Solvency ii News January 2013


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Solvency ii News January 2013

  1. 1. Solvency ii Association 1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 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 Certified Solvency ii Equivalence Professional (CSiiEP) DistanceLearning and Online Certification II and legal challenges…EIOPA wants national supervisors to ensure that insurance firms have inplace Solvency II based risk management, corporate governance andOwn Risk and Solvency Assessment (ORSA), well before the Solvency IIdeadline. The interesting legal challenge: Does EIOPA have theauthority and the legal power to implement early a regime that has yet tocome into effect, and is not final yet?These weeks we have the debate about how much capital insurersshould hold to meet life insurance policy guarantees. The EuropeanParliament plenary vote on Omnibus 2 was pushed back toaccommodate this study and is currently scheduled for June 10. _________________________________________ Solvency ii Association
  2. 2. Sebastian von Dahlen and Goetz von PeterNatural catastrophes and globalreinsurance – exploring the linkagesNatural disasters resulting in significant losseshave become more frequent in recent decades,with 2011 being the costliest year in history.This feature explores how risk is transferredwithin and beyond the global insurance sectorand assesses the financial linkages that arise inthe process.In particular, retrocession and securitisation allow for risk-sharing withother financial institutions and the broader financial market.While the fact that most risk is retained within the global insurancemarket makes these linkages appear small, they warrant attention due totheir potential ramifications and the dependencies they introduce.The views expressed in this article are those of the authors and do notnecessarily reflect those of the BIS, the IAIS or any affiliated institution.We would like to thank Anamaria Illes for excellent research assistance,and Claudio Borio, Stephen Cecchetti, Emma Claggett, DanielHofmann, Anastasia Kartasheva, Andrew Stolfi and Christian Upper forhelpful commentsThe physical destruction caused by severe natural catastrophes triggers aseries of adverse effects.Damaged production facilities, shattered transportation infrastructureand business interruption produce both direct losses and indirectmacroeconomic costs in the form of foregone output (von Peter et al(2012)). _________________________________________ Solvency ii Association
  3. 3. Beyond these economic costs are enormous human suffering and a hostof longerterm socioeconomic consequences, documented by the WorldBank and United Nations (2010).By examining catastrophe-related losses over the past three decades, thisspecial feature explores the linkages that arise in the transfer of risk frompolicyholders all the way to the ultimate bearer of risk.It describes the contracts and premiums exchanged for protection, andthe way reinsurers diversify and retain risks on their balance sheets.In so doing, the feature traces how losses cascade through the systemwhen large natural disasters occur.Losses from insured property and infrastructure first affect primaryinsurers, who in turn rely on reinsurers to absorb peak risks – low-probability, high-impact events.Reinsurers, in turn, use their balance sheets and, to a lesser extent,retrocession and securitization arrangements, to manage peak risksacross time and space.[Retrocession takes place when a reinsurer buys insurance protectionfrom another entity.Securitisation refers to the transfer of insurance-related risks (liabilities)to financial markets.]This global risk transfer creates linkages within the insurance industryand between insurers and financial markets.While securitisation to financial markets remains relatively small,linkages between financial institutions produced through retrocessionhave not been fully assessed as detailed data are lacking.Further linkages can arise when reinsurers go beyond their traditionalinsurance business to engage in financial market activities such as _________________________________________ Solvency ii Association
  4. 4. investment banking or CDS writing; the implications of those activitiesare beyond the scope of this feature.Comprehensive information is needed to monitor the entire risk transfercascade and assess its wider repercussions in financial markets.Physical damage and financial lossesNatural catastrophes resulting in significant financial losses havebecome more frequent over the past three decades (Kunreuther andMichel-Kerjan (2009), Cummins and Mahul (2009)).The year 2011 witnessed the greatest natural catastrophe-related losses inhistory, reaching $386 billion (Graph 1, top panel).The trend in loss developments can be attributed in large measure toweather-related events (Graph 1, bottom right-hand panel).And losses have been compounded by rising wealth and increasedpopulation concentration in exposed areas such as coastal regions andearthquake-prone cities.These factors translate into greater insured losses where insurancepenetration is high.At $110 billion, insured losses in 2011 came close to the 2005 record of$116 billion (in constant 2011 dollars).The reinsurance sector absorbed more than half of insured catastrophelosses in 2011.This considerable burden on reinsurers reflected the materialisation ofvarious peak risks, notably in Japan, New Zealand, Thailand and theUnited States.The level of insured losses also depends on catastrophes’ geography and _________________________________________ Solvency ii Association
  5. 5. physical type.The bottom panels of Graph 1 show that losses due to earthquakes(geophysical events) have been less insured on average than those fromstorms (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%(lefthand panel).Droughts can be even more difficult to quantify and insure.By contrast, the right-hand panel of Graph 1 shows that meteorologicalevents produced record losses in 2005, when Hurricanes Katrina, Ritaand Wilma devastated a region of the US Gulf Coast having 50% or morein insurance coverage.The volume of insured losses differs substantially across continents,depending on the availability of and demand for insurance.While overall a slight upward trend can be discerned over the past 10years, the wide dispersion in insurance density indicates that the stage ofa region’s economic development plays an important role (Graph 2, left-hand panel).Residents of North America, Oceania and Europe spend significantamounts on non-life (property and casualty) insurance, whereas manypopulous countries in Latin America, Asia and Africa hostunderdeveloped insurance markets.Poor countries typically lack the financial and technical capacity toprovide affordable insurance coverage.For example, less than 1% of the staggering economic losses due toHaiti’s 2010 earthquake were insured. _________________________________________ Solvency ii Association
  6. 6. The pattern of insured losses thus only partly reflects the geography ofnatural catastrophes.Sources: Centre for Research on the Epidemiology of Disasters EM-DAT database; MunichRe NatCatSERVICE; authors’ calculations. _________________________________________ Solvency ii Association
  7. 7. North America accounts for the largest insured losses associated withnatural disasters (Graph 2, right-hand panel).In 23 of the 32 years since 1980, more than half of global insured lossesoriginated in the region, though part of this volume was redistributedthrough global reinsurance companies.Asia, Oceania and, to a lesser extent, Latin America saw increases incatastrophe-related losses on the back of rising insurance density overthe past 10 years.Correspondingly, these three regions account for a rising share ofinsured losses.Risk transferNatural catastrophe-related losses are large and unpredictable. _________________________________________ Solvency ii Association
  8. 8. The insured losses shown in Graphs 1 and 2 reflect recent experience.This section describes the sequence of payments based on contractualobligations that is triggered when an insured event materialises.One can think of the insurance market as organising risk transfer in ahierarchical way.Losses cascade down from insured policyholders to the ultimatebearers of risk (Graph 3).When catastrophe strikes, the extent of physical damage determinestotal economic losses, a large share of which is typically uninsured.The insured losses, however, must be shouldered by the global insurancemarket (Graph 3, light grey area).The public sector, when it insures infrastructure, often does so directlywith reinsurers through public-private partnerships, although more datawould be necessary to pin down the exact scope worldwide.The majority of the losses relate to private entities contracting withprimary insurers, the firms that locally insure policyholders against risks.Claims for reimbursement thus first affect primary insurers.But they absorb only some of the losses, having ceded (transferred) ashare of their exposure to reinsurance companies.Reinsurers usually bear 55–65% of insured losses when a large naturaldisaster occurs.They diversify concentrated risks among themselves and pass a fractionof losses on to the broader financial market, while ultimately retainingmost catastrophe-related risk (see section below). _________________________________________ Solvency ii Association
  9. 9. Before disaster strikes, however, there is a corresponding premium flowin exchange for protection.Based on worldwide aggregate premium payments in 2011, policyholdersand insured entities, both private and public sector, spent $4,596 billionto receive insurance protection.Some 43% of this global premium volume ($1,969 billion) relates to non-life insurance and the remainder to life insurance products (IAIS (2012)).Primary insurers, in turn, paid close to $215 billion to buy coverage fromreinsurers.The lion’s share, nearly $165 billion, came from primary insurers activein the non-life business.About one third of this amount, $65 billion, was geared towardsprotection against peak risks, with $18 billion for specific naturalcatastrophe contracts.By way of comparison, life insurance companies spent 2% of theirpremium income, $40 billion, on reinsurance protection.This comparatively low degree of reinsurance protection is due to thefact that results are typically less volatile in life insurance than in non-lifeinsurance.Following any risk transfer, insurers remain fully liable vis-à-vis thepolicyholder based on the initial contractual obligations, regardless ofwhether or not the next instance pays up on the ceded risk. _________________________________________ Solvency ii Association
  10. 10. Reinsurance companies, in turn, buy protection against peak risks fromother reinsurers and financial institutions. _________________________________________ Solvency ii Association
  11. 11. In this process of retrocession, reinsurers spent $25 billion in 2011 tomitigate their own downside risk.The bulk of this amount represents retroceded risks transferred to otherreinsurance companies ($20 billion in premiums), while a relatively smallshare is ceded to other market participants such as hedge funds andbanks ($4 billion) and financial markets ($1 billion).An important aspect of this structure is the prefunding of insured risks.Premiums are paid ex ante for protection against an event that may ormay not materialise over the course of the contract.These payments by policyholders and insurers generate a steadypremium flow to insurers and reinsurers, respectively.Only if and when an event with the specified characteristics occurs arethe claims payments shown in Graph 3 triggered.At all other times, premium flows are accumulated in the form of assetsheld against technical reserves (see next section).Reinsurance contracts come in two basic forms which differ in the wayprimary insurers and reinsurers determine premiums and losses.Proportional reinsurance contracts share premiums and losses in apredefined ratio.Since the 1970s, non proportional contracts have increasingly been usedas a substitute.Instead of sharing losses and premiums in fixed proportions, bothparties agree on the insured risks and calculate a specific premium onthat basis. _________________________________________ Solvency ii Association
  12. 12. The typical non-proportional contract specifies the amount beyondwhich the reinsurer assumes losses, up to an agreed upon ceiling (firstlimit).Depending on the underlying exposure, a primary insurer may decide tobuy additional layers of reinsurance cover, for example with otherreinsurers, on top of the first limit.“Excess of loss” agreements are the most common form of non-proportional reinsurance cover.For natural catastrophes, these contracts are known as CatXL(catastrophe excess of loss) and cover the loss exceeding the primaryinsurer’s retention for a single event.A major earthquake, for example, is likely to affect the entire portfolio ofa primary insurer, leading to thousands of claims in different lines ofbusiness, such as motor, business interruption and private propertyinsurance.As a result, primary insurers often purchase CatXL coverage to protectthemselves against peak risks.Peak risks and the reinsurance marketA reinsurer’s balance sheet reflects its current and past acceptance ofrisks through its underwriting activity.Dealing with exposure to peak risks, which relate to naturalcatastrophes, is the core business of the reinsurance industry.Natural catastrophes are rooted in idiosyncratic physical events such asearthquakes.When underwriting natural catastrophe risks, reinsurers can rely to alarge extent on the fact that physical events do not correlateendogenously in the way financial risk does. _________________________________________ Solvency ii Association
  13. 13. To achieve geographical diversification, reinsurers offer peak riskprotection not just for one country but ideally on a worldwide basis.Another form of diversification takes place over time.Premiums are accumulated over years, and claims payments are usuallypaid out over the course of months or sometimes years.Graph 4 (left-hand panel) shows the average payout profile for CatXLcontracts.Statistics on reinsurance payments show that claims are typically settledover an extended period.On average, 63% of the ultimate obligations are paid within a year and82% within two years, and it takes more than five years after a naturaldisaster strikes for the cumulative payout to reach 100%. _________________________________________ Solvency ii Association
  14. 14. The premium inflows not immediately used for paying out claims areinvested in various assets held for meeting expected future claims.In this way, reinsurers build specific reserves called technical provisions.These constitute the largest block of reinsurers’ on-balance sheetliabilities (Graph 4, right-hand panel).Insured losses are met by running down assets in line with thesetechnical reserves.Losses in any one year typically lead to loss ratios (incurred losses as ashare of earned premium) of between 70 and 90%.To determine whether a reinsurer can withstand severe andunprecedented (yet plausible) reinsured events, regulators look forsufficient technical provisions and capital on the reinsurer’s balancesheet.The occurrence of a major natural catastrophe dents reinsurers’underwriting profitability, as reflected in the combined ratio.This indicator sets costs against premium income.A combined ratio above 100% is not sustainable for an extended period.By contrast, temporary spikes in the combined ratio are indicative of oneoff extreme events which can be absorbed by an intertemporal transfer ofrisk.The combined ratio spiked in the years featuring the most costly naturalcatastrophes to date (Graph 5, blue line): 2005, the year of majorhurricanes in the US, and 2011, following earthquakes and flooding inAsia and Oceania.Both occasions also reduced the stock of assets reserved for meetingclaims. _________________________________________ Solvency ii Association
  15. 15. Yet these temporary spikes in the combined ratio did not cut through toshareholder equity to any significant extent.Catastrophes affect equity only if losses exceed the catastrophe reserve.Recent market developments caused shareholder equity to decreasemore than insurers’ core underwriting business ever has.During the global financial crisis of 2008–09, shareholder equity (bookvalue) declined by 15% (Graph 5, red line), and insurance companies’share prices dropped by 59% (yellow line), more than after any naturalcatastrophe to date.In contrast, shareholder equity remained resilient in 2005 and 2011, whenreinsurers weathered record high catastrophe losses.In dealing with the consequences of peak catastrophe risks, the industryhas gravitated towards a distinctive market structure.One important element is the size of reinsurance companies.Assessing and pricing a large number of different potential physicalevents involves risk management capabilities and transaction costs on alarge scale.Balance sheet size is therefore an important tool for a reinsurer to attainmeaningful physical diversification on 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 Association
  16. 16. _________________________________________ Solvency ii Association
  17. 17. In spite of the reinsurance market’s size and concentration, failures ofreinsurance companies have remained limited in scope.The largest failures to date, comprising two bankruptcies in 2003, led toan essentially inconsequential reduction in available reinsurancecapacity of 0.4% (Graph 6, left-hand panel).That said, any failure of a reinsurer leads to a loss of reinsurancerecoverables by primary insurers, and could cause broader markettensions in the event of a disorderly liquidation of large portfolios.In this respect, the degree of connectedness within the global insurancemarket plays an important role.Based on their business model, reinsurers enter into contracts with alarge number of primary insurance companies, giving rise to numerousvertical links (Graph 3).In addition, risk transfer between reinsurers leads to horizontal linkages.We estimate that 12% of natural catastrophe-related risk accepted byreinsurers is transferred within the reinsurance industry, which impliesthat the industry as a whole retains most of the risks it contracts.In 2011, reinsurers paid 3% of earned premiums to cede catastrophe riskto entities outside the insurance sector.Judging by premium volume, the global insurance market transfers asimilarly small share of accepted risk to other financial institutions andthe wider financial markets.Linkages with financial marketsArrangements designed to transfer risk out of the insurance sector createlinkages with other financial market participants.Retrocession to other financial institutions uses contractualarrangements similar to those between reinsurers, and commits banks _________________________________________ Solvency ii Association
  18. 18. and other financial institutions to pay out if the retroceded riskmaterialises.Securitisation, on the other hand, involves the issuance of insuranceliabilities to the wider financial market.The counterparties are typically other financial institutions, such ashedge funds, banks, pension funds and mutual funds.Among insurance-linked securities, catastrophe bonds are the maininstrument for transferring reinsured disaster risks to financial markets.The exogenous nature of the underlying risks supports the view thatcatastrophe bonds provide effective diversification unrelated to financialmarket risk.For these reasons, industry experts had high expectations for theexpansion of the catastrophe bond market (eg Jaffee and Russell (1997),Froot (2001)).The issuance of catastrophe bonds involves financial transactions with anumber of parties (Graph 7).At the centre is a special purpose vehicle (SPV) which funds itself byissuing notes to financial market participants.The SPV invests the proceeds in securities, mostly government bondswhich are held in a collateral trust.The sponsoring reinsurer receives these assets in case a natural disastermaterializes as specified in the contract.Verifiable physical events, such as storm intensity measured on theBeaufort scale, serve as parametric triggers for catastrophe bonds.Investors recoup the full principal only if no catastrophe occurs. _________________________________________ Solvency ii Association
  19. 19. In contrast to other bonds, the possibility of total loss is part of thearrangement from inception, and is compensated ex ante by a highercoupon. _________________________________________ Solvency ii Association
  20. 20. Despite experts’ high expectations, the catastrophe bond market hasremained relatively small.Bond issuance has never exceeded $7 billion per year, limiting theoutstanding capital at risk to $14 billion (Graph 8).Very few catastrophe bonds have been triggered to date.The 2005 Gulf Coast hurricanes activated payouts from only one of ninecatastrophe bonds outstanding at the time (IAIS (2009)).Likewise, the 2011 Japan earthquake and tsunami triggered one knowncatastrophe bond, resulting in a payout of less than $300 million.Payouts to reinsurers from these bonds are small when compared to thesum of insured losses ($116 billion in 2005 and $110 billion in 2011).The global financial crisis has also dealt a blow to this market. _________________________________________ Solvency ii Association
  21. 21. The year 2008 saw a rapid decline in catastrophe bond issuance,reflecting generalised funding pressure and investor concern over thevulnerability of insurance entities.The crisis also demonstrated that securitisation structures introduceadditional risk through linkages between financial entities.A case in point was the Lehman Brothers bankruptcy in September 2008.Four catastrophe bonds were impaired – not due to natural catastrophes,but because they included a total return swap with Lehman Brothersacting as a counterparty.Following Lehman’s failure, these securitization arrangements were nolonger fully funded, and their market value plunged.Investors thus learned that catastrophe bonds are not immune to“unnatural” disasters such as major institutional failures.A further set of financial linkages arises with other financial institutionsthrough cross-holdings of debt and equity.Insurance companies hold large positions in fixed income instruments,including bank bonds.At the same time, other financial entities own bonds and stocks ininsurance companies.For instance, the two largest reinsurance companies stated in their latest(2011) annual reports that Warren Buffett and his companies (BerkshireHathaway Inc, OBH LLC, National Indemnity Company) own votingrights in excess of the disclosure threshold (10% in one case and 3.10% inanother).Additional shareholders with direct linkages to the financial sector havebeen disclosed by a number of reinsurance companies. _________________________________________ Solvency ii Association
  22. 22. The ramifications of such linkages in this part of the market are difficultto assess.ConclusionThe upward trend in overall economic losses in recent decadeshighlights the global economy’s increasing exposure to naturalcatastrophes.This development has led to unprecedented losses for the globalinsurance market, where they cascade from the policyholders via primaryinsurers to reinsurance companies.Reinsurers cope with these peak risks through diversification,prefunding and risk-sharing with other financial institutions.This global risk transfer creates linkages within the insurance industryand between insurers and financial markets.While securitisation to financial markets remains relatively small,linkages between financial institutions arising from retrocession havenot been fully assessed.It is important for regulators to have access to the data needed formonitoring the relevant linkages in the entire risk transfer cascade, as nocomprehensive international statistics exist in this area. _________________________________________ Solvency ii Association
  23. 23. EIOPA – Risk DashboardSystemic risks and vulnerabilitiesOn the basis of observed market conditions, data gathered fromundertakings, and expert judgment, EIOPA assesses the main systemicrisks and vulnerabilities faced by the European insurance industry overthe coming quarters to be:• Macro risks:Recessionary pressure in a number of economies in the EU exemplifythe macro-economic risks which are still at an elevated level.Although several important steps have been taken recently both at theEuropean and national level, uncertainty remains with regard to anyremaining implementation risks. _________________________________________ Solvency ii Association
  24. 24. In addition, the combination of austerity measures, risingunemployment and a prolonged period of subdued growth could havenegative effects on insurance demand.• Credit and market risk:The trend of decreasing CDS spreads has continued.However, this development certainly is also driven by excess liquidity,the difficult global financial investment environment and investors’ riskappetite striving for an appropriate balance of yield versus risk.Recent changes in asset allocation of European insurers rather hint at areduced risk appetite concerning credit investments.They tend to shift investments towards less riskier counterparties,reducing their European sovereign and banking exposure.This indicates a continuation of a negative outlook/perception on thatcredit category.Market risks are still dominated by the low yield environment with 10year swap rates in Western Europe having again reached new lows in thepast months.• Stabilisation in life insurance business:The declining trend in life gross written premiums has been reversed,however growth rates are still rather subdued.Lapse rates in the sample have improved from their peak in Q4 2011 andremained stable since last quarter. _________________________________________ Solvency ii Association
  25. 25. Use of expert judgmentUse of expert judgment after the mechanical aggregation:• Macro risk:Slightly upwards due to high heterogeneity in growth figures across EUcountries and general uncertainty about the medium term growthpotential and its implications for the demand of insurance products.In addition, implementation risks around the various crisis managementtools used in the sovereign debt crisis are non negligible.• Credit risk:Slightly upwards as the observed decrease of the mechanistic score isconsidered too large given the uncertain macro outlook, potentiallydistorted bond prices as a result of excess liquidity while at the same _________________________________________ Solvency ii Association
  26. 26. time investors have limited alternatives to substantially reduce theircredit risk exposure.• Market risk:Slightly upwards due to the severe consequences a prolonged low yieldenvironment could have on the profitability and solvency of theinsurance sector.Improvements in other indicators, e.g. equity risk, are not considered tomake up the effects of recently observed new historic lows in 10_yearswap rates, given the on average small equity investments of insurers.• Liquidity&funding:Slightly downwards as the increase of the mechanistic score is solelydriven by low issuance volume of cat bonds in Q3 which is seasonallydriven and is already picking up substantially in October and November.Other indicators remained stable.• Insurance risk:Slightly upwards due to reduced buffers of reinsurers for catastrophelosses after Hurricane Sandy and potential price hikes in upcomingrenewals, which are not reflected in Q3 figures yet.In addition, insurers’ business model might be impacted in a low yieldenvironment when lower investment returns cannot counter balancepotential underwriting losses. _________________________________________ Solvency ii Association
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  30. 30. Sovereign risk – a world without risk-free assetsPanel comments by Mr Patrick Honohan,Governor of the Central Bank of Ireland, atthe BIS Conference on “Sovereign risk – aworld without risk-free assets”, Basel, 8January 2013.What’s new about sovereign risk since thecrisis began?Conceptually, not so much, I would suggest – and nothing that cannotbe fully explained within standard models of finance.But in practice, and in particular in the euro area, two linked elementsthat were always potentially present or implicit have leapt intoprominence in a way and to an extent that was not foreseen.The first is that markets have begun to price default risk in a sovereign’shome-currency;The second is the contamination of the functioning and economiceffectiveness of banks by the weak credit rating of their sovereigns (aswell as vice 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 has certainly displayed these two elements in a dramatic way,but they are evidently present in half a dozen other euro area countriesalso and to an extent which has had implications for the functioning ofthe Eurosystem as a whole, and therefore on the global financial system. _________________________________________ Solvency ii Association
  31. 31. Let me take these two points in turn.First the pricing-in of sovereign default risk in “home currency”.Why did the default premium suddenly emerge?Evidently, even though everyone understood the rules, no such pricing-in occurred for the first decade of the Eurosystem (Figure 1).Risk appetite was high for much of that period, but the market’sperception of sovereign risk must also have remained low.(Perhaps, despite Treaty prohibitions, market participants assumed thatany sovereign that got into trouble would be bailed-out).Indeed, sovereign spreads in the euro area were almost totally insensitiveto credit ratings before the crisis (Figure 2).One often-heard interpretation of what happened during that decade isthat the complacent market environment relaxed the budget constrainton euro-area sovereigns and led them to borrow recklessly.Actually this story doesn’t fit the facts very well.After all, although sovereign debt ratios in most of the Eurosystem didnot fall as much as they could and should have on the good years, atleast they did not increase dramatically before the crisis (Figure 4).(Private debt ratios, and in particular the size of the bank and near-banksystems did increase, but that is a somewhat different story, to which Iwill turn shortly).It’s possible alternatively that there was a multiple equilibrium here, withthe “good” or low interest equilibrium (with a self-fulfilling degree ofconfidence in the creditworthiness of all the sovereigns) being selectedby the market at the start of the euro, and events during the financial _________________________________________ Solvency ii Association
  32. 32. crisis – not least those associated with Greece – having tripped thesystem into the “bad” or high interest equilibrium with default riskpremia moving a number of sovereigns into a more challenging debtsustainability position.Most likely, what we have seen is a combination of factors:(i) a sharp reduction in risk appetite resulting in even little-changed debtratios, as in Italy, looking more challenging and in need of a risk-premium; and in addition (for most countries)(ii) a sharp increase in debt ratios as governments reacted to the crisis(including, but not at all confined to, the socialisation in most countriesof some private banking losses through their assumption bygovernments) (Figure 4 again).The increased sensitivity of sovereign spreads to ratings, and theincreased range of ratings themselves – both illustrated in Figure 2 –suggest that both factors are at work.(As spreads widened in stressed countries, their fluctuations – whichwould not concern hold-to-maturity investors – added a risk factor forothers and probably ratcheted up the average level of the spreads.)In the specific case of Ireland, the depth of the recession and theremarkably high elasticity of tax revenues and the Government deficit tothe downturn, combined with the unfortunate decision to lock-in a verycomprehensive bank guarantee before the potential scale of the bankinglosses could at all be appreciated, meant that Ireland’s actual andprospective general government debt made a shocking turnaround fromabout 25 per cent of GDP in 2007 to 117 per cent just five years later.Historians will debate the exact triggers for the market’s loss ofconfidence in the Irish sovereign.Even as late as April 2010, after the first sampling indicated the scale ofthe banking losses, sovereign spreads were little more than 1 per cent. _________________________________________ Solvency ii Association
  33. 33. By November of that year (just a few weeks after the Deauville statementwhich persuaded the markets that private sector holders of eurosovereign debt would not be immune from loss-sharing) large bankingoutflows and spreads exceeding five per cent made recourse to officialassistance inevitable.(Figure 3 shows the plot with some relevant news stories flagged).Perhaps the most significant take-away from the sequence of spikes andtroughs is the fact that some of them clearly relate to news that iscountry-specific, some of them to euro area general news.The same is doubtless true for all of the stressed sovereigns.Default risk vs. devaluation risk vs. redenomination riskIt’s worth pausing to recall that raw sovereign spreads such as we areseeing today in the euro area are not remotely unprecedented in pre-eurohistory.On the contrary, they were the norm as is illustrated by Figure 1.The difference is that these spreads reflected a combination of defaultrisk and currency risk.During the last fiscal crisis of the 1980s Irish sovereign spreads balloonedout also.But that was for local currency denominated debt.Eurobond borrowing by the Irish Government remained at fairly tightspreads despite the high overall debt ratio (higher than today), and thefact that almost half of the national debt was denominated in foreigncurrency.The high spreads reflected devaluation expectations and currency riskgenerally. _________________________________________ Solvency ii Association
  34. 34. And there were devaluations, though less than was baked into thespreads – by between 250 and 300 basis points on average during the lastten years of that ill-fated regime, the narrow-band EMS.It is not that default and devaluation are close substitutes; not at all, andfor several reasons.For one thing, default has potential reputational consequences for theissuer qualitatively different to those of devaluation.In addition, though, devaluation affects not only the international valueof the Government’s debt promises, but also that of all other contractsdenominated in local currency; as a result, depending on the speed ofprice-resetting (pass-through) it can affect competitiveness throughoutthe economy.These differences have not been sufficiently emphasised, I feel, in recentdiscussion.As an example, I could mention the Irish devaluation of August 1986.The main goal of this important action was restoration of wagecompetitiveness, not a lowering of the real value of the local currency-denominated debt.(Indeed, I recall that some domestic policymakers were confused on thispoint and thought that the debt burden would actually increase as aresult of translation effect on the foreign currency debt!)Such currency risk can be so extreme as to make it impossible for thesovereign to issue any sizable amount of local-currency denominateddebt to international lenders.In the literature, such countries – all in the developing world (and notincluding Ireland, cf. Figure 5) – were said to suffer from “Original Sin”. _________________________________________ Solvency ii Association
  35. 35. Happily, the number of countries suffering “Original Sin” has beendiminishing in recent years.Instead, we have to acknowledge the emergence in market pricing of anew phenomenon, “redenomination risk”.How can we recognise redenomination risk?This is not straightforward, not least because the term could refer to anumber of different scenarios.One suggested way of approaching the question is to use econometricestimates of the cross-sectional determinants of sovereign spreads forforeign currency-denominated borrowing to predict current spreads instressed euro area countries: a positive residual might suggest aredenomination risk premium.Comparisons of current spreads of euro area sovereigns in euro and inforeign currency-denominated borrowings provides for an alternativeapproach.My own favourite approach is to look at the co-movement in the timeseries of euro area country spreads.Some of this co-movement can be attributed to fluctuations in marketrisk-appetite; the remainder could be interpreted as a system-wideredenomination premium.This brief summary already suggests the complexity and ambiguity ofsome of the concepts involved and their measurement.Evidently, redenomination risk, as imagined by market commentators,combines default and currency risk in a novel way not contemplated bythe Treaty that established the euro area. _________________________________________ Solvency ii Association
  36. 36. The ECB has made clear its determination to do what is necessary topreserve the euro and remove unfounded euro break-up premia insovereign yields.The OMT, designed as a backstop to inhibit negative self-fulfillingmarket dynamics, provides the necessary tools to deliver on thatcommitment.The programme does not go overboard in the direction of removing theincentive for governments to manage their finances in such a way as torecover and retain the confidence of the market, but it will ensure thatdisciplined governments will not have to pay spreads that could onlyreflect market concerns about a system break-up.As announced, the ECB will only buy bonds at the shorter end of thematurity spectrum, but the OMT can be expected to have an influencetransmitted by market forces throughout the yield curve, and indeedspreads have tightened right across all maturities since the OMT wasannounced.Still, it is not to be expected that the OMT will by itself restore the tightuniformity of spreads that prevailed for the first decade of the euro.Forcing such a tight uniformity would not be generally considered safeabsent more reliable alternative mechanisms for ensuring disciplinedfiscal policy in the countries concerned.More likely would be a potentially extended period of sovereign spreadsthat, albeit narrower than at their worst, remain material.Sovereign spreads and the banksThat being so, we need to ask what are the consequences of thesespreads for the rest of the economy, and in particular for the operation ofthe banking system. _________________________________________ Solvency ii Association
  37. 37. Regardless of the condition of the balance sheet and the profit and lossaccount of the banks, experience shows how hard it is for banks in ajurisdiction where the sovereign is under stress to access the moneymarkets on the finest terms.In essence, the market fears that a stressed sovereign could in extremisreach to the banks as a source of last resort financing – if necessaryusing national legislation to do so.From such a perspective, providers of funds to banks will tend to price-inthe possibility that, at the margin, they could end up as indirectproviders of funds to a stressed sovereign.There are many examples in history of this happening, and theconsequences for bank funding costs have often been severe.In other words, while we have all become sensitised to the pressurewhich socialized banking losses can place on the sovereign, markets arealso acutely aware of the potential damaging links in the other direction.Either way, there are consequences for the funding costs of both thesovereign and the banks.Given the scale of banking in the euro area, even a relatively smalldifference in funding costs can be consequential.Once again, the Irish situation dramatises what can happen when thetwo-way feedback loop between banks and sovereign causes a loss ofaccess to risk-free rates.As is well known, the Irish banks have suffered severe loan losses in theaftermath of the bursting of the property price and construction bubblewhich they had so enthusiastically financed.Very sizable capital injections (about 50 per cent of GNP from theIrish Government alone – a sum which proved too great to be financedwithout the protection of an IMF programme) have ensured that the _________________________________________ Solvency ii Association
  38. 38. Irish banks more than satisfy regulatory requirements once again, buttheir future profitability is constrained by the emergence and likelypersistence of the sovereign spreads, and the knock-on effect of thespreads on the banks’ funding costs.Euro-area risk-free rates are not now the most relevant indicator of themarginal cost of funds to the Irish banking sector.It is, of course, true that the Irish banks (like those in other stressedcountries) have been drawing heavily on ECB refinancing facilitiesduring the crisis, especially following the huge outflow of funds thatoccurred in early 2009 and again in the last few months of 2010.This access to refinancing has been vital to the continuing operationof the banking system, and it has come at the policy rate.(Let me mention as an aside a curious feature of the current monetarypolicy environment in the euro area.The two key ECB rates – the main refinancing operations rate and thedeposit rate – are 75 basis points and zero, respectively.Access to both the refinancing and deposit facilities are both close to all-time highs.But in practice, the bulk of the refinancing is going to banks in thestressed countries, while the bulk of the deposits are placed by banks innon-stressed countries.To the extent that the stressed countries have tended to have weakereconomic performance during the crisis, this pattern might beconsidered paradoxical.But it is of course a reflection and semi-automatic consequence of thefragmentation which has developed in the euro area. _________________________________________ Solvency ii Association
  39. 39. To be sure, the ECB policy rate is clearly below the marginal cost offunds in the stressed countries.)But access to ECB funds at the policy rate is limited by the availability ofeligible collateral and the haircuts that are applied to such collateral(despite the relaxation of eligibility criteria).About 20 per cent of the total financing of the three going concern Irishcontrolled banks comes from this source at present (16 per cent of thebalance sheet total).Competition for deposits therefore remains strong and rates high.It’s not just that higher bank funding costs will now be passed on to newborrowers, adding headwinds to the economic recovery, though that iscertainly a factor.Indeed, the lower policy interest rates set by the ECB since the crisisbegan have only been partly transmitted to borrowers in Ireland and inthe other stressed euro area countries (Figure 6).(As is seen by the results of a recursive regression exercise, the pass-through from policy rate to Irish residential mortgage SVR rates hashalved since the start of the crisis – Figure 7.)Some of this can be rationalised as reflecting a higher credit risk-premium being charged by the banks, but some is also due to the highermarginal cost of funds.Worse still for the health of the banks, and their ability to contribute tothe economic recovery, is the fact that they are still coping with theconsequences of their marginal cost of funds having delinked so sizablyfrom the ECB policy rate.These consequences arise because of the long-term mortgage contractsthe banks made when they assumed that their marginal cost of fundswould always remain close to the (risk-free) policy rate. _________________________________________ Solvency ii Association
  40. 40. Suffice it to say that a large block of residential mortgages was granted atinterest rates which track the ECB policy rate plus a very low spread.These tracker mortgages, many of which have an average remainingmaturity of 15–20 years or more, yield less than the marginal cost offunds (Figure 8 which is drawn on the assumption, not strictly valid, thatthe average spread of the trackers over policy rate was unchanged overtime).In effect, by assuming that their cost of funds would not deviate muchfrom the ECB policy rate, the banks exposed themselves to a very large“basis risk”.In principle, they could escape this trap if there were a willing purchaser(public or private) with access to funding at a cost that is notcontaminated by the sovereign stress.Until such a purchaser comes forward, the banks will have to continue tofund this portfolio at a loss, even on performing mortgages, whoseeffects will spill over onto their customers and their owners (not least theState).ConclusionIrish Sovereign spreads may no longer be bloated by redenominationrisk, but at 300 basis points at the long-end, they do seem to reflect acredit risk premium that is poor reward, so far, for what has been asizable fiscal adjustment effort.Reflecting on where we have got to, it seems that there are distinctparallels with the fiscal crisis of the EMS period.As I mentioned, spreads (then reflecting devaluation risk) exceeded whatwould have been needed ex post to compensate for actual exchange ratemovements by almost the same amount (250–300 basis points). _________________________________________ Solvency ii Association
  41. 41. Those spreads were transmitted to the banking system then also.The Irish financial situation is relatively extreme, and as such illustratesclearly some of the key problems that have been faced also in otherstressed parts of the euro area.While it has delivered a much lower inflation rate, the euro is no longerinsulating financial markets from the impact of excessive debt inmember countries.The early insulation of the monetary transmission mechanism fromfiscal problems of participating countries has worn through.The pernicious feedback loop from banks to sovereign and fromsovereign to banks that re-emerged in the crisis remains strong anddamaging.Getting back to the “good” equilibrium will require a healing processwhich removes the market’s fear of default.It is inevitably a protracted process needing not only firm adherence toconsistently disciplined policies but also the creation of institutions thatcan prevent future crises, or at least cope with them better if they cannotbe avoided. _________________________________________ Solvency ii Association
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  48. 48. Report from the Commissionto the European Parliamentand the CouncilThe review of theDirective 2002/87/EC of the European Parliament and theCouncil on the supplementary supervision of credit institutions,insurance undertakings and investment firms in a financialconglomerate1. Introduction and Objectives1.1. BackgroundThe rapid development in financial markets in the 1990s led to thecreation of financial groups providing services and products in differentsectors of the financial markets, the so-called financial conglomerates.In 1999, the European Commission’s Financial Services Action Planidentified the need to supervise these conglomerates on a group-widebasis and announced the development of prudential legislation tosupplement the sectoral legislation on banking, investment andinsurance.This supplementary prudential supervision was introduced by theFinancial Conglomerate Directive (FICOD) on 20 November 2002.The Directive follows the Joint Forum’s principles on financialconglomerates of 1999.The first revision of FICOD (FICOD1) was adopted in November 2011following the lessons learnt during the financial crisis of 2007-2009.FICOD1 amended the sector-specific directives to enable supervisors toperform consolidated banking supervision and insurance group _________________________________________ Solvency ii Association
  49. 49. supervision at the level of the ultimate parent entity, even where thatentity is a mixed financial holding company.On top of that, FICOD1 revised the rules for the identification ofconglomerates, introduced a transparency requirement for the legal andoperational structures of groups, and brought alternative investmentfund managers within the scope of supplementary supervision in thesame way as asset management companies.FICOD1’s Article 5 requires the Commission to deliver a review reportbefore 31 December 2012 addressing in particular the scope of theDirective, the extension of its application to non-regulated entities, thecriteria for identification of financial conglomerates owned by wider non-financial groups, systemically relevant financial conglomerates, andmandatory stress testing.The review was to be followed up by legislative proposals if deemednecessary.It should be noted that since the adoption of FICOD1 some issues, suchas addressing systemic importance of complex groups, and recovery andresolution tools beyond the living wills requirement in FICOD1 havebeen or will be resolved in other contexts and have therefore become lessrelevant for this review.1.2. The purpose of the review and the Joint Forum’s revisedprinciplesThis review is guided by the objective of FICOD, which is to provide forthe supplementary supervision of entities that form part of aconglomerate, with a focus on the potential risks of contagion,complexity and concentration — the so-called group risks — as well asthe detection and correction of ‘double gearing’ — the multiple use ofcapital.The review aims to analyse whether the current provisions of _________________________________________ Solvency ii Association
  50. 50. FICOD, in conjunction with the relevant sectoral rules on group andconsolidated supervision, are effective beyond the additional provisionsintroduced by FICOD1.The review is justified as the market dynamics in which conglomeratesoperate have changed substantially since the Directive entered into forcein 2002.The financial crisis showed how group risks materialised across theentire financial sector.This demonstrates the importance of group-wide supervision of suchinter-linkages within financial groups and among financial institutions,supplementing the sector specific prudential requirements.The limited approach of FICOD1 was partially based on the anticipationof the Joint Forum’s revised principles, which were due to be addressedin the present review.These principles were published in September 2012 with the two mainissues being the inclusion of unregulated entities within the scope ofsupervision to cover the full spectrum of risks to which a financial groupis or may be exposed and the need to identify the entity ultimatelyresponsible for compliance with the group-wide requirements.This review takes the revised principles duly into account together withthe evolving sectoral legislation as presented below.1.3. Evolving regulatory and supervisory environmentFICOD rules are supplementary in nature.They supplement the rules that credit institutions, insuranceundertakings and investment firms are subject to according to therespective prudential regulations. _________________________________________ Solvency ii Association
  51. 51. Currently this sectoral legislation is being overhauled in a major way andthe regulatory environment is evolving.The CRD IV and Omnibus II are pending proposals before theEuropean Parliament and the Council, and Solvency II includesenhanced group supervision provisions which are not yet applicable.Once these provisions are applicable, the Commission will closelymonitor the implementation of these new frameworks, which alsocomprise a number of delegated and implementing acts, includingregulatory technical standards to be developed over a number of years bythe Commission and the European supervisory authorities (ESAs).In addition, the changes recently made to FICOD will not be in placebefore mid-2013, so cannot yet be fully examined in practice before late2014.These include the regulatory and implementing technical standards andcommon guidelines to be issued by the ESAs.Finally, the Banking Union Regulation proposal calls for a major changein the supervision of European banks and will have an impact on thesupervision of conglomerates as one of the tasks conferred to theEuropean Central Bank would be to participate in supplementarysupervision of a financial conglomerate.As this report shows, there are areas of supplementary supervision whereimprovements could be made.However, as with any legislation, the benefits of amending legislationalways have to be weighed against the costs connected with legislativechanges.According to the European Committee on Financial Conglomerates atits meeting on 21 September 2012, the supervisory community throughthe ESA’s advice to the Commission, and the industry in its responses tothe consultation carried out by the Commission, the optimal timing for _________________________________________ Solvency ii Association
  52. 52. revising FICOD will only be once the sectoral legislation has beenadopted and is applicable.2. The Scope of the Directive and the Legal Adressees of theRequirements2.1. Scope2.1.1. The scope of FICOD and the sectoral legislationMost of the groups operating in the financial sector have a broadspectrum of authorisations.Focusing on the supervision of only one type of authorised entity ignoresother factors that may have a significant impact on the risk profile of thegroup as a whole.Fragmented supervisory approaches are not sufficient to cope with thechallenges that current group structures pose to supervision.The supplementary supervision framework for conglomerates is meantto strengthen and complete the full set of rules applicable to financialgroups, across sectors and across borders.However, from a regulatory standpoint, additional layers of supervisionhave to be avoided when the sectoral requirements already cover all thetypes of risk that may arise in a group.2.1.2. Coverage of unregulated entities, including those notcarrying out financial activitiesIn order to address group risks, which was the original aim of FICODand the Joint Forum principles, as re-affirmed by the revised principles,group supervision should cover all entities in the group which arerelevant for the risk profile of the regulated entities in the group. _________________________________________ Solvency ii Association
  53. 53. This includes any entity not directly prudentially regulated, even if itcarries out activities outside the financial sector, including non-regulatedholding and parent companies at the top of the group.Each unregulated entity may present different risks to a conglomerateand each may require separate consideration and treatment.Among unregulated entities, special importance is attached to specialpurpose entities (SPEs).The number of SPEs and the complexity of their structures increasedsignificantly before the financial crisis, in conjunction with the growth ofmarkets for securitisation and structured finance products, but havedeclined since then.While the use of SPEs yields benefits and may not be inherentlyproblematic, the crisis has illustrated that poor risk management and amisunderstanding of the risks of SPEs can lead to disruption and failure.The need for enhanced monitoring of intra-group relationships withSPEs was highlighted in the Joint Forum’s 2009 SPE report.2.1.3. Coverage of systemically relevant financial conglomeratesThe challenges of supervising conglomerates are most evident forgroups whose size, inter-connectedness and complexity make themparticularly vulnerable and a source of systemic risk.Any systemically important financial institution (SIFI) should in the firstplace be subject to more intense supervision through application of theCRD IV and Solvency II framework, both at individual and group/consolidated level.If the SIFI is also a conglomerate, supplementary supervision underFICOD would also be applicable. _________________________________________ Solvency ii Association
  54. 54. Although most SIFIs are conglomerates, this is not always the case.Also, systemic risks are not necessarily the same as group risks.Therefore, it does not seem meaningful to try to bring all SIFIs underFICOD.Furthermore, discussions at international level are still continuing oninsurance SIFIs, and the sectoral legislation, including the treatment ofbanking SIFIs, is not yet stable.2.1.4. Thresholds for identifying a financial conglomerateAll the issues mentioned above are linked to the definition of aconglomerate and the thresholds for identifying one.The two thresholds set out in Article 3 of FICOD take into accountmateriality and proportionality for identifying conglomerates that shouldbe subject to supplementary supervision of group risks.The first threshold restricts supplementary supervision to thoseconglomerates that carry out business in the financial sector and thesecond restricts application to very large groups.The combined application of the two thresholds and the use of theavailable waiver by supervisors have led to a situation where very bigbanking groups that are also serious players in the European insurancemarket are not subject to supplementary supervision.Furthermore, the wording of the identification provision may leave roomfor different ways to determine the significance of cross-sectoralactivities.It could be improved to ensure consistent application across sectors andborders. _________________________________________ Solvency ii Association
  55. 55. To ensure legal clarity, it is important to have easily understandable andapplicable thresholds.However, the question remains whether the thresholds and the waiversshould be amended or complemented to enable supervision in aproportionate and risk-based manner.2.1.5. Industrial groups owning financial conglomeratesWhile there is agreement that regulated financial entities are exposed togroup risks from the wider industrial group to which they might belong,no conclusion can be drawn at this stage as to how to extend the FICODrequirements to wider nonfinancial groups.The FICOD1 review clause required the Commission to assess whetherthe ESAs should, through the Joint Committee, issue guidelines forassessment of the material relevance of the activities of theseconglomerates in the internal market for financial services.Currently there is no legislation on the supervision of industrial groupsowning financial conglomerates and the ESAs have no empowerment toissue guidelines.Therefore, while the ESAs will certainly play a key role in ensuring theconsistent application of FICOD, it is premature to reach anyconclusions on the need for the ESAs to issue guidelines on this specifictopic.2.2. Entities responsible for meeting the group-levelrequirementsImposing requirements at group level will not ensure compliance unlessthis is accompanied by clear identification of the entity ultimatelyresponsible in the financial group for controlling risks on a group-widebasis and for regulatory compliance with group requirements. _________________________________________ Solvency ii Association
  56. 56. This would allow more effective enforcement of the requirements by thesupervisory authorities (discussed in section 4 below).Interaction with company law provisions governing the responsibilitiesof the ultimately responsible entity needs to be taken into consideration.This ultimate responsibility might need to be extended to non-operatingholding companies at the head of conglomerates, even though a limitedscope may be envisaged for those holding companies whose primaryactivity is not in the financial sector.3. Provisions Needed to Ensure the Detection and Control ofGroup RisksThe objective of supplementary supervision is to detect, monitor,manage and 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 toachieve this objective.Amongst other criteria, they should be assessed against the need tostrengthen the responsibility of the ultimate parent entity ofconglomerates.3.1. Capital (Article 6)The capital requirements for authorised entities on a stand-alone andconsolidated basis are defined by the sectoral legislation dealing with theauthorisation of financial firms.Article 6 of FICOD requires supervisors to check the capital adequacy ofa conglomerate. _________________________________________ Solvency ii Association
  57. 57. The calculation methods defined in that Article aim to ensure thatmultiple use of 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.The draft regulatory technical standard (RTS) developed under FICODArticle 6(2), published for consultation on 31 August 2012, specifies themethods for calculating capital.The technical standard is expected to deal sufficiently with theinconsistent use of capital calculation methods for the purpose ofregulatory capital requirements and to ensure that only transferablecapital is counted as available for the regulated entities of the group.Indeed, as this RTS should ensure a robust and consistent calculation ofcapital across Member States, when negotiating the CRD IV proposal, itappeared that no changes to FICOD to address Basel III objectivesregarding a potential double counting of capital investments inunconsolidated insurance subsidiaries were necessary.However, the discussions accompanying the development of thistechnical standard revealed further concerns regarding group-widecapital policy.Supervisors sometimes lack insight into the availability of capital at thelevel of the conglomerate.This could be addressed by requesting the supervisory reporting andmarket disclosure of capital on an individual or sub-consolidated basis inaddition to the consolidated level. _________________________________________ Solvency ii Association
  58. 58. 3.2. Risk concentrations (Article 7) and intra-group transactions(Article 8)Articles 7 and 8 on risk concentrations and intra-group transactions setout reporting requirements for undertakings.Combined with the potential extension of supervision to unregulatedentities and identification of the entity ultimately responsible forcompliance with FICOD requirements, including reporting obligations,these requirements should provide an adequate framework forsupplementary supervision with regard to risk concentrations and intra-group transactions.The guidelines to be developed by ESAs, as requested by FICOD1,should ensure that the supervision of risk concentrations and intra-grouptransactions is carried out in a consistent way.3.3. Governance (Articles 9 and 13)Given the inherent complexity of financial conglomerates, corporategovernance should carefully consider and balance the combination ofinterests of recognized stakeholders of the ultimate parent and the otherentities of the group.The governance system should ensure that a common strategy achievesthat balance and that regulated entities comply with regulation on anindividual and on a group basis.FICOD, as amended, contains a requirement for conglomerates to havein place adequate risk management processes and internal controlmechanisms, a fit and proper requirement for those who effectivelydirect the business of mixed financial holding companies, a ‘living will’requirement, a transparency requirement for the legal and organisationalstructures of groups, and a requirement for supervisors to make the bestpossible use of the available governance requirements in CRD andSolvency II. _________________________________________ Solvency ii Association
  59. 59. CRD III and the proposal for CRD IV require, as will Solvency II, furtherstrengthening of corporate governance and remuneration policyfollowing the lessons learnt during the crisis.The living will requirement in FICOD1 would be strengthened by theBank Recovery and Resolution Framework.What these frameworks do not yet cover is the enforceable responsibilityof the head of the group or the requirement for this legal entity to beready for any resolution and to ensure a sound group structure and thetreatment of conflicts of interest.The Bank Recovery and Resolution Framework would require thepreparation of group resolution plans covering the holding company andthe banking group as a whole.4. Supervisory Tools and Powers4.1. The current regime and the need to strengthen supervisorytools and PowersArticle 14 enables supervisors to access information, also on minorityparticipations, when required for supervisory purposes.Article 16 empowers the coordinator to take measures with regard to theholding company, and the supervisors of regulated entities to act againstthese entities, upon non-compliance with requirements concerningcapital, risk concentrations, intra-group transactions and governance.The Article only refers to ‘necessary measures’ to rectify the situation,but does not specify such measures.Omnibus I gave the ESAs the possibility to develop guidelines formeasures in respect of mixed financial holding companies, but theseguidelines have not yet been developed. _________________________________________ Solvency ii Association
  60. 60. Article 17 requires Member States to provide for penalties or correctivemeasures to be imposed on mixed financial holding companies or theireffective managers if they breach provisions implementing FICOD.The Article also requires Member States to confer powers on supervisorsto avoid or deal with the circumvention of sectoral rules by regulatedentities in a financial conglomerate.The wording of Article 16 and the lack of guidelines have led to asituation where there is no EU-wide enforcement framework specificallydesigned for financial conglomerates.As a result, the supervision of financial conglomerates is sectorally basedwith differences in national implementation.Furthermore, the ESAs point out that strengthening the sanctioningregime as advocated in the CRD IV proposal may create an unevenplaying field between financial conglomerates depending on whetherthey are bank or insurance-led.At the same time, according to the ESAs, most national supervisoryauthorities consider that the measures available for sectoral supervisionare equally appropriate for the supervision of financial conglomerates.Strengthening the supervision of financial conglomerates could thereforebe achieved by improving the actual use of the existing instruments.As to the Article 17 requirement for Member States to provide forcredible sanctions to make the requirements credibly enforceable, nosuch sanctioning regime is known for conglomerates.The ESAs provide eight recommendations both to enhance the powersand tools at the disposal of supervisors and to strengthen enforcementmeasures, also taking into account the differences in nationalimplementation. _________________________________________ Solvency ii Association
  61. 61. Those recommendations include establishing an enforcement regime forthe ultimately responsible entity and its subsidiaries.This implies a dual approach, with enforcement powers to deal with thetop entity for group-wide risks and to hold the individual entities toaccount for their respective responsibilities.In addition, the supervisor should have available a minimum set ofinformative and investigative measures.Supervisors should be able to impose sanctions upon mixed activityholding companies, mixed activity insurance holding companies orintermediate financial holding companies.4.2. The possibility to introduce mandatory stress testingThe possibility to require conglomerates to carry out stress tests mightbe an additional supervisory tool to ensure the early and effectivemonitoring of risks in the conglomerate.FICOD1 introduced the possibility (though not an obligation) for thesupervisor to perform stress tests on a regular basis.In addition, when EU-wide stress tests are performed, the ESAs maytake into account parameters that capture the specific risks associatedwith financial conglomerates.5. ConclusionThe criteria for the definition and identification of a conglomerate, theidentification of the parent entity ultimately responsible for meeting thegroup-wide requirements and the strengthening of enforcement withrespect to that entity are the most relevant issues that could be addressedin a future revision of the financial conglomerates directive.The identification of the responsible parent entity would also enhancethe effective application of the existing requirements concerning capital _________________________________________ Solvency ii Association
  62. 62. adequacy, risk concentrations, intra-group transactions and internalgovernance.The regulatory and supervisory environment with regard to creditinstitutions, insurance undertakings and investment firms is evolving.All the sectoral prudential regulations have been significantly amendedon several occasions in the last few years, and even more significantchanges to the regulatory rules are pending before the legislators.Furthermore, the proposal for the Banking Union significantly changesthe supervisory framework.Therefore, and taking into account also the position of the EuropeanFinancial Conglomerates Committee, the supervisory community andthe industry, the Commission considers it advisable not to propose alegislative change in 2013.The Commission will keep the situation under constant review todetermine an appropriate timing for the revision. _________________________________________ Solvency ii Association
  63. 63. EU-U.S. Dialogue ProjectTechnical Committee ReportsComparing Certain Aspects of theInsurance Supervisory and RegulatoryRegimes in the European Union and the United StatesImportant partsThe Steering Committee of the EU-U.S. Dialogue Project presentsherewith the final reports of seven technical committees comparingcertain aspects of the insurance supervisory regimes in the EuropeanUnion and the United States.Attached is background information on the Project and the reportsthemselves.The reports informed the Steering Committee as to the keycommonalities and differences between the EU’s insurance regulatoryand supervisory regime and the state-based insurance and regulatoryregime in the U.S.The Steering Committee has agreed to common objectives andinitiatives to be pursued over the next five years which are set out in theWay Forward document available at[].The Steering Committee acknowledges the valuable contributions of thetechnical committee members and those who provided commentsduring the public consultation process. _________________________________________ Solvency ii Association
  64. 64. Introduction to the EU-U.S. Dialogue ProjectIn the EU, the European Parliament, the Council of the European Unionand the European Commission (EC), technically supported by theEuropean Insurance and Occupational Pensions Authority (EIOPA), aremodernizing the EU’s insurance regulatory and supervisory regimethrough the Solvency II Directive (Directive 2009/138/EC), in placesince 2009.This so-called Framework Directive was the culmination of work begunin the 1990s to update existing solvency standards in the EU.Current work aims to further specify the Framework Directive withtechnical rules and guidelines, which are necessary for a consistentapplication by insurers and supervisors of the framework.In the United States, the states are the primary regulators of theinsurance industry.State insurance regulators are members of the National Association ofInsurance Commissioners (NAIC), a standard-setting and regulatorysupport organization created and governed by the chief insuranceregulators from the 50 states, the District of Columbia and five U.S.territories.As part of an evolutionary process, through the NAIC, state insuranceregulators in the U.S. are currently in the process of enhancing theirsolvency framework through the Solvency Modernization Initiative(SMI).SMI is an assessment of the U.S. insurance solvency regulationframework and includes a review of international developmentsregarding insurance supervision, banking supervision, and internationalaccounting standards and their potential use in U.S. insuranceregulation. _________________________________________ Solvency ii Association
  65. 65. In early 2012, the EC, EIOPA, the NAIC and the Federal InsuranceOffice of the U.S. Department of the Treasury (FIO) agreed toparticipate in dialogue and a related project (Project) to contribute to anincreased mutual understanding and enhanced cooperation between theEU and the U.S. to promote business opportunity, consumer protectionand effective supervision.The project is considered to be part of and builds on the on-going EUUSDialogue which has been in place for over 10 years.The work was carried out in collaboration with EIOPA and competentauthorities in the EU Member States, and with state insurance regulatorsand the NAIC in the United States.The objective of the Project is to deepen insight into the overall design,function and objectives of the key aspects of the two regimes, and toidentify important characteristics of both regimes.Project Governance and Process: The Project is led by a six-memberSteering Committee comprised of three EU and three U.S. officials, asfollows:- Gabriel Bernardino – Chairman of EIOPA- Edward Forshaw – Manager in the Prudential Policy division, UK Financial Services Authority, and EIOPA Equivalence Committee Chair- Karel Van Hulle – Head of Unit for Insurance and Pensions, Directorate-General Internal Market and Services, EC- Kevin M. McCarty– Commissioner, Office of Insurance Regulation, State of Florida, and current President of the NAIC- Michael McRaith – Director, FIO, United States Department of the Treasury _________________________________________ Solvency ii Association
  66. 66. - Therese M. (Terri) Vaughan – Chief Executive Officer, NAICSince the Project began, the Steering Committee held face-to-facemeetings in Basel, Brussels, Frankfurt and Washington DC, as well asnumerous conference calls.In a first step, the topics to be discussed were agreed upon and a processfor information exchange under confidentiality obligations wasestablished.The Steering Committee agreed upon seven topics fundamentallyimportant to a sound regulatory regime and to the protection ofpolicyholders and financial stability.The seven topics are:- Professional secrecy/confidentiality;- Group supervision;- Solvency and capital requirements;- Reinsurance and collateral requirements;- Supervisory reporting, data collection and analysis;- Supervisory peer reviews; and- Independent third party review and supervisory on-site inspections.A separate Technical Committee (TC) was assembled to address eachtopic.Each TC was comprised of experienced professionals from both theEuropean Union as well as the United States, specifically, from FIO, theEC, the NAIC and EIOPA, as well as representatives from state _________________________________________ Solvency ii Association
  67. 67. insurance regulatory agencies in the United States and competentauthorities of EU Member States.The various professionals who comprised the technical committees wereselected because of their qualifications and experience with respect tothe subject matter of each topic, including insurance regulators andsupervisors, attorneys, accountants, examiners, and other specialists.The teams worked jointly to develop objective, fact-based reportsintended to summarize the key commonalities and differences betweenthe Solvency II regime in the EU, and the state-based insuranceregulatory regime in the United States.Supporting documentation, e.g., regulations, directives, and supervisoryguidance, was exchanged as requested by either side.The accompanying seven technical committee reports were jointlydrafted to reflect the consensus views of each respective technicalcommittee’s members.The draft reports were subsequently released for public consultation.The written consultation was complemented by two public hearings heldin October 2012, one in Washington DC and another in Brussels.Based on oral and written comments received through the consultationprocess, factual inaccuracies noted in the draft reports were correctedand limited clarifications were made.The reports were not amended further despite recommendations to do soby some commenters, i.e., the scope of the Project was not expanded asa result of the consultation process.Notwithstanding this, all oral and written comments have been takeninto consideration in the Steering Committees deliberations as part ofthe second phase of the project. _________________________________________ Solvency ii Association
  68. 68. No action has been taken by the governing bodies of the organizationsrepresented on the Steering Committee to formally adopt the factualreports and thus this document should not be considered to expressofficial views or positions of any organization.The reports represent the culmination of work from the Project, andinformed the work of the Steering Committee in agreeing to theaforementioned common objectives and initiatives.A detailed project plan will be developed in early 2013 and will beupdated periodically.The information that is the subject of the accompanying seven reportspertains to the insurance regulatory and supervisory regimes in both theEU and the United States.The statebased approach in the U.S. as described in the reports is insome respects based on NAIC Model laws and regulations that are giveneffect only through legislative enactment in each respective state.While some of these model laws have yet to be adopted andimplemented in certain states, a core set of common solvency regulatorystandards are in place in all states.In the case of the EU, the approach described in the reports is largelybased on the approach set out in the Solvency II Directive.However, in order to ensure a comprehensive comparison with the State-based Regime in the U.S., reference is also made in some cases to theapproach envisaged for the technical rules that will implement theDirective.It is important to note that those technical rules are still underdevelopment and have yet to be adopted by the European Commissionin the form of delegated acts. _________________________________________ Solvency ii Association
  69. 69. These rules and certain NAIC models are in some instances referred toin the present tense in the Technical Committees’ reports, i.e., as if theyare currently in place, even though they have not yet been adopted orimplemented, with respect to these rules in the EU or, in the case of themodel laws in the United States, by all states.The report does not purport to represent or pre-judge the views and/orthe formal proposals of the Commission.The approach described is largely based on what was tested in the lastfull quantitative impact study (QIS5), the technical specifications forwhich are publicly available.Insurance is a specialized and complex industry, and insuranceregulatory and supervisory matters can be just as specialized andcomplex.Terminology used in the reports reflects the background of therespective members of each technical committee, and thus theterminology and writing styles may vary somewhat from one committeereport to another.The Steering Committee expects that interested parties who may have aninterest in the Project and in submitting comments are familiar with theinsurance industry and its regulation in the EU, the U.S., or both.Accordingly, the technical committees have endeavoured to preparetheir reports in a manner that is appropriate for their own purposes andthat of the Steering Committee.There is some technical terminology that is used in the reports and,where considered appropriate, definitions have been provided therein.Some terms are unique to the U.S. and the EU but have the samemeaning, for example, insurers and undertakings; and reserves andtechnical provisions. _________________________________________ Solvency ii Association
  70. 70. Other terms exist in both the U.S. and the EU, e.g., review, audit orORSA, but differ in content/substance.Numerous abbreviations and acronyms have been used throughout theseven reports, definitions of which have been included in a separateappendix for the convenience of readers.The text of this report can be quoted but only with adequate attributionto the source document.The Contributing PartiesThe Federal Insurance Office, U.S. Department of the TreasuryThe Federal Insurance Office (FIO) of the U.S. Department of theTreasury was established by the Dodd-Frank Wall Street Reform andConsumer Protection Act.The FIO monitors all aspects of the insurance industry, includingidentifying issues or gaps in the regulation of insurers that couldcontribute to a systemic crisis in the insurance industry or the UnitedStates financial system.The FIO serves on the U.S. Financial Stability Oversight Council.The FIO coordinates and develops U.S. Federal policy on prudentialaspects of international insurance matters, including representing theUnited States, as appropriate, in the International Association ofInsurance Supervisors.The FIO assists the Secretary in negotiating certain internationalagreements, and serves as the primary source for insurance sectorexpertise within the Federal government.The FIO monitors access to affordable insurance by traditionallyunderserved communities and consumers, minorities, and low- andmoderate-income persons. _________________________________________ Solvency ii Association
  71. 71. The FIO also assists the Secretary in administering the Terrorism RiskInsurance Program.The European CommissionThe European Commission (EC) is one of the main institutions of theEuropean Union.It represents and upholds the interests of the EU as a whole.The EC is the executive branch of the EU and is responsible forproposing new European laws to Parliament and the Council.The EC oversees and implements EU policies by enforcing EU law(together with the Court of Justice), and represents the EUinternationally, for example, by negotiating international tradeagreements between the EU and other countries.It also manages the EUs budget and allocates funding.The 27 Commissioners, one from each EU country, provide theCommission’s political leadership during their 5-year term.The National Association of Insurance CommissionersThe National Association of Insurance Commissioners (NAIC) is thestandard-setting and regulatory support organization created andgoverned by the chief insurance regulators from the 50 states, theDistrict of Columbia and five U.S. territories.Through the NAIC, state insurance regulators establish standards andbest practices, conduct peer review, and coordinate their regulatoryoversight that is exercised at the state level. _________________________________________ Solvency ii Association
  72. 72. NAIC staff supports these efforts and represents the collective views ofstate regulators domestically and internationally.NAIC members, together with the central resources of the NAIC, formthe national regime of state-based insurance regulation in the UnitedStates.European Insurance and Occupational Pensions AuthorityThe European Insurance and Occupational Pensions Authority(EIOPA) was established as a result of the reforms to the structure ofsupervision of the financial sector in the European Union.The reform was initiated by the EC, following the recommendations of aCommittee of Wise Men, chaired by Mr. de Larosière, and supported bythe European Council and Parliament.EIOPA technically supports the EC, amongst others, in themodernization of the EU’s insurance regulatory and supervisory regime.Current work aims to further specify the Solvency II FrameworkDirective with technical rules and guidelines, which is necessary for aconsistent application by insurers and supervisors of the framework.In cross-border situations, EIOPA also has a legally binding mediationrole to resolve disputes between competent authorities and may makesupervisory decisions directly applicable to the institution concerned.EIOPA is part of the European System of Financial Supervisionconsisting of three European supervisory authorities, the others beingthe national supervisory authorities and the European Systemic RiskBoard.EIOPA is an independent advisory body to the EC, the EuropeanParliament and the Council of the European Union. _________________________________________ Solvency ii Association
  73. 73. EIOPA’s core responsibilities are to support the stability of the financialsystem, transparency of markets and financial products as well as theprotection of insurance policyholders, pension scheme members andbeneficiaries.Other Contributing PartiesThe Steering Committee of this Dialogue Project gratefully recognizesthe contributions of their organization’s staff, of insurance supervisorsand regulators from various EU Member States as well as from variousstate insurance departments in the United States who served on thevarious technical committees.The Technical Committee ReportsIn developing their reports, the Technical Committees acknowledgedthe overall policy objective of insurance regulation, the protection ofpolicyholders.Both regimes aim to ensure the ongoing solvency of domestic insuranceand reinsurance companies.Additional regulatory objectives include facilitating an effective andefficient marketplace for insurance products, and ensuring financialstability.These overarching policy objectives – which are common to both thestate-based regime in the U.S. as well as the EU regime – provide afoundation for each of the accompanying seven reports.In addition, the Steering Committee acknowledges that each solvencyregime must be considered from a holistic perspective and is alsomindful that differences between the respective regulatory frameworksare in some cases attributable to different philosophical approaches andlegal foundations. _________________________________________ Solvency ii Association