Despite frustration over political delays, European regulators want to use the time wisely to prepare for implementing Solvency II, he said. However, he said he still has concerns that the Directive fails to detail the appropriate level of diversification of risk on insurers' balance sheets, with the Directive insisting the issue "to be thrashed out between firm and supervisor in the approval process".
"The heart of the issue is whether long-term guarantee products should be subject to the same market consistent evaluation framework as other insurance liabilities under the Directive. After considerable debate there is acceptance, but by no means universal acceptance, of a compromise whereby certain annuity products that cannot be exited early and which have clearly defined and matched assets can effectively be carved out from the full rigour of market consistent valuation, by allowing a matched premium adjustment.
However, more contentious is the question of whether this more liberal treatment should be extended to a wider range of long-term guarantee products where asset matching is less clear and, crucially, the ability to exit a policy is permitted. The advocates of a wider application of the matched principal framework argue that the contractual ability to surrender a policy should not be the only concern and that companies can model the likely behaviour of policyholders. Detractors worry that early termination of policies can crystallise impaired market values in matching assets. Underlying this debate is the suspicion that if some insurers apply a market consistent valuation approach to the back book of existing guarantees in current market conditions then this will lead to severe strains on solvency levels.
It is important that a sensible solution be found to this issue if we are to get Solvency II concluded. The treatment of long-term guarantees is however an issue of considerable prudential concern, as will be evident when I shortly explain the work of EIOPA on long-term low interest rates. Nevertheless, my personal view is that prudent insurance regulators could live with a more flexible approach to allow matched premium adjustments for a wider range of long-term guarantee products on three conditions. First, that the regime would only apply to back books and would therefore be transitional in nature. Second, that insurance companies be required to make a pillar III disclosure setting out their solvency position both with and without the matched principal adjustment. And third, that national supervisory authorities have flexibility to impose supplementary pillar II charges to take account of inadequate solvency buffers on a case-by-case basis. This framework would, I believe, allow a transition period for back book guarantee products while also providing a clear line of sight as to the solvency position of individual firms alongside the necessary supervisory tools to deal with particular problem cases.
One way or another it is important that a balanced compromise is found and the directive package can be brought to a swift and successful conclusion. With European elections looming next year, it is important that this process concludes in the autumn at the latest. Like those in the industry, the regulators around the EIOPA table find the delay in concluding the political negotiations frustrating. It is important that we have a credible new timetable for implementation. While a significant portion of the costs of Solvency II implementation involves a necessary and welcome upgrading of risk management systems and techniques, it is equally clear that the level of cost has been exacerbated by the uncertainties in the implementation timeline and the delays in the political process. These unnecessary cost overruns are insupportable. This autumn, the political process has one further chance to put this right..."
"The Central Bank (in common with a number of other supervisors) is concerned to ensure that the design of models enables a prudent recognition of diversification effects within insurance company balance sheets, but does not go so far as to erode solvency buffers through over-optimistic correlation assumptions that do not stand up in times of stress. This is partly a design weakness in the text of Solvency II, as the directive does not impose specific constraints on correlation and diversification recognition in internal models per se, but requires this to be thrashed out between firm and supervisor in the approval process. (In contrast, the banking regulatory framework provides such hard, binding constraints on diversification in internal models.) As I have explained previously, I’m concerned that this case-by-case approach is vulnerable in a number of ways. Supervisory quants are at risk of being outgunned by industry quants in the minutiae of a correlation debate. Supervisors are exposed to the weakest link of an overly generous approval in some perhaps under-resourced jurisdiction which sets the bar too low and creates competitive equality pressures.
Fundamentally, what is needed is a broad agreement on the outer bounds of acceptable levels of diversification in the model approval process. One approach being explored actively in another jurisdiction is that of setting a floor at some proportion of the MCR derived under Solvency II, when agreeing the SCR output from an internal model. Pending active development at a European level of an agreed approach to ensure a level playing field, the Central Bank’s message to Irish firms is to take a conservative approach to the recognition of diversification and to think very hard about how well this will hold up in extreme tail event stress scenarios..."
Elderfield finished by setting out his personal thoughts on the four key elements that need to be preserved to ensure strong supervision continues [abridged]:
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Element one is an adequately resourced and high quality supervisory staff.
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A second element is a strong set of powers, such as is currently being adopted in the Dail.
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A third element, which I’ve already spoken about, is a supervisory philosophy that encourages challenge of firms and that problems are tackled decisively and definitively, rather than being allowed to fester, even if that is uncomfortable or inconvenient; and
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The final element is a supervisory institution that is independent.
Full speech
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