must be shoulderedby the global insurancemarket (Graph 3, light grey area).Thepublic sector, whenit insuresinfrastructure, often doessodirectlywith reinsurersthrough public-privatepartnerships,although more datawouldbe necessarytopin down the exact scope worldwide.Themajorityof the lossesrelate to privateentitiescontractingwithprimaryinsurers,the firms that locallyinsure policyholders against risks.Claimsfor reimbursement thusfirst affect primary insurers.But theyabsorbonlysome of the losses,having ceded (transferred) ashareof their exposure toreinsurancecompanies.Reinsurersusuallybear 55–65% of insuredlosseswhena largenaturaldisasteroccurs.Theydiversify concentrated risksamong themselvesand passa fractionof losseson to thebroader financial market, whileultimatelyretainingmost catastrophe-relatedrisk (seesection below).Solvency ii
  9. 9. Before disaster strikes,however, there isa correspondingpremium flowin exchangefor protection.Basedon worldwideaggregate premium paymentsin 2011, policyholdersand insured entities, both privateand public sector, spent $4,596billion toreceiveinsuranceprotection.Some43% of this global premium volume ($1,969billion) relatestonon-life insuranceand theremainder tolife insuranceproducts(IAIS(2012)).Primary insurers, in turn, paid closeto$215billiontobuy coveragefromreinsurers.Thelion‘sshare, nearly$165billion, camefrom primary insurersactivein thenon-life business.About onethird of this amount, $65billion, wasgeared towardsprotection against peak risks, with $18 billion for specific naturalcatastrophecontracts.By wayof comparison, life insurance companiesspent 2% of theirpremium income, $40billion, on reinsuranceprotection.This comparatively lowdegreeof reinsuranceprotection isdue to thefactthat resultsare typically lessvolatile in life insurancethan in non-lifeinsurance.Followinganyrisk transfer, insurersremain fullyliablevis-à-visthepolicyholder based on the initial contractual obligations,regardless ofwhetheror not the next instancepaysup on the ceded risk.Solvency ii
  10. 10. Reinsurancecompanies, in turn, buy protection against peak risksfromother reinsurersand financial institutions.Solvency ii
  11. 11. In thisprocessof retrocession, reinsurersspent $25billion in 2011tomitigatetheir own downsiderisk.Thebulk of thisamount representsretrocededriskstransferredto otherreinsurancecompanies ($20billion in premiums), whilea relatively smallshareisceded to other market participantssuch ashedgefundsandbanks($4 billion) and financial markets($1billion).An important aspect of thisstructure isthe prefunding of insured risks.Premiumsare paid ex antefor protectionagainst an event that may ormay not materialise over thecourse of the contract.Thesepaymentsbypolicyholders and insurersgeneratea steadypremium flowto insurersand reinsurers,respectively.Onlyif and when anevent withthe specified characteristicsoccursaretheclaims paymentsshown in Graph 3 triggered.At all other times,premium flowsare accumulatedin the form of assetsheld against technical reserves(seenext section).Reinsurancecontractscome in twobasic forms whichdiffer in the wayprimaryinsurersand reinsurersdeterminepremiumsand losses.Proportional reinsurancecontractsshare premiumsand lossesin apredefined ratio.Sincethe 1970s,non proportional contractshave increasinglybeen usedasa substitute.Instead of sharinglossesand premiumsin fixed proportions,bothpartiesagree on theinsured risksand calculate a specific premium onthat basis.Solvency ii
  12. 12. Thetypical non-proportional contract specifiestheamount beyondwhichthe reinsurer assumeslosses,up toan agreed upon ceiling (firstlimit).Depending on the underlying exposure, a primary insurer may decidetobuy additional layersof reinsurancecover, for examplewithotherreinsurers,on top of the first limit.―Excessof loss‖ agreementsare themost common form of non-proportional reinsurancecover.For natural catastrophes,thesecontractsare knownasCatXL(catastropheexcessof loss) and cover thelossexceedingtheprimaryinsurer‘sretention for a singleevent.Amajor earthquake,for example, is likelyto affect the entire portfolio ofa primary insurer, leadingtothousandsof claims in different linesofbusiness,such asmotor, businessinterruption and privatepropertyinsurance.As a result, primary insurersoftenpurchaseCatXL coveragetoprotectthemselvesagainst peak risks.Peak risksand the reinsurance marketAreinsurer‘sbalancesheet reflectsitscurrent and past acceptanceofrisksthrough itsunderwritingactivity.Dealingwith exposureto peak risks, whichrelateto naturalcatastrophes,is thecore businessof thereinsuranceindustry.Natural catastrophesare rootedin idiosyncratic physical eventssuchasearthquakes.When underwritingnatural catastropherisks, reinsurerscan rely toalargeextent on the fact that physical eventsdonot correlateendogenouslyin thewayfinancial risk does.Solvency ii
  13. 13. To achievegeographical diversification, reinsurersoffer peak riskprotectionnot just for one country but ideallyon a worldwidebasis.Another form of diversification takesplaceover time.Premiumsare accumulatedover years, and claimspaymentsare usuallypaid out over the course of monthsor sometimesyears.Graph 4 (left-handpanel) showstheaveragepayout profile for CatXLcontracts.Statisticson reinsurancepaymentsshow that claimsare typically settledover anextendedperiod.On average, 63% of theultimateobligationsare paid withina year and82%within twoyears, and it takesmore than five years after a naturaldisasterstrikesfor thecumulativepayout to reach 100%.Solvency ii
  14. 14. Thepremium inflowsnot immediately usedfor paying out claims areinvestedin variousassetsheld for meeting expectedfuture claims.In thisway, reinsurersbuild specific reserves calledtechnical provisions.Theseconstitutethelargest block of reinsurers‘on-balancesheetliabilities(Graph 4, right-hand panel).Insuredlossesaremet by running downassetsin linewiththesetechnicalreserves.Lossesin any one year typically lead to lossratios(incurred lossesasashareof earned premium) of between70 and 90%.Todetermine whethera reinsurer can withstandsevereandunprecedented(yet plausible) reinsuredevents,regulatorslook forsufficient technical provisionsand capital on the reinsurer‘sbalancesheet.Theoccurrenceof a major natural catastrophedentsreinsurers‘underwritingprofitability, asreflectedin thecombinedratio.This indicatorsetscostsagainst premium income.Acombined ratioabove 100% is not sustainablefor an extendedperiod.By contrast, temporary spikesin the combined ratioare indicativeof oneoff extreme eventswhichcan be absorbed by an intertemporal transfer ofrisk.Thecombined ratiospiked in theyearsfeaturing themost costlynaturalcatastrophestodate(Graph 5, blue line): 2005, the year of majorhurricanesin the US, and 2011, followingearthquakesand floodinginAsia and Oceania.Both occasionsalsoreducedthe stock of assetsreserved for meetingclaims.Solvency ii
  15. 15. Yet thesetemporaryspikesin the combined ratio did not cut through toshareholder equitytoany significant extent.Catastrophesaffect equityonly if lossesexceedthecatastrophereserve.Recent market developmentscausedshareholder equityto decreasemore than insurers‘coreunderwritingbusinessever has.During the global financial crisisof 2008–09,shareholder equity(bookvalue) declinedby 15% (Graph 5, red line), and insurancecompanies‘sharepricesdropped by 59% (yellow line), more than after anynaturalcatastropheto date.In contrast, shareholder equityremainedresilient in 2005and 2011, whenreinsurersweatheredrecord high catastrophelosses.In dealingwiththe consequencesof peak catastropherisks,the industryhasgravitatedtowardsa distinctivemarket structure.One important element isthe size of reinsurancecompanies.Assessing and pricinga largenumber of different potential physicaleventsinvolvesrisk management capabilitiesand transaction costson alargescale.Balancesheet size is thereforean important tool for a reinsurertoattainmeaningful physical diversificationon a global scale.Partly as a result, the 10 largest reinsurance companies account for morethan 40% of the global non-life reinsurance market (Graph 6, right-handpanel).Solvency ii
  16. 16. Solvency ii
  17. 17. In spite of thereinsurancemarket‘ssizeand concentration, failures ofreinsurancecompanies have remained limitedin scope.Thelargest failurestodate, comprising twobankruptciesin 2003, ledtoan essentiallyinconsequential reduction in availablereinsurancecapacityof 0.4% (Graph 6, left-handpanel).That said, any failureof a reinsurer leadsto a lossof reinsurancerecoverablesbyprimary insurers,and could causebroader markettensionsin the event of a disorderlyliquidationof largeportfolios.In thisrespect, the degreeof connectednesswithin the global insurancemarket plays an important role.Basedon their businessmodel, reinsurersenter intocontractswithalargenumber of primary insurancecompanies,giving rise tonumerousverticallinks(Graph 3).In addition, risk transferbetweenreinsurersleadstohorizontal linkages.We estimatethat 12% of natural catastrophe-relatedrisk accepted byreinsurersistransferred withinthereinsurance industry, whichimpliesthat the industry asa wholeretainsmost of therisksit contracts.In 2011, reinsurerspaid 3% of earnedpremiumstocede catastropherisktoentitiesoutsidethe insurancesector.Judgingby premium volume, the global insurancemarket transfersasimilarlysmall share of accepted risk toother financial institutionsandthewider financialmarkets.Linkageswith financial marketsArrangementsdesignedtotransfer riskout of the insurancesectorcreatelinkageswithother financial market participants.Retrocessiontoother financial institutionsusescontractualarrangementssimilar tothosebetweenreinsurers,and commitsbanksSolvency ii
  18. 18. and other financial institutionsto pay out if the retrocededriskmaterialises.Securitisation, on theother hand, involvesthe issuanceof insuranceliabilitiestothe widerfinancial market.Thecounterpartiesare typically other financial institutions,such ashedgefunds, banks, pension fundsand mutual funds.Among insurance-linkedsecurities, catastrophebondsare themaininstrument for transferringreinsureddisaster risksto financial markets.Theexogenousnature of theunderlying risks supportsthe view thatcatastrophebondsprovide effectivediversificationunrelated tofinancialmarket risk.For thesereasons,industry expertshad high expectationsfor theexpansion of the catastrophebond market (eg Jaffeeand Russell(1997), Froot (2001)).Theissuanceof catastrophebondsinvolvesfinancial transactionswithanumber of parties(Graph 7).At the centre is a special purposevehicle (SPV) whichfundsitself byissuingnotestofinancial market participants.TheSPV investsthe proceedsin securities,mostly government bondswhichareheld in a collateraltrust.Thesponsoringreinsurer receivestheseassetsin casea natural disastermaterializesasspecified in thecontract.Verifiablephysical events, such asstorm intensitymeasuredon theBeaufort scale, serve asparametrictriggersfor catastrophebonds.Investorsrecoup thefull principal only if no catastropheoccurs.Solvency ii
  19. 19. In contrast toother bonds, thepossibilityof total lossispart of thearrangement from inception, and iscompensatedex anteby a highercoupon.Solvency ii
  20. 20. Despiteexperts‘high expectations,the catastrophebond market hasremainedrelativelysmall.Bond issuancehasnever exceeded$7 billion per year, limitingtheoutstandingcapital at risk to$14billion(Graph 8).Very few catastrophebondshave beentriggeredto date.The2005Gulf Coast hurricanesactivatedpayoutsfrom only one of ninecatastrophebondsoutstandingat the time (IAIS(2009)).Likewise, the2011Japan earthquakeand tsunami triggeredone knowncatastrophebond, resultingin a payout of lessthan $300million.Payoutsto reinsurersfrom these bondsare small whencompared tothesum of insured losses($116billion in 2005and $110billion in 2011).Theglobal financial crisishasalsodealt a blow to thismarket.Solvency ii
  21. 21. Theyear 2008saw a rapid declinein catastrophebondissuance,reflectinggeneralisedfunding pressureand investorconcernover thevulnerabilityof insuranceentities.Thecrisisalsodemonstrated that securitisationstructuresintroduceadditional risk through linkagesbetweenfinancial entities.Acasein point wasthe Lehman Brothersbankruptcyin September 2008.Four catastrophebondswereimpaired – not duetonaturalcatastrophes,but becausetheyincluded a total return swapwithLehmanBrothersacting asa counterparty.FollowingLehman‘sfailure, thesesecuritizationarrangementswerenolonger fullyfunded, and their market valueplunged.Investorsthuslearnedthat catastrophebondsare not immune to―unnatural‖ disasterssuch asmajor institutional failures.Afurther set of financial linkagesariseswith other financial institutionsthrough cross-holdingsof debt and equity.Insurancecompanieshold largepositionsin fixedincomeinstruments,includingbank bonds.At the same time, other financial entitiesownbondsand stocks ininsurancecompanies.For instance, the twolargest reinsurancecompaniesstatedin their latest(2011) annual reportsthat Warren Buffett and his companies (BerkshireHathawayInc, OBH LLC, National IndemnityCompany) ownvotingrightsin excessof thedisclosurethreshold (10%in one caseand 3.10% inanother).Additional shareholderswithdirect linkagestothe financial sector havebeen disclosedby a number of reinsurancecompanies.Solvency ii
  22. 22. Theramificationsof such linkagesin thispart of themarket aredifficulttoassess.ConclusionThe upward trend in overall economic losses in recent decadeshighlights the global economy‘s increasing exposure to naturalcatastrophes.This development hasled tounprecedentedlossesfor theglobalinsurancemarket, where theycascadefrom the policyholdersvia primaryinsurersto reinsurancecompanies.Reinsurerscopewith these peak risksthroughdiversification, prefunding and risk-sharingwithotherfinancial institutions.This global risk transfercreateslinkageswithin the insuranceindustryandbetweeninsurersand financial markets.While securitisation tofinancial marketsremainsrelativelysmall, linkagesbetweenfinancial institutionsarisingfromretrocessionhavenot been fullyassessed.It is important for regulatorstohave accesstothe data neededformonitoring the relevant linkagesin theentire risk transfer cascade,asnocomprehensiveinternational statistics exist in this area.Solvency ii
  23. 23. EIOPA – Risk DashboardSystemic risks and vulnerabilitiesOn thebasis of observed market conditions, data gathered fromundertakings,and expert judgment, EIOPAassessesthemain systemicrisksand vulnerabilitiesfacedby the European insuranceindustry overthecoming quarterstobe:• Macrorisks:Recessionarypressure in a number of economiesin the EU exemplifythe macro-economicrisks whichare still at an elevatedlevel.Although several important stepshave been taken recentlyboth at theEuropean and national level, uncertaintyremainswithregard to anyremainingimplementation risks.Solvency ii
  24. 24. In addition, thecombination of austeritymeasures,risingunemployment and a prolonged period of subduedgrowthcould havenegativeeffectson insurancedemand.• Credit and market risk:Thetrend of decreasingCDSspreadshascontinued.However, thisdevelopment certainlyisalsodriven by excessliquidity, thedifficult global financial investment environment andinvestors‘riskappetitestriving for an appropriatebalanceof yield versusrisk.Recent changesin asset allocation of European insurersrather hint at areducedrisk appetiteconcerning credit investments.Theytend to shift investmentstowardslessriskiercounterparties,reducingtheir European sovereign and bankingexposure.This indicatesa continuation of a negativeoutlook/ perceptionon thatcredit category.Market risksare still dominated bythe low yield environment with10yearswapratesin Western Europe having again reachednew lowsin thepastmonths.• Stabilisationin life insurance business:Thedecliningtrend in life grosswrittenpremiumshasbeenreversed, however growthratesare still rather subdued.Lapseratesin the samplehave improved from their peak in Q4 2011andremainedstablesincelast quarter.Solvency ii
  25. 25. Use of expert judgmentUse of expert judgment after the mechanical aggregation:• Macrorisk:Slightlyupwardsdue to high heterogeneityin growthfiguresacrossEUcountriesand general uncertaintyabout themedium term growthpotential and itsimplicationsfor the demand of insuranceproducts.In addition, implementationrisksaround thevariouscrisismanagementtoolsused in the sovereigndebt crisisare non negligible.• Credit risk:Slightlyupwardsastheobserved decreaseof themechanistic score isconsideredtoolargegiventhe uncertainmacro outlook, potentiallydistortedbond pricesasa result of excessliquiditywhile at the sameSolvency ii
  26. 26. timeinvestorshave limitedalternativestosubstantiallyreducetheircredit risk exposure.• Market risk:Slightlyupwardsdue to the severe consequencesa prolonged low yieldenvironment could haveon the profitability and solvencyof theinsurancesector.Improvementsin other indicators,e.g. equityrisk, arenot considered tomake up theeffectsof recentlyobserved new historic lowsin 10_yearswaprates, giventhe on averagesmall equityinvestmentsof insurers.• Liquidity&funding:Slightlydownwardsasthe increaseof the mechanistic score is solelydriven by low issuancevolume of cat bondsin Q3 whichisseasonallydriven and isalready pickingup substantiallyin October and November.Other indicatorsremained stable.• Insurancerisk:Slightlyupwardsdue to reducedbuffersof reinsurersfor catastrophelossesafter HurricaneSandy and potential price hikes in upcomingrenewals,whicharenot reflected in Q3 figuresyet.In addition, insurers‘businessmodel might be impacted in a lowyieldenvironment whenlowerinvestment returnscannot counter balancepotential underwritinglosses.Solvency ii
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  30. 30. Sovereign risk – a world without risk-free assetsPanel commentsbyMr PatrickHonohan, Governor of theCentral Bank ofIreland, at the BISConferenceon―Sovereign risk – a worldwithout risk-freeassets‖,Basel,8January2013.What‘snew about sovereignrisk sincethecrisisbegan?Conceptually, not somuch, I wouldsuggest – and nothingthat cannotbefullyexplainedwithinstandard modelsof finance.But in practice, and in particular in theeuro area, twolinkedelementsthat werealwayspotentiallypresent or implicit have leapt intoprominencein a wayand toan extent that wasnot foreseen.Thefirst isthat marketshave begun to price default risk in a sovereign‘shome-currency;Thesecond is the contamination of the functioningand economiceffectivenessof banks by theweakcredit rating of their sovereigns(aswell asvice versa).I have to admit to the possibility that my remarks may be subject tosome professional deformation here, in that my perspective on thesematters is likely coloured by my pre-occupation with the situation inIreland.Ireland hascertainlydisplayed thesetwoelementsin a dramaticway, buttheyare evidentlypresent in half a dozen other euroareacountriesalsoandtoan extent whichhashad implicationsfor the functioningof theEurosystem asa whole, and thereforeon the global financial system.Solvency ii
  31. 31. Let me take thesetwopointsin turn.First the pricing-inof sovereigndefault risk in ―home currency‖.Why did the default premium suddenly emerge?Evidently, even though everyone understood the rules, nosuch pricing-in occurred for the first decade of theEurosystem (Figure 1).Riskappetitewashigh for much of that period, but the market‘sperception of sovereign risk must alsohaveremained low.(Perhaps,despiteTreatyprohibitions,market participantsassumedthatanysovereign that got intotroublewouldbe bailed-out).Indeed, sovereign spreadsin the euro area werealmost totallyinsensitivetocredit ratingsbefore the crisis(Figure 2).One often-heard interpretation of what happened during that decade isthat the complacent market environment relaxed the budget constrainton euro-areasovereignsand ledthem toborrow recklessly.Actuallythis story doesn‘t fit the factsvery well.After all, although sovereign debt ratiosin most of the Eurosystem didnot fall asmuch astheycould and should have on thegood years, atleast theydid not increasedramaticallybeforethecrisis(Figure 4).(Private debt ratios, and in particularthesize of the bank and near-banksystems did increase, but that is a somewhat different story, towhichIwill turn shortly).It‘s possiblealternativelythat there wasa multipleequilibrium here, withthe―good‖ or lowinterest equilibrium (with a self-fulfillingdegreeofconfidencein the creditworthinessof all thesovereigns) beingselectedbythemarket at thestart of theeuro, and eventsduring thefinancialSolvency ii
  32. 32. crisis– not least thoseassociated withGreece– havingtrippedthesystem intothe ―bad‖ or high interestequilibrium with default riskpremia moving a number of sovereignsinto a more challengingdebtsustainability position.Most likely, what wehave seen is a combination of factors:(i)a sharp reductionin risk appetite resultingin even little-changeddebtratios, asin Italy, lookingmore challengingand in need of a risk-premium;and in addition(for most countries)(ii)a sharp increasein debt ratiosasgovernmentsreacted tothecrisis(including, but not at all confined to, thesocialisationin most countriesof some privatebanking lossesthrough their assumption bygovernments) (Figure 4 again).Theincreasedsensitivityof sovereign spreadstoratings, and theincreasedrangeof ratingsthemselves– both illustratedin Figure 2 –suggest that both factorsare at work.(As spreadswidenedin stressedcountries,their fluctuations– whichwouldnot concernhold-to-maturityinvestors– added a risk factor forothersand probablyratchetedup the averagelevel of the spreads.)In the specific caseof Ireland, the depth of the recession and theremarkablyhigh elasticityof tax revenuesand the Government deficit tothedownturn, combined with theunfortunate decision to lock-in a verycomprehensivebank guarantee beforethepotential scaleof the bankinglossescould at all be appreciated, meant that Ireland‘sactual andprospectivegeneral government debt made a shockingturnaround fromabout 25per cent of GDP in 2007to 117per cent just five yearslater.Historianswill debatethe exact triggersfor the market‘slossofconfidencein the Irishsovereign.Even aslate asApril 2010,after the first samplingindicated the scaleofthe banking losses, sovereign spreadswerelittlemore than 1per cent.Solvency ii
  33. 33. By November of that year (just a few weeksafter the Deauvillestatementwhichpersuaded themarketsthat private sector holdersof euro sovereigndebt wouldnot be immune from loss-sharing) largebankingoutflowsandspreadsexceedingfiveper cent made recoursetoofficial assistanceinevitable.(Figure 3 showstheplot withsome relevant newsstories flagged).Perhapsthemost significant take-awayfrom thesequenceof spikes andtroughsis thefact that some of them clearlyrelate to newsthat iscountry-specific, some of them to euro area general news.Thesame is doubtlesstrue for all of the stressedsovereigns.Default risk vs. devaluation risk vs. redenomination riskIt‘s worthpausing torecall that raw sovereign spreadssuch asweareseeingtoday in theeuro area are not remotely unprecedentedin pre-eurohistory.On thecontrary, theywerethenorm asisillustrated by Figure1.Thedifferenceisthat thesespreadsreflecteda combination of defaultrisk and currency risk.During the last fiscal crisisof the 1980sIrish sovereign spreadsballoonedout also.But that wasfor local currencydenominateddebt.Eurobond borrowingby the Irish Government remained at fairlytightspreadsdespite thehigh overall debt ratio(higher than today), and thefact that almost half of thenational debt wasdenominatedin foreigncurrency.Thehigh spreadsreflecteddevaluation expectationsand currencyriskgenerally.Solvency ii
  34. 34. And there weredevaluations,though lessthan wasbaked intothespreads– bybetween250and 300basispointson averageduring thelast tenyears of that ill-fatedregime, thenarrow-bandEMS.It is not that default and devaluation are closesubstitutes;not at all, andfor several reasons.For onething, default haspotential reputational consequencesfor theissuer qualitativelydifferent tothoseof devaluation.In addition, though, devaluation affectsnot onlythe international valueof the Government‘sdebt promises,but alsothat of all other contractsdenominatedin local currency; asa result, dependingon thespeedofprice-resetting(pass-through) it can affect competitivenessthroughouttheeconomy.Thesedifferenceshave not been sufficientlyemphasised, I feel, in recentdiscussion.As an example, I could mention the Irish devaluation ofAugust 1986.Themain goal of thisimportant action wasrestoration of wagecompetitiveness,not a loweringof the real value of the localcurrency-denominateddebt.(Indeed, I recall that somedomestic policymakers wereconfused onthispoint and thought that the debt burden wouldactuallyincreaseasa resultof translationeffect on the foreign currencydebt!)Such currency risk can be so extreme asto make it impossible for thesovereign to issue any sizable amount of local-currency denominateddebt tointernational lenders.In the literature,such countries – all in the developingworld(and notincludingIreland, cf. Figure 5) – weresaid to suffer from ―Original Sin‖.Solvency ii
  35. 35. Happily, thenumber of countries suffering―Original Sin‖ hasbeendiminishingin recent years.Instead, wehave to acknowledgetheemergencein market pricingof anew phenomenon, ―redenomination risk‖.How can werecogniseredenomination risk?This is not straightforward,not least becausethe term could refer toanumber of different scenarios.One suggestedwayof approachingthequestion isto useeconometricestimatesof thecross-sectional determinantsof sovereign spreadsforforeign currency-denominated borrowingto predict current spreadsinstressedeuro area countries:a positiveresidual might suggestaredenominationrisk premium.Comparisonsof current spreadsof euro area sovereignsin euroand inforeign currency-denominated borrowingsprovidesfor an alternativeapproach.My ownfavourite approach is tolook at the co-movement in the timeseriesof euro area country spreads.Someof thisco-movement can be attributedtofluctuationsin marketrisk-appetite;the remainder could be interpreted asa system-wideredenominationpremium.This brief summaryalready suggeststhecomplexityand ambiguityofsomeof theconceptsinvolved and their measurement.Evidently, redenomination risk, as imagined by marketcommentators, combines default and currency risk in a novel way notcontemplatedbythe Treatythat establishedthe euro area.Solvency ii
  36. 36. TheECB hasmade clear its determinationto dowhat isnecessarytopreservethe euro and removeunfounded euro break-up premia insovereign yields.TheOMT, designed asa backstop to inhibit negative self-fulfillingmarket dynamics, providesthenecessarytools to deliver on thatcommitment.Theprogrammedoesnot gooverboard in thedirection of removing theincentivefor governmentstomanagetheir financesin such a wayastorecover and retain theconfidenceof themarket, but it will ensure thatdisciplinedgovernmentswill not have to pay spreadsthat could onlyreflectmarket concernsabout a system break-up.As announced, theECB will only buy bondsat theshorter end of thematurityspectrum, but the OMT can beexpectedtohave an influencetransmittedbymarket forcesthroughout theyield curve, and indeedspreadshave tightenedright acrossall maturitiessincethe OMT wasannounced.Still, it is not tobe expectedthat theOMT will by itselfrestore the tightuniformityof spreadsthat prevailed for the first decadeof the euro.Forcingsuch a tight uniformitywouldnot be generallyconsidered safeabsent more reliablealternativemechanismsfor ensuring disciplinedfiscalpolicy in the countriesconcerned.Morelikely wouldbe a potentiallyextendedperiod of sovereign spreadsthat, albeit narrowerthan at their worst, remain material.Sovereign spreadsand the banksThat beingso, weneed toaskwhat are the consequencesof thesespreadsfor the restof the economy, and in particular for theoperation ofthebanking system.Solvency ii
  37. 37. Regardlessof the condition of thebalancesheet and the profit and lossaccount of the banks, experienceshowshowhard it is for banks in ajurisdictionwherethesovereign isunder stresstoaccessthemoneymarketson the finest terms.In essence, themarket fearsthat a stressed sovereigncould in extremisreachtothe banksasa sourceof last resort financing– if necessaryusingnational legislationto doso.From such a perspective, providersof fundsto bankswill tend to price-inthepossibility that, at the margin, they could end up asindirect providersof fundstoa stressed sovereign.There aremanyexamplesin historyof this happening, and theconsequencesfor bank fundingcostshave often been severe.In other words,while wehave all become sensitisedtothe pressurewhichsocializedbankinglossescan placeon thesovereign, marketsarealsoacutely awareof thepotential damaginglinksin the other direction.Either way, there areconsequencesfor the funding costsof both thesovereign and the banks.Given the scaleof banking in the euro area, even a relativelysmalldifferencein fundingcostscan be consequential.Once again, the Irish situation dramatises what can happen when thetwo-way feedback loop between banks and sovereign causes a loss ofaccessto risk-freerates.As is well known, the Irish banks have suffered severe loan lossesin theaftermath of the bursting of the property price and construction bubblewhichtheyhad soenthusiasticallyfinanced.Very sizablecapital injections(about 50per cent of GNP from theIrishGovernment alone– a sum whichprovedtoogreat to befinancedwithout theprotectionof an IMF programme) haveensuredthat theSolvency ii
  38. 38. Irish banksmore than satisfy regulatoryrequirementsonce again, buttheir future profitabilityis constrained by theemergenceand likelypersistenceof the sovereignspreads,and the knock-on effect of thespreadson thebanks‘funding costs.Euro-arearisk-freeratesare not now themost relevant indicator of themarginal cost of fundstothe Irish banking sector.It is, of course, true that the Irishbanks(like thosein other stressedcountries) have beendrawingheavily on ECB refinancingfacilitiesduring thecrisis, especiallyfollowingthe huge outflowof fundsthatoccurred in early2009and again in the last few monthsof 2010.This accessto refinancinghasbeen vital tothe continuingoperationof the bankingsystem, and it hascome at the policyrate.(Let me mention asan asidea curiousfeature of thecurrent monetarypolicy environment in the euro area.Thetwokey ECB rates– the main refinancingoperationsrateand thedeposit rate – are 75 basispointsand zero, respectively.Accesstoboth therefinancing and deposit facilitiesare both closeto all-timehighs.But in practice, the bulk of the refinancingis goingto banksin thestressedcountries,while thebulk of thedepositsare placed by banks innon-stressedcountries.Tothe extent that thestressed countrieshavetendedto have weakereconomicperformanceduring the crisis, thispattern might beconsideredparadoxical.But it is of course a reflectionand semi-automatic consequenceof thefragmentationwhichhasdeveloped in the euro area.Solvency ii
  39. 39. Tobe sure, the ECB policy rateis clearlybelow themarginal cost offundsin the stressedcountries.)But accessto ECB fundsat thepolicyrate is limitedby the availabilityofeligiblecollateral and thehaircutsthat are appliedtosuchcollateral(despitethe relaxation of eligibilitycriteria).About 20 per cent of thetotal financingof the three going concern Irishcontrolledbankscomesfrom this sourceat present (16per cent of thebalancesheet total).Competition for depositsthereforeremainsstrong and rateshigh.It‘s not just that higher bank funding costswill now be passedon tonewborrowers,addingheadwindstotheeconomic recovery, though that iscertainlya factor.Indeed, the lowerpolicy interest ratesset by theECB sincethecrisisbeganhave only been partlytransmittedtoborrowersin Ireland and intheother stressedeuro area countries(Figure 6).(As is seen by the resultsof a recursive regression exercise, the pass-through from policy rate to Irish residential mortgage SVR rates hashalved sincethestart of the crisis– Figure7.)Someof thiscan be rationalisedasreflectinga higher credit risk-premium beingcharged by thebanks, but some isalsoduetothehighermarginal cost of funds.Worsestill for thehealth of the banks, and their ability tocontributetotheeconomic recovery, is thefact that theyare still copingwiththeconsequencesof their marginal cost of fundshavingdelinked sosizablyfrom theECB policyrate.Theseconsequencesarise becauseof thelong-term mortgagecontractsthebanks made when theyassumed that their marginal costof fundswouldalwaysremain closetothe (risk-free) policy rate.Solvency ii
  40. 40. Suffice it to saythat a largeblock of residential mortgageswasgranted atinterest rateswhichtrack the ECB policy rate plusa very lowspread.Thesetracker mortgages,many of whichhave an averageremainingmaturityof 15–20years or more, yield lessthan themarginal cost of funds(Figure 8 whichis drawnon the assumption, not strictlyvalid, that theaveragespread of the trackersover policy rate wasunchangedover time).In effect, by assumingthat their cost of fundswouldnot deviatemuchfrom theECB policyrate, thebanks exposedthemselvesto a very large―basisrisk‖.In principle, theycould escapethis trap if there werea willingpurchaser(publicor private) withaccesstofundingat a cost that isnotcontaminatedby thesovereign stress.Until such a purchaser comesforward, thebankswill have to continuetofund this portfolio at a loss, even on performingmortgages, whose effectswill spill over ontotheir customersand their owners(not leasttheState).ConclusionIrish Sovereign spreadsmay no longer bebloated by redenominationrisk, but at 300basispointsat thelong-end, theydoseem toreflect acredit risk premium that is poor reward, sofar, for what hasbeen asizablefiscal adjustment effort.Reflectingon wherewehave got to, it seemsthat there aredistinctparallelswiththe fiscal crisisof the EMS period.As I mentioned, spreads (then reflectingdevaluation risk) exceededwhatwouldhave been needed ex post tocompensatefor actual exchangeratemovementsbyalmost thesame amount (250–300basispoints).Solvency ii
  41. 41. Thosespreadsweretransmittedtothe bankingsystem thenalso.TheIrish financial situationis relatively extreme, and assuch illustratesclearlysome of the key problemsthat have been facedalsoin otherstressedpartsof theeuro area.While it hasdelivered a much lowerinflationrate, theeuro is nolongerinsulatingfinancial marketsfrom the impact of excessivedebt inmember countries.Theearlyinsulationof themonetarytransmissionmechanism fromfiscalproblems of participatingcountrieshas wornthrough.Theperniciousfeedback loop from banksto sovereign and fromsovereignto banksthat re-emerged in thecrisisremainsstrong anddamaging.Gettingback to the―good‖ equilibrium will require ahealingprocesswhichremovesthemarket‘sfear of default.It is inevitablya protracted processneedingnot only firm adherencetoconsistentlydisciplinedpoliciesbut alsothe creationof institutionsthatcan prevent future crises,or at least copewith them better if theycannotbeavoided.Solvency ii
  42. 42. Solvency ii
  43. 43. Solvency ii
  44. 44. Solvency ii
  45. 45. Solvency ii
  46. 46. Solvency ii
  47. 47. Solvency ii
  48. 48. Report from theCommissiontothe European Parliamentandthe CouncilThe review of theDirective 2002/87/EC of the European Parliament and theCouncil on the supplementary supervision of creditinstitutions, insurance undertakingsand investment firms in afinancial conglomerate1.Introduction and Objectives1. BackgroundTherapid development in financial marketsin the1990sledtothecreationof financial groupsprovidingservicesand productsin differentsectorsof the financial markets, theso-calledfinancial conglomerates.In 1999, the European Commission‘sFinancial ServicesAction Planidentifiedtheneed tosupervisetheseconglomerateson a group-widebasisand announced the development of prudential legislationtosupplement thesectorallegislationon banking, investment andinsurance.Thissupplementaryprudential supervisionwasintroduced by theFinancial Conglomerate Directive(FICOD) on 20November 2002.TheDirective followsthe Joint Forum‘s principleson financialconglomeratesof 1999.Thefirst revision of FICOD (FICOD1) wasadopted in November 2011followingthe lessonslearnt during thefinancial crisisof 2007-2009.FICOD1 amended the sector-specific directivesto enablesupervisorstoperform consolidated banking supervision and insurancegroupSolvency ii
  49. 49. supervision at the level of theultimateparent entity, even wherethatentityisa mixed financial holding company.On top of that, FICOD1 revisedthe rulesfor theidentificationofconglomerates,introduceda transparencyrequirement for the legal andoperational structuresof groups,and brought alternativeinvestmentfund managerswithinthe scope of supplementarysupervision in thesamewayasasset management companies.FICOD1‘sArticle 5 requiresthe Commissiontodeliver a review reportbefore31December 2012addressingin particularthescope of theDirective, the extension of itsapplicationto non-regulatedentities,thecriteria for identificationof financial conglomeratesowned by widernon-financial groups, systemicallyrelevant financial conglomerates,andmandatorystresstesting.Thereview wasto befollowedup by legislative proposalsif deemednecessary.It should be noted that sincetheadoption of FICOD1 some issues,suchasaddressingsystemic importanceof complex groups, and recovery andresolution toolsbeyond the livingwillsrequirement in FICOD1havebeenor will be resolvedin other contextsand have thereforebecome lessrelevant for this review.1.2. The purpose of the review and the Joint Forum‘s revisedprinciplesThis review isguided by theobjectiveof FICOD, which is toprovide forthe supplementarysupervision of entitiesthat form part of aconglomerate, witha focus on the potential risksofcontagion, complexityand concentration — theso-calledgroup risks—aswell asthe d et ect ion and correct ion of ‗d ou b le gearin g‘ —themultipleuse of capital.Thereview aimstoanalyse whetherthecurrent provisionsofSolvency ii
  50. 50. FICOD, in conjunction withtherelevant sectoralruleson group andconsolidatedsupervision, areeffectivebeyond theadditional provisionsintroduced by FICOD1.Thereview is justifiedasthemarket dynamicsin which conglomeratesoperatehave changed substantiallysincetheDirective entered intoforcein 2002.Thefinancial crisisshowed how group risksmaterialisedacrosstheentire financial sector.This demonstratesthe importanceof group-widesupervision of suchinter-linkageswithinfinancial groupsand among financialinstitutions,supplementingthesector specific prudential requirements.Thelimitedapproach of FICOD1 waspartiallybasedon the anticipationof the Joint Forum‘s revisedprinciples,whichweredue to beaddressedin thepresent review.Theseprincipleswerepublishedin September 2012withthetwomainissuesbeingthe inclusionof unregulatedentitieswithin thescope ofsupervision to cover the full spectrum of risks to whicha financial groupis or may be exposed and the need toidentify the entityultimatelyresponsiblefor compliancewiththe group-wide requirements.This review takesthe revisedprinciplesduly intoaccount together withtheevolving sectoral legislationaspresented below.1.3. Evolving regulatory and supervisory environmentFICOD rulesare supplementary in nature.Theysupplement therulesthat credit institutions,insuranceundertakingsand investment firms aresubject toaccordingto therespectiveprudential regulations.Solvency ii
  51. 51. Currentlythis sectoral legislationisbeingoverhauledin a major wayandtheregulatoryenvironment is evolving.TheCRD IV and OmnibusII are pending proposalsbeforetheEuropean Parliament and the Council, and Solvency II includesenhancedgroup supervisionprovisionswhich arenot yet applicable.Once theseprovisionsare applicable, the Commission will closelymonitorthe implementationof these new frameworks,which alsocomprise a number of delegated and implementingacts, includingregulatorytechnical standardsto be developedover a number of years bythe Commission and theEuropean supervisoryauthorities(ESAs).In addition, thechangesrecentlymade toFICOD will not bein placebeforemid-2013,socannot yet be fullyexamined in practicebeforelate2014.Theseincludethe regulatoryand implementingtechnical standardsandcommon guidelinestobe issued by theESAs.Finally, the BankingUnion Regulation proposal callsfor a major changein thesupervision of Europeanbanksand will have an impact on thesupervision of conglomeratesasone of the tasksconferred totheEuropean Central Bank wouldbe to participatein supplementarysupervision of a financial conglomerate.As this report shows, there are areasof supplementarysupervision whereimprovementscould be made.However, as with any legislation, the benefits of amending legislationalways have to be weighed against the costs connected with legislativechanges.Accordingtothe European Committee on Financial Conglomeratesat itsmeetingon 21September 2012,the supervisorycommunitythrough theESA‘sadvice to theCommission, and theindustry in itsresponsesto theconsultationcarried out by theCommission, the optimal timing forSolvency ii
  52. 52. revisingFICOD will only be oncethe sectoral legislationhasbeenadopted and is applicable.2.The Scope of the Directive and the Legal Adressees of theRequirements1. Scope1.The scope of FICOD and the sectoral legislationMost of thegroupsoperatingin the financial sector have a broadspectrum of authorisations.Focusingon the supervisionof onlyone type of authorised entity ignoresother factorsthat may have a significant impact on the risk profileof thegroup asa whole.Fragmented supervisoryapproachesare not sufficient to cope with thechallengesthat current group structuresposetosupervision.Thesupplementarysupervision framework for conglomeratesis meanttostrengthen and completethe full set of rules applicableto financialgroups,acrosssectorsand acrossborders.However, from a regulatory standpoint, additional layers of supervisionhave to be avoided when the sectoral requirements already cover all thetypesof risk that may arise in a group.2.Coverage of unregulated entities, including those notcarrying out financial activitiesIn order toaddressgroup risks,whichwasthe original aim of FICODandtheJoint Forum principles,asre-affirmedby the revisedprinciples,group supervision should cover all entitiesin the group whicharerelevant for the risk profile of theregulatedentitiesin thegroup.Solvency ii
  53. 53. This includesanyentitynot directlyprudentiallyregulated, even if itcarriesout activitiesoutsidethe financial sector, includingnon-regulatedholdingand parent companiesat thetop of the group.Each unregulated entitymay present different riskstoa conglomerateand eachmay require separate considerationand treatment.Among unregulatedentities,special importanceis attachedtospecialpurpose entities(SPEs).Thenumber of SPEsand thecomplexityof their structuresincreasedsignificantlybeforethefinancial crisis, in conjunction with thegrowthofmarketsfor securitisationand structuredfinanceproducts,but havedeclinedsincethen.While theuse of SPEs yieldsbenefits and may not be inherentlyproblematic, the crisis hasillustrated that poor riskmanagement and amisunderstandingof the risksof SPEs can lead todisruptionand failure.Theneed for enhancedmonitoring of intra-grouprelationshipswithSPEs washighlightedin the Joint Forum‘s2009SPE report.2.1.3. Coverage of systemically relevant financial conglomeratesThechallengesof supervisingconglomeratesare most evident forgroupswhosesize, inter-connectednessand complexitymake themparticularlyvulnerableand a sourceof systemic risk.Any systemically important financial institution (SIFI) should in the firstplacebe subject to more intensesupervisionthrough application of theCRD IV and SolvencyII framework, both at individual and group/ consolidatedlevel.If the SIFI is alsoa conglomerate, supplementarysupervisionunderFICOD wouldalsobe applicable.Solvency ii
  54. 54. Although most SIFIsare conglomerates,thisis not alwaysthecase.Also, systemic risksare not necessarilythesame asgroup risks.Therefore, it doesnot seem meaningful totry tobring all SIFIsunderFICOD.Furthermore, discussionsat international level are still continuing oninsuranceSIFIs, and the sectoral legislation, includingthe treatment ofbankingSIFIs, is not yet stable.2.1.4. Thresholds for identifying a financial conglomerateAll theissuesmentioned above are linkedto thedefinitionof aconglomerateand the thresholdsfor identifying one.Thetwothresholdsset out inArticle 3of FICOD take intoaccountmaterialityand proportionalityfor identifying conglomeratesthat shouldbesubject tosupplementarysupervisionof group risks.Thefirst threshold restrictssupplementarysupervision to thoseconglomeratesthat carryout businessin the financial sector and thesecond restrictsapplicationtoverylargegroups.Thecombined applicationof the twothresholdsand the use of theavailablewaiverby supervisorshave led toa situation wherevery bigbankinggroupsthat are alsoseriousplayers in theEuropean insurancemarket are not subject to supplementary supervision.Furthermore, the wordingof the identificationprovisionmay leaveroomfor different waystodeterminethe significanceof cross-sectoralactivities.It couldbe improved to ensure consistent application acrosssectorsandborders.Solvency ii
  55. 55. Toensure legal clarity, it is important tohaveeasilyunderstandableandapplicablethresholds.However, the question remainswhetherthethresholdsand thewaiversshould be amendedor complementedtoenablesupervisionin aproportionateand risk-basedmanner.2.1.5. Industrial groupsowning financial conglomeratesWhile there is agreement that regulatedfinancial entitiesareexposed togroup risksfrom thewiderindustrial group towhichtheymightbelong,no conclusion can be drawnat thisstageasto how to extend theFICOD requirementstowidernonfinancial groups.TheFICOD1 review clauserequired the Commissionto assesswhethertheESAsshould, through the Joint Committee, issueguidelinesforassessment of thematerial relevanceof the activitiesof theseconglomeratesin the internal market for financial services.Currentlythere isnolegislationon thesupervision of industrial groupsowningfinancial conglomeratesand theESAshave noempowerment toissueguidelines.Therefore, whilethe ESAswill certainlyplaya keyrolein ensuring theconsistent application of FICOD, it is premature toreach anyconclusionson theneed for theESAsto issueguidelineson this specifictopic.2.2. Entities responsible for meeting the group-levelrequirementsImposingrequirementsat group level will not ensurecomplianceunlessthisis accompaniedby clear identificationof the entityultimatelyresponsiblein the financial group for controllingriskson a group-widebasisand for regulatory compliancewithgroup requirements.Solvency ii
  56. 56. This would allowmore effectiveenforcement of therequirementsby thesupervisoryauthorities(discussed in section 4below).Interaction withcompany law provisionsgoverningthe responsibilitiesof the ultimatelyresponsibleentityneedsto be takenintoconsideration.This ultimateresponsibilitymight need to be extendedtonon-operatingholdingcompaniesat the head of conglomerates,even though a limitedscopemay be envisagedfor thoseholding companieswhoseprimaryactivityis not in thefinancial sector.3.Provisions Needed to Ensure the Detection and Control ofGroup RisksTheobjectiveof supplementarysupervisionis todetect, monitor, manageand control group risks.The current requirements in FICOD concerning capital adequacy(Article 6), risk concentrations (Article 7), intra-group transactions(Article 8) and internal governance (Articles 9 and 13) are meant toachievethisobjective.Amongst other criteria, theyshould be assessedagainst theneed tostrengthen the responsibilityof the ultimate parent entityofconglomerates.1. Capital (Article 6)Thecapital requirementsfor authorisedentitieson a stand-aloneandconsolidatedbasisare definedby thesectoral legislation dealingwiththeauthorisationof financial firms.Article 6 of FICOD requires supervisorstocheck the capital adequacyofa conglomerate.Solvency ii
  57. 57. Thecalculationmethodsdefined in that Article aim to ensurethatmultipleuseof capital is avoided.The JCFC‘s Capital Advice from 2007 and 2008 revealed a wide range ofpractices among national supervisory authorities in calculating availableand required capital at the level of the conglomerate.Thedraft regulatorytechnical standard (RTS) developed under FICODArticle 6(2), publishedfor consultationon 31August 2012,specifiesthemethodsfor calculatingcapital.Thetechnical standard is expectedtodeal sufficientlywiththeinconsistent useof capital calculationmethodsfor thepurposeofregulatorycapital requirementsand toensure that onlytransferablecapital is counted asavailable for the regulated entitiesof the group.Indeed, asthisRTS should ensure a robust and consistent calculationofcapital acrossMember States,when negotiatingtheCRD IV proposal, itappearedthat nochangestoFICOD toaddressBaselIII objectivesregardinga potential double countingof capital investmentsinunconsolidatedinsurance subsidiarieswerenecessary.However, the discussionsaccompanying thedevelopment of thistechnicalstandard revealed further concerns regarding group-widecapital policy.Supervisorssometimeslack insight intothe availability of capital at thelevel of theconglomerate.This could be addressed by requestingthe supervisoryreportingandmarket disclosure of capital on an individual or sub-consolidated basisinadditiontothe consolidatedlevel.Solvency ii
  58. 58. 2.Risk concentrations(Article 7) and intra-group transactions(Article 8)Articles7 and 8 on riskconcentrationsand intra-group transactionssetout reporting requirementsfor undertakings.Combined withthe potential extensionof supervision to unregulatedentitiesand identificationof the entityultimately responsibleforcompliancewith FICOD requirements,includingreportingobligations,theserequirementsshould providean adequate frameworkfor supplementarysupervisionwithregard torisk concentrationsandintra- group transactions.Theguidelinestobe developed by ESAs, asrequested byFICOD1, should ensure that the supervision of risk concentrationsandintra-grouptransactionsis carried out in a consistent way.3. Governance (Articles9 and 13)Given the inherent complexityof financial conglomerates,corporategovernanceshould carefullyconsider and balancethe combinationofinterestsof recognizedstakeholdersof the ultimateparent and the otherentitiesof thegroup.Thegovernancesystem should ensurethat a common strategy achievesthat balanceand that regulatedentitiescomplywithregulation on anindividual and on a group basis.FICOD, asamended, containsa requirement for conglomeratestohavein placeadequate risk management processesand internal controlmechanisms, a fit and proper requirement for thosewhoeffectivelydirectthebusinessof mixed financial holding companies,a ‗livingwill‘requirement, a transparencyrequirement for the legal and organisationalstructuresof groups, and a requirement for supervisorstomake the bestpossibleuseof the availablegovernancerequirementsin CRD andSolvencyII.Solvency ii
  59. 59. CRD III and theproposal for CRD IV require, aswill SolvencyII, furtherstrengtheningof corporategovernanceand remuneration policy followingthelessonslearnt during the crisis.Thelivingwill requirement in FICOD1 wouldbe strengthenedby theBank Recovery and Resolution Framework.What these frameworksdonot yet cover is the enforceableresponsibilityof the head of the group or therequirement for thislegal entityto bereadyfor any resolution and toensure a sound group structure and thetreatment of conflictsof interest.TheBank Recovery and Resolution Framework wouldrequire thepreparation of group resolution planscoveringthe holding companyandthe banking group asa whole.4. Supervisory Tools and Powers1.The current regime and the need to strengthen supervisorytools and PowersArticle 14 enablessupervisorstoaccessinformation, alsoon minorityparticipations,whenrequired for supervisorypurposes.Article 16 empowersthecoordinatortotake measureswithregard to theholdingcompany, and the supervisorsof regulated entitiestoact againsttheseentities,upon non-compliancewithrequirementsconcerningcapital, risk concentrations,intra-grouptransactionsand governance.TheArticle only refersto ‗necessarymeasures‘to rectify thesituation, but doesnot specify such measures.OmnibusI gavetheESAsthe possibilitytodevelop guidelinesformeasuresin respect of mixed financial holdingcompanies,but theseguidelineshave not yet been developed.Solvency ii
  60. 60. Article 17 requires Member Statesto provide for penaltiesor correctivemeasuresto be imposed on mixed financial holding companies or theireffectivemanagersif they breach provisionsimplementingFICOD.TheArticle alsorequires Member Statesto confer powerson supervisorstoavoid or deal with the circumvention of sectoral rulesby regulatedentitiesin a financial conglomerate.ThewordingofArticle 16and the lack of guidelineshave led to asituation wherethereis noEU-wideenforcement frameworkspecificallydesignedfor financial conglomerates.As a result, the supervisionof financial conglomeratesis sectorallybasedwith differencesin national implementation.Furthermore, the ESAs point out that strengtheningthesanctioningregimeasadvocatedin the CRD IV proposalmay createan unevenplaying field betweenfinancial conglomeratesdepending on whethertheyare bank or insurance-led.At the same time, accordingto theESAs, most national supervisoryauthoritiesconsider that the measuresavailablefor sectoral supervisionare equallyappropriate for the supervisionof financial conglomerates.Strengtheningthesupervision of financial conglomeratescould thereforebeachieved by improvingthe actual useof the existinginstruments.As to theArticle 17 requirement for Member Statestoprovideforcrediblesanctionstomake the requirementscrediblyenforceable,nosuch sanctioningregimeis known for conglomerates.TheESAs provide eight recommendationsboth to enhancethe powersandtoolsat the disposal of supervisorsand tostrengthen enforcementmeasures,alsotaking intoaccount thedifferencesin nationalimplementation.Solvency ii
  61. 61. Thoserecommendationsincludeestablishingan enforcement regime fortheultimatelyresponsibleentityand itssubsidiaries.This impliesa dual approach, withenforcement powerstodeal withthetop entityfor group-widerisksand tohold theindividual entitiestoaccount for their respectiveresponsibilities.In addition, thesupervisor should have available a minimum set ofinformativeand investigativemeasures.Supervisors should be able to impose sanctions upon mixed activityholding companies, mixed activity insurance holding companies orintermediatefinancial holdingcompanies.4.2. The possibility to introduce mandatory stresstestingThepossibilityto require conglomeratesto carryout stresstestsmightbean additional supervisorytool to ensure theearlyand effectivemonitoring of risks in the conglomerate.FICOD1 introducedthe possibility (though not an obligation) for thesupervisortoperform stresstestson a regular basis.In addition, whenEU-widestresstestsare performed, the ESAs maytake intoaccount parametersthat capture thespecific risksassociatedwith financial conglomerates.5. ConclusionThecriteria for the definition and identificationof a conglomerate, theidentificationof theparent entityultimatelyresponsiblefor meetingthegroup-widerequirementsand the strengtheningof enforcement withrespect tothat entityare themost relevant issuesthat could beaddressedin a future revision of the financial conglomeratesdirective.Theidentificationof the responsibleparent entitywould alsoenhancetheeffectiveapplication of theexistingrequirementsconcerning capitalSolvency ii
  62. 62. adequacy, risk concentrations,intra-grouptransactionsand internalgovernance.Theregulatoryand supervisory environment with regard tocreditinstitutions,insuranceundertakingsand investment firms is evolving.All thesectoral prudential regulationshave been significantlyamendedon several occasionsin thelast few years, and evenmore significantchangestothe regulatoryrulesare pendingbefore the legislators.Furthermore, theproposal for the Banking Union significantlychangesthesupervisory framework.Therefore, and takingintoaccount alsothe position of the EuropeanFinancial ConglomeratesCommittee, thesupervisorycommunity andtheindustry, the Commissionconsidersit advisablenot toproposealegislativechangein 2013.TheCommission will keep the situationunder constant review todeterminean appropriate timingfor therevision.Solvency ii
  63. 63. EU-U.S. Dialogue ProjectTechnical Committee ReportsComparing CertainAspectsof theInsuranceSupervisory and RegulatoryRegimesin the European Union and the UnitedStatesImportant partsTheSteeringCommitteeof the EU-U.S. Dialogue Project presentsherewiththe final reportsof seventechnicalcommitteescomparingcertainaspectsof the insurancesupervisoryregimesin the EuropeanUnion and theUnited States.Attached isbackground information on the Project and the reportsthemselves.Thereportsinformed the Steering Committeeasto the keycommonalitiesand differencesbetweenthe EU‘s insuranceregulatoryand supervisory regime and thestate-basedinsuranceand regulatoryregimein the U.S.TheSteeringCommitteehasagreed to common objectivesandinitiativesto be pursued over thenext five years which are set out in theWay Forward document availableat[https:// publications/reports/index.html].TheSteeringCommitteeacknowledgesthe valuablecontributionsof thetechnicalcommitteemembers and thosewho provided commentsduringthepublic consultation process.Solvency ii
  64. 64. Introduction to the EU-U.S. Dialogue ProjectIn the EU, the European Parliament, the Council of the European UnionandtheEuropean Commission (EC), technicallysupportedby theEuropean Insuranceand Occupational PensionsAuthority (EIOPA), aremodernizingtheEU‘s insurance regulatory and supervisory regimethrough the SolvencyII Directive(Directive 2009/138/EC), in place since2009.This so-calledFramework Directivewasthe culmination of workbegunin the1990stoupdateexistingsolvencystandardsin the EU.Current work aims to further specify the Framework Directive withtechnical rules and guidelines, which are necessary for a consistentapplication byinsurersand supervisorsof the framework.In the United States,the statesare the primary regulatorsof theinsuranceindustry.Stateinsuranceregulatorsare membersof theNationalAssociation ofInsuranceCommissioners(NAIC), a standard-settingand regulatorysupport organizationcreatedand governedbythe chief insuranceregulatorsfrom the50states,the District of Columbia and five U.S.territories.As part of an evolutionary process, through the NAIC, state insuranceregulatorsin the U.S. are currentlyin the processof enhancingtheirsolvencyframeworkthrough theSolvencyModernizationInitiative(SMI).SMI is an assessment of theU.S. insurancesolvencyregulationframeworkand includesa review of international developmentsregardinginsurancesupervision, bankingsupervision, and internationalaccountingstandardsand their potential usein U.S.insuranceregulation.Solvency ii
  65. 65. In early2012,theEC, EIOPA, theNAIC and the Federal InsuranceOffice of theU.S.Department of the Treasury(FIO) agreed toparticipatein dialogueand a relatedproject (Project) to contribute toanincreasedmutual understanding and enhancedcooperation betweentheEU and the promotebusinessopportunity, consumer protectionand effectivesupervision.Theproject is considered to be part of and buildson the on-goingEUUSDialoguewhichhasbeen in placefor over 10years.Theworkwascarriedout in collaborationwithEIOPAand competentauthoritiesin theEU Member States,and withstate insuranceregulatorsandtheNAIC in theUnitedStates.Theobjectiveof theProject isto deepen insight intothe overalldesign, functionand objectivesof the keyaspectsof thetworegimes,and toidentify important characteristicsof both regimes.Project Governanceand Process:The Project is led by a six-memberSteeringCommitteecomprised of three EU and three U.S.officials,asfollows:- Gabriel Bernardino– Chairman of EIOPA- Edward Forshaw – Manager in the Prudential Policy division, UKFinancial Services Authority, and EIOPA Equivalence CommitteeChair- Karel Van Hulle– Head of Unit for InsuranceandPensions,Directorate-GeneralInternal Market andServices, EC- Kevin M. McCarty– Commissioner, Office of InsuranceRegulation, Stateof Florida, and current President of theNAIC- Michael McRaith– Director, FIO, United StatesDepartment of theTreasurySolvency ii
  66. 66. -ThereseM. (Terri) Vaughan – Chief Executive Officer, NAICSincethe Project began, theSteering Committeeheld face-to-facemeetingsin Basel, Brussels,Frankfurt and Washington DC, aswellasnumerousconferencecalls.In a first step, thetopics tobe discussedwereagreed upon and a processfor information exchangeunder confidentialityobligationswasestablished.TheSteeringCommitteeagreed upon seventopics fundamentallyimportant toa sound regulatory regimeand totheprotection ofpolicyholders and financial stability.Theseven topicsare:- Professional secrecy/ confidentiality;- Group supervision;- Solvencyand capital requirements;- Reinsuranceand collateral requirements;- Supervisoryreporting, data collection and analysis;- Supervisorypeer reviews;and- Independent third partyreview and supervisoryon-site inspections.AseparateTechnical Committee(TC) wasassembledto addresseachtopic.Each TC wascomprised of experiencedprofessionalsfrom both theEuropean Union aswell asthe United States,specifically, from FIO, theEC, theNAIC and EIOPA, aswell asrepresentativesfrom stateSolvency ii
  67. 67. insuranceregulatoryagenciesin the UnitedStatesand competentauthoritiesof EU Member States.Thevariousprofessionalswhocomprised the technical committeeswereselectedbecauseof their qualificationsand experiencewith respect tothesubject matter of each topic, includinginsuranceregulatorsandsupervisors,attorneys, accountants,examiners,and other specialists.Theteamsworked jointlyto develop objective,fact-basedreportsintendedto summarize the key commonalities and differencesbetweentheSolvencyII regime in theEU, and thestate-based insuranceregulatoryregime in the United States.Supportingdocumentation, e.g., regulations,directives,and supervisoryguidance,wasexchangedasrequested by either side.Theaccompanying seventechnical committeereportswerejointlydrafted to reflect theconsensusviewsof each respectivetechnicalcommittee‘smembers.Thedraft reportsweresubsequentlyreleasedfor public consultation. Thewrittenconsultation wascomplementedby twopublic hearings heldin October 2012,onein Washington DC and another in Brussels.Basedon oral and writtencommentsreceived through the consultationprocess, factual inaccuraciesnoted in thedraft reportswerecorrectedand limited clarificationsweremade.Thereportswerenot amended further despiterecommendationstodosobysome commenters, i.e., thescope of theProject wasnot expandedas aresult of the consultationprocess.Notwithstandingthis, all oral and writtencommentshavebeen takenintoconsideration in theSteeringCommittees deliberationsaspart ofthesecond phaseof the project.Solvency ii
  68. 68. No action hasbeen taken by the governing bodies of theorganizationsrepresented on the SteeringCommitteetoformallyadopt thefactualreportsand thusthis document should not beconsidered to expressofficial viewsor positionsof any organization.Thereportsrepresent the culmination of workfrom theProject, andinformed the work of the SteeringCommitteein agreeingtotheaforementionedcommon objectivesand initiatives.Adetailedproject plan will be developed in early2013and will beupdatedperiodically.Theinformationthat is thesubject of the accompanying seven reportspertainsto the insuranceregulatory and supervisoryregimesin both theEU and the UnitedStates.Thestatebasedapproach in the U.S.asdescribed in thereportsis in somerespectsbased on NAIC Model lawsand regulationsthat are given effectonlythrough legislativeenactment in each respectivestate.While some of thesemodel lawshave yet tobe adopted and implementedin certain states,a core set of common solvencyregulatorystandardsarein placein all states.In the caseof the EU, the approachdescribedin the reportsis largelybased on the approachset out in the SolvencyII Directive.However, in order toensure a comprehensive comparison withtheState-based Regimein the U.S., referenceis alsomade in some casestotheapproachenvisagedfor the technicalrulesthat will implement theDirective.It is important to note that thosetechnical rulesare still underdevelopment and have yet to be adopted by theEuropean Commissionin theform of delegatedacts.Solvency ii
  69. 69. Theserulesand certain NAIC models are in some instancesreferred toin the present tensein the Technical Committees‘ reports,i.e., asif theyare currentlyin place, eventhough theyhavenot yet been adopted orimplemented, withrespect totheserulesin the EU or, in thecaseof themodel lawsin theUnited States,by all states.Thereport doesnot purport torepresent or pre-judgethe viewsand/ ortheformal proposalsof the Commission.Theapproach described islargely basedon what wastestedin the lastfull quantitativeimpact study (QIS5), the technical specificationsforwhicharepublicly available.Insuranceis a specializedand complex industry, and insuranceregulatoryand supervisorymatterscan be just asspecializedandcomplex.Terminologyused in the reportsreflectsthebackground of therespectivemembersof each technicalcommittee,and thustheterminology and writingstylesmay vary somewhat from onecommitteereport toanother.TheSteeringCommitteeexpectsthat interestedpartieswhomay have aninterest in theProject and in submittingcommentsare familiar withtheinsuranceindustry and itsregulation in the EU, the U.S., or both.Accordingly, thetechnical committeeshaveendeavoured to preparetheir reportsin a manner that is appropriate for their own purposesandthat of the SteeringCommittee.There is some technical terminologythat is used in the reportsand, whereconsideredappropriate, definitionshave been providedtherein.Sometermsareunique to the U.S. and theEU but have the samemeaning, for example, insurersand undertakings;and reservesandtechnicalprovisions.Solvency ii
  70. 70. Other termsexistin both the U.S. and theEU, e.g., review, audit orORSA, but differ in content/ substance.Numerousabbreviationsand acronymshavebeen used throughout thesevenreports,definitionsof which havebeen includedin a separateappendix for theconvenience of readers.Thetext of thisreport can be quoted but only withadequateattributiontothe sourcedocument.The Contributing PartiesThe Federal Insurance Office, U.S. Department of the TreasuryTheFederal InsuranceOffice (FIO) of the U.S.Department of theTreasurywasestablishedby the Dodd-Frank Wall Street Reform andConsumer ProtectionAct.TheFIO monitorsall aspectsof theinsurance industry, includingidentifying issuesor gapsin the regulationof insurersthat couldcontributeto a systemic crisisin the insurance industry or theUnitedStatesfinancial system.TheFIO serveson the U.S. Financial StabilityOversight Council.TheFIO coordinatesand developsU.S.Federal policy on prudentialaspectsof international insurance matters,includingrepresentingtheUnitedStates,asappropriate, in the InternationalAssociation ofInsuranceSupervisors.The FIO assists the Secretary in negotiating certain internationalagreements, and serves as the primary source for insurance sectorexpertisewithin the Federal government.TheFIO monitorsaccessto affordableinsuranceby traditionallyunderserved communitiesand consumers, minorities,and low- andmoderate-incomepersons.Solvency ii
  71. 71. TheFIO alsoassiststheSecretary in administeringthe Terrorism RiskInsuranceProgram.The European CommissionTheEuropean Commission (EC) is one of the main institutionsof theEuropean Union.It representsand upholdstheinterestsof the EU asa whole.TheEC is theexecutive branchof the EU and isresponsibleforproposingnew European lawstoParliament and theCouncil.TheEC overseesand implementsEU policiesby enforcing EU law(together withtheCourt of Justice), and representstheEUinternationally, for example, bynegotiatinginternational tradeagreementsbetweentheEU and other countries.It alsomanagestheEUsbudget and allocatesfunding.The27Commissioners,one from each EU country, providetheCommission‘spolitical leadership duringtheir 5-year term.The National Association of Insurance CommissionersTheNationalAssociation of InsuranceCommissioners(NAIC) is thestandard-settingand regulatory support organizationcreatedandgovernedby the chief insuranceregulatorsfrom the 50states,theDistrict of Columbia and five U.S. territories.Throughthe NAIC, state insuranceregulatorsestablish standards andbest practices, conduct peer review, and coordinatetheir regulatoryoversight that is exercisedat thestatelevel.Solvency ii
  72. 72. NAIC staff supportstheseeffortsand representsthe collectiveviewsofstateregulatorsdomesticallyand internationally.NAIC members, together withthecentral resourcesof the NAIC, formthe national regime of state-based insuranceregulation in theUnitedStates.European Insurance and Occupational PensionsAuthorityTheEuropean Insuranceand Occupational PensionsAuthority(EIOPA) wasestablishedasa result of thereforms tothe structure ofsupervision of the financial sector in theEuropean Union.The reform wasinitiated by the EC, following the recommendations of aCommittee of Wise Men, chaired by Mr. de Larosière, and supported bytheEuropean Council and Parliament.EIOPA technicallysupportsthe EC, amongst others, in themodernizationof the EU‘s insuranceregulatory and supervisoryregime.Current workaimstofurther specify the SolvencyII FrameworkDirectivewithtechnical rules and guidelines,whichis necessaryfor aconsistent application by insurersand supervisorsof the framework.In cross-bordersituations,EIOPA alsohasa legallybindingmediationroleto resolvedisputesbetweencompetent authoritiesand may makesupervisorydecisionsdirectlyapplicabletothe institution concerned.EIOPA is part of theEuropeanSystem of Financial Supervisionconsistingof three European supervisoryauthorities, the othersbeingthenational supervisoryauthoritiesand theEuropean Systemic RiskBoard.EIOPA is an independent advisorybody to theEC, theEuropeanParliament and theCouncil of theEuropean Union.Solvency ii
  73. 73. EIOPA‘score responsibilitiesare tosupport thestabilityof the financialsystem, transparencyof marketsand financial productsaswell astheprotection of insurancepolicyholders, pension schememembers andbeneficiaries.Other Contributing PartiesTheSteeringCommitteeof this DialogueProject gratefullyrecognizesthecontributionsof their organization‘sstaff, of insurancesupervisorsand regulatorsfrom variousEU Member Statesaswell asfrom variousstateinsurancedepartmentsin the United Stateswhoserved on thevarioustechnical committees.The Technical Committee ReportsIn developing their reports, the Technical Committeesacknowledgedtheoverall policyobjectiveof insuranceregulation, the protectionofpolicyholders.Both regimesaim toensure the ongoing solvencyof domesticinsuranceand reinsurancecompanies.Additional regulatory objectives include facilitating an effective andefficient marketplace for insurance products, and ensuring financialstability.Theseoverarchingpolicy objectives– which arecommon toboth thestate-based regime in theU.S.aswellastheEU regime – provideafoundation for each of the accompanying seven reports.In addition, theSteering Committeeacknowledgesthat each solvencyregimemust be consideredfrom a holistic perspectiveand isalsomindful that differencesbetween the respectiveregulatory frameworksare in some casesattributabletodifferent philosophical approachesandlegal foundations.Solvency ii
  74. 74. For example, thedifferent solvencytoolsoutlinedin the TechnicalReportsare usedtovarying degreesbyeach regime.Such differenceswill be considered asappropriatein thesecond phaseoftheProject, but, apart from the inclusion of cross-referencesbetweenthetopics, it wasdeemed to be beyond thescope of the Project tomakefurther amendmentsto the individual Technical Committee reportsin thisregard.Thereport givesnonethelessa comprehensiveoverview of thekey partsof both regimeseven if depictedseparately.Thestate-basedsolvency regime in theU.S. is basedon 7 coreprinciples, asfollows:- Principle1: Regulatoryreporting, disclosure and transparency- Principle2: Off-siteMonitoring andAnalysis- Principle3: On-siteRisk-focusedExaminations- Principle4: Reserves,CapitalAdequacy and Solvency- Principle5: RegulatoryControl of Significant, Broad-basedRisk-related Transactions/ Activities- Principle6: Preventiveand CorrectiveMeasures,includingenforcement-Principle7: Exitingthe Market and ReceivershipTheEU Solvency II followsa three pillar approach.- Pillar I: Quantitativerequirementsrelatingto valuationof assetsandliabilities,includingtechnical provisions,thequalityof own fundsand Minimum and SolvencyCapital RequirementsSolvency ii
  75. 75. - Pillar II: System of Governanceand risk management requirements- Pillar III: Supervisory reportingand public disclosureThere arecommonalitiesaswell asdifferencesbetween the CorePrinciplesidentified in the U.S. state-basedregime‘sInsuranceFinancialSolvencyFramework and thethree pillar approachof SolvencyII.Thereportsof the TechnicalCommitteeswhichfollowhighlight thekey commonalitiesand differencesfor eachof the seven topical areasselectedfor them bytheSteeringCommitteeto review.Each technical committeefocusedon only one of the aforementionedtopics.In practice, theregulatory aspectsthat arethe topic of each respectivetechnicalcommitteereport operateon an integratedbasis,aswellaswith other regulatorytools and powersthat are not coveredby theaccompanyingreports.Whereappropriate, the report of a technical committeemakesreferencetothe reportsof oneor more other technicalcommittees.For example, a referencein any one of theaccompanying reports to―TC3‖ meansthereport of Technical Committee3, whichis listedin theTableof Contentsof thiscombined document as―3. Solvencyand CapitalRequirements.‖Thereportsof thetechnical committeesrefer tovariousEU directivesand regulations,aswell asto variousNAIC model lawsand regulations.In the EU, a directiveis a legal act that lays down certain end resultsthatmust be achievedin every Member State.National authoritieshavetoadapt their lawstomeet thesegoals,but arefreetodecidehow todo so.Solvency ii
  76. 76. In caseof maximum harmonization directives,Member Statesmay notforeseerequirementsother than thoselaid downby the Directive.EU regulationsare themost direct form of law;assoonastheyarepassed, theyhave binding legal force throughout everyMember State, ona par with national laws.National governmentsdonot have totakeactionthemselvestoimplement EU regulations.Regulationsare passed either jointlyby the Council of the EuropeanUnion and European Parliament, or in some specific areas,by theCommission alone.Thestate-basedregime in the U.S., through theNAIC, utilizesmodellawsand regulationsdeveloped by stateinsuranceregulators.Although thesemodel lawsand regulationsrequire statelegislativeenactment to becomeeffective,a coreset of solvencyregulationstandardsare effectivelyobligatoryby operation of theNAICAccreditationProgram.Although the statesare primarily responsiblefor the regulation ofinsurancein the U.S., certain federal lawsreferencedherein may alsoapplytoinsurersor specific insuranceactivities.1. Professional Secrecyand ConfidentialityExecutive summary- TC1organised itsanalysisof the keycommonalitiesand differencesbyfocusing on theanalysisof the followingsubjects:policy objectivesof confidentialitylaws;therelationship betweenfreedom of informationlawsand insuranceconfidentialitylawsin the U.S. and the EU;Solvency ii
  77. 77. theroleof theNationalAssociation of InsuranceCommissioners(NAIC), the European Insuranceand Occupational PensionsAuthority (EIOPA) and theFederal InsuranceOffice (FIO) asdistinctfrom insuranceregulators/ supervisorsin the U.S.statesand EUMember States;authoritytoshare information acrossborders and the lawsassociatedwith informationexchanges,methodsfor exchanginginformation, such asMemorandaof Understanding(MoUs) andconfidentialityagreements, and the confidentialityof non-publicsupervisoryinformation receivedby theFIO.- Both regimesseek tobalancethe objectiveof maintainingprofessional secrecywith appropriate flexibilityto share informationwith other supervisory authoritieswitha legitimateand materialinterest in theinformation.Against thiskey commonality, key differencesin structural approachcan be observed.In the EU, the basic presumption incorporated in insurancelegislationis that virtuallyall informationacquired by the supervisoryauthoritiesin the courseof their activitiesis bound by the obligationof professional secrecy.Aseriesof ―gateways‖ then facilitatesinformationexchangewithother relevant authorities.In the U.S., statelawsgenerallyprovide for the confidentialityofcertain information submittedto, obtained by, or otherwisein thepossession of an insurancedepartment.Theapproach is more often focused on protectingspecificinformation from beingavailablefor public inspection.Solvency ii
  78. 78. - Freedomof information (FOI) lawsconcerninggovernment recordsand actionsare premised on public accesstoofficial actions.In both the EU regime and the state based regimein theU.S., lawsexpressthe general policy of public accessto governmentinformation, but thispublic policy is qualified by specificprotectionsfrom disclosure for certaincategoriesof information.Theresult is that both regimesprovide for broad confidentialityprotectionsfor sensitiveinformationwhileallowingfor thesharing ofthat information among regulatorsin appropriatecircumstances.- In both regimes, primary regulatory responsibility rests with thevarious state insurance departmentsin the U.S. and with the EUMemberState supervisoryauthorities, respectively.Thefunctionsof both setsof supervisorsare supplemented by theNAIC in the U.S.and EIOPAin the EU.TheNAIC and EIOPA, in varying ways,assist the supervisoryauthoritiesin their regulatory rolesand, in doingso, may receivecertain confidential information pursuant to thelawsof the relevantjurisdictions.- Thenewly-created FIO establishesa center of insuranceexpertisewithin theU.S.federal government.In carrying out certain of its functions,FIO will continueto interactwith insuranceand other regulatorsin the U.S.and theEU, and mayparticipatein exchangesof confidential information.TheDodd-Frank Act requires the FSOC, the FIO, and the Office ofFinancial Research (OFR), whichis an office within theU.S.Department of theTreasurythat wasalsoestablishedby theDodd-FrankAct, tomaintain theconfidentialityof anydata, information, and reportssubmittedunder that Federal law.Solvency ii
  79. 79. All FSOC membersenteredintoa MoU that setsout theunderstandingof all FSOC membersregardingthetreatment of non-public information.TheMoU presumesthat non-public informationexchangedunder itstermsis confidential.- Both regimesincludegeneral authorizationstoshare confidentialinformation with other financial regulators,law enforcement officialsand other governmental bodiesin need of such informationtoperform their duties.Confidential information may onlybedisclosed to such personsiftheycan maintain confidentialityand/ or demonstrate their abilitytoprotect such information from disclosurewhen the information is intheir possession.Both regimesacknowledgethepossibilityof utilizingand disclosinginformation in receivership and bankruptcyactions, prosecutingregulatoryand criminal actions,and pursuant tocertain courtactions.- Both regimesallowfor regulatorstoenter intoagreementsor MoUswith counterparts in other jurisdictionstofacilitatethe sharingofconfidential information.Both regimesprovide broad discretion toregulatorstoestablishthetermsof such agreements,includingthe verification of eachregulator‘sabilityto maintain the confidentialityof informationreceivedfrom another jurisdiction.Both regimesaddressthe issueof potential sharing of informationwith third parties, but achievesimilar outcomesin different ways.EU Member State requirementsthat therecipient of confidentialinformation obtain explicit permission from theoriginatingsourcebeforesharingwithanother regulator are often developed asa resultSolvency ii
  80. 80. of legal constraintsunder theEU directives,while state insuranceregulatorsin the U.S. are bound by general legalrequirementstorespect the confidentialityof informationunder the lawsof theprovidingjurisdictionand thememorializationof this respect inwrittenconfidentialityagreements.- Thesimilaritiesbetweenthe tworegimesare greater than anticipatedprior tothebeginningof this dialogue.While there may be differencesin the form and application ofprofessional secrecyand confidentialitylawsbetweenthetworegimes,theyare substantiallysimilar in the subject matteraddressedand the outcome to be achieved.It is acknowledgedon both sidesthat there is littleevidenceofpractical problemsrelatedtotheexchangeof confidential informationbetweenstateinsuranceregulatorsin theU.S.and EUregulators,althoughthe flowof information hasnot been substantialsofar and may havebeen inhibitedby theinteractionof EU directiveconstraintsand concerns over professional secrecy.Topic 1:Policy objectives in relation to professional secrecy andthe exchange of informationKey Commonalities:Neither regime includesa single, all-encompassingdefinitionof theterm ―confidential information.‖Howeverboth regimesidentify general or specificcategoriesofinformation that will be considered confidential by law and not subjecttodisclosureexcept under specific definedcircumstances.- Legal sources, asprimarily expressed through statutesanddirectives,providethe foundation for the confidentialityof certaincategoriesofSolvency ii
  81. 81. information and thecircumstancesunder whichconfidentialinformation may be used and disclosed.While statutes and directives provide the foundation, both regimesrecognize that confidentiality requirements may be complementedthrough administrativeregulations,judicial opinionsand MoUs.- Both regimesprovidea rangeof penaltiesthat may be leviedagainstpersonswhobreach professional secrecyobligations.Under both regimes, thepenaltiescan includelossofemployment, civil and administrativefines,imprisonment or acombinationof thesepenalties.Thedefinitionof thepenalties, aswellastheir enforcement, ishandled at the U.S.state or EU Member State level.Key Differences:- Thestructural approach toconfidentialityis very different.TheEU approachstarts from thepresumption of confidentialityandidentifiesexceptions.Within the U.S., theprovisionson professional secrecyvary fromstateto stateasthere is a cleareremphasis on accessto publicrecords.Thepresumption in most casesis that informationis publiclyavailableunlessit isdesignatedconfidential through statelawsorstatutes.However, both regimestend towardthesame outcomesin terms ofprotectinginformation identifiedasconfidential while facilitatinginformation exchangeamong supervisoryauthoritiesacrossjurisdictions.Solvency ii
  82. 82. Discussion/ Description of the Two Regimes:The EU Approach:TheSolvencyII Directiveprovisionson professional secrecyreflectsimilar provisionsin the EU insurancedirectivescurrentlyin force.Theseoperateon thebasisthat anyconfidential information receivedinthecourseof the performanceitsdutiesby the supervisoryauthorityshall not be divulged to any person or authority whatsoever, except insummaryor aggregateform, such that individual insurance andreinsuranceundertakingscannot be identified.There are limited exceptions to the general rule, covering cases coveredby criminal law and disclosure where a firm has been declared bankruptor is being compulsorilywoundup.Theprofessional secrecyobligationcontinuesto applyafter employeeshaveleft the supervisoryauthority, and the obligationalsoappliesequallyto auditorsand expertsactingon behalf of thesupervisoryauthority.While there is nodefinition incorporated in either the existingEUdirectivesor Solvency II of what constitutesconfidential information, theinterpretation of thescopeof theprofessional secrecyprovision hasbeenwideranging.It is generallytakento encompassall firm specific information receivedbysupervisoryauthoritiesunlessit is alreadyin the public domain andnot just information that might be explicitlylabeledconfidential.Supervisoryassessmentsof firmsundertaken by national supervisoryauthoritiesare not disclosed, and thepublic availabilityof informationon theperformanceof insurersunder theexistingdirectiveswill varyfrom EU MemberState toMember Statedependingon provisionsinnational legislation.Solvency ii