IMPROVING FINANCIAL REGULATION
INTERNATIONAL ISSUES
Putting the world to rights
The IAIS Holistic Framework is finalised and the Insurance Capital Standard is entering a crucial phase
Olav Jones
Deputy director general, Insurance Europe
“De-globalisation” is currently much discussed in this era of geopolitical uncertainty and supply-chain disruptions, but our world of online connections and fast travel remains stubbornly and irrevocably interconnected, and businesses continue to look beyond their borders to thrive.
Insurance is no exception, with EU companies active globally for many, many years and now leading the global insurance and reinsurance industry. Indeed, 50% of all internationally active insurance groups are European1.
The EU’s Solvency II regulatory framework has, however, worsened the competitive position of EU insurers. Non-EU insurers are able to use their capital more effectively to serve their ability to accept risks and to increase their investment capacity. This is because the way Solvency II currently measures insurers’ capital leads to excessive requirements and exaggerated volatility in solvency measurements, particularly for long-term products and investments.
And the situation for EU insurers competing globally will soon become even more challenging. The designation of “provisional equivalence” assigned by the European Commission to the US, Canada, Japan, Australia, Brazil and Mexico to allow EU insurers to apply local solvency requirements for their business in those jurisdictions will expire at the end of 2025. Without this designation of equivalence, EU insurers will have to apply Solvency II capital rules to their local business, making them uncompetitive. For example, an EU insurer offering business in the US under Solvency II may have to operate with 20–30% higher levels of capital.
Elements of the current calibration of Solvency II are putting European insurers at a global competitive disadvantage
50% of all internationally active insurance groups are European
The review of Solvency II that is currently underway is an opportunity to address the fact that EU insurers have to hold more capital for the same business than other global (re)insurers with whom they compete. Without action, the EU’s leadership of the global (re)insurance industry will be hampered and the attractiveness of the EU as a base for global (re)insurance will be substantially harmed. The EU’s insurers have proposed changes to Solvency II (see article here) to better align it to insurers’ real risks, while still ensuring extremely strong customer protection. After the needed improvements, Solvency II would remain the international gold standard for prudential regimes.
“Without action in the Solvency II review, the attractiveness of the EU as a base for global (re)insurance will be substantially harmed.”
International capital standard under development
Meanwhile, the coming months will be a crucial period in the long battle by the International Association of Insurance Supervisors (IAIS) to create a prudential standard for internationally active groups. Insurance Europe has supported the IAIS Insurance Capital Standard (ICS) project as long as it results in a measurement framework that correctly captures insurers’ risks and long-term business and is a single standard applied widely and in all key insurance markets globally. Such a global standard will have the potential to help level out the international playing field, safeguard financial stability and strengthen coordination between international supervisors.
To be fit for implementation as a global prescribed capital requirement (PCR) it needs to be based on a common methodology that achieves comparable (ie, substantially similar) outcomes in all jurisdictions. To be comparable in a way that is robust and quantifiable, the ICS and any methodologies deemed comparable (including the Aggregation Method, see box) need to have equivalent target criteria for regulatory capital requirements and result in very similar supervisory responses to changing economic and other conditions. This is necessary to ensure the same levels of policyholder protection and the same supervisory actions in times of stress, as well as to deliver a global level playing field.
It is also important that the ICS permits (re)insurers with larger, more complex risks to use — subject to supervisory approval — their own, sophisticated and more accurate internal models rather than standard formulas to calculate regulatory solvency capital requirements. Internal models must be a permanent and integral part of the ICS framework.
The ICS should be considered for implementation in Europe only if all major jurisdictions commit to implementing it consistently. It is far from clear at this stage whether this commitment is achievable. A consultation package on the ICS as a PCR is planned for the third quarter of the year and revisions to the Insurance Core Principles on valuation (ICP 14) and capital adequacy (ICP 17) are also planned. Insurance Europe will remain fully engaged in these discussions.
If discussions do progress to the implementation stage, Insurance Europe wishes to see the reviewed — and improved — version of Solvency II become the implementation of the ICS in the EU, avoiding the unacceptable situation of EU (re)insurers having to run their business under two prudential regimes.
A holistic view of systemic risk
Insurance Europe has also been closely engaged in the work of the Financial Stability Board (FSB) on the potential for systemic risk in the insurance industry. Part of this initiative was to identify and set supervisory measures and higher capital requirements for companies deemed to be global systemically important insurers, or G-SIIs. The insurance industry was highly critical of this approach (see box) and in a positive development — for which the industry had called for many years — the FSB decided in December 2022, in consultation with the IAIS, to discontinue the annual identification of G-SIIs in favour of the IAIS Holistic Framework.
While, by its very nature, insurance does not intrinsically present systemic risk, Insurance Europe supports an activity-based supervisory approach of regularly assessing large globally active insurers that could create concern if certain activities, such as banking-type activities, became material.
Insurance Europe therefore supported the adoption by the IAIS in 2019 of the Holistic Framework, which has been implemented since the beginning of 2020. It is applied to large internationally active insurance groups based on criteria defined by the IAIS and is based on three key elements:
The implementation of the Holistic Framework in Europe is progressing well. Insurance Europe continues to engage with regulators and supervisors on outstanding elements, including a well-designed and proportionate recovery and resolution regime (see article here) and appropriate gathering of information on climate and liquidity risks.
Insurance Europe would, however, like to see more proportionality applied to the annual data collection exercise and does not see the need to continue to develop further ancillary indicators, such as those for reinsurance or credit risk. These are not needed to assess potential systemic risk at an aggregate level and are not expected to provide any additional value but are likely to create additional burdens for insurers.
1. Based on the IAIS definition
Views on the Aggregation Method
The US and other interested jurisdictions are developing an Aggregation Method (AM) for calculating group capital adequacy that builds on the existing requirements in their jurisdictions. This is a different methodology to that of the ICS for calculating capital.
The AM can only be considered as comparable if a group’s prescribed capital requirement (PCR) requires them to hold similar overall levels of capital to the ICS and if the PCR is breached at similar points as under the ICS, leading to the same supervisory actions. Sufficient evidence of this must be explicitly included in the comparability assessment. That assessment must be subject to high levels of transparency in terms of exactly what will be tested, how it will be tested and by whom. At present, many of these important aspects have not yet been disclosed by the IAIS.
It is also important to recognise that the current ICS (ICS 2.0) is not yet final and that improvements are needed to correctly reflect insurers’ real risks and business model. So, any conclusions on the AM would need to be updated to take account of the final ICS.
Insurers are neither banks nor non-banks
The designation of global systemic important insurers (G-SIIs) was initiated in 2013, based on the same approach in the banking industry to designate global systemic important banks (G-SIBs).
However, unlike banks, insurers are not intrinsically systemic, as there is:
Automatically setting higher capital requirements for supposedly systemic insurance activities, despite the very low risk, is not a risk-based approach and would not prevent the rare potential cases of systemic failure.
While the designation of G-SIIs has been discontinued, the insurance sector is often wrongly categorised in the “non-bank” or “shadow-bank” sector. Following recent economic developments, many international organisations, such as the International Monetary Fund, are now increasingly commenting on the risks the non-banking sector presents to financial stability.
However, unlike some others categorised as “non-banks”, European insurers are comprehensively regulated through Solvency II and, although there are some key differences, it — like the banking prudential framework — has three pillars: capital, governance, and risk management and reporting. Solvency II requirements are as, if not more, extensive than those for banking.
For example, for the Pillar 1 capital requirements under the standard formula, insurers have to quantify and include up to 28 different risks, while for banking there are fewer than 10. The Solvency II review and the Insurance Recovery and Resolution Directive will add yet more requirements, including several macro-prudential ones. The international Holistic Framework also provides an effective approach to monitoring any potential systemic risks that could arise from the insurance sector.
Therefore, the focus of policymakers’ attention should be on any financial sectors that are not fully regulated and supervised — on non-banks and non-insurers.