The Solvency II directive will affect corporates’ ability to fund and mitigate financial risk negatively. One example reported by the EuroTreasurer of the Financial Gates GmbH, in issue 03, 23 February 2012: Asset-backed Securities (ABS) will have to be backed up by more equity, affecting for instance the automotive industry hard since they rely heavily on ABS funding. EuroTreasurer also states: “…the European Private Equity and Venture Capital Association (EVCA) is afraid of considerable shifts in asset allocation [by Solvency II]: While volatile asset classes could lose their attractiveness, fixed-income assets could become much more attractive.” Are those effects anything we should aspire? These consequences are added on top of the negative effects for corporates from other regulation. We have asked Fredrik Torkildsen, a senior financial expert and management consultant, to explain Solvency II to us, in this, the first (?) ever “Solvency II for Dummies”.
Solvency II and Basel III attack the corporate from two separate directions, via the investors and via the banks.
The Solvency II Directive 2009/138/EC is an EU Directive codifying and harmonizing the EU insurance regulation. Primarily this concerns the amount of capital that EU insurance companies must hold to reduce the risk of insolvency. Often called “Basel for insurers”, Solvency II is somewhat similar to the banking regulations of Basel II. Similar to Basel II, Solvency II has largely left unchanged the question of how to actually define capital, which diverges from accounting equity in important respects.
During the Lehman crisis in September 2008 AIG suffered from a liquidity squeeze when its credit ratings were downgraded below “AA” levels after concerns of continuing losses on mortgage-backed securities (MBS). AIG’s London unit sold credit protection through credit default swaps (CDS) without depositing collateral at their trading counter-parties. The CDS made huge losses forcing the Federal Reserve Bank to create a secured credit facility of up to US$85 billion to salvage AIG. This was the largest government bailout of a private company in the history of the US. While some argue that the financial crisis demonstrated weaknesses in the framework, others have criticized it for actually increasing the effects in a downward spiral.
This blog many times highlights that it is very likely that the financial regulation during the past 25 years actually has forced misallocation of capital from the private to the public sector. The solution should therefore not just be adding new regulation. Instead it has to be sensible regulation taking into account more than saving the financial institutions from default. We should consider creating the financial regulation in harmony involving all relevant stakeholders.
In response to the credit crisis, the Basel Committee published revised global standards, popularly known as Basel III. When revising the Basel framework it was decided to also update the Solvency framework.
The proposed Solvency II framework has three main areas:
Pillar 1 is all about the calculations, models and capital requirements. The Solvency Capital Requirement (SCR) is a risk responsive capital measure calibrated to ensure each insurer will be able to meet its obligations over the next 12 months with a probability of 99,5%. If this level of capital is not reached it will likely result in regulatory intervention and require remedial action. The Minimum Capital Requirement (MCR) is the minimum amount of capital the insurer needs to cover its risks. If an insurer´s risk capital falls below the MCR they will be prohibited from writing any further business. The SCR can be calculated by using a Standard model or an Internal. An Internal model can be implemented fully or partially if it satisfies the tests and requirements of the supervisors, which is only recommended for the largest firms.
Pillar 2 is maybe the most comprehensive of all three pillars taking the Own Risk & Solvency Assessment (ORSA) in consideration. The ORSA can be defined as “the entirety of the processes and procedures employed to identify, assess, monitor, manage, and report the short and long term risks a reinsurance undertaking faces or may face and to determine the own funds necessary to ensure that overall solvency needs are met at all times”. It is thus the process by which the company demonstrates how the SCR will continue to be met whilst executing its business plan. It is the key linkage between the company´s risk capital modeling capability and the way the business operates and should be an integral part of the business strategy, taken into account strategic decisions and should be used to help identify and manage risk. Another key aim of the ORSA is to promote a forward looking perspective, typically 3-5 years. The ORSA should not be too burdensome and therefore not overly complex, and be proportionate to the nature. The ORSA shall also scale and the complexity of the risks inherent in the business should take into account risks that may appear in the future with a reasonable degree of probability. Methods can range from simple stress tests to more or less sophisticated economic capital models. A small insurer might produce a report of a couple of pages whilst it may be several hundred pages for an international group supported by appendices. There is no framework or guideline for the output because the regulators want the board of the company to own the ORSA process. The ORSA is important because within the Supervisory Review Process the ORSA contributes to a qualitative view of the management’s ability to assess, measure and manage its own business and the inherent risks within the organisation. This assessment requires insurance undertakings to properly determine their overall solvency needs for short and long term risk and shall be part of the risk management system. A statement shall explain how the undertaking was determined in relation to its solvency requirements needs and risk profile. It requires a description of how the ORSA process and outcome is appropriately evidenced and internally documented as well as independently reviewed.
Pillar 3 is about supervisory purposes, disclosure and transparency requirements like Solvency & Financial Condition Report (SFCR) and Quantitative Report Template (QRT) – the output area.
The main challenges for asset management and service providers are data management which is essential for the SCR calculations and reporting to the supervisors. Strategies should be reviewed from several dimensions like expected return, risk assessment, capital requirements and tax on financial income. Service level agreements have to be renegotiated with reinsurers, asset managers and service providers.
Tip: The easiest way complying with Solvency II is making a light version of a Due Diligence, name it ORSA and you are done!
An insurance contract involves the exchange of a fixed periodic or single premium payment against uncertain future claims payments conditional on the occurrence of each event. Insurers invest collected premium payments from a large number of policyholders, pooling the risks until claims become due. Matching the maturity of assets to the long-term maturity profile of the expected liabilities is the key to risk management. Life insurers are particularly well placed to buy and hold long-term investments.
The core functions of a bank, on the other hand, are to accept deposits, provide payment services and extend credit. Maturity transformation is inherent in this business model, as short-term liabilities such as deposits are typically used to fund long-term lending as corporate loans or mortgages. In contrast to insurance risks, many of the financial risks assumed by banks are short term with a limited pooling effect.
Insurer’s liabilities are illiquid and cannot be called at short notice, and only at a significant cost to policyholders and involving a cancellation period. Claims on insurers are thus largely independent of the economic cycle but depend on the statistical distribution of the underlying risks. Conversely, banks’ liabilities are traditionally deposit-based. Deposits may be a mix of transactions, savings, and time deposit accounts. These deposits are inherently liquid and therefore at risk of being called at any time or on short notice. Depending on circumstances, liquidity problems can spread contagiously among large, interconnected institutions. The insurers invest in banks and get affected by bank runs but we would thus not expect a run on insurance companies per se.
As insurers’ liabilities tend to be long-dated with restrictions on how and when they can be redeemed, an insurer would typically be expected to become insolvent (as a result, for example, of a shortfall in the value of its assets) long before it becomes illiquid. Bank failures occur much faster and have the characteristics of being more disorderly. For this reason, bank regulators place particular emphasis on bank liquidity, both in “business as usual” and in stressed conditions. However, insurance failures differ fundamentally from those of banks with respect to the causes, time horizons, scope of mitigating actions and potential system-wide consequences. The policy response to such concerns takes such differences into account. The separate regulatory regimes being developed for banks, European insurers, and American insurers create different incentives for asset holdings, largely reflecting the differing capital requirements. Using the latest capital requirements prescribed for Solvency II, the NAIC Risk-Based Capital factors and industry benchmark data for Basel III’s Advanced Internal Ratings Based method (A-IRB), present a set of sample capital factors for corporate bonds, sovereign bonds, and residential mortgages. For high-quality shorter duration bonds, the capital charges of Basel III and Solvency II are similar. However, as the credit quality of the bond decreases, the increase in capital charge is much smaller, particularly for short-term bonds, under Solvency II than under Basel III. The effect of the different treatment of duration is likely to incentivize European insurers to hold short-dated, lower-quality bonds than those of banks and American insurers. This finding does not seem consistent with what might have been intended or maybe insurers are expected to play an important role raising capital of banks? Remember Basel III aims to make banks become cheap ATMs for public debt.
This text was compiled by Fredrik Torkildsen and revised by Magnus Lind in February 2012.