40 years of eu insurance regulation the long and winding road

1

40 years of EU insurance regulation

– The long and winding road

Gabriel BernardinoEIOPA ChairmanFrankfurt, 9 February 2012

International Center for

Insurance Regulation at the

House of Finance

Outline

Towards the single insurance market

The three generations of insurance Directives

The process of Solvency modernization

The Müller report

The Solvency I Directives

The Sharma report

Solvency II – An economic risk-based approach

EIOPA – Towards a European supervisoryculture

Early experiences

Objectives

Challenges

3

Towards the single insurance market

The three generations of insurance Directives

The Treaty of Rome

The Treaty of Rome establishing the European Economic Community (25 March 1957) provided the basis for a common insurance market freedom of establishment

freedom to provide services

free movement of capital

Directive 64/225/EEC Abolition of restrictions on freedom of establishment and freedom to provide

services in respect of reinsurance and retrocession

“The establishment of the framework for the internal insurance market, in particular the realisation of the fundamental freedoms, proved itself to be extremely difficult.”

Dr. Helmut Müller in

Legal Bases of the Internal Insurance Market in Europe

The EU legislative path

The first generation of EU Directives

Non-Life - 73/239/EEC

Obligation for each Member state to make the taking-up of non-life insurance business subject to an official authorisation

Conditions for the licencing include the submission of a scheme of operations (including policy conditions and tariffs) and a proven minimum guarantee fund

Each Member state is responsible for ensuring that undertakings maintain an adequate solvency margin and establish sufficient technical reserves

Technical reserves should be covered by equivalent and matching assets localized in each country where business is carried on

Life - 79/267/EEC

Requirements consistent with the First Non-life Directive

Basis of solvency calculation is the mathematical provision and the capital at risk


The intermediate generation of EU Directives

Non-Life - 88/357/EEC

Free movement of cross border services for “large risks” (transport, credit and suretyship risks and large industrial and commercial risks)

Regulation and supervision of large risks in accordance with the model of home state control and mutual recognition

Host country principle continues to be applicable in the retail and small commercial business

Mandatory communication of policy conditions and tariffs abolished for large risks

Complex rules on the cooperation between supervisory authorities

Life – 90/619/EEC

Similar changes to cases where the policyholder took the initiative of seeking out the commitment from a foreign undertaking (passive free movement of services)

Policyholder has a right of cancellation in this contracts (14 to 30 days)


The third generation Directives

Non-Life - 92/49/EEC and Life – 92/96/EEC

Introduces the single insurance licence to do business throughout the Community with the home country supervisory control and a minimum co-ordination of prudential rules for assets backing technical reserves and the solvency margin

Maintains systematic notification of policy conditions for compulsory insurance and health cover substituting for social security schemes

In Life insurance member states can require the systematic notification of the technical bases used in calculating the premiums and technical provisions

Freedom of companies to establish policy conditions is bounded by the need to respect Member State provisions designed to protect the 'general good', insofar as such provisions are proportional, and do not unnecessarily obstruct freedom of services or establishment

Long list of information to be disclosed prior to and after the conclusion of life insurance contracts


The third generation Directives (cont.) Right of cancellation applied to all life insurance contracts

Rules relating to technical provisions and valuation of assets are laid down in the Accounts Directive of December 1991

Acceptance of different methods for calculating the maximum rate of interest to discount life mathematical provisions

Investments must respect principles of safety, yield and marketability

Investments must be diversified and adequately spread

New mechanism of control of shareholders of insurance companies and obligation of supervisory authorities to ensure that the managers of insurance companies are honourable and qualified

The EU Single Insurance Market

was born on

the 1st July 1994

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The process of Solvency modernization

The Müller report


The Sharma report

Solvency II – An economic risk-based approach

From “Solvency 0” to Solvency I

EU Commission was mandated by the third life and non-life Directives to submit a report to the Insurance Committee "on the need for further harmonization of the solvency margin" by mid-1997 at the latest

The Insurance Committee requested the Conference of the Insurance Supervisory Authorities of the European Union Countries in 1994 to have the solvency regulations examined in more detail by a working group

The report was elaborated under the chairmanship of Dr Helmut MÜLLER, Vice-President of Bundesaufsichtsamt für das Versicherungswesen (Germany Insurance supervisory Authority)

The Müller report (1994-1997)

Main objectives

Overview of the experience of supervisory authorities

Examine whether the regime allows supervisors to intervene early enough

Examine whether the minimum solvency requirements still adequately take account of the nature and size of the risks insurance undertakings are exposed to

Consider the experience of the risk-based capital approach applied in the USA and the solvency rules applicable to banks in the EU

Examine the quality and admissibility of capital elements

Investigate the pros and cons of controlling the investment of assets to cover the solvency margin

Consider the need to up-date the thresholds and amounts of the minimum guarantee fund


Technical risks

Current risks:

Risk of insufficient tariffs

Deviation risk

Evaluation risk

Reinsurance risk

Operation expenses risk

Major losses risk (only non-life)

Accumulation or catastrophe risk

Special risks:

Growth risk

Liquidation risk


Investment risks

Depreciation risk

Liquidity risk

Matching risk

Interest rate risk

Evaluation risk

Participation risk

Risks related to the use of derivative financial instruments


Non-technical risks

Management risk

Risks in connection with guarantees in favour of third parties

Risk of the loss of receivables due from insurance intermediaries

General business risks


Main risks connected with observed difficulties

Management risk (proves to be an intrinsic danger factor)

“Controlling and ensuring sound and prudent management is far more important than the solvency system, because management errors by their nature cannot be compensated by solvency requirements”

Other significant risks:

Investment risk

Valuation risk for technical reserves (potential danger of

under-provision, especially for long-tail business)

Growth risk (especially in connection with rising costs and an

inappropriate underwriting policy)

Reinsurance risk


Interesting considerations

On solvency requirements based on asset risk:

“A solvency regulation based, even if it was only partly, on the assets would influence the investment strategies of the insurance industry in an unacceptable way by leading the companies to invest only in low-risk assets (mainly in bonds issued by the state) in order to present a lower solvency amount.”

“Compared to the banking sector the investment risk in insurance is considerably restricted by other preventive measures (investment catalogue, principle of diversification and spreading, matching assets)”

“A point against the approach taken from the banking sector is that insurance undertakings, in contrast to banks, are mainly interested in the liabilities side of the balance sheet.”


Interesting considerations

On the level of harmonization:

“Opinions diverge on whether a definite coordination of the Directives’ requirements in the sense of generally applicable rules for all countries is necessary, or if the Directives should merely represent minimum requirements.”

“A reason stated in favour of a complete coordination is that an equal treatment of all insurance undertakings in the Common Market avoids discriminations against insurance undertakings and moves to less strict countries. Also the intended introduction of a Directive for insurance groups asks for equal requirements for all undertakings.”

“A reason stated against a complete coordination is that in some questions an agreement could not be reached. Moreover, the discussion has shown that some countries interpret certain rules in very different ways and that there are still differences in what certain terms are understood to mean.”


Conclusions on the solvency regime

The insurance system created by the community in 1973 and 1979 has proved itself and there is therefore no reason to totally revise it

Some amendments and additions:

The minimum amounts of the guarantee funds are to be raised considerably to take account at least of the inflation

A provision index is to be applied in addition to the premium and claims indices in order to better take account of the high settlement risks inherent in the so-called long-tail business

No majority support for the proposal to take account of the investment risk both in life insurance and in non-life insurance by applying a separate investment index


Conclusions on supervisory powers

The measures provided in the directive are not sufficient to protect the insured from financial losses

The measures are only available in extreme emergency situations when the undertaking is often already so badly affected financially that it is beyond rescue

Suggested additions to the powers provided in the directives:

Supervisory authorities must be empowered to intervene and correct the situation at an early stage, i.e. when the technical provisions have not yet proven to be insufficient but when the interests of the insured appear to be at risk

The situations and means of intervention, similar to the degrees of intervention under the RBC system, should not be described in more detail in order to give the supervisory authorities the flexibility for any regulative measures


Life – 2002/12/EC and Non-Life 2002/13/EC

Increase of the minimum guarantee fund taking into account the rate of inflation

Increase of the thresholds for premiums and claims in non-life insurance (adaptation to the rate of inflation)

Reinforced early intervention powers for supervisors when the interests of policyholders can be jeopardised

Supervisors can limit the reduction of the solvency margin when the nature or quality of reinsurance contracts has changed significantly or where there is an insignificant risk transfer under the reinsurance contracts

Higher solvency margin for non-life insurance classes which are subject to a particularly volatile risk profile (aircraft liability, liability for ships and general liability)


Life – 2002/12/EC and Non-Life 2002/13/EC

Member States to set more stringent capital requirement rules for the undertakings they authorise than the minimum requirements set in the Directive

Additional capital requirement for permanent health insurance

For unit-linked business inclusion of a requirement for a solvency margin where a firm bears no investment risk and the allocation to cover management expenses is not fixed for a period exceeding five years

Categorization of the capital elements in three groups

By 2007 implicit items for future profits must be restricted to a certain threshold and from 31 December 2009 they will no longer be allowed

Insurance Groups and Conglomerates

Directives

Directive 98/78/EC – Insurance groups

Supplementary supervision of insurance undertakings in an insurance group (solo-plus supervision)

Supervision of intragroup transactions

Elimination of the multiple use of capital (“double gearing”)

Additional solvency test at the level of the parent company

Directive 2002/87/EC – Financial conglomerates

Prevent the “multiple gearing” of capital

Prevent the inappropriate creation of “own funds”

Three methods for the calculation of solvency at the level of the conglomerate

Rules for intra-group transactions, risk concentration and fit and proper

From Solvency I to Solvency II

In May 2001 the European Commission began a fundamental review of insurance regulation, the ‘Solvency II’ project

The EU Insurance Supervisors Conference was asked to make recommendations for that review

The report was prepared under the chairmanship of Paul Sharma, Head of the Prudential Risks Department of the UK’s Financial Services Authority

The Sharma report (2001-2002)

Main objectives

Build on the 1997 Müller report to formulate a more up-to-date picture of the risks that European insurance firms face Identify and analyse the risks that have led to actual solvency problems

between 1996 and 2001, or created a significant threat to the solvency of a firm (‘near misses’), including any new and emerging risks; and

Prioritise each risk that has been identified;

Evaluate how supervisors might respond to these risks, by looking at: How effectively the current solvency system (and its three building blocks of

assets, liabilities and capital) has detected in advance firms in difficulty over the last six years;

How effectively current supervisory tools prevent, detect in advance and cure problems; and

Typical early warning signals, including both quantitative and qualitative factors, and possible new signals.


Risk Map

1

2

3 4 5

6

7


Detailed

Risk Map

1

2


3 4 5


6

7


Key findings

Most obvious causes of problems were:

Inappropriate risk decisions

External ‘trigger event’

Adverse financial outcomes

But, causal chains began with underlying internal causes:

Management are competent but have an excessive risk appetite or a lack of integrity or independence; or

They operate outside their field or level of competence;

They fail to put in place adequate decision-making processes or adequate internal controls.


Main conclusions

The review of solvency needs to encompass governance and risk management

Supervision of insurance firms needs to be more focused on qualitative factors such as quality of management and suitability of systems and controls - such areas are subjective and rely heavily on supervisory skill and experience

Risk management systems, internal control and certain ‘people issues’ (for example incentive structures) should be examined in more detail

Need to agree on a common system of early warning signals and sharing ideas on more detailed signals, setting a framework and common standards for sharing data, and setting a framework for crisis management


Lessons about supervisory toolkits

Informal dialogue with the firm, as well as with auditors and actuaries and with other participants in the market, is an important part of supervisory practice. It is particularly useful for determining the quality of management and of internal controls

Preventative tools can include both restrictive tools to prevent undesirable behaviours and incentives to encourage desirable behaviours

Encourage other methods for aligning management’s interests with prudent management of the business (internal models)


Lessons about capital

Capital has a preventative and curative role in the prudential regime

A buffer is needed for variances even in well-managed risks, and a higher early warning level is needed, which can trigger intervention before the company is close to breach of the minimum limit

The minimum and the early intervention levels in particular need to be better correlated to the types of risk they are to cover. This will make the relative size of the buffer more appropriate to the firm’s circumstances, and make the early warning level more accurate and responsive

The most powerful potential purpose of capital responsive to risk is that it can also be an incentive for the firm to manage its risks well as better risk management will result in a lower solvency requirement and early warning level

Directive 2009/138/EC

Supervision of solo undertakings and groups

Focus on firm’s

responsibility

Better risk-based

information

Increased transparency

Total balance sheet

approach

Market-consistent

valuation

Approval of internal

models

Quantitative

Requirements

Technical provisions MCR and SCR – SF/IM

Prudent person investment rule

Own funds

Qualitative

requirements

Internal control and risk management (incl. ORSA)

Supervisory review process (qualit. & quant -Add-ons)

Reporting and disclosure

Supervisory reporting

Public disclosure

Market discipline

Pillar 1 Pillar 2 Pillar 3

Convergence of

supervisory practices

Harmonized

supervisory reportingHarmonized Valuation

standards

Solvency II

Increased protection of policyholders by:

Better alignment between risk and capital

Improved risk management

Fostering the convergence of supervision

Solvency II

Better alignment between risk and capital

Market consistent valuation of all assets and liabilities

Economic assessment and consistent measurement of risks

Risk-based capital requirements (standard formula or internal model) – MCR and SCR

Solvency II

Improved risk management

Ultimate responsibility of the management body to ensure that the implemented risk management system is suitable, effective and proportionate

Should cover all material risks the undertaking might be exposed to

Shall be integrated into the organizational structure of the undertaking and into its decision-making processes

Solvency II

Improved risk management – ORSA

Enhancing awareness of the interrelationships between the risks and the internal capital needs that follow from this risk exposure

Should help to promote a strong culture of risk management, and, more widely, in soundly running the business

It is a top-down process (Models cannot replace leadership)

Capital is not the answer for poor risk management

Capital is not the solution for all the risks

Solvency II

Fostering the convergence of supervision

Harmonised reporting to supervisors

Improved group supervision (role of the colleges of supervisors)

Common framework for the Supervisory Review Process (Role of EIOPA)

Solvency II

Are there unintended consequences?

Impact on the investment policy of insurance undertakings

Further consolidation of the market

Procyclicality of the capital requirements

Crisis - Did we learn the lessons?

How to increase long term stability and regain consumer confidence?

Encourage realistic risk assessment and pricing

Promote a responsible business conduct

Increase transparency towards markets and consumers

Reinforce preventive supervision and timely enforcement

41

EIOPA – Towards a European supervisory

culture

Early experiences

Objectives

Challenges

EIOPA’s early experiences

REGULATION (EU) No 1094/2010

EIOPA in 2011 – Learning to fly, but alreadydelivering

Regulation

Oversight

Financial stability

Consumer protection

International relations

The European System of Financial Supervision

ECB Council (with insurance and

securities alter-nates where necessary)

Chairs of EBA, EIOPA & ESMA

European Commission

European Systemic Risk Board (ESRB)

+ +

EuropeanBanking Authority

(EBA)

EuropeanSecurities & Markets

Authority (ESMA)

National Banking

Supervisiors

NationalInsurance

Supervisors

National Securities

Supervisors

Information exchange Advice and warnings

EuropeanInsurance & Oc. Pensions

Authority (EIOPA)

Main objectives for the nexttwo years

On Regulation:

Technical standards, guidelines and recommendations toimplement SII

Develop the single rule book - IMDII, PRIPS, IORPII

On Oversight:

Common framework for the Supervisory Review Processunder SII

Increased focus on Peer Reviews

Foster the exchange of information within Colleges ofsupervisors

On Financial stability:

Create a centralized hub of information for stabilitypurposes

Monitor the system risk in the EU insurance market

On Consumer protection:

Closer look at unfair practices that lead to consumer detriment

Reinforce the standardization and comparability of theinformation provided

A new governance framework for product suitability

Strengthen conduct of business supervision

Ensure cross-sectoral consistency – Role of the Joint Committee

On International relations

Contribute to the development of robust international standardsfor International Active Insurance Groups

Main objectives for the nexttwo years

Challenges

The ESAs and the NSAs

Independent but closely cooperating

Need to foster supervisory convergence

Regulation - One size does not fit all

Closer look at proportionality

Do not treat equally what is different (different sectors have different risks)

Principles versus details

Sound principles should be the basis

Level playing field calls for more detail

Challenges

Creation of a truly European supervisory culture that:

Promotes stability

Enhances transparency

Fosters consumer protection

A culture based on intelligent and effective regulation

A culture that adds credibility and promotes goodpractices

48

"The more you learn from your past and

present, the more you are able to create

the future you seek."

Gabriel Bernardino, Chairman

40 years of eu insurance regulation the long and winding road

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