House of Lords - European Union

Select Committee on European Union Sixth Report

CHAPTER 2: IMPACT OF THE DIRECTIVE

8. In this chapter, we consider some specific changes to insurance and reinsurance regulation which we believe will have a considerable impact on the industry. We also note some of the broader impacts of the proposal.

Capital Requirements

9. All insurance companies are required to maintain a solvency margin—an amount of capital that is readily available and can be used to meet unforeseen claims. Solvency II will introduce the principle that the capital required should be weighed against the severity of the risks that an individual insurance firm faces and will ensure that the capital held by the firm meets certain minimum standards[6]. Companies or groups with wide-ranging businesses unlikely to face claims from all policyholders simultaneously will be able to take this diversification into account. The Association of British Insurers (ABI) welcomed this change (p 12) and we were told by the Comité Européen des Assurances (CEA) that "the majority of companies [in Europe] have already implemented" this risk-based approach for internal management purposes and as such the Directive will reflect current practice (Q 115).

10. The Solvency II Directive proposes that regulators should impose two levels of capital requirements for companies to meet: the Solvency Capital Requirement (Articles 99-124) and the Minimum Capital Requirement (Articles 125-128). The Solvency Capital Requirement (SCR) is calculated using value-at-risk techniques, either in accordance with a standard formula (Articles 102-108)[7], or using a firm's own internal model (see paragraphs 16-21): either way, all potential losses, including adverse revaluations of assets and liabilities, over the next 12 months must be assessed. The SCR reflects the true risk profile of the company, taking account of all quantifiable risks, as well as the net impact of risk mitigation. The SCR is to be calculated at least once a year, monitored on a continuous basis, and recalculated as soon as the risk profile of the undertaking deviates significantly. The SCR will be closely aligned to the risks the company faces providing policyholders with reasonable assurance that payments will be met as they fall due. The FSA told us that in a recent study 80% of UK firms surveyed already met the SCR (Q 65). We were told that the SCR will be calibrated at a 99.5% level of confidence that the firm's assets remain sufficient to meet its liabilities, over a 1 year time-horizon (p 31, Q 81).

11. The Minimum Capital Requirement (MCR), calculated quarterly, is a level of capital holdings below which policyholders' interests would be seriously endangered if the undertaking were allowed to continue to operate. Undertakings are therefore required to hold immediately accessible funds[8] to meet the MCR and will be expected to hold sufficient funds to meet the SCR. A breach of the SCR would require regulatory intervention but the company would remain solvent. If the available capital lies between the SCR and the MCR, this is an early indicator to the supervisor and the company that action needs to be taken. If the available capital is less than the MCR, the company is technically insolvent and the supervisor's authorisation to the company would be automatically withdrawn, except in exceptional circumstances.

12. It is clear that the calculation of the Capital Requirements is of prime importance in ensuring that there is adequate consumer protection at reasonable cost. We heard evidence about different approaches to calculating the MCR (Q 42, p 12) and we note that the outcomes of this testing have proved that in some cases the models are generating an MCR higher than the SCR for some participants in the studies (QQ 42, 65, 68), which will require correction. We welcome the work that has been undertaken by CEIOPS to model different approaches to calculating the SCR, MCR and the rules regarding admissible capital. We note that this issue remains unresolved and ask the Government to keep the Committee informed of progress.

Group supervision

13. Articles 219 to 277 of the proposed Directive introduce the concept of a "group supervisor". For each group of co-owned companies[9], a single regulatory authority (that of the group parent company's home Member State) will be given primary responsibility for all key aspects of group supervision (i.e. group solvency, intra-group transactions, risk concentration, risk management and internal control). Each "local" subsidiary operation in each Member State will be regulated in that Member State and the lead supervisor will cooperate and consult with the local supervisors. In line with the Financial Conglomerates Directive, all supervisors involved will be required to exchange "essential" information automatically and "relevant" information on request, to consult each other prior to important decisions, and to handle requests for verification of information in accordance with the rules set out in the Directive. However, we note witnesses' concerns regarding the quality of the supervisory authorities in newer Member States (QQ 26-27, 127) although this is expected to improve before Solvency II is implemented. We are also reassured by the amount of joint work that is undertaken through bodies such as CEIOPS.

14. This collegiate approach is a change in philosophy: current EU law considers group supervision as merely supplementary to solo supervision. This text contains many provisions which will directly influence the way in which local supervision is carried out on entities belonging to a group. Witnesses welcomed this proposal, noting that it would allow groups with diverse risks to offset these against each other as long as each subsidiary firm continued to meet the minimum capital requirement for that subsidiary's business and that capital held centrally to meet the SCR was genuinely interchangeable to all subsidiaries. The benefit for industry will be that additional capital can be pooled and invested where it can make a better return (QQ 14-15). In addition, the ABI noted that regulatory costs would fall as duplication of work was removed (p 12). The Association also noted that 21% of insurers authorised in the UK are foreign-owned, so there would be a significant impact on the UK industry.

15. We note, however, concerns that small Member States' regulators may have about a loss of influence to the authorities in the larger Member States from where groups will be supervised (QQ 91, 101) and are concerned that this may lead to pressure for changes to this proposal. The Committee welcomes the group supervision proposals as currently drafted and dilution should be resisted.

Internal Models and Risk Management

16. Solvency II will allow a firm or group to undertake its own bespoke assessment of the amount of capital that it requires to meet the SCR.[10] The assessment of risk under these "internal models" (Articles 109-124) will address the unique set of risks that the business faces, which can never be replicated in a standard formula. Internal models are already in common use within larger and more sophisticated insurance and reinsurance firms, and here again the proposed Directive is adapting regulatory practice to meet current industry standards. Firms may also use a partial model, with some components of the standard formula SCR replaced by results from an internal model, although those doing this will be scrutinised to ensure that they are not cherry-picking those elements that will provide capital relief. In addition, supervisors may instruct a firm to develop a full or partial internal model if it is considered that the firm's risk profile deviates significantly from that assumed when calibrating the standard formula SCR. The ABI expected that, over time, a significant proportion of its members would wish to use either a full or partial internal model (p 12).

17. This proposal also allows regulators to be proactive: in considering applications for internal models, or the need to direct a firm to introduce one, a regulator will need to gain a full picture of the risk management capabilities of the organisation and so will look at all business processes rather than just results and outputs. Risk management is the subject of Pillar 2 of the Solvency II proposals, and the draft Directive introduces measures designed to encourage insurers to implement a broad internal risk management process that embraces all the key risks that are faced across the enterprise. Pillar 2 also stresses the importance of corporate governance and clearly defined roles and responsibilities for the executive team.

18. Article 28 states that the regulatory system should rely on sound economic principles and make optimal use of information provided by financial markets. Under Article 36, the supervisor will have the power to force firms to remedy any weaknesses and deficiencies it identifies in their system of governance, including strategies, processes and reporting procedures, in order to give greater confidence in the overall solvency position. Regulators may also conduct on-site assessments of an insurer (Article 34). The sanction under this Pillar is at Article 37: if they are unimpressed with the firm's assessment of capital required or believe the firm has material governance failures then the supervisor can impose an "add-on" to the Capital Requirements. The ABI stated that measures in this area are too prescriptive (p 13, Q 49) but other witnesses did not raise this issue.

19. While these measures are to be welcomed, the Committee were concerned about how risk management capability could be measured. We note that risk management is often judgemental and qualitative as opposed to the more clear-cut measurements of capital. While the FSA told us that Solvency II had an increased focus on the quality of the firm's managers over the status quo (Q 77), we remain concerned that this is, by definition, difficult for a supervisor to measure. The FSA also noted that the depth of the UK financial services market allowed firms to recruit experts in niche markets, whereas other European regulators had had to rely on a more quantitative approach to risk management and faced a larger cultural change (Q 78). We hope that this will not lead to the watering down of this proposal. The CEA agreed with the FSA's observation (Q 122) and welcomed the focus on this area. They noted that risk management had often been the cause of failure in the past but reported that firms were already taking steps to improve their internal processes (Q 114-115). They supported the approach based on consideration of risk management alongside capital adequacy and not instead of it (Q 121).

20. In its Explanatory Memorandum[11], the Commission states that it expects regulators to introduce a principles-based rather than rules-based approach to supervision, which will grant the management of undertakings more responsibility than at present. This was supported by the ABI and CEA (p 13, Q 118). In addition, regulators must make transparent appointments to their management boards (Article 30). We particularly welcome the improvements in transparency and accountability imposed upon supervisory authorities.

21. The Committee welcomes the focus on firms' internal risk management processes and the use of internal models. The Committee supports a principles-based approach to supervision. However, the Committee remains concerned that measures introduced at later stages of the implementation process could move from the current balanced approach and become too detailed, inflexible and prescriptive. Legislators and regulators must focus on the goals they would like regulation to achieve and allow industry the flexibility to meet their targets in the most efficient manner. We look to the Government and the FSA to ensure that the implementing measures adopt the current approach.

Disclosure of information

22. The third pillar of the proposed Directive relates to disclosure requirements which will be enhanced to allow investors a clearer picture of the risk and return profile of a firm or group. Articles 50-55 cover public disclosure: firms will be required to publish an annual report on solvency and financial condition[12]. Many UK-based firms already publish much of this information in their annual report and accounts and may be able to duplicate or make reference to this material, and for well-run firms any other material is likely to be produced internally already. The FSA and the ABI noted that the reporting requirements should not repeat the errors made in earlier Directives whereby the combination of national requirements had created an excessive burden (QQ 42, 66).

23. The ABI noted that the requirements should be flexible and linked to the internal model if the firm is using one (p 13). There is also potential for conflict between the disclosure requirements and the need for supervisors to maintain orderly markets: a publicly listed firm or group might not be able to delay announcing to a stock market that a regulator has imposed a capital add-on or that a firm had fallen below the SCR if it was required to provide prompt notification of such an event under market listing rules. Prompt disclosure might cause market uncertainty and unnecessary worry to consumers. The ABI raised similar concerns (p 13, Q 45). The FSA concurred that a regulator would need "breathing space" to react intelligently (Q 66-67) and we note that for group supervision there would be ample time for the lead supervisor to consult national supervisors. The Committee does not accept that the regulatory burden of the Pillar 3 requirements is excessive. But in the light of the strains on banks' balance sheets in 2007 we invite the Government, in their response to this report, to clarify how the disclosure requirements introduced by Solvency II will mesh with those which listed companies must meet.

Implementation costs

24. In its Explanatory Memorandum (p 29), the Government notes that the one-off implementation costs for the entire EU insurance and reinsurance sector have been calculated by the Commission at €2.0-€3.0 billion, and that the on-going costs will be €0.3-€0.5 billion per year. If these costs are applied evenly across Europe, UK-based firms would expect to meet one quarter of these amounts, as that proportion of the industry is located in this country. As the UK has already introduced a prudential regime for insurance and reinsurance regulation, some of these costs may have already been incurred. However, there will be differences between the current arrangements and Solvency II and the Minister writes that "it would be incorrect to assume that adapting to the new EU-wide framework will not entail substantial costs for UK insurers" (p 29).

25. The Committee notes the likely burden on business but recognises that there is likely to be benefit to consumers and shareholders (see paragraphs 28-29). We understand that at this stage of the legislative process, precise costs will not be available. However the Committee would welcome further details of the likely costs to UK-based firms of measures under Pillars 2 and 3 when they are available, and estimates of the amount of capital that would be freed up (or additionally required) by UK firms to meet the proposed SCR compared with the current UK regime.

Impact upon smaller firms and consumers

26. The proposed Directive notes repeatedly[13] the need to ensure that the new solvency regime is not too burdensome for small and medium-sized companies. Article 28(3) requires Member States to ensure that all implementing measures are proportionate to the "nature, complexity and scale of risks inherent of the business" of the regulated undertaking. Smaller companies may outsource their risk management function and the Directive introduces measures for the supervision of outsourced work. The FSA has been able to gather data about the impact of the proposals on small firms through the participation of a sample of firms in the QISs, and the next QIS will include modelling of the simplifications available for small firms (pp 31, 33).

27. The FSA stated that the ability to use a partial model to calculate SCR will particularly benefit smaller firms who will be able to revert to the standard formula for lesser risks and use a bespoke approach for the business in which they specialise (p 33). This counters the ABI's concerns that smaller firms may find it impossible to meet the requirements for ongoing modelling of their whole business (Q 46) and Professor Dickinson's belief that the complexity of the proposals would weigh more on smaller firms (QQ 3-7). The FSA also noted that the third QIS study had shown that within each Member State, firm size did not impact upon the likelihood of meeting the SCR; it is confident that the regime would not be a barrier to new entrants (Q 71). The CEA were also unconcerned (Q 116) and the ABI noted that as long as a company understood its risk, size was not an issue (Q 40) and niche firms could indeed prosper (Q 43). Peter Skinner, the European Parliament rapporteur on this subject, explained that many small businesses had told him that the economic requirements would be difficult for them to meet, particularly as they are not able to raise funds on the capital markets as easily as the larger firms (QQ 91-92). However, the Government noted that costs of regulation are proportionally higher for smaller firms but that this was not a feature unique to Solvency II; firms which are already well-run would not face significant extra cost (Q 70).

28. Mr Skinner also expected the more efficient use of capital in the European insurance market to generate savings which would be to the benefit of policyholders (Q 96). The effects will be felt less in the UK, where the industry is already relatively consolidated (Q 73). However, should the increased regulation drive consolidation, there might be decreased choice and higher cost for policyholders. Consumers may also perceive increased premiums as companies price products at more realistic levels—although in fact the higher cost will be a more accurate reflection of the cost of protection (QQ 31-36, 57-58, 130).

29. Most witnesses expected consolidation in the European insurance market, albeit not necessarily driven by regulatory factors, and Professor Dickinson predicted a world of "supermarkets and boutiques" (QQ 4-6, 70, 93, 95). The Committee expect the pace of consolidation to increase, but as EU-wide competition will also increase, doubt this will reduce consumer choice. The calibration of the Capital Requirements should take into account the impacts upon smaller insurance firms, although this is a separate issue to consumer protection.

Impact on UK insurance and reinsurance industry

30. The Government and the FSA are confident that UK firms will benefit from the proposed Directive. The move towards a single market for European insurance and reinsurance will benefit the City of London as it is already a global centre for the industry (QQ 84-86) and has had to deal with the dual application of existing EU directives and the FSA's domestic requirements (p 28). As firms have already had to adapt to the similar regime that the FSA has introduced in the UK, they are not expected to be harmed by competition from other Member States (Q 87).

Broader issues

31. The Committee welcomes the alignment of the proposed Directive with the Basel II approach and its reflection of proposed International Accounting standards (Q 2). The Committee is also pleased to note that other Member States agree with the fundamental principles of Solvency II (QQ 54, 62, 65, 81-83). We are impressed by the way in which industry, regulators and legislators appear to have worked together to advance this legislation. Witnesses also noted that the Solvency II approach was being watched outside the EU and was likely to be copied in other jurisdictions (QQ 2, 28-29, 48, 87-88, 102-103).

32. The Committee supports the approach adopted by the FSA, who have worked to engage UK stakeholders (p 31) and promote their regulatory approach across the EU (p 32, Q 30). The UK is a world leader in this field following the introduction of the FSA's Individual Capital Adequacy Standards regulatory regime in 2004. The entire financial sector should take credit for leading these changes, and should benefit from their expansion (QQ 30, 84, 102).

33. We note the FSA's concerns that "the Level II provisions could in some areas emerge as over-prescriptive and 'maximum harmonising'" (p 32); we similarly oppose "gold-plating" and call on the FSA and the Government to continue in their efforts to ensure that there are no setbacks during the negotiations. We also welcome the attention that the UK authorities are already dedicating to Level II of the Lamfalussy process and hope that they will maintain pressure through the Council and CEIOPS to ensure that there is a consistent and prompt implementation date—with no derogations—across Europe, which is met by all Member States (Q 65).

Scrutiny Reserve

34. This Directive will have a major impact on the insurance and reinsurance industry and marks a paradigm shift in the regulation of the business. It is therefore crucial that the measures it introduces are proportionate, accurately reflect market needs, and have no inadvertent negative effects.

35. Article 27 of the draft Directive states that the main objective of insurance and reinsurance supervision is "the protection of policyholders and beneficiaries" and the Committee is content that this legislation will succeed in that aim. The Government, in its Explanatory Memorandum, writes that it supports the project and in its evidence it has addressed the risks to its policy priorities. The Committee supports both the principles of Solvency II and the Government's approach to this dossier. There are, however, a number of issues where the final outcome of the negotiations remains unclear and the Committee has therefore decided to continue to hold this document under scrutiny until further information is available.

6 There are five key criteria: subordination, loss-absorbency, permanence, perpetuality and absence of servicing costs. Professor Dickinson of the Geneva Association explained the benefits of the new approach (Q 15). Back

7 In its Explanatory Memorandum on the draft Directive, the Commission notes its aim that the SCR standard formula will balance risk-sensitivity and practicality. It is also adaptable; as the market develops, Article 108(2) enables the Commission to adopt temporary implementing measures laying down investment limits and asset eligibility criteria whilst the formula is being updated through the Lamfalussy process. Back

8 Articles 85 to 98 of the proposed Directive outline the classification of firms' financial resources. Firms would be required to hold funds equivalent to the MCR on their balance sheet, of which at least half must meet qualitative criteria set out in Article 92. Back