On 2nd November, insurance supervisors from across the world will converge on Kuala Lumpur for an annual conference that will take stock of progress in establishing a global capital standard for insurers dubbed the ‘Insurance Capital Standard Version 1.0’. On the eve of this conference, this blog analyses progress in the discussions to date and the key issues that remain outstanding and could yet hinder an agreement.1
We plan to issue a follow up blog in the light of the conference outcome to assess whether or how far progress has been made.
The Inherent Difficulty of Establishing Global Insurance Capital Standards
Unlike for internationally active banks, which have been supervised in line with global standards developed by the Basel Committee on Banking Supervision (BCBS) since the 1990s, there is no equivalent global standard for internationally active insurance companies.
In fact, it was only at the beginning of 2016 that the patchwork of different insurance standards in the European Union (EU) was harmonised through the Solvency II Directive. In the United States, regulation of insurance firms is predominantly state-based.
The BCBS’s equivalent organisation, the International Association of Insurance Supervisors (IAIS) is hoping to transform this landscape, before the end of the present decade, through the development of the first global standard for insurance. A globally comparable standard that can be implemented across heterogeneous insurance markets is no easy task.
The rationale for developing a global standard for insurance is essentially the same as often used to justify harmonising global banking capital standards and insurance regulatory standards in Europe: that is, a single set of rules will allow firms to operate cross-border efficiently, reducing costs and bringing benefits to consumers. Moreover, as with banking, a common standard for insurance will promote cooperation between regulatory authorities and avoid the risk of regulatory arbitrage.
These are all laudable reasons for the development of a global standard, but experience suggests that there can be significant costs involved too when developing a common standard for a set of heterogeneous markets. Solvency II took more than a decade to develop and is estimated to have cost £2.6 billion to the UK industry alone in one-off implementation costs. While Solvency II has increased transparency and comparability, the jury is still out on how far it has achieved its other main objective of ensuring a level playing field for insurance firms across Europe. In particular, the extensive use of transitional arrangements and departures from a pure market consistent approach make it difficult to use Solvency II ratios to compare firms across Europe.
An example of such variation is the differences in the way that discount curves used to calculate solvency are derived and applied under different currencies and in different national markets; this can lead to large differences in the solvency positions of firms according to where they are located in the EU. The Bank of England has highlighted that the regulatory Euro curve is significantly higher than the market Euro curve2 , which has level playing field implications in Europe. The graph below shows the present scale of difference beyond 21 years for EIOPA prescribed Euro risk-free interest rate term structure and market swap rates3 . EIOPA has published a revised methodology, so over time, the gap will narrow, but this narrowing will stretch over at least five years and some of the gap may still remain.
Another area in which EIOPA has so far been unable to agree a consistent approach is the use of ‘Dynamic Volatility Adjustment’. Some EU authorities have given insurers permission to attempt to model changes in the value of the Volatility Adjustment in a way that anticipates how it might be determined by the regulatory authorities under stress conditions; but this so called ‘dynamic’ approach has been expressly ruled out in the UK.
THE ICS: where matters currently stand
The IAIS plans to develop the ICS in three stages, with the intention that the next iteration (ICS Version 2.0) will be suitable for implementation from 2019. The following are the three key issues that we think are most important for the IAIS to resolve, each of which has the potential to be a stumbling block to an eventual agreement:-
Achieving a single valuation basis is akin to the ‘holy grail’ for developing the global insurance standard. A single valuation basis will allow the ICS to be robustly comparable across jurisdictions, thereby giving supervisors and investors an ‘apples and apples’ tool to compare firms across markets and jurisdictions.
However, this ‘holy grail’ has so far proved elusive due to sharply differing philosophies on the validity of market consistency as a valuation basis for measuring insurer regulatory solvency. The focus now has shifted to achieving comparability between two different valuation methods included in the ICS Version 1.0: these are either a Market Adjusted Valuation (MAV), which is conceptually consistent with Solvency II, or a Generally Accepted Accounting Principles with adjustments (GAAP plus) based approach, which generally reflects the approach used by shareholder-owned insurance companies in the US market.
If a single valuation basis cannot be reached before the ICS is implemented, this will call into question whether the ICS will achieve its intended objective of ensuring a level playing field4.
(II) Internal Models
Internal models are an integral part of the Solvency II framework; many EU and non-EU firms have invested heavily in developing their internal capital models. As a result, in a number of European jurisdictions, a substantial proportion of the insurance sector’s capital requirement is now determined by capital models approved by the national regulator. While there is a strong support in the Europen insurance sector for firms to be allowed to use internal models as part of an international standard, it is well known that some members of the IAIS have serious reservations about the use of internal models and would prefer the ICS to be based largely on a standard formula.
While no internal model framework has been developed for the ICS Version 1.0, discussions on the incorporation of internal models into the ICS framework are expected to take place later this year. The outcome of these discussions will be very important for European firms.
(III) Margin Over Current Estimate (MOCE)
The MOCE is the ICS equivalent to the risk margin in Solvency II. Under the Solvency II framework, the risk margin is intended to provide an extra layer of protection for policyholders through an addition to the value of liabilities and hence technical provisions, the idea being that this will improve the prospects of another insurer being willing to take over the insurance obligations if the firm were to get into trouble.
However, the current Solvency II methodology for calculating the risk margin, which uses a 6% fixed costs of capital against a market-based risk-free discount rate, is highly interest rate sensitive and significantly increases the volatility of certain life insurance firms’ balance sheets in a way the Bank of England considers pro-cyclical. The capital cost and volatility of the risk margin has led to many UK firms in particular to move their longevity risk offshore through reinsurance contracts and longevity swaps.
The European Commission and EIOPA are currently reviewing the methodology for the risk margin, but it is unclear at this stage if this review will lead to a satisfactory solution. Therefore, an international standard may offer a route out of this problem.
In international discussions, however, there are different views among stakeholders on the purpose of MOCE and its interaction with capital requirements. Some stakeholders argue for Prudence-MOCE (P-MOCE), which should be loss-absorbent and therefore could be deducted directly from capital resources. This departs from the design of the risk margin under Solvency II. However, the second approach that is being discussed is the Cost of Capital MOCE (C-MOCE), which is an addition to the value of liabilities and hence closer to the design of the Solvency II risk margin.
Two methods for calculating the C-MOCE are being tested. If agreed, one of these methods would risk essentially hard baking the current EU problem with the risk margin at an international level, whereas the second approach might offer a way out of the problem:
- The first approach uses a 5% fixed cost of capital as opposed to the 6% fixed cost of capital under Solvency II. This is a reduction as compared with Solvency II risk margin and will have a lower capital impact for firms underwriting significant amounts of long-duration non-hedgeable risk. However, this approach is unlikely to ease the balance sheet volatility experienced by firms caused by changes in risk-free interest rates.
- The second approach uses an adjustable cost of capital that moves in step with the level of the risk-free interest rate: cost of capital = 3% + 10-year risk-free rate, subject to an absolute cap of 10% and an absolute floor of 3%. This approach could both reduce the size of the risk margin and the balance sheet volatility experienced by firms and so would represent a better outcome for European firms writing significant long-duration non-hedgeable risks.
Opportunities and risks for firms
As with any major global supervisory initiative, there are both opportunities and risks for firms. We think that the ICS could present an opportunity to improve on Solvency II in some areas, in particular, the risk margin. More generally, firms have the opportunity of the development of this standard to engage with regulators to try to ensure problems with the Solvency II framework are not replicated with the ICS.
The two significant areas of opportunity are:
- Risk Margin – the C-MOCE approach taken under ICS could reduce the capital requirements for firms underwriting significant long-term non-hedgeable risk (like longevity risk underwritten by annuity providers). Depending on the final outcome, the C-MOCE has the potential both to reduce the size of risk margin and make it less volatile, and pro-cyclical on the balance sheet.
- Matching Adjustment portfolio – the asset eligibility criteria under the ‘Own Assets with Guardrails’ approach taken in the ICS to determine credit spread adjustments for risk-free discounted cash flows are more flexible than the current approach under the Matching Adjustment. This more principles-based framework could eliminate the artificial incentives for firms to restructure internally certain assets like Equity Release Mortgages in order to make them eligible for the ‘fixed cash flow’ requirement under the Matching Adjustment.
However, the ICS could also present risks for firms:
- Implementation costs – an eventual settlement on the ICS may see a standard employing market consistent approach, perhaps with an option for GAAP plus approach in some jurisdictions. However, to the extent that the ICS deviates significantly from the Solvency II framework, European firms may incur significant further implementation costs, on top of those already ‘sunk’ into costly implementation of Solvency II.
- Matching Adjustment portfolio – firms have invested heavily in developing and obtaining regulatory approval for their Matching Adjustment portfolio. While a move to a more principles-based framework would be welcome for firms and some supervisors, the final design could yet result in a lower calibration for the benefit firms can take from matching their long-term assets with long-term liabilities.
There are lessons to be learned from the development of Solvency II for the IAIS: sometimes, simpler, more outcomes-based frameworks may be better than a complicated or overly rules-based framework. And there can be clear benefits of allowing some room, perhaps on a transitional basis, for local adaptation within an over-arching international framework. However, the room for local adaption should not be so wide as to vitiate the original objectives of developing a global standard.
It is too early to say what the overall capital impact of ICS will be across the European insurance firms. The impact will depend on the final design of ICS Version 2.0 (including the aspects discussed in this blog). And wider geopolitics may yet determine the degree of momentum behind the work to reach a comparable global standard.
Given the robustness of Solvency II, we think it is unlikely that the new global standard will significantly raise capital requirements across European insurance firms taken as a whole, but it is possible that there will be individual capital impact at the firm level. Accordingly, we recommend that firms engage with the process and follow developments on the key design parameters of the final standard.
1Further information on the IAIS’s work can be found in the report titled ‘Enhanced insurance prudential standards and global capital regimes: Change on the horizon?’ and the readout from the IAIS’s 10th annual global seminar prepared by the Deloitte Center for Financial Services and the Deloitte Center for 2Regulatory Strategy Americas.
Bank of England Response to European Commission Call for Evidence on EU Regulatory Framework for Financial Services.
4Moreover, there could be significant time and resources implications for firms to calculate ICS if it does not leverages their existing basis for regulatory reporting as much as possible, while producing a result that is comparable enough not to lead to confusion or misinterpretation in the market.