Post-crisis regulatory reform for the insurance sector passed a significant milestone at the beginning of this year. While the banking sector has, for good reasons, dominated the post-crisis re-engineering of financial services regulation, the FSB1 nonetheless tasked the IAIS2 in 2013 with a similar objective for the insurance sector in the areas of resilience, supervision and systemic risk. The IAIS has now provided its response in the form of a package of measures that start in 2020.Despite the undoubted importance of this task, insurers may be forgiven for wondering what has changed. The new measures are highly unlikely to result in immediate changes to regulation in individual jurisdictions. However, in our view their influence will be felt tangibly as insurance regulation evolves in the coming years. Understanding the reform package is, therefore, a precursor to understanding and predicting developments in insurance regulation within individual jurisdictions.
This blog takes stock of the IAIS’s adopted measures3, and discusses three important areas in which they may materially influence future regulation:
- The future of Solvency II
- International regulatory recognition and equivalence
- Macroprudential policy and surveillance
The future of Solvency II
As we discussed in our previous series of blogs, the Insurance Capital Standard (ICS) presents some novel approaches to market-consistent valuation and solvency that could influence the future development of Solvency II. In particular:
- The ICS equivalent of the risk margin, the MOCE4, is calculated as a given percentile on the normal distribution of which the ICS capital charge represents the 99.5th percentile. The MOCE should not, therefore, be as inherently sensitive to interest rates as the Solvency II risk margin, which is calculated using a fixed cost of capital approach.5
- ICS risk free discount curves apply a market-based “last observed term” (equivalent to the Solvency II “last liquid point”), and an illiquidity premium adjustment that blends different “buckets” representing different degrees of matching into a single adjustment. This could produce quite different discount curves compared to Solvency II, particularly for the euro.6
The Solvency II Directive is being reviewed in both these areas, and the ICS methodology is likely to provide important counterpoints to the current Solvency II approach. The calculation of the risk margin has proved controversial in the UK especially, and there is likely, in our view, to be significant pressure for the methodology to be reformed in the UK following Brexit, as we discuss in our recent report, Solvency II – Continuity, change and divergence in a post-Brexit world.
We emphasise that, despite its recent adoption, the ICS methodology has not yet been finalised. It will be implemented for monitoring and reporting only over the next five years, with some details to be filled in this year, and some critical decisions still to be taken (as discussed further below). In essence, this will constitute another five years of testing and evaluation. However, this could provide space for key differences between the ICS and other important global standards to be explored further, and potentially for further alignment and commonality, in particular during this important phase of the Solvency II review.
International regulatory recognition and equivalence
The ICS is highly unlikely to replace established solvency regimes such as Solvency II or United States (US) RBC. However, it is likely to be seen as a benchmark against which to measure the outcomes of different solvency regimes7, and/or applied to create a consistent view across multinational groups. The ICS is thus an important international standard, even if it is not itself binding as a matter of national regulation.8 Some of the most important questions on implementation, therefore, concern how the ICS will recognise and be recognised by other regulatory regimes.
This question is already on the IAIS’s workplan with respect to the future US aggregation method, which the IAIS will start to assess for comparability of outcomes from 2023. The IAIS is also highly likely to need to consider the same question for Solvency II. (For many internationally active insurance groups (IAIGs), this question will overlap with whether the IAIS decides to recognise internal model calculations as an acceptable “other method” for the ICS capital charge.) In our view, the IAIS is more likely than not to recognise these regimes as achieving comparable outcomes – a course of action that would provide a smooth path for the ICS to be, in effect, implemented in the US and Europe, despite the very different approaches to prudential solvency regulation in those jurisdictions.
A parallel question is whether the ICS might be recognised as equivalent by other regimes. For example, recognition as equivalent for use in Solvency II group solvency calculations could give the ICS an important practical role in calculating group solvency for some European groups.
Macroprudential policy and surveillance
The IAIS’s Holistic framework – in its final form a set of updates to the Insurance Core Principles (ICPs) – is focused on macroprudential surveillance and analysis,9 and on the measures that supervisors may apply in response, including preventive and corrective measures.10
The IAIS’s final position on macroprudential policy and surveillance needs to be viewed in the context of the near-continuous debate that has taken place on whether the insurance sector poses systemic risk and whether a macroprudential regulatory framework should be applied to it. Much of this debate has turned on whether individual insurers and/or the insurance industry as a whole create or amplify systemic risks, and whether the regulatory response requires a dedicated macroprudential toolkit on similar lines to that applied to the banking sector.
In ICP 10, the IAIS specifies expected powers which supervisors should be capable of applying in response to either microprudential or macroprudential risks. However, ICP 10 does not go into detail on how and when supervisors should exercise these powers where they identify financial stability risks. In particular, ICP 10 does not address what is likely to be a very difficult practical question, namely how supervisors should take action against individual insurers in response to systemic risks relating to the activities of the industry as a whole (it is easy to imagine how such actions could, for example, create level playing field issues).
The outcomes of the Solvency II review are likely to influence strongly the direction of any future macroprudential regulatory framework for the insurance sector. Consequently, whether the Solvency II review introduces dedicated macroprudential tools and powers – as recommended by EIOPA – will be an important decision for European insurers and beyond. In our view, the IAIS’s Holistic framework lends broad support to the concept of a macroprudential regulatory toolkit, but leaves unanswered some critical questions on how such a framework should be implemented.
Conclusion: the real significance of the IAIS measures
While prudential insurance regulation has appeared broadly settled over the last few years following the implementation of Solvency II, the next few years could once again bring substantial changes to insurance regulation and supervision.
The IAIS’s ICS, ComFrame and Holistic framework are key components of the FSB-sponsored post-crisis regulatory reform programme for insurance. Accordingly, they are important inputs to future reforms of insurance regulation, in particular the Solvency II review, and the development of the aggregation method in the US. Understanding the settled form of these initiatives therefore provides essential context for understanding and predicting regulatory developments in individual jurisdictions.
The major caveat to the above, however, is that the ICS is, essentially, far from finalised, with substantial differences of philosophical perspective and in some cases outright disagreement between Europe and the US on its construction and approach. The next five years will, none the less, see the IAIS continue to develop the standard, as well as important discussions on how it will operate alongside existing regulatory regimes. In our view, it is essential for international insurers to remain engaged in the ICS project, both for the development of the ICS methodology itself, and with a view to how it will influence, affect, and be applied alongside directly-applicable jurisdictional regulation.
1 Financial Stability Board
2 International Association of Insurance Supervisors
3 The IAIS adopted, at its annual conference late last year, the ICS, the Common framework for the supervision of internationally active insurance groups (ComFrame), and the Holistic framework for systemic risk in the insurance sector (Holistic framework). These collectively address capital, supervision and systemic risk assessment for the insurance sector. The ICS is a risk-based capital standard capable of being applied globally, and as such is by far the most important part of the package. ComFrame and the Holistic framework provide standards and guidance on the regulation and supervision of the insurance industry. They are not binding in individual regulatory jurisdictions, although IAIS members – of which there are 215 – are expected to regulate consistently with them.
4 Margin Over Current Estimate
5 The calculation of the MOCE is discussed further in our previous blog.
6 The calculation of long term discount rates is discussed further in our previous blog.
7 The most important future role for the ICS could, in theory, be as a benchmark against which different regimes can be assessed and mutually-recognise one another on a multilateral basis. Such an outcome appears highly unlikely in the short term, at least on a formal basis for major regulatory regimes, but comparable use on a non-binding and informal basis could well be imagined.
8 It is yet to be determined how, in practice, the ICS will be implemented as a “prescribed capital standard” (PCR) at the end of the five year monitoring period. The ICS may also, of course, function as a starting point for regulatory regimes developing risk-based standards in the future.
9 Insurance core principle 24 – Macroprudential supervision.
10 Insurance core principle 10 – Preventive measures, corrective measures, and sanctions.