Select Committee on European Union Minutes of Evidence

Memorandum by the Association of British Insurers (ABI)

  The ABI (Association of British Insurers) represents the collective interests of the UK's insurance industry. The ABI speaks out on issues of common interest; helps to inform and participate in debates on public policy issues; and also acts as an advocate for high standards of customer service in the insurance industry. Many of our leading players are internationally active with operations around the globe. Some are not headquartered in the UK.

The ABI has around 400 companies in membership. Between them, they provide 94% of domestic insurance services sold in the UK. Our member companies account for almost 20% of investments in the London stock market.


  On 10 July 2007 the European Commission published a proposal for a Solvency II Framework Directive. The draft Directive sets out a comprehensive new framework at EU level for the prudential regulation of insurance companies. This includes determination of appropriate capital standards and supervision of insurers' risk management and governance. The proposal has been published following a long period of consultation with national authorities, industry bodies, consumer groups, and especially at the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), the EU committee where national insurance regulators meet. The Commission's objective is to introduce a more sophisticated, risk-based approach to prudential regulation of insurance applied on a consistent basis across the EU. Regulatory capital requirements will be set using modern techniques for a market-based valuation of the assets and liabilities on insurance companies' balance sheets.

  The current EU level regime for the prudential supervision of insurers ("Solvency I") dates back to the 1970s. Capital requirements are calculated using a percentage of premiums paid by policyholders, with no attempt made at a realistic assessment of risk. Many regulatory bodies, including FSA in the UK, but also the Dutch and Swiss insurance regulators, have moved to a more accurate assessment of risk, based on sophisticated internal models and stress tests.

  In the UK the Individual Capital Adequacy Standards (ICAS) were introduced in 2003. These reforms have been internationally acknowledged as a success, aligning insurers regulatory capital assessment with their own internal risk assessment. An overhaul of the EU framework is therefore very timely and highly desirable.

  The Commission's proposal similarly seeks to apply a more sophisticated approach to risk and capital assessment across the EU, recognising the important role insurers' own internal capital models can play in this process. Accordingly, Solvency II will require insurers to develop more sophisticated tools to understand and manage their risks, which will ensure a more accurate allocation of capital to mitigate these risks.

  This should:

    —  encourage a more competitive single EU market for the benefit of consumers;

    —  achieve a more efficiently priced market for insurance products and help EU insurers expand their businesses around the world; and

    —  increase efficiency in the use of capital, improving financial returns.


  Annex A sets out the anticipated timetable for agreement of the Solvency II project, which follows the Lamfalussy process. We expect agreement on the Level I Framework Directive in the Council of Ministers and European Parliament by end 2008. The Commission will then propose Level II implementing legislation, to be agreed by early 2011. Transposition into national legislation will follow. We expect Solvency II to be in force in the UK by 2013.

  The Solvency II proposal follows the model first introduced by the Basel Committee on Banking Supervision, grouping requirements into three pillars.

    —  Pillar I defines the capital an insurer requires to remain solvent.

    —  Pillar II defines the qualitative aspects of the relationship between insurer and supervisor, for example internal risk management processes, and aspects of operational risk.

    —  Pillar III addresses public disclosure.

  Two thresholds are defined in Pillar I:

    —  The highest is the Solvency Capital Requirement (SCR). If an insurer's capital dips below this level, a series of regulatory and/or supervisory interventions is triggered, leading by stages down to the Minimum Capital Requirement (MCR).

    —  Where the MCR is breached this is likely to lead to swift, draconian supervisory action, for example, preventing the insurer writing new business or seeking a transfer of operations to a third party.

  The Solvency II proposal also consolidates the existing EU legislation on insurance regulation. However, only the text on prudential regulation includes substantive changes. The remainder of the text represents consolidation of existing legislation and is not expected to be the subject of debate or amendment.


  The key proposals welcomed by the industry across Europe are:

Market Consistent Valuation of Assets and Liabilities

  One of the most important aspects of Solvency II is that it proposes a modern and sensible way of calculating assets and liabilities that gives answers broadly consistent with what the market would give. European insurers have long argued for this approach to the valuation of technical provisions, and it is a considerable benefit of the proposed new regime.

Effective risk management

  Solvency II will require insurers to have, and supervisors to review, good quality risk management across their businesses. European standards in this area will help create a common basis for supervision with common, robust protection for European consumers. Accordingly, the Directive allows insurers to calculate their capital (the Solvency Capital Requirement, SCR) either by a standard, formula-based approach, or by using an internal model, which must be individually approved by the insurer's regulator. It will be crucial to ensure that model standards are not unduly onerous as we would expect over time a significant proportion of insurers would wish to seek approval to use either a full or partial internal model for regulatory purposes.

Group supervision

  Another major benefit of the current Directive is the new approach to group supervision, which will particularly benefit major insurance companies with operations in more than one member state.The existing approach to supervising insurance groups is based on considering the group as a collection of separate legal entities, all supervised individually by their national supervisor. This brings significant duplication of work for groups operating across Europe and does not reflect the economic reality of groups being increasingly managed centrally as a single entity, especially within the EU. It also constrains the efficient use of capital across the group.

  European groups have long called for more streamlined group supervision and greater freedom in capital allocation—we believe the Directive is a significant step towards this goal. The proposal must not be diluted if its benefits are to be realised.

  Group supervision will mean that national supervisors need to work more closely together. Regular information exchange will be needed to ensure that the interests of both the group supervisor and the local supervisor are fully taken into account.

  Group supervision would have a significant impact in the UK, where 21% of insurers authorised in the UK are foreign-owned. Those headquartered in other EU member states might well expect to be supervised for prudential purposes by their home state supervisor.

Principles-based approach

  We also strongly support the intention to create a principles-based solvency regime in Solvency II. This means that detailed legislation is kept to an appropriate level, with more opportunity for supervisors to amend and develop guidance and practice in the light of experience. This will be a challenge for Europe's regulators but it offers the prospect of a more flexible, yet robust supervisory system for Europe's insurance companies.


  However, there are a number of areas where further work is needed:

Minimum Capital Requirement

  As stated earlier, the Directive proposes two main levels of capital requirements, the SCR and the MCR. There is a strong case for calculating both the SCR and the MCR in a similar way, using the "compact" approach. This method sees the MCR set as a percentage of the SCR. If the MCR is calculated independently, based on aggregation of individual risk modules, the "modular" approach, the gap between SCR and MCR becomes erratic, providing potentially conflicting signals to the firm's management and to supervisors, which may create a tension when considering the most appropriate response to a particular stress event. It is also likely to lead to a MCR which is either too low or much too high, as seen in the recent CEIOPS Quantative Impact Study 3.


  The Groups proposals are exciting and innovative because they create a European framework for supervision. However, for these proposals to work as intended, we need recognition that capital held at the group level can be used to meet regulatory capital requirements across the group. Whilst the "basic" MCR would always be held locally in high quality capital, the Solvency II proposals would see a much greater degree of capital efficiency made possible, through the development of a common framework for risk and capital management across Europe. This is one of the most radical reforms contained in Solvency II and presents the opportunity to break with the past where insurers struggled with individual national requirements and instead introduce a common and consistent approach across Europe. This will be essential if we are to ensure there is a proper recognition of the diversification of risks across a group.

Pillar 2—Systems of governance—Risk management

  The current text on the risk management functions is very prescriptive. This could be particularly damaging for small and medium sized insurers, which often outsource or merge some of the governance functions. Instead the framework directive should be principles-based in this area and state outcomes, rather than specifying how firms should achieve these outcomes.

  Greater detail would be more appropriately placed in Level 2 measures, delivered through common supervisory practices across the EU.

Pillar 3—Public disclosure

  Better public disclosure is necessary for Solvency II to work, primarily so that capital markets can better evaluate the risk return features of a business, and price capital for it accurately. In doing this, the market and supervisory actions work to support each other. However, when it comes to public disclosure, more isn't necessarily better.

  For this reason it is crucial that the public disclosure requirements are kept proportionate. For example, if a firm is using an approved internal model, that should be the basis for disclosure, rather than a standard approach that its management is not using. Similarly, insurers need sufficient time to submit and implement a recovery plan for breaches of the MCR and SCR before they must be disclosed.

Third countries

  Thinking on third country regimes is fairly embryonic in the current text. It will be important to find a way for major European insurers to achieve diversification benefits from their international operations by applying a Solvency II calculation to them. Equally, where insurers from around the globe are moving to a modern Solvency II like approach to supervision and risk management then they should get supervisory recognition of this in the EU, including in the calculation of capital requirements.

  The Solvency II project is based on principles agreed by the International Association of Insurance Supervisors. Considerable interest in Solvency II is already evident in the US and other developed and developing insurance markets.


  Provided the broad outlines of the Commission's proposal are supported in the European Parliament and the Council of Ministers, the Solvency II project should deliver positive benefits for policyholders, insurers and regulators alike:

    —  For policyholders, it is vital that capital requirements are set at the right level. Too high, and they lead to unnecessarily high premiums; too low, and the risk of default by the insurer becomes too great.

    —  For insurers, the benefit lies in efficient capital management. Regulatory risk assessment will be aligned with internal management.

    —  For regulators, the proposals for group supervision are key to delivering benefits. Greater co-operation between national regulators, and a clear set of procedures in case of difficulty, will increase regulators' understanding of the insurers in their jurisdiction.

  We believe that Solvency II can deliver a world-class regulatory regime which will enable European insurers to compete effectively with overseas insurers in the international markets.

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