Solvency 2: Key messages for getting the detail right
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Speech by Sally Dewar, Managing Director, Wholesale, FSA
ABI Solvency 2 Conference
10 June 2008
Good morning ladies and gentlemen. I’m delighted to be here and my thanks go to the ABI for the chance to address you this morning, on the important subject of Solvency 2. As Hector Sants wrote in his Overview of our Business Plan, this directive is a big commitment for the FSA over the coming years and is perhaps the most important EU‑driven policy work we are engaged upon.
The FSA has supported the development of a modern EU regulatory standard for insurance from the very start of this project. This reform is needed to strengthen further the supervision of insurers in Europe and to enable both regulators and the regulated to break free from the confines of an ‘ancien regime’ that stands in the way of the adoption of modern methods and the spread of best practice.
Agreement on the Level 1 text of the Directive itself is expected within months. So we are nearing the end of the beginning of the project. What I would like to do today is to touch upon some key issues that remain open and which are central to the eventual success of the new solvency regime. I shall start by emphasising the importance of a sensible articulation of the implementing measures – so‑called “Level 2” - touch on the need for an effective approach to the supervision of groups and adequate reserving for equity risk. I will then conclude with a few words on the plans for the implementation in the UK.
Process and disciplines for Solvency 2 policy-making
But before all that, I think it is only right to start by commending the European Commission on their progressive and balanced proposal. Evolution of the Directive has illustrated European policy making at its best. Based on early open consultation with the relevant stakeholders, and under-pinned by rigorous cost-benefit analysis, the results of this good groundwork are reflected in the quality of the Commission’s proposal.
The Proposal contains several key elements that we believe are essential for a modern solvency regime: a strong focus on risk-management, supported by market-consistent valuation of assets and liabilities, with the responsibility for the running of the firm on the shoulders of senior management. The Commission Proposal delivers on all these counts.
But the eventual success of the new regime is very much dependent on getting the detail right. We must follow the same common-sense approach to the development of the implementing measures as was followed prior to the launch of the Commission Proposal for Level 1. It would be a lost opportunity if we were pushed into a hasty implementation and in the process got the detail wrong. We know from past Directive implementation projects that it takes time for both the supervisors and the industry to get the right systems in place and to train staff. It is for this reason the eventual date for “switching on” the new rules must be carefully set. The overriding objective must surely be to get a high quality outcome – this is in everyone’s interest.
It is a clear priority for the FSA in the next 12 to 18 months to work with our European colleagues in CEIOPS and with the Commission in getting Level 2 right. I am confident that the commitment made by the Commission to follow the same processes and disciplines of open consultation and impact assessment as it has for Level 1, will be instrumental in ensuring that the implementing measures are of a high standard.
Focus on the outcomes
I would briefly like to touch on another general issue relating to the direction that the new regime seems to be heading. A key theme of Solvency II is the requirement for firms to assess their own unique situation and apportion capital and other resources accordingly. We feel this is the right approach, and best captures the individual risks that each firm faces.
In a similar vein, sufficient room should be left for supervisors to exercise their judgment and discretion when deciding on a proportionate and appropriate supervisory response, best suited for the specific circumstances of each individual firm or event.
We must take care not to fall into the trap of seeking an absolute and prescriptive harmonisation of supervisory processes and practices. The Directive sets out a clearly defined and harmonised standard for policyholder protection across the EU. And this is absolutely right. The aim should be the harmonisation of outcomes, not processes. We will not achieve comparable levels of protection for consumers, buying different products under different circumstances in different jurisdictions, if supervisors are asking the same exact questions or ticking the same number of boxes.
It seems rather odd that at the same time when trying to move firms away from a compliance-focussed, ‘box-ticking’ culture, to focus on risks, that supervisors might be pushed in the opposite direction. We need to find other pragmatic ways of achieving comparable supervisory outcomes. I believe a good starting point is the development of transparent supervisory approaches and guidance that enable comparison between jurisdictions. And we see CEIOPS playing an important role in fostering practical supervisory convergence through training and exchange of staff.
I would now like to move on to discuss some topical issues of interest, beginning with groups.
Groups
The Commission proposal to upgrade and streamline the supervision of groups has attracted much attention. And rightly so. Regulatory structures must adapt to recognise the economic realities of groups.
From the outset we have supported the direction of the Commission’s Proposal to make the supervision of groups more effective. Key to this is the appointment of a group supervisor for each group, with clearly defined responsibilities. This is particularly important if the possibility of using internal models at group level is to make any sense in practice. The Capital Requirement Directive sets out the minimum that Solvency 2 must deliver in this respect.
But we should not forego the opportunity that Solvency 2 represents to make further progress beyond this. I refer specifically to the option for groups to opt-in to the so-called ‘group support regime’. There are 2 issues central to the groups debate from a supervisory perspective on which I should comment.
There are a number of conditions that groups must satisfy before they can access the group support regime. The Directive sets out tough requirements surrounding risk management practices, effective systems and controls and internal governance that groups have to satisfy.
Furthermore groups will have to demonstrate that their capital can be transferred to those subsidiaries using group support if needed. In practice, this means that fungibility of capital will need to be assessed on a case-by-case basis, taking account of the differing circumstances of individual groups. From a supervisory perspective, this is central to making these arrangements work in practice.
And we should not forget the requirement for firms to be able to demonstrate and justify to their supervisors the diversification benefit they believe they should be entitled to. This will not be easy and will require investment and effort from groups to put in place systems and models capable of delivering.
So, in effect, groups will be required to ‘go the extra mile’ in their risk management to reflect the increased complexity that comes with conducting their business cross border. But if they are able to deliver on those higher standards, this should provide supervisors with a sufficient degree of comfort to justify “rewarding” the group with the permission to manage their capital centrally. Restricting groups’ ability to reap justified advantage from their enhanced risk and capital management would bring no real benefit to policy holders. But it would leave Europe less competitive as a location for doing insurance business.
The second point I would like to make is to emphasise the key role that we see for supervisory colleges in delivering effective supervision. Their role should be recognised as sitting at the centre of a framework for the co-ordination of the overall supervisory effort, and for the sharing and analysis of information. It is worth noting in this respect that the Directive does not introduce a pure ‘lead supervisor’ approach. Rather, it sees the group supervisor and the supervisors of the subsidiaries working together to better capture the risks of insurance groups, thus enhancing the level of protection for policyholders. We strongly support this development, recognising that the group supervisor for groups writing much business with UK policyholders will lie in Germany, France or elsewhere in Europe.
An often overlooked aspect of the Commission Proposal is that all subsidiaries must hold capital locally at least up to their MCR. This additional buffer, sitting on top of technical provisions calculated on a market consistent basis, means that a substantial amount of capital will reside with the subsidiary to ensure that policyholder liabilities can be either transferred or run-off in an orderly fashion if needed. This is an important safeguard to protect against consumer detriment in the event of an insurer failing.
To take the debate forward, we have recently published a joint discussion paper with HMT that suggests some amendments to fine-tune the Commission’s Proposal to take account of some concerns raised thus far. We believe that, with the few tweaks proposed in this Paper, the group support regime can work in practice.
Equity stress-test
Moving on from the opportunity available on groups, I turn to a topic of fundamental importance across the whole system, namely equity risk. Being often the largest risk on the asset-side, it is absolutely clear to us that developing an appropriately robust treatment for equities is fundamental to the regime acting as an effective prudential standard.
In order to achieve this, the equity stress in the standard formula must reflect economic realities. Empirical evidence supports a stress of around 38-39%. This is also supported by the CRO Forum internal models bench-marking study.
In line with the underlying philosophy of Solvency 2, riskier investments must be backed up by more capital in order to arrive at a sufficient degree of protection for policyholders, as well as to safeguard the stability of the markets.
The 32% stress tested in QIS3 and carried forward to QIS4 therefore appears imprudent and I know that many of our European colleagues agree with us on this point. To address this, we, together with other jurisdictions, are asking firms to use a more realistic test in QIS4.
Having an equity stress in the standard formula that is consistent with economic reality is also essential to support the effective introduction of internal models. The Directive requires firms modelling their own risks to do so in line with economic realities. A move away from this in the standard formula creates an inconsistency that is difficult to justify and, crucially, introduces a disincentive for firms to model. It would be foolish to undermine one of the key features of Solvency II by getting this point of detail wrong.
Transition to Solvency 2
The next issue I will cover concerns something where I believe the need for us to work closely together is particularly great - namely the progressive implementation of the new framework, and ensuring a smooth transition from ICAS to Solvency 2.
Although the actual implementation of Solvency 2 is some years away, if there is a lesson to be learnt from the implementation of Basel 2, it is that we should be planning key aspects of implementation even before the ink is dry on the details of the new requirements. Whether you are planning to use the new European Standard Formula, or an internal model, the least you should be doing now is to improve your understanding of the differences between our existing ICAS standards and Solvency 2.
In this respect, QIS4 represents your best opportunity to see what ‘life will be like’ under the new solvency standard. The QIS4 technical specification is currently the most tangible articulation of what is likely to be required from firms, and as such offers an excellent opportunity to assess how it might affect you specifically. Feedback from a broad spectrum of firms following QIS3 suggests that many discovered a potential issue particular to their business that they had not considered previously. We think QIS4 participation is a good way to start your Solvency 2 implementation project.
We are pleased to see that participation is up from QIS3. Data from previous studies has helped us in focussing on specific issues needing further work that may not have come to light otherwise. By way of example, the calibration of the non-life underwriting risk module was revised downwards as a direct result of the information provided by the industry through QIS3. So not only does your participation in the Quantitative Impact Studies help you begin thinking about the implications of this change, it also contributes to the design of a sensible and practicable solvency framework.
Thus far, industry involvement in Solvency 2 has been exemplary. We appreciate that the many consultations require effort and investment from you, but this is the quid pro quo for the transparent policy-making framework so central to the Lamfalussy-style of legislating. I would note however, that there has been a distinct bias in those who have engaged with us towards the larger players in the market.
And although this is not surprising, I would like to see a change in this going forward. More of the smaller firms need to start engaging in the process. Solvency 2 will happen, and the best approach of dealing with it is not to bury your heads in the sand.
The FSA and other stakeholders are ready to help, but we also need firms to show initiative through exercises such as QIS4. I would like to thank our hosts for their efforts in this area, as with their help we have been able to offer some training specifically for smaller firms, helping them to partake in the exercise. This is a good start, but we should look to build on this momentum.
Before I conclude my remarks, I will turn as promised to the practicalities of how as the supervisor the FSA will be tackling the transition to Solvency 2. It is all very well to speak of grand designs, but eventually those designs must be put into practice. And I know many of you here today would like to know how we intend to make the required changes in the provisions of our Handbook and in our supervisory practice.
First of all, we need open and frank dialogue with you throughout this process. We shall after all be implementing in co-operation with individual firms of every shape and size. So co-operation in designing the process is essential to sustaining confidence and trust. We will be looking to build on existing channels, such as the Insurance Standing Group and its sub-groups. I also hope you will invite me back to any future ABI conferences!
We have started to scope out some initial thoughts on implementation time-lines and plans internally. We will firm these up and communicate them to you as soon as practicable. But in so doing, I hope you appreciate that also we have to deal with the same uncertainty that you face, arising from the fact that CEIOPS advice on implementing measures will not be ready until late next year, and the Commission is not scheduled to present their implementing measures until late 2010 or early 2011.
That said, to kick start the dialogue with you, we will publish a Discussion Paper on Solvency 2 later this year. This will outline some initial thinking on what implications the Directive might have for systems of governance, reporting, internal models, standard formula and other elements of ‘Pillar 1’, based on the Directive proposal. Under all these headings we will welcome your feedback as to what you would find particularly helpful from us.
The Discussion Paper will include suggestions as to what firms’ priorities can most usefully be over the next 12 to 18 months in helping to prepare for implementation. Although ICAS and Solvency 2 have some similarities, they are not the same. There are differences that you will need to understand and prepare for.
With the experience that UK firms already have in running a more risk-based solvency system, and by working together, I am confident that the UK market will be well-placed to take advantage of the opportunities offered by Solvency 2.
So, to conclude, we have come a long way but there is still some way to go. We must remain focussed to get the detail of the new regime right and work together towards as smooth a transition to Solvency 2 as possible. We look forward working with all players in the industry on these challenges.