Solvency ii News January 2013

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Solvency ii News January 2013

Solvency ii News January 2013

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  • 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 CertificationProgram:www.solvency-ii-association.com/CSiiP_Distance_Learning_Online_Certification_Program.htm2. Certified Solvency ii Equivalence Professional (CSiiEP) DistanceLearning and Online Certification Program:www.solvency-ii-association.com/CSiiEP_Distance_Learning_Online_Certification_Program.htm_____________________________________________________________Solvency 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 10. Reinsurance companies, in turn, buy protection against peak risks fromother reinsurers and financial institutions. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 16. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 27. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 28. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 29. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 42. _________________________________________ Solvency ii Association www.solvency-ii-association.com
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  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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[https://eiopa.europa.eu/publications/reports/index.html].The Steering Committee acknowledges the valuable contributions of thetechnical committee members and those who provided commentsduring the public consultation process. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 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 www.solvency-ii-association.com
  • 74. For example, the different solvency tools outlined in the TechnicalReports are used to varying degrees by each regime.Such differences will be considered as appropriate in the second phase ofthe Project, but, apart from the inclusion of cross-references between thetopics, it was deemed to be beyond the scope of the Project to makefurther amendments to the individual Technical Committee reports inthis regard.The report gives nonetheless a comprehensive overview of the key partsof both regimes even if depicted separately.The state-based solvency regime in the U.S. is based on 7 coreprinciples, as follows:- Principle 1: Regulatory reporting, disclosure and transparency- Principle 2: Off-site Monitoring and Analysis- Principle 3: On-site Risk-focused Examinations- Principle 4: Reserves, Capital Adequacy and Solvency- Principle 5: Regulatory Control of Significant, Broad-based Risk- related Transactions/Activities- Principle 6: Preventive and Corrective Measures, including enforcement- Principle 7: Exiting the Market and ReceivershipThe EU Solvency II follows a three pillar approach.- Pillar I: Quantitative requirements relating to valuation of assets and liabilities, including technical provisions, the quality of own funds and Minimum and Solvency Capital Requirements _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 75. - Pillar II: System of Governance and risk management requirements- Pillar III: Supervisory reporting and public disclosureThere are commonalities as well as differences between the CorePrinciples identified in the U.S. state-based regime’s Insurance FinancialSolvency Framework and the three pillar approach of Solvency II.The reports of the Technical Committees which follow highlight thekey commonalities and differences for each of the seven topical areasselected for them by the Steering Committee to review.Each technical committee focused on only one of the aforementionedtopics.In practice, the regulatory aspects that are the topic of each respectivetechnical committee report operate on an integrated basis, as well aswith other regulatory tools and powers that are not covered by theaccompanying reports.Where appropriate, the report of a technical committee makes referenceto the reports of one or more other technical committees.For example, a reference in any one of the accompanying reports to“TC3” means the report of Technical Committee 3, which is listed in theTable of Contents of this combined document as “3. Solvency andCapital Requirements.”The reports of the technical committees refer to various EU directivesand regulations, as well as to various NAIC model laws and regulations.In the EU, a directive is a legal act that lays down certain end results thatmust be achieved in every Member State.National authorities have to adapt their laws to meet these goals, but arefree to decide how to do so. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 76. In case of maximum harmonization directives, Member States may notforesee requirements other than those laid down by the Directive.EU regulations are the most direct form of law; as soon as they arepassed, they have binding legal force throughout every Member State, ona par with national laws.National governments do not have to take action themselves toimplement EU regulations.Regulations are passed either jointly by the Council of the EuropeanUnion and European Parliament, or in some specific areas, by theCommission alone.The state-based regime in the U.S., through the NAIC, utilizes modellaws and regulations developed by state insurance regulators.Although these model laws and regulations require state legislativeenactment to become effective, a core set of solvency regulationstandards are effectively obligatory by operation of the NAICAccreditation Program.Although the states are primarily responsible for the regulation ofinsurance in the U.S., certain federal laws referenced herein may alsoapply to insurers or specific insurance activities.1. Professional Secrecy and ConfidentialityExecutive summary- TC1 organised its analysis of the key commonalities and differences by focusing on the analysis of the following subjects: policy objectives of confidentiality laws; the relationship between freedom of information laws and insurance confidentiality laws in the U.S. and the EU; _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 77. the role of the National Association of Insurance Commissioners (NAIC), the European Insurance and Occupational Pensions Authority (EIOPA) and the Federal Insurance Office (FIO) as distinct from insurance regulators / supervisors in the U.S. states and EU Member States; authority to share information across borders and the laws associated with information exchanges, methods for exchanging information, such as Memoranda of Understanding (MoUs) and confidentiality agreements, and the confidentiality of non-public supervisory information received by the FIO.- Both regimes seek to balance the objective of maintaining professional secrecy with appropriate flexibility to share information with other supervisory authorities with a legitimate and material interest in the information. Against this key commonality, key differences in structural approach can be observed. In the EU, the basic presumption incorporated in insurance legislation is that virtually all information acquired by the supervisory authorities in the course of their activities is bound by the obligation of professional secrecy. A series of “gateways” then facilitates information exchange with other relevant authorities. In the U.S., state laws generally provide for the confidentiality of certain information submitted to, obtained by, or otherwise in the possession of an insurance department. The approach is more often focused on protecting specific information from being available for public inspection. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 78. - Freedom of information (FOI) laws concerning government records and actions are premised on public access to official actions. In both the EU regime and the state based regime in the U.S., laws express the general policy of public access to government information, but this public policy is qualified by specific protections from disclosure for certain categories of information. The result is that both regimes provide for broad confidentiality protections for sensitive information while allowing for the sharing of that information among regulators in appropriate circumstances.- In both regimes, primary regulatory responsibility rests with the various state insurance departments in the U.S. and with the EU Member State supervisory authorities, respectively. The functions of both sets of supervisors are supplemented by the NAIC in the U.S. and EIOPA in the EU. The NAIC and EIOPA, in varying ways, assist the supervisory authorities in their regulatory roles and, in doing so, may receive certain confidential information pursuant to the laws of the relevant jurisdictions.- The newly-created FIO establishes a center of insurance expertise within the U.S. federal government. In carrying out certain of its functions, FIO will continue to interact with insurance and other regulators in the U.S. and the EU, and may participate in exchanges of confidential information. The Dodd-Frank Act requires the FSOC, the FIO, and the Office of Financial Research (OFR), which is an office within the U.S. Department of the Treasury that was also established by the Dodd- Frank Act, to maintain the confidentiality of any data, information, and reports submitted under that Federal law. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 79. All FSOC members entered into a MoU that sets out the understanding of all FSOC members regarding the treatment of non- public information. The MoU presumes that non-public information exchanged under its terms is confidential.- Both regimes include general authorizations to share confidential information with other financial regulators, law enforcement officials and other governmental bodies in need of such information to perform their duties. Confidential information may only be disclosed to such persons if they can maintain confidentiality and/or demonstrate their ability to protect such information from disclosure when the information is in their possession. Both regimes acknowledge the possibility of utilizing and disclosing information in receivership and bankruptcy actions, prosecuting regulatory and criminal actions, and pursuant to certain court actions.- Both regimes allow for regulators to enter into agreements or MoUs with counterparts in other jurisdictions to facilitate the sharing of confidential information. Both regimes provide broad discretion to regulators to establish the terms of such agreements, including the verification of each regulator’s ability to maintain the confidentiality of information received from another jurisdiction. Both regimes address the issue of potential sharing of information with third parties, but achieve similar outcomes in different ways. EU Member State requirements that the recipient of confidential information obtain explicit permission from the originating source before sharing with another regulator are often developed as a result _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 80. of legal constraints under the EU directives, while state insurance regulators in the U.S. are bound by general legal requirements to respect the confidentiality of information under the laws of the providing jurisdiction and the memorialization of this respect in written confidentiality agreements.- The similarities between the two regimes are greater than anticipated prior to the beginning of this dialogue. While there may be differences in the form and application of professional secrecy and confidentiality laws between the two regimes, they are substantially similar in the subject matter addressed and the outcome to be achieved. It is acknowledged on both sides that there is little evidence of practical problems related to the exchange of confidential information between state insurance regulators in the U.S. and EU regulators, although the flow of information has not been substantial so far and may have been inhibited by the interaction of EU directive constraints and concerns over professional secrecy.Topic 1: Policy objectives in relation to professional secrecy andthe exchange of informationKey Commonalities:Neither regime includes a single, all-encompassing definition of theterm “confidential information.”However both regimes identify general or specific categories ofinformation that will be considered confidential by law and not subjectto disclosure except under specific defined circumstances.- Legal sources, as primarily expressed through statutes and directives, provide the foundation for the confidentiality of certain categories of _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 81. information and the circumstances under which confidential information may be used and disclosed. While statutes and directives provide the foundation, both regimes recognize that confidentiality requirements may be complemented through administrative regulations, judicial opinions and MoUs.- Both regimes provide a range of penalties that may be levied against persons who breach professional secrecy obligations. Under both regimes, the penalties can include loss of employment, civil and administrative fines, imprisonment or a combination of these penalties. The definition of the penalties, as well as their enforcement, is handled at the U.S. state or EU Member State level.Key Differences:- The structural approach to confidentiality is very different. The EU approach starts from the presumption of confidentiality and identifies exceptions. Within the U.S., the provisions on professional secrecy vary from state to state as there is a clearer emphasis on access to public records. The presumption in most cases is that information is publicly available unless it is designated confidential through state laws or statutes. However, both regimes tend toward the same outcomes in terms of protecting information identified as confidential while facilitating information exchange among supervisory authorities across jurisdictions. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 82. Discussion/ Description of the Two Regimes:The EU Approach:The Solvency II Directive provisions on professional secrecy reflectsimilar provisions in the EU insurance directives currently in force.These operate on the basis that any confidential information received inthe course of the performance its duties by the supervisory authorityshall not be divulged to any person or authority whatsoever, except insummary or aggregate form, such that individual insurance andreinsurance undertakings cannot 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 compulsorily wound up.The professional secrecy obligation continues to apply after employeeshave left the supervisory authority, and the obligation also appliesequally to auditors and experts acting on behalf of the supervisoryauthority.While there is no definition incorporated in either the existing EUdirectives or Solvency II of what constitutes confidential information, theinterpretation of the scope of the professional secrecy provision has beenwide ranging.It is generally taken to encompass all firm specific information receivedby supervisory authorities unless it is already in the public domain andnot just information that might be explicitly labeled confidential.Supervisory assessments of firms undertaken by national supervisoryauthorities are not disclosed, and the public availability of informationon the performance of insurers under the existing directives will varyfrom EU Member State to Member State depending on provisions innational legislation. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 83. By contrast, the Solvency II regime will incorporate provisions requiringa higher level of public disclosure of financial information across the EU,including the requirement on firms to report annually on their solvencyand financial condition.A common professional secrecy provision means that there is no legalblock to the exchange of confidential information between nationalsupervisory authorities within the EU, and facilitates the participation inEU colleges.No further cooperation agreements are required, but in practice collegesoften develop their own MoU to formalise the expected informationexchange in respect of the particular group.The Approach in the State-based Regime in the U.S.:State insurance laws include many specific references to the types ofinformation that will be considered confidential, and notably state lawsgenerally provide that examination work papers and related information,risk-based capital information and holding company act filings andexamination information are confidential.Nevertheless the extent of the availability of firm specific information inthe public domain can help reinforce market discipline.The obligation of professional secrecy on the employees of statesupervisory authorities is applied through various means.State laws generally declare that confidential information shall bemaintained as confidential, and confidential information shall not bedisclosed except as authorised by state law.However, the professional secrecy obligation on the employees ofstate supervisors can also be applied, or supplemented, by employmentlaw provisions, contractual obligations or the internal rules of the statesupervisor. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 84. In many states, public employee obligations and penalties particularlyfocus on the disclosure of confidential information for personal gain.In some U.S. states, the law clearly states that confidentiality obligationsfollow public employees upon departure from public services.In other U.S. states, the statutory obligation is less explicitly expressedalthough general requirements to maintain confidentiality andprofessional obligations appear to achieve the same outcome.Auditors and experts acting on behalf of the state supervisory authorityare equally covered by the obligation of professional secrecy as directemployees of the authority.More generally, both the EU and U.S. regimes recognize thatprofessionals such as lawyers, actuaries, accountants and auditors aresubject to professional and ethical codes independent of those laws andregulations specifically concerning the regulation of insurance.Professionals may be subject to a range of professional sanctions,including the loss of licensure, for breaching confidentiality obligationsapplicable to their positions.While the variation in the structure of state laws dealing withconfidential information and professional secrecy could be perceivedpotentially to inhibit information exchange among state supervisoryauthorities in the U.S., this issue has been addressed with the MasterInformation Sharing and Confidentiality Agreement developed underNAIC auspices.One of the standard clauses of the agreement states that the stateinsurance regulator requesting or obtaining confidential informationfrom another is obliged to protect the information from disclosure “atleast to the same extent the Confidential Information is protected fromdisclosure under the laws applicable to the Responding Department, andfurther agrees to take all actions reasonably necessary to preserve, _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 85. protect and maintain all privileges or other protections from disclosurerelated to such Confidential Information.”Topic 2: The inter-relationship of FOI provisions withprofessional secrecy provisionsKey Commonalities:The relationship between EU Member State FOI provisions andSolvency II, as well as the relationship between state FOI laws andconfidentiality protections in the U.S., results in similar environments forinformation identified and maintained as confidential.The FOI principle is an essential element of appropriate public access togovernment information but general grants of confidentiality exemptfrom disclosure confidential information acquired by the supervisoryauthority.Key Differences:Under topic 1 the stronger emphasis on access to information in the USwas noted.For the state-based regime in the U.S., FOI provisions (with variationsfrom state to state) potentially provide broader access to supervisoryinformation, but those same laws also provide general and specificconfidentiality protections for certain supervisory information.One notable difference from this approach is that EU law does notenumerate the specific types of information that will be exempted fromdisclosure but expresses it in a more general way.While state laws in the U.S. may categorize certain items of informationas confidential, such as examination work-papers, EU law imposes ageneral obligation of professional secrecy on public employees andbroadly exempts confidential information from disclosure. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 86. Discussion:The Approach in the State-based Regime in the U.S.:State freedom of information (FOI) laws in the U.S. generally providethat the public policy of the state is for access to public records and otherinformation concerning the official activities of public employees andofficials.State laws provide for a range of exceptions to the disclosurerequirements contained within the state FOI law.These exceptions may be expressed as specific exceptions within theFOI law, specific exceptions within another section of the statutory code(e.g., the state’s insurance code) that directly cross reference the stateFOI law, or specific declarations in the state insurance code that certaininformation shall be considered confidential by law thereby indirectlyexcepting the information from the scope of the FOI law.State insurance laws include many specific references to the types ofinformation that will be considered confidential.It has already been noted that state laws generally provide thatexamination workpapers and related information, risk-based capitalinformation, and holding company act filings and examinationinformation are confidential.In addition to specific references, state FOI laws and insurance lawsinclude general references to categories of information that are to beconsidered confidential by law and not subject to subpoena.These general references include trade secrets, competitive information,and information provided or disclosed under an expectation oragreement of confidentiality.State insurance laws generally provide for the commissioner to shareconfidential information pursuant to statutory authorization. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 87. The gateways for sharing confidential information will be detailed inanother section of this paper.State insurance laws generally provide that, as a condition to sharingconfidential information with other governmental entities, thecommissioner may be required to enter into a written agreement for thatpurpose and the receiving party must have the authority to maintain theconfidentiality of the information provided.Similarly, state insurance laws generally provide that the commissionermay receive confidential information from other sources, including otherregulators, and that such information will be maintained as confidential(and thus beyond the scope of the state FOI laws) if it is provided withthe notice or understanding that the information is confidential underthe laws of the providing jurisdiction.In some cases, the ability to receive and maintain confidentialinformation from another source will be stated generally, either in theFOI law or the insurance code; in other cases, states receive thisauthority through specific insurance code references such as thosecontained within the examination or holding company law.There is no single statutory framework to information sharing andconfidentiality among U.S. states, but this does not create a barrier toconfidential information sharing.Some states rely on a general legal authority to share and maintainconfidential information, while other states may derive such authorityfrom more specific (including subject-matter specific) provisions in theirstatutes.Many state laws provide for a combination of general and specificconfidentiality protections.Although there may be some variance in specific legal provisions, stateFOI laws and state insurance laws operate together to preserve the _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 88. public policy of open government and protect sensitive information frominappropriate disclosure.The EU approach:FOI laws and confidentiality protections operate similarly in the EU.Member State laws generally provide for access for information related tothe public administration of laws, but analogous provisions providing forthe confidentiality of sensitive information often are stated in moregeneral terms.Member State laws typically state that virtually all information acquiredby the regulator in course of its supervisory work will be deemedconfidential by law.This general grant of confidentiality is embedded in the existing EUcore insurance legislation – the Reinsurance Directive, Consolidated LifeDirective and Third Non-Life Insurance Directive.The professional secrecy and information sharing provisions inSolvency II are substantially similar, and requires that informationacquired by a supervisory authority and its employees will be consideredconfidential and may not be disclosed except as specifically provided.Solvency II provides for the circumstances and where applicableprocedural requirements for disclosing confidential information withwhat it identifies as permitted recipients.These are the exceptions to the obligation of professional secrecy.The details of specific gateways for information sharing are coveredunder Topic 4 in this paper, but Solvency II states that the obligation ofprofessional secrecy does not preclude the sharing of information withsupervisors in other EU Member States. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 89. Information sharing agreements, such as MoUs, may be concluded withsupervisors in non-EU countries provided the information to bedisclosed is subject to equivalent guarantees of professional secrecy andthe information is intended for use in the performance of supervisoryduties in that country.This would include evidence and/or commitments that confidentialinformation would not become subject to disclosure through operationof a FOI law in a non-EU country.Topic 3: Relationships with national/regional bodies (i.e.,EIOPA, NAIC, FIO)Key Commonalities:In the U.S. and in the EU, primary regulatory responsibility rests withthe U.S. state insurance departments and the EU Member Statesupervisory authorities, respectively.The functions of both sets of supervisors are supplemented by the NAICin the U.S. and EIOPA in the EU.The NAIC and EIOPA, in varying ways, assist the supervisoryauthorities in their regulatory roles and, in doing so, may receive certainconfidential information pursuant to the laws of the relevantjurisdictions.The FIO monitors all aspects of the insurance industry, serves on theFinancial Stability Oversight Council and coordinates and develops U.S.Federal policy on prudential aspects of international insurance matters.In carrying out certain of its functions, FIO will continue to interact withregulators in the U.S. and in the EU and will participate in exchanges ofconfidential information. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 90. Key Differences:Under the EU regime, EIOPA has the task of contributing to a commonsupervisory culture by ensuring consistent, efficient and effectiveapplication of relevant legislation, and has a particular role in EUcolleges where it participates as a competent authority in its own right.In the U.S., the NAIC is not considered a supervisory authority althoughit coordinates certain activities among state supervisorsand provides aseries of analytical and support services.In both regimes, EIOPA and the NAIC may have access to firm-specificinformation through the respective supervisory authorities or othergrants of legal authority; however, the EU regime is different in that itallows EIOPA to request information directly from (re)insuranceundertakings in certain instances.Discussion:The EU Approach:The Regulation that established EIOPA applies the same professionalsecrecy obligations to EIOPA and its employees that apply to thesupervisory authorities in EU Member States but does not include thesame gateways for disclosure that are available for national supervisoryauthorities.EIOPA management and staff, as well as consultants engaged byEIOPA, are subject to EU laws concerning professional secrecy.EIOPA’s internal professional secrecy rules define confidential materialas including any information obtained from a national supervisoryauthority that is considered confidential under the laws of the providingjurisdiction. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 91. EIOPA has access to firm specific information through a number ofavenues, including EIOPA’s engagement in supervisory colleges, riskidentification, crisis management and stress testing.Accordingly, EIOPA is required to observe absolute confidentiality withrespect to such information, and confidential information may be usedonly for the purposes of carrying out EIOPA’s duties as stated inEIOPA’s founding regulation (“EIOPA Regulation”).Specifics regarding the future nature of regulatory reporting underSolvency II and the extent of EIOPA’s access in this respect will beunder discussion in the near future.EIOPA provides aggregated information on the EU insurance market tothe European Systemic Risk Board (ESRB) to assist it in achieving itskey task of preventing or mitigating systemic risks, and avoidingepisodes of widespread financial distress.The ESRB can make a reasoned request to EIOPA for data that is not insummary or aggregate form where it appears necessary for achieving theBoards tasks, but has not exercised this option to date.EIOPA is required to cooperate with the ESRB in having in placeadequate internal procedures for the transmission of confidentialinformation, in particular information regarding individual financialinstitutions.There is no gateway that would allow national supervisory authorities orEIOPA to share firm specific confidential information with the EUinstitutions (European Commission; European Council; EuropeanParliament).Any information provided on the insurers activity in the market wouldneed to be in summary or aggregate form so that individual firmsactivities cannot be identified. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 92. The Approach in the State-based Regime in the U.S.:In the U.S., the states – rather than the federal government – haveprimary regulatory responsibility for regulating the business ofinsurance, including for laws related to professional secrecy.The Dodd-Frank Act established the Federal Reserve Board ofGovernors (FRB) as the primary consolidated regulator for savings andloan holding companies, many of which are firms engaged primarily inthe business of life insurance.The FRB has entered into memoranda of understanding with stateinsurance regulators regarding insurance entities.Federal government knowledge and involvement in insurance matters isenhanced by the establishment of the FIO, which has authority tomonitor all aspects of the insurance industry and coordinate and developU.S. Federal policy on prudential aspects of international insurancematters.While there is no federal body mandating uniformity, state insuranceregulators in the U.S. operate collectively to establish uniform standardsin a variety of areas, including professional secrecy.State laws authorize the filing of certain information with the NAIC anddeclare that certain categories of information disclosed to the NAIC willbe considered confidential in the possession of the NAIC.Although states are authorized to share confidential information with theNAIC in certain circumstances, the NAIC does not supersede theregulatory authority of the state insurance departments.Accordingly, the NAIC may not independently disclose confidentialinformation provided to it by state insurance departments to othersupervisory authorities, but the NAIC may facilitate such informationexchanges among regulators as permitted under relevant law. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 93. Because the NAIC is not a department or agency of state orfederal government, the NAIC does not fall within the types ofgovernment entities to which freedom of information laws may apply.The NAIC occasionally enters into specific information sharing andconfidentiality agreements with individual states.The scope of the agreement may vary depending on the subject matter ofthe project for which an agreement is required, the confidentialinformation to be provided to the NAIC, and the manner in which suchinformation is to be used and/or stored by the NAIC.The NAIC maintains confidentiality policies to protect confidentialinformation from disclosure.As a condition of employment, all NAIC employees agree to be boundby such policies during – and following – their term of employment.NAIC model laws and the financial regulatory accreditation programprovide means for establishing standards against which state regulatorshold each other accountable.Several NAIC model laws provide a legal template for enhancingconfidentiality protections as well as authorizing the commissioner todisclose and receive confidential information with other regulators,including international regulators.Exemplary model laws include the Model Law on Examinations, theRisk-Based Capital Model Act, the Insurance Regulatory InformationSystem Model Act, the Insurance Holding Company System RegulatoryAct, and the Producer Licensing Model Act.As illustrated below, many of these model laws provide key legalelements associated with the NAIC accreditation program. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 94. It is important to note, however, that states have not necessarilyamended their insurance statutes exactly as the model laws maypropose.For example, many state confidentiality statutes pre-date theamendments to the NAIC model laws.States may have determined their existing statutes sufficiently providedfor the confidentiality and information sharing intended to be authorizedby the model laws and as required for purposes of the NAICaccreditation program.The NAIC Financial Regulation Standards and Accreditation Program,in part, requires states to have certain statutes in place that evidence thelegal authority to regulate for financial solvency.In order to achieve accreditation, states must have specific laws relatedto information sharing.Accreditation standards and guidelines require the insurance departmentto demonstrate it has the authority to share confidential information withstate, federal and international regulators; that the department has theauthority to keep confidential information obtained those sameregulators from disclosure; and that the department has a written policyconcerning information exchanges with other regulators.Additionally, states also must demonstrate they have statutes related toinformation sharing on the specific topics of examination authority, risk-based capital and holding company systems.2. Group SupervisionIntroductionIn general terms, a “group” refers to more than one company thatcoexists as part of a corporate family by virtue of ownership or affiliation. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 95. Generally speaking, an insurance group is comprised of two or moreinsurers, but there could be other legal entities involved as well – holdingcompanies; subsidiaries or affiliates such as agencies, service providersor third party administrators whose business is tangential to that of themember insurers; and other entities whose business is unrelated to theinsurance operations of the group.Again in general terms, group supervision is the application of regulatoryoversight to a group.Group supervision has become an important aspect of the overallsupervisory process because group membership can pose unique risks(e.g. reputational risk) as well as benefits (e.g. capital options, riskdiversification) to one or more insurance undertakings that are membersof the group.Group supervision therefore is an important complement to solosupervision in ensuring policyholder protection.In this TC2 report the state-based insurance regulatory regime in theU.S. and the Solvency II regime in the EU are compared as to theirrespective requirements and processes for group supervision.For certain U.S. insurance groups, with a bank or thrift, consolidatedsupervision is conducted by the Federal Reserve Board with an emphasison protecting the depository institution.In the EU, financial conglomerates are regulated under the FinancialConglomerates Directive (FICOD).Executive Summary:- Policy Objectives: The over-arching objectives are essentially the same i.e., to protect policyholders and to enhance financial stability. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 96. That said, there are various differences between the EU and state- based U.S. regimes in the manner in which those objectives are achieved with respect to group supervision.- Scope of Group Supervision: In both regimes, various legal entities within the group can be included in the scope of group supervision. The scope of group supervision in the EU according to the Solvency II Directive is the entire group, i.e., all entities within the group, regulated or otherwise, on a global basis. However, the group supervisor has authority to narrow that scope subject to prescribed criteria. In the U.S., traditional application of group supervision has focused on the holding company and its insurance subsidiaries in the U.S.- Supervisory Colleges: Both regimes are generally similar in terms of the operations of supervisory colleges; however the role, tasks, powers and content of the group-wide supervisor differ between the two regimes. Moreover, the EU’s Solvency II regime provides for a legally binding regime, whereas the U.S. operates a less formal, nonbinding one. Nonetheless, both approaches are intended to drive joint /collaborative decisions as to any supervisory actions in the EU at the solo and group level and in the U.S. at solo level as well as actions aiming to achieve outcomes at the group level.- Supervisory Powers at the group level: Under Solvency II in the EU, there is a single group supervisor with explicit duties and powers that are applicable to legal entities and as well as to insurance holding companies which are located in the European Economic Area (EEA). _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 97. Group supervisors in the EU can request insurance holding companies in the EU to hold more capital to cover excessive risk in other jurisdictions. However, in the case of an insurance holding company located in a Member State other than that of the group supervisor, the group supervisor needs to inform the competent supervisor or jurisdiction where the holding company is located with the aim to have that supervisor take the necessary action. The U.S. state-based regime focuses on the application of powers at the legal entity level and with regard to insurance holding company systems on information gathering and examination. Insurance regulators have limited extra-territorial powers and rely on communications and cooperation with other regulators in other jurisdictions who have the authority to take necessary actions.- Reporting at the group level: In the EU, reporting is standardized and required for all groups on a consolidated basis. Groups have to make similar submissions to that of solo undertakings (Solvency and Financial Condition Report (SFCR), Regular Supervisory Report, Quantitative Reporting Templates (QRTs), Own Risk and Solvency Assessment (ORSA)) but with additional information and data which are group-specific. In the state-based regime in the U.S., reporting at the group level is focused on extensive intra-group reporting requirements to support required priorapproval processes based on legal standards and financial analysis; consolidated financial information is used in the U.S. where available, i.e., for listed companies, those that otherwise voluntarily provide such information, and where state insurance regulators otherwise require it through filing, analysis or examination processes. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 98. - Group Capital: The EU has an explicit group capital requirement, whereas the state based regime in the U.S. does not.- Group ORSA: Both regimes have an ORSA requirement that is similar in concept, but the EU sets in law the process and key components of the assessment and has guidelines that are more prescriptive, whereas in the U.S., more management discretion is allowed as to the use of methodologies, with disclosure and justification.- Group Governance: In both regimes, companies have to comply with corporate governance requirements as set forth in federal and state laws. Publicly-listed companies also must abide by rules set by the various stock exchanges. U.S. insurers are subject to state corporate laws, in addition to various governance requirements embedded in state insurance laws and regulations. In addition to corporate governance requirements, EU Solvency II internal governance requirements also exist, e.g., with respect to internal controls and risk management systems as well as key functions. In the U.S., supervisors assess those aspects during on-site examinations for the purpose of designing examination procedures.- Regulation of Financial Conglomerates: For those insurance groups which are Bank Holding Companies (BHCs) or Savings & Loan Holding Companies (SLHCs), the Federal Reserve has explicit capital requirements. In the EU requirements for conglomerates are set in FICOD. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 99. 3. Solvency and Capital RequirementsThe primary objective of both regulatory regimes is to protect thepolicyholders.For this purpose, the two regimes have two different approaches each ofwhich must be considered from a holistic perspective.The respective regulatory frameworks are in some cases attributable tothe different philosophical approaches and legal foundations of thoseregimes.Under the state-based regime’s risk-based capital (RBC) system in theU.S., the Company Action Level (CAL) sets a minimum amount ofcapital before corrective action is prompted.That amount of regulatory capital is likely to be lower than the EUSolvency Capital Requirement (SCR).The CAL RBC level (and the three other levels) for regulatoryintervention is not calibrated to an overarching confidence level or timehorizon (calibration of risk categories are also not derived from explicittarget criteria).Under the EU Solvency II regime, the supervisory ladder of interventionis based on the SCR and the Minimum Capital Requirement (MCR)which are calibrated to 99.5% and 85% confidence levels respectively,using a value-at-risk measure of the Basic Own Funds derived from atotal balance sheet approach.The Mandatory Control Level RBC is most likely lower than theSolvency II MCR.The term “internal models” indicates a different meaning under thestate-based regime in the U.S. than it does under Solvency II, and thescope of application of models is more limited under the RBC system inthe U.S. than it is under Solvency II. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 100. Specifically, RBC limits the application of models in the U.S. to specificproducts and risk modules, using prescribed parameters and timehorizons and the models are not subject to a prior approval by thesupervisor, though they are subject to regulatory minimum/floorscenarios.Under Solvency II, as a way to more precisely reflect the risk profile ofthe regulated entity, internal models can be used for the calculation ofthe SCR for all or some of the risks.The use of internal models is subject to prior supervisory approval,ongoing monitoring and compliance with specific requirementsincluding the integration of the model in risk management and decisionmaking processes.Both regimes have a similar concept of the own risk and solvencyassessment (ORSA), but the EU sets in law the process and prescribesthat the qualitative and quantitative assessments are performed against aset standard.The EU also provides guidelines that are more prescriptive.In the U.S., more management discretion is allowed as to the use ofmethodologies, with disclosure and justification.The state-based Statutory Accounting Principles (SAP) regime in theU.S. and the valuation approach used in Solvency II deviate from thebases used for general purpose reporting in those jurisdictions(respectively, U.S. GAAP and IFRS) in valuing certain assets andliabilities.SAP looks to establish more of a winding-up value based on the statutoryaccounts and the use of amortized cost methodologies, whereas the EUregime assesses a company on a going-concern basis based on a marketconsistent balance sheet. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 101. This difference is consistent with the SCR potentially being an earlierintervention point than the RBC CAL and explains why available capitalis likely to be more subject to variation over time in response tochanging market conditions under the European regime.Technical provisions are valued on a market-consistent basis underSolvency II.Technical provisions comprise the sum of the best estimate and a riskmargin.The best estimate represents the probability weighted average of allfuture cash flows discounted using a risk free rate term structure.The risk margin represents the cost of capital to support the productuntil liabilities are fully run-off.The RBC regime by contrast uses a discount rate based on corporatebond yields for life insurance reserves and a best estimate (for whichdiscounting is restricted to certain lines of business) for property &casualty insurance reserves.Whilst the US regime contains explicit or implicit reserve margins indifferent places, the EU regime has no such margins, but does containthe risk margin as defined above.It is to be highlighted that these two concepts are not directlycomparable; their underlying purposes are different.The reserving bases are different and an assessment of the relativestrength of the EU and U.S. bases will depend on the specific productunder consideration.Under RBC requirements, capital is defined as statutory capital andsurplus with prudential adjustments (including ones made for non-admitted and limited admissibility assets). _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 102. In the EU, capital resources are generally equal to the net asset value ofthe firm plus subordinated liabilities (basic own funds) and ancillaryown funds.Solvency II includes a three-tier classification of capital and providesspecific provisions for the classification of hybrid and subordinatedcapital instruments.To the extent that instruments do not provide the best form of lossabsorbency, they are restricted in counting towards covering capitalrequirements.Investment restrictions are consistent with the prudent person principleunder Solvency II.In the state-based regime in the U.S., investment restrictions are basedupon defined limits or a prudent person approach (or somecombination) depending on the state.For RBC results, corrective actions are triggered when the capitalresources of a company are less than the Company Action Level RBC,while, under Solvency II capital requirements, corrective actions aretriggered when a company breaches its SCR.Topic 1: Policy ObjectivesOverall Policy ObjectivesThe primary objective of both the state-based regulatory regime in theU.S. and the EU’s Solvency II is to protect policyholders.The protection of policyholders presupposes that companies are subjectto effective solvency requirements that result in the maintenance ofadequate capital resources that cover all of the risks to which an insureris or could be exposed. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 103. Accordingly, capital requirements are a key tool for accomplishing theobjective of policyholder protection under both regimes.Financial stability and fair and stable markets are other objectives ofinsurance regulation and supervision that should also be taken intoaccount but that should not undermine the main objective.Overall Policy Framework & Supervisory SystemUnder the state-based regime in the U.S., RBC requirements are a toolfor legally authorized and defined company or regulatory action atspecified levels.State regulators also have regulatory authority for Companies Deemed tobe in Hazardous Financial Condition (NAIC Model 385) to imposetailored timely intervention (pursuant to other solvency tools) prior toan RBC action-level trigger.RBC sets out a minimum capital requirement and does not aim to be anevaluation of economic or target capital level.Therefore, it is not used to establish or compare well-capitalizedcompanies.RBC requirements target material risks for each of the primary insurertypes (life, property & casualty and health).In addition to RBC requirements and other financial tools used toimplement corrective action, the overall state-based solvency frameworkin the U.S. also includes the following:- restrictions on insurers’ activities to mitigate or eliminate some risks in the insurance business;- prudential accounting filters which result in conservative surplus recognition and provide counter-cyclical effects; and _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 104. - a back-stop of financial protection when insurer rehabilitation or liquidation is required via the State Guaranty Fund System.As such, RBC is calculated from valuations that are usually moreconservative (e.g., non-admitted assets, deferred acquisition costs areexpensed rather than capitalized) and less volatile (e.g., many fixedincome instruments are valued at amortized cost) than valuations underfinancial accounting standards such as GAAP.Insurer risk management issues are addressed in multiple areas outsideof RBC, most heavily in the on-site examination process (see TC 7) butalso in reporting and analysis (see TC 5).As discussed further below, state regulators may also impose additionalcapital requirements (for example, for deficiencies in risk managementand other areas) outside of the RBC calculation.In the EU, Solvency II follows a “Total Balance Sheet Approach” wherethe determination of an insurer’s capital that is available and needed forsolvency purposes is based upon a market consistent or economicvaluation approach.Solvency II capital requirements target all quantifiable risks and aredetermined on the basis of the risk profile of the company and themanagement of those risks (e.g. the use of risk mitigations).Solvency II capital requirements therefore provide incentives for soundrisk management practices and enhanced transparency (e.g., in the caseof governance deficiencies, supervisors may impose capital add-on – seeCapital add-on below).Key Commonalities:- RBC in the state-based regulatory regime in the U.S., and Solvency II capital requirements in the EU, play a key role in meeting the goal of policyholder protection, which is central to both regimes. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 105. - Both regimes provide thresholds for regulatory actions.- For both regimes, the capital requirements are supported by requirements on governance, supervisory review, reporting to supervisors. In addition, both rely on market discipline through public disclosure.Key differences:- The Solvency II market-consistent balance sheet provides a going- concern view of an insurer’s solvency position, while RBC represents capital more on a winding-up basis, thereby influencing the part they play in the respective regimes.- The SCR under Solvency II includes all quantifiable risks of the insurer while RBC includes risks considered material to the industry with some modules looking at company specific assumptions.- The Solvency II framework, including the SCR, is designed to provide incentives for risk management, whereas the RBC primarily relies on supervisory tools other than capital requirements to address risk management concerns.Topic 2: Assessment of Risk and Capital AdequacyScope of regulatory capital calculationThe RBC calculation under the state-based regime in the U.S. is mainlya standardized approach tied to annual statement data with increasinguse of internally-generated company information for model approaches.RBC assesses risk by applying risk weights (called “factors”) withineach risk module, although, certain lines of business and risks (e.g.interest rate risk) are assessed using models. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 106. Each of the primary insurance types (life, property & casualty, andhealth) has a separate RBC formula, with each containing its own set offactors covering the material risks identified in each formula.The components of the life insurance formula include the following: riskrelated to certain affiliated investments; risk on other financial assets(e.g. risk of default, change in market value); insurance risk; interestrate, health credit risk, and market risk; and general business risk.The components of the property & casualty insurance formula include:risk related to affiliated company investments; risk on fixed incomeassets; risk on equities; credit risk (related to reinsurance recoverables);underwriting risk (related to reserves); and underwriting risk (related tonet written premium).The components of the health insurance RBC formula include thefollowing: risk related to certain affiliated investments; risk on otherfinancial assets; underwriting risk; credit risk; and business risk.Asset concentrations are also assessed via risk charges to reflect theadditional risk of high concentrations in single issuers.However, currency risk is not taken into account and catastrophe risk isnot addressed directly and completely, although a catastrophe riskcharge currently is being developed as part of Solvency ModernizationInitiative.A standard factor for operational risk is included in the Life RBCformula, but not in the P&C formula.The RBC formula includes a covariance calculation (that also variesdepending on line of business) that is designed to measure correlationbetween risks.Investments in affiliated insurance companies are excluded from thecovariance calculation based upon the assumption that diversificationdisappears when the entity experiences financial distress. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 107. Four RBC action and control levels establish risk-based requirementsthat provide a baseline to more discretionary regulatory interventionresulting from analysis and examination oversight activities (see Topic 4for additional discussion of the RBC action and controllevels).In the EU, the Solvency II framework sets out two different levels ofcapital requirements, an upper level, the SCR, and a lower bound, theMCR.The SCR is designed to take into account all quantifiable risks to whicha firm is exposed, to include at least the following: (life, non-life andhealth) underwriting risks; market risk; credit risk; operational risk.Each of these risks includes various sub-risks.For instance, market risk includes interest rate risk, equity risk, propertyrisk, spread risk, currency risk, and market risk concentration.The SCR takes into account risk mitigation techniques (e.g. reinsurance)provided that credit risk and other risk arising from the risk mitigationare also reflected in the SCR.The SCR is a risk-sensitive requirement used for timely supervisoryintervention (to prompt corrective action by the company).The MCR is designed to correspond to a minimum solvency level, belowwhich policyholders and beneficiaries are exposed to an unacceptablelevel of risk, if the insurer were allowed to continue its operations.The MCR is a simple linear formula, calculated independently from theSCR calculation, comprising a set of risk factors applied to the individualcompany liabilities.The MCR must be within 25% and 45% of the SCR and is subject toabsolute minimum amounts. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 108. As an alternative to using the SCR standard formula, a company may,subject to regulatory approval, replace some parameters of theunderwriting risks modules with some other parameters based on thecompany’s own data.In accordance with the risk-oriented approach to the SCR, companiescan, subject to supervisory approval, use either partial or full internalmodels for the calculation of that requirement (this is reflected in aseparate section).The framework is completed with the existence of dampeners, bothquantitative (e.g. the symmetric adjustment mechanism for equity riskunder the standard formula) and qualitative (e.g. provision for takingdue care to avoid pro-cyclical effect when requiring plan to restorecompliance with the SCR), that aim to address potential pro-cyclicaleffects of the regime.Calibration of regulatory capitalThere is no overall formula calibration under RBC.Instead, state regulators refine individual risk weights through analysisof historical data and probabilities using expert judgment.A separate calibration process is applicable to partial models used toassess interest rate and other risks.In short, RBC factors were developed based on industry norms withsome factors adjusted by company specific experience.Risk weights, partial model calibration, and any other formula changeare accomplished via a transparent process incorporating input frominsurance market representatives. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 109. Under Solvency II, the MCR uses a standardized approach based uponValue at Risk calibrated to an 85% confidence level over a 1-year timehorizon;That calibration is floored and capped at 25% and 45% respectively ofthe undertaking’s Solvency Capital Requirement and is subject to anabsolute floor, which depends on the nature of the undertaking, that theMCR cannot go below.The SCR is based upon Value at Risk calibrated to 99.5% confidencelevel over a 1-year horizon for all risk modules and for the overallformula.The outputs of the modules (and submodules) of the standard formulaare calibrated to the 99.5% Value at Risk over a 1-year horizon and thenaggregated using a prescribed variance/covariance matrix based uponfixed correlation factors between risk modules.This has been calibrated using a combination of data and regulatoryjudgment.The calibration was developed through a transparent process involvinginsurance market representatives via public consultations and was testedthrough quantitative impact studies.Frequency of calculation of the regulatory capitalRBC is an annual filing to the NAIC.However, supervisors may require more frequent filings directly to thestate for undertakings of concern (typically quarterly).Under Solvency II, a company is required to calculate the SCR at leastonce a year, but may be required to do so more frequently if the riskprofile of the firm deviates (or there is evidence to suggest that it hasdeviated) significantly from the assumptions underlying the last reportedSCR. The frequency of calculation of the MCR is at least quarterly. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 110. Capital Add-on to regulatory capitalUnder Solvency II, supervisors have the power to impose a capital add-on to the SCR following the supervisory review process.Capital add-ons may be imposed where the risk profile of the firmdeviates significantly from the assumptions underlying the SCR ascalculated using the standardised approach or the internal model inorder to restore the firm to the 99.5% confidence level, using a value-at-risk measure.Capital add-ons may also be imposed where there are significantgovernance deficiencies.In the event the standardized approach does not adequately reflect thespecific risk profile of an undertaking supervisor may require thedevelopment of an internal model.In the event of significant deficiencies in the full or partial internal modelor significant governance failures the supervisors ensure that the insurermakes every effort to remedy the deficiencies that led to the impositionof the capital add-on.The capital add-on should be retained for as long as the circumstancesunder which it was imposed are not remedied.Under the Hazardous Financial Condition model regulation, stateinsurance regulators in the U.S. have the discretion to impose additionalcapital requirements when one or any combination of twenty listedstandards is breached.The additional capital is not an increase to the RBC calculation.Instead, it is an increase to the level of capital the insurer is actuallyholding and therefore becomes an effective minimum capitalrequirement. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 111. Furthermore, state regulators are in the process of adding trend tests forProperty and Casualty RBC and for health RBC.A trend test for Life RBC has existed since the inception of the formula.Triggering the trend test can result in the regulator asking theinsurer to hold more capital.Disclosure of trend test results is not foreseen at this stage.Own Risk Solvency Assessment (ORSA) and economic capitalThe states, through the NAIC, are in the process of implementing anORSA standard.According to the Risk Management and Own Risk and SolvencyAssessment Model Act that is currently being adopted, the ORSAsummary report shall be prepared consistent with the ORSA GuidanceManual.Section 3 of the NAIC ORSA Manual refers to Group Risk Capital andProspective Solvency Assessment and sets the goal of the assessment toprovide an overall determination of group risk capital needs for theinsurer, based upon the nature, scale and complexity of risk within thegroup and its risk appetite, and to compare that risk capital to availablecapital to assess capital adequacy.According to the interpretation of NAIC experts also, a legal entity thatdoes not belong to a group is not exempted from having to completesection 3.In the EU, ORSA is Solvency II directive requirement.Under both regimes, ORSA will encompass the processes andprocedures used to identify, assess, monitor, manage and report theshort and long term risks a (re)insurance company faces or may face and _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 112. to determine the capital adequacy (including a prospective solvencyassessment) from the company-own perspective.Both regimes have an ORSA requirement that is similar in concept, butthe EU sets by Directive the process and prescribes the qualitative andquantitative assessments that have to performed, and provides guidancethat are more prescriptive, whereas in the U.S., more managementdiscretion is allowed as to the use of methodologies, with disclosure andjustification.In the EU, the ORSA is an integral part of the risk management andshall be taken into account on an on-going basis in the strategicdecisions of the insurer.According to Art. 45, the ORSA will need to cover at least: the overallsolvency needs taking into account the specific risk profile, approvedrisk tolerance limits and the business strategy of the undertaking, thecompliance, on a continuous basis, with the capital requirements, andwith the requirements regarding technical provisions, as well as thesignificance with which the risk profile of the undertaking concerneddeviates from the assumptions underlying the SCR, calculated with thestandard formula or with its partial or full internal model.The ORSA will essentially provide that all companies, regardless of thesolvency calculations required by supervisory regulations, are required todetermine their actual risk profile realistically based on economic criteriaand to control the same and integrate it into their risk managementprocesses.Under the state-based regime in the U.S., the ORSA is one element of aninsurer’s broader Enterprise Risk Management (ERM) framework.The ORSA requirement includes an exemption for insurers with annualpremium revenue less than $500 million but this is subject tocommissioner discretion. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 113. The NAIC’s ORSA Guidance Manual requires an internal assessment ofthe risk associated with the insurer’s current and projected futurebusiness plan and an assessment of the sufficiency of capital resourcesto support those risks in both the current and stressed environments.As specified in the ORSA Guidance Manual, the ORSA Summary Reportshould discuss, at a minimum, the three major areas of:1) A description of the insurer’s risk management framework (includingat a minimum the risk culture and governance; the process for riskidentification and prioritization; the risk appetite, tolerances and limits;the description of risk management and controls; and risk reporting andcommunication);2) The insurer’s assessment of risk exposure (quantitative and qualitativeassessments of risk exposure in both normal and stressed environmentsfor each material risk category); and3) The group risk capital and prospective solvency assessment(documenting how the company combines the qualitative elements of itsrisk management policy and the quantitative measures of risk exposure(in both normal and stressed environments) in determining the level offinancial resources it needs to manage its current business and over alonger term business cycle such as the next 2-5 years).Although economic capital targeted by insurers for commercial purposesis higher than the regulatory capital requirements in both regimes, SCRgenerally yields a regulatory capital requirement that is closer to sucheconomic capital than RBC for companies targeting the same creditrating.Key Commonalities:- Both regimes calculate risk-based capital requirements based on a company’s own risk profile. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 114. However, the risk factors included in RBC are established to cover risks that are material for the industry, while the SCR of the Solvency II regime should cover all quantifiable risks to which a company is exposed.- Both regimes have an ORSA requirement that is similar in concept.- Both allow some modification of the standard formula calculations for companyspecific experience (using undertaking-specific parameters under Solvency II or weighted company-own factors under RBC).- Both regimes allow regulators the discretion to impose capital add- ons. The state based regime in the U.S. allows use of capital add-ons in specific situations deemed hazardous to the undertaking’s financial condition. The insurer is required to hold the additional capital, and this becomes the firm’s minimum regulatory capital. Triggering the RBC trend test can also result in regulator asking an insurer to hold more capital. Solvency II demands an explicit increase to the insurer’s regulatory capital, through the use of capital add-ons where there are significant governance failures or where the risk profile of the firm is significantly different from the assumptions underlying the SCR calculation. The capital add-on is imposed in order to restore the regulatory capital to a 99.5% confidence level. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 115. Key differences:- Solvency II provides for a risk-sensitive capital requirement (SCR) that is based upon a prospective calculation of capital charges calibrated to an overall value at risk with a confidence level of 99.5%. RBC is not based on an overarching calibration target, although it does provides for specific calibration at individual risk level.- RBC capital requirements cover a specified list of factors that focus on the most material risks at the industry level and that are differentiated by type of insurer (life, P/C, health). The SCR is required to take into account all quantifiable risks for a firm The MCR is a linear formula based on a set of risk factors applied to individual company liabilities, and is much simpler than either the SCR or RBC.- While an ORSA will exist in both regimes, the primary difference is that in the EU ORSA is a more prescriptive legal requirement linking risk management and capital management (including assessment of the significance with which the risk profile of the undertaking deviates from the assumptions underlying the SCR), whereas under RBC it is a legal requirement tied to analysis and regulatory oversight with more discretion initially left to management to determine (and justify) the specific risk assumption and mitigation methodologies chosen.- Under Solvency II, supervisors may impose an additional capital add-on to increase the SCR to the calibration target and the resulting SCR will be disclosed. Under RBC, the regulators may require a company to hold a higher level of capital if the trend test is triggered. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 116. Additional capital outside than the RBC calculation may be required, but that does not constitute an increase to the RBC calculation.- Currently, currency risk and catastrophe risk are excluded from RBC, although there are plans to include catastrophe risk as part of SMI; it is planned that the 2013 formula will capture this. A standard factor for operational risk is included in the Life RBC formula, but not in the P&C formula. Since the overwhelming majority of business written by US domiciled insurers is in US currency, currency risk is not currently a material risk for the industry and thus is not incorporated into the RBC formulas. It is noted though, that bilateral EU–US recognition may result in an increase of EU–US cross-border business. For a particular undertaking that has a material amount of currency risk, this would be disclosed as part of the required statutory financial statement and monitored by the supervisor in the analysis and examination processes.4. Reinsurance and Collateral RequirementsExecutive summary:TC4 covers the key commonalities and differences that exist betweenboth regimes in relation to the supervisory requirements for reinsuranceand collateral.The main topics analyzed include the policy objectives, risk transferrequirements, credit for reinsurance and collateral requirements, capitalrequirements and consistency. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 117. A number of additional topics, including requirements relating toaffiliated reinsurance transactions, concentration risk, securitization,reporting and U.S. market statistics are also considered.Several commonalities between the two regimes can be observed interms of the overall policy objectives and the risk transfer requirements.Both regimes seek to ensure the ongoing solvency of domestic insuranceand reinsurance companies in order to protect policyholders.Under both regimes, risk mitigation techniques must fulfill criteriarelating to genuine and effective risk transfer in order to receive credit,although some differences between the two regimes do exist.Each also requires that ceding companies reflect the counterpartydefault risk associated with reinsurance in their capital requirements,although this is done in different ways.Both have specific requirements for reinsurance ceded by domesticinsurers to foreign reinsurers and have recently established frameworksfor reviewing the reinsurance solvency and supervisory regimes of otherjurisdictions.However, there are key differences between the two regimes with respectto the requirements for recognition of reinsurance ceded to foreignreinsurers, and the frameworks for reviewing the regulatory regimes offoreign jurisdictions are different.In the EU, Member States are prohibited from requiring collateral inrelation to reinsurance arrangements entered into with companiessituated in equivalent third countries (reinsurance arrangements withthese companies would be treated in the same manner as reinsurancearrangements concluded with EU reinsurers).Under the state-based regime in the U.S., the 2011 amendments to theNAIC Credit for Reinsurance Model Law (#785) and Credit forReinsurance Model Regulation (#786) (NAIC Credit for Reinsurance _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 118. Models) serve to reduce the prior reinsurance collateral requirements fornon-U.S. licensed reinsurers that are licensed and domiciled in qualifiedjurisdictions, and those reinsurers will be required to post collateralaccording to their assigned rating.In the EU, decisions on third country equivalence in relation toreinsurance are effective across the EU and cannot be overridden byMember States, while in the U.S., collateral reduction is optional on thepart of the states.5. Supervisory Reporting, Data Collection and Analysis andDisclosureExecutive summaryWhile there are differences in the means by which the EU regime andthe state-based regime in the U.S. handle reporting, data collection andanalysis, there is much similarity in the overall objectives and approach.Both regimes seek or require:- Harmonized comprehensive reporting requirements, covering both solo undertakings and groups;- Data analysis to identify key risks for insurers/groups and the market as a whole;- A comprehensive database and repository, based on a harmonized IT format, to facilitate the analysis process at the solo, group and market levels; however, there is a difference in the main point of entry and repository for data (NAIC on behalf of the states in the U.S., national supervisory authorities in the EU);- Disclosure requirements on undertakings/groups; and _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 119. - The use of reporting to monitor compliance with regulatory requirements.In the EU, ORSA reporting will be in place under Solvency II.ORSA reporting will also be in place for the state-based regime in theU.S (see also the report of TC2 for ORSA reporting by groups).6. Supervisory Peer ReviewsOverviewThis report provides an overview of the peer review processesoperational in the European Union (EU) and under the state-basedinsurance regulatory regime in the U.S.The report focuses on the practices of EIOPA and the NAIC, referring tothe activities of other institutions (e.g., EC), where relevant.The NAIC Accreditation Program and the EIOPA Peer Review Processconstitute the main focus of the report (sections 1- 4).The report is structured to address issues relevant to the scope, processand outcomes of the Accreditation Program and the EIOPA ReviewProcess.Where other peer review-type processes are considered relevant, they areseparately referred to in the report (section 5).7. Independent Third Party Review and Supervisory On-SiteInspectionsExecutive summaryTC7 covers significantly different areas of external scrutiny, internal _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 120. controls and supervisory inspections within the supervisory regime.Specifically, this report covers three key topics, independent audits,actuarial reports and on-site examinations.With the exception of the independent audit topic, the front sections ofthis TC7 report compare current/implemented policies and proceduresunder the state-based insurance regulatory regime in the U.S. withanticipated EU policies and procedures.In addition, and with regard to the supervisory regime in the EU, eachtopic has been reviewed from the perspective of different time periods,as follows:- When Solvency II will be fully implemented, based on published directives and guidance that describe what will be in place at that time. This aspect of TC7’s review was limited in part, e.g., because the EU’s draft SRP Guideline (for further information, please refer to TC5, 4.3) is not yet publicly available and was thus not available for inspection by TC7 members in the U.S. either.- Current practices, as determined from a survey of a selected EU Member States and as described in the last section of this report. In the area of audits, the two regimes are largely the same and can be compared easily. The main difference lays in the Solvency II requirement of an internal audit function, which is a common practice and a SEC-filer requirement in the U.S. For the topic of on-site examinations, the two regimes are conceptually the same – providing authority for supervisors to conduct examinations on the solvency and financial condition of insurers to ensure policyholder protection using a risk-focused examination approach. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 121. However, key differences exist within the application of the regimes.These differences include state insurance regulatory requirements inthe U.S. that prescribe the frequency of examinations, a process forcompleting risk-focused exams, example tests of controls andexamination procedures to address specific risks and assertions,training and certification programs for examiners, minimumexamination report components and activities to ensure consistencybetween states, which are not currently envisaged in the EU underSolvency II.For the area of actuarial reports, the two regimes mandate anestablished actuarial function, and specify requirements for thosethat complete that function.In the U.S., state insurance regulatory requirements includeadherence to professional standards mandated by a professionalactuarial association, whereas the EU does not require thismembership.Also, although both regimes require actuarial reports, the prescribedminimum content and distribution of reports are different.In the U.S., actuaries are required by state insurance regulations torelease a public opinion, along with other reports that are restrictedto the company and supervisors.In the EU, there is no public opinion, but internal reports can beaccessed by supervisors. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 122. Acronyms and Abbreviations _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 123. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 124. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 125. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 126. The Liikanen Report takes a holistic approachInterview with BaFins Chief ExecutiveDirector Raimund RöselerFor some time, considerable efforts havebeen made at global, European and nationallevel towards better equipping bankingsystems to deal with a crisis.Attention is currently focused primarily onthe Liikanen Report and the G20 decision torequire global systemically important banksto develop recovery plans.“How should the European banking sector be structured in future?”That was the Commissions question to an expert group chaired by thegovernor of the Bank of Finland, Erkki Liikanen.The most important proposal is that retail banking activities should besegregated from trading activities within universal banks.BaFins Chief Executive Director Raimund Röseler gives his perspectivein this interview.Mr Röseler, how do you see the Liikanen Reports proposals currentlybeing discussed at EU level and in the member states?The report of the group of experts chaired by Mr Liikanen is a thoroughand in-depth study of key aspects of financial market regulation and the“too big to fail” problem.The “too big to fail” problem has still not been solved despite all thework regarding recovery and resolution plans. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 127. Instead, both the size of the banking sector and concentration within ithas grown since the start of the crisis.The proposals by the Liikanen group of experts are an importantcontribution to tackling this problem.It is well worth considering the proposals in detail and without any bias.Difficult questions need to be answered before we can set aboutimplementing the proposal.But that doesnt mean that we shouldnt look for answers to thesequestions.The report centres on the proposal of segregating trading activities fromtraditional banking operations without breaking up universal banks.Does that go far enough to mitigate the risks?I dont think that we can eliminate the interconnectedness in thebanking sector just by implementing this proposal.The risks wont automatically disappear just because we segregateindividual business activities.Thats why the proposals also want to ban credit relationships withcertain financial market players such as hedge funds.However, the segregation of trading activities from the retail bankingbusiness could contribute to reducing the complexity of large banks.Incentives for the banks to improve the transparency of their structurescould also be created.This makes the Liikanen proposals an attractive alternative – particularlyas the report takes a holistic approach.What do you mean by that? _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 128. The proposals don’t stop at a segregation of trading activities from therest of a banks operations.This measure is only a supplementary element, which is closely linked tohigher capital requirements and improved corporate governance, andalso to the future resolution regime.The supervisory authorities would have to prepare efficient and credibleresolution plans and they would get considerable ex-ante powers ofintervention – up to and including economic and organisationalseparation of critical business activities.The recovery plans which systemically important banks will soon have tosubmit will help us here.The G20 has only required global systemically important banks to dothis. Why does BaFin want domestic systemically important institutionsto submit recovery plans too?We view recovery planning as a type of extended risk managementwhich better equips banks against crises.If credit institutions and supervisory bodies consider ahead of time whatwill need to be done in an emergency, they can then act more quicklyand effectively.Thats why its important for all the major German banks to submitrecovery plans for our critical review.Together with the Bundesbank, BaFinhas drafted a circular that willhelp the institutions to develop their recovery plans.Market participants were invited to comment on a draft in November. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 129. The Liikanen Report contains not only the approaches mentionedabove, but also a proposal on remuneration requirements. What do youthink about that?The proposal is largely within the scope of what CRD III requires andwhat is also currently being discussed for CRD IV.This is true, for example, of linking variable remuneration to fixedremuneration.As soon as the European requirements, in particular those of CRD IV,have been finalised, they will be fully transposed into Germanlegislation.One element is new: the expert groups proposal to pay a fixed,mandatory component of variable remuneration in the form of bail-ininstruments.This should put a stop to “gambling for resurrection,” i.e. institutionsclose to insolvency using high-risk strategies in a last-ditch effort forrecovery.In addition, such remuneration in instruments could provide incentivesto employees that are more like those of an owner with a long-terminterest in the businesses’ sustainable development. This is a welcomestep.However its important that the incentives should be carefully calibrated,particularly as the bail-in instrument has not yet been finally decided.The proposals are on the table – what is the next step?The wealth of good ideas should now be implemented with a view towhat we want to achieve.The goal must be to make the system more secure. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 130. From my point of view, it is right that the report focuses on the largeinstitutions and the firms with a high proportion of trading activities.The stricter requirements will thus only apply to institutions which areso large and interlinked that they could present a danger to financialmarket stability.Most medium-sized and smaller institutions, on the other hand, will notbe impacted. _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 131. Solvency II Speakers BureauThe Solvency II Association has established the Solvency II SpeakersBureau for firms and organizations that want to access the expertise ofCertified Solvency ii Professionals (CSiiPs) and Certified Solvency iiEquivalence Professionals (CSiiEPs).The Solvency II Association will be the liaison between our certifiedprofessionals and these organizations, at no cost. We strongly believethat this can be a great opportunity for both, our certified professionalsand the organizers.To learn more:www.solvency-ii-association.com/Solvency_II_Speakers_Bureau.html Course Title Certified Solvency ii Professional (CSiiP): Preparing for the Solvency ii Directive of the EU (3 days)Objectives:This course has been designed to provide with the knowledge and skillsneeded to understand and support compliance with the Solvency iiDirective of the European Union.Target Audience:This course is intended for decision makers, managers, professionalsand consultants that:A. Work in Insurance or Reinsurance firms of EEA countries.B. Work in Groups - Financial Conglomerates (FC), Financial HoldingCompanies (FHC), Mixed Financial Holding Companies (MFHC),Insurance Holding Companies (IHC) - providing insurance and/or _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 132. reinsurance services in the EEA, whose parent is located in a country ofthe EEA.C. Want to understand the challenges and the opportunities after theSolvency ii Directive.This course is highly recommended for supervisors of EEA countriesthat want to understand how countries see Solvency II as a CompetitiveAdvantage.This course is also recommended for all decision makers, managers,professionals and consultants of insurance and/or reinsurance firmsinvolved in risk and compliance management.About the CourseINTRODUCTION  The European Union’s Legislative Process  Directives and Regulations  The Financial Services Action Plan (FSAP) of the EU  Extraterritorial Application of European Law  Extraterritorial Application of the Solvency II Directive  Solvency ii and the Lamfalussy Process  Level 1: Framework Principles  Level 2: Detailed Technical MeasuresLevel 3: Strengthening Cooperation Among Regulators  Level 4: Enforcement  Weaknesses of Solvency I  From Solvency I to Solvency II  Solvency ii Players  Solvency ii ObjectivesTHE SOLVENCY II DIRECTIVE  A Unified Legislative Basis for Prudential Regulation of Insurers and Reinsurers _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 133.  Risk-Based Capital Allocation  Scope of the Application  Important Definitions  Value-at-Risk in Solvency II  Authorisation  Corporate Governance  Governance Functions  Risk Management  Corporate Governance and Risk Management - Level 2  Fit and proper requirements for persons who effectively run the undertaking or have other key functions  Internal Controls  Internal Audit  Actuarial Function  Outsourcing  Board of Directors: Role and Solvency ii Responsibilities  12 Principles – System of Governance (Level 2)PILLAR 2  Supervisory Review Process (SRP)  Focus on Risk Management and Operational Risk  Own Risk and Solvency Assessment (ORSA)  ORSA - The Internal Assessment Process  ORSA - The Supervisory Tool  ORSA - Not a Third Solvency Capital Requirement  Capital add-onPILLAR 3  Disclosure Requirements  The Solvency and Financial Condition Report (SFC)PILLAR I  Valuation Of Assets And Liabilities Technical Provisions _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 134.  The Solvency Capital Requirement (SCR)  The Value-at-Risk Measure Calibrated to a 99.5% Confidence Level over a 1-year Time Horizon  The Standard Approach  The Internal Models  The Collection of Additional Historical Data  External Data  The Minimum Capital Requirement (MCR)  Non-Compliance with the Minimum Capital Requirement  Non-Compliance with the Solvency Capital Requirement  Own Funds  Investment RulesINTERNAL MODEL APPROVAL  CEIOPS Level 2 - Tests and Standards for Internal Model Approval  CEIOPS Level 2 - The procedure to be followed for the approval of an internal model  Internal Models Governance  Group internal models  Statistical quality standards  Calibration and validation standards  Documentation standardsSOLVENCY II, GROUP SUPERVISION AND THIRD COUNTRIES  Solvency I: Solo Plus Approach  Group Supervision under Solvency II  Rights and duties of the group supervisor  Group Solvency - Methods of calculation  Method 1 (Default method): Accounting consolidation-based method  Method 2 (Alternative method): Deduction and aggregation method _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 135.  Parent Undertakings Outside the Community - Verification of Equivalence  Parent Undertakings Outside the Community - Absence of Equivalence  The head of the group is in the EEA and the third country regime is not equivalent  The head of the group is in the EEA and the third country regime is equivalent  The head of the group is outside the EEA and the third country is not equivalent  The head of the group is outside the EEA and the third country regime is equivalent  Small and Medium-Sized Insurers: The Proportionality Principle  Captives and Solvency IIEQUIVALENCE WITH SOLVENCY II AROUND THE WORLD  Solvency ii and Countries outside the European Economic Area  The International Association of Insurance Supervisors (IAIS)  The Swiss Solvency Test (SST) and Solvency ii:  Solvency ii and the Offshore Financial Centers (OFCs)  Solvency ii and the USA  Solvency ii and the US National Association of Insurance Commissioners (NAIC) - The Federal Insurance Office created under the Dodd-Frank Wall Street Reform and Consumer Protection Act in the USA, and the ORSA in the USAFROM THE REINSURANCE DIRECTIVE TO THE SOLVENCY IIDIRECTIVE  Directive 2005/68/EC of 16 November 2005 on Reinsurance - The Reinsurance Directive (RID)CLOSING  The Impact of Solvency ii Outside the EEA  Providing Insurance Services to the European Client _________________________________________ Solvency ii Association www.solvency-ii-association.com
  • 136.  Competing with Banks  Learning from the Basel ii Framework  Regulatory Arbitrage: A Major Risk for Countries that see Compliance as an Obligation, not an Opportunity  Basel II, Basel III, Solvency II and Regulatory Arbitrage  Challenges and Opportunities: What is next  Regulatory Shopping after Solvency IITo learn more about the course:www.solvency-ii-association.com/Certified_Solvency_ii_Training.htmWe are pleased to announce our new:1. Certified Solvency ii Professional (CSiiP) Distance Learning andOnline Certification Program:www.solvency-ii-association.com/CSiiP_Distance_Learning_Online_Certification_Program.htm2. Certified Solvency ii Equivalence Professional (CSiiEP) DistanceLearning and Online Certification Program:www.solvency-ii-association.com/CSiiEP_Distance_Learning_Online_Certification_Program.htm _________________________________________ Solvency ii Association www.solvency-ii-association.com